“From ‘AAA to AA+”

Introduction
In an unprecedented move on Friday Aug 5th, Standard & Poor’s popularly known as S&P downgraded the US government’s ‘AAA’ Sovereign credit rating; it lowered the long-term sovereign credit rating of the United States of America to ‘AA+’ from ‘AAA’. And also said that the outlook on the new U.S. credit rating is “negative,” indicating another downgrade  was possible in the next 12 to 18 months.

Before delving into the issue, let us make ourselves clear on certain terms, such as what is a bond, Sovereign Debt, Credit Rating and who is S&P.

Bonds:
Bonds are debt instruments issued by the government, banks, and companies to raise the money from public. This money will be used for meeting the future expenses, expansion plans for the companies, building infrastructure for the country, etc. In short, the bond holders are the lenders to the bond issuers.

Sovereign Debt:
Before knowing about the sovereign debt, you must know about the other two terms Sovereign Bond and Government Bond.
When government is in short of money, it will issue the bonds in its local currency or the international currency. If the bonds are in the local currency, it is called as the Government Bonds. In turn the Bond holders would receive the specified interest income on the specified periods. The principal amount will be returned at the time of maturity. People would be more interested in buying the government bonds because of its high security and returns are assured. The government bonds are categorized based on the tenure of the bonds. Government bonds are bonds with maturity period of more than ten years

Sovereign Bonds:
The main difference between government bonds and sovereign bonds are the issuing currency. Sovereign bonds are issued in the international currency and it can be sold to the other countries and foreign investors. It is very common that when a country needs huge capital to support the spending, it can borrow money from other countries by issuing the sovereign bonds.

What is Sovereign debt then? Sovereign debt is the bonds sold to other countries or money borrowed from outside (it is equivalent of borrowing money from other countries or public) to meet the country’s spending.
Why should a country go for Debt?

  • Whenever the country’s public expenditure is more than the public revenue, then it will be facing a budget deficit and when we say expenditure it includes the interest payment for the debt outstanding with other countries and public. In order to meet the spending, government will have to borrow money from outsiders and fill the gap on budget deficit. Budget deficit is always denominated in the percentage of Gross Domestic Product (GDP).

Accumulated budget deficit will be converted as the sovereign debt when the country starts borrowing money from the other countries. That is the reason it is good to maintain the minimum level of budget deficit every year.

  
Source: Scotia Capital
 
Credit Rating:
Credit Rating is an assessment of the credit worthiness of the individuals and the corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities. A credit rating measures credit worthiness, or the ability to pay back a loan. A higher credit rating implies low borrowing cost (Lower interest rates) for the nation, since the risk associated with that bond is lower and vice versa.

Who is Standard & Poor (S&P)?
Standard & Poor’s (S&P) is a United States-based financial services company. The company is one of the Big Three credit-rating agencies, which also include Moody’s Investor Service and Fitch Ratings. As a credit-rating agency (CRA), the company issues credit ratings for the debt of public and private corporations. It is one of several CRAs that have been designated a nationally recognized statistical rating organization by the U.S. Securities and Exchange Commission. S&P split into two separate entities, a credit rater and McGraw-Hill Financial.

S&P uses the following codes for its credit rating:
‘AAA’—extremely strong capacity to meet financial commitments. Highest Rating.
‘AA’—Very strong capacity to meet financial commitments.
‘A’—Strong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.
Like the above coding, it continues to AAA, AA, A, BBB, BB, B, CCC, CC, C, D. …

Note: Ratings from ‘AA’ to ‘CCC’ may be modified by the addition of a plus (+) or minus (-) sign to show relative standing within the major rating categories.
 

Now let us look into what happened on that day, Aug 5th Friday:
Standard & Poor’s removed the U.S. government from its list of risk-free borrowers for the first time; the move, downgrade in the credit rating from ‘AAA’ to ‘AA+’, reflected the deterioration in the global economic standing of the United States, which has had an AAA credit rating from S&P since 1941. Treasury bonds (US Bonds), once indisputably seen as the safest security in the world, are now rated lower than bonds issued by countries such as Britain, Germany, France or Canada.

As a rule, a lower credit rating means higher borrowing costs for debtor nations. The downgrade could lead investors to demand higher interest rates from the federal government and other borrowers, raising costs for governments, businesses and home buyers.

JPMorgan Chase & Co. estimated that a downgrade would rise the nation’s borrowing costs by $100 billion a year. The U.S. spent $414 billion on interest expense in fiscal 2010, or 2.7 percent of gross domestic product, according to Treasury Department data.

But many analysts say the impact could be modest, in part because the other ratings agencies, Moody’s and Fitch, have decided not to downgrade the government at this time.

The other two major credit rating agencies reaffirmed their versions of AAA ratings. But Fitch also said it was keeping its US rating under review until the end of August.

“S&P had notified the US Treasury on Friday afternoon Aug 5th that it was planning to lower the credit rating, according to government officials, and the company has sent a draft of its analysis to the White House.

The Obama administration reacted with indignation, noting that the company had made a significant mathematical mistake in a document that it provided to the Treasury Department, overstating the federal debt by about $2 trillion. And said,

“A judgment flawed by a $2 trillion error speaks for itself”

Defending itself against attack by the Treasury, S&P later issued a statement flatly rebutting the criticism, saying it “had no impact on the rating decision”.

The theme running throughout S&P’s analysis is the breakdown in the ability of the Democratic and Republican parties to govern effectively.

Justification used by S&P:

The fiscal consolidation plan which Congress and the administration recently agreed ** to “falls short of what, in our view, would be necessary to stabilize the government’s medium-term debt dynamics.”

“More broadly, the downgrade  reflects our view that the effectiveness, stability, and predictability of American policymaking and political institutions have weakened at a time of ongoing fiscal and economic challenges to a degree more than we envisioned when we assigned a negative outlook to the rating on April 18, 2011,” the agency said.

S&P blamed both parties for the US fiscal mess – and had harsh words for the Republican Party for ruling out any taxes increases.           

Are Credit Ratings absolute measures of default probability?
Since there are future events and developments that cannot be foreseen, the assignment of credit ratings is not an exact science. For this reason, Standard & Poor’s ratings opinions are not intended as guarantees of credit quality or as exact measures of the probability that a particular issuer or particular debt issue will default.
Instead, ratings express relative opinions about the creditworthiness of an issuer or credit quality of an individual debt issue, from strongest to weakest. The likelihood of default is the single most important factor in the assessment of creditworthiness.
For example, a corporate bond that is rated ‘AA’ is viewed by Standard & Poor’s as having a higher credit quality than a corporate bond with a ‘BBB’ rating. But the ‘AA’ rating isn’t a guarantee that it will not default, only that, in our opinion, it is less likely to default than the ‘BBB’ bond.
 
Foreign Creditors:

S&P’s move is also likely to concern foreign creditors especially China, which holds more than $1 trillion of U.S. debt. Beijing has repeatedly urged Washington to protect its U.S. dollar investments by addressing its budget problems.
 
Impact on India:
 
Downgrading of the US sovereign rating by S&P would not really impact India – SBI.
 

The crisis emanating from downgrading of the US sovereign debt rating would have only limited impact on India – RBI.
 
“As India’s growth story is strong we could see foreign institutional investors seeing India as an attractive investment destination even if there is any temporary outflow,” said the finance minister.
 
Last Note:

“The Person who shook the world economy with an unprecedented downgrade of US credit rating earlier this month is Deven Sharma: The Jharkhand-born Indian-American analyst. And the thing to be noted here is, he is stepping down as President of Standard & Poor (S&P). They say he has stepped down to take up new challenges, But……………….”