In a surprising move, Fitch Ratings on Tuesday downgraded the United States' long-term foreign currency issuer default rating to ‘AA+’ from ‘AAA’, citing fiscal deterioration as well as a high and growing government debt burden. The American credit rating agency, which had placed the country's rating on negative watch in May due to the debt ceiling fight, has removed it and assigned a stable outlook. The country ceiling has been affirmed at 'AAA'.

“The rating downgrade of the United States reflects the expected fiscal deterioration over the next three years, a high and growing general government debt burden, and the erosion of governance relative to 'AA' and 'AAA' rated peers over the last two decades that has manifested in repeated debt limit standoffs and last-minute resolutions,” the U.S.-based rating agency says in a report.

According to Fitch, there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters, notwithstanding the June bipartisan agreement to suspend the debt limit until January 2025.

The agency in its report says that repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management. Adding to it, the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process. These factors, along with several economic shocks as well as tax cuts and new spending initiatives, have contributed to successive debt increases over the last decade, it adds.

“Additionally, there has been only limited progress in tackling medium-term challenges related to rising social security and Medicare costs due to an aging population.”

On rising general government (GG) deficits, Fitch says it expects the deficit to widen to 6.3% of GDP in 2023, from 3.7% in 2022, reflecting cyclically weaker federal revenues, new spending initiatives and a higher interest burden. Additionally, state and local governments are expected to run an overall deficit of 0.6% of GDP this year after running a small surplus of 0.2% of GDP in 2022.

Fitch forecasts a GG deficit of 6.6% of GDP in 2024 and a further widening to 6.9% of GDP in 2025, driven by weak 2024 GDP growth, a higher interest burden and wider state and local government deficits of 1.2% of GDP in 2024-2025. The interest-to-revenue ratio is expected to reach 10% by 2025 (compared to 2.8% for the 'AA' median and 1% for the 'AAA' median) due to the higher debt level as well as sustained higher interest rates compared with pre-pandemic levels.

Fitch warns that the U.S. economy may slip into a mild recession in Q423 and Q124 due to tighter credit conditions, weakening business investment, and a slowdown in consumption. The agency sees U.S. annual real GDP growth slowing to 1.2% this year from 2.1% in 2022 and overall growth of just 0.5% in 2024.

On Fed’s monetary tightening, the agency expects one further hike to 5.5% to 5.75% by September. The Fed raised interest rates by 25bp in March, May and July 2023.

Highlighting the medium-term fiscal challenges, Fitch says that over the next decade, higher interest rates and the rising debt stock will increase the interest service burden, while an aging population and rising healthcare costs will raise spending on the elderly absent fiscal policy reforms. Additionally, the 2017 tax cuts are set to expire in 2025, but there is likely to be political pressure to make these permanent as has been the case in the past, resulting in higher deficit projections, it says.

Will U.S. credit rating downgrade impact Indian markets?

V K Vijayakumar, Chief Investment Strategist at Geojit Financial Services, says Fitch’s downgrade of U.S. sovereign rating has impacted bond and currency markets with the U.S. 10-year yield rising above 4%. “Paradoxically, during uncertainties the dollar's safe haven status improves even when the downgrade is that of the U.S. credit rating. This has happened in the past also.”

Vijayakumar further says the impact on the Indian stock markets is likely to be negative but not large since the U.S. economy is now headed for a soft landing and not a recession, as markets feared earlier. “U.S. 10-year yield rising above 4% and the dollar index appreciating to 102 are negative for emerging markets. Also, indicators like PMI from the Euro Zone and China suggest slowdown in these economies. In brief, the economic backdrop is negative.”

He suggested investors to wait and watch for the dust to settle before jumping in to buy on dips.

Here’s how stock markets reacted to rating downgrade

In the overnight trade, Wall Street ended lower on Tuesday, the first day of August, after Fitch downgraded the United States’ long-term rating. The S&P 500 closed 0.27% lower and the Nasdaq Composite dropped 0.43%, while the Dow Jones Industrial Average rose 0.2% ahead of U.S. jobs data.

Tracking weak cues from the U.S. market, stock exchanges in the Asia-Pacific region fell on Wednesday as investors turn cautious about the fragile economic situation of the world’s largest economy. Japan’s Nikkei 225 was the worst performer in the region with a 2% loss, while South Korea’s Kospi fell 0.5% in early trade. China’s Shanghai SE Composite Index tumbled 0.85%, while Australia’s ASX 200 dropped nearly 1%.

Meanwhile, the Indian equity market opened lower, extending losses for the second straight session, mirroring weakness in global peers. The BSE Sensex opened lower at 66,064 against the previous closing of 66,459. In the first hour of trade so far, the benchmark index fell as much as 462 points, or 0.7%, to 65,997 level. Similarly, Nifty50 declined 138 points, or 0.7%, to 19,595 mark, after opening lower at 19,655 against Tuesday’s closing level of 19,734. 

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