Can the U.S. Lose its AAA Credit Rating?

The credit rating agency Standard & Poor’s (S&P) issued a warning on May 21, 2009, that Britain’s credit rating was at risk of being downgraded due to rapidly growing government deficits. The statement sparked fears that the U.S. could next in line for a potential ratings downgrade. Just the thought of this sent tremors through the currency and U.S. Treasury markets.

It’s important to know that the S&P did not actually downgrade Britain’s AAA credit rating. The ratings agency changed its outlook on Britain from “stable” to “negative” and cited a “one-in-three chance” that the country’s credit rating may be cut. It’s also important to know that the S&P did not issue any warning about the U.S. being downgraded. Like Britain, the U.S. still has a AAA rating which is the best rating a country can receive.

A downgrade in a country’s credit rating (a measure of the default risk) can drive a government’s borrowing costs and make it harder to sell bonds. Both of these factors can lead a country to raise taxes or cut spending significantly.

Fears that the U.S. is in imminent danger of losing its AAA credit rating are largely overblown. Although the U.S. dollar took a hit on May 21, when the S&P made its statement about the U.K., it recovered the following week.

The possibility of an imminent ratings downgrade is very low, and the possibility of the U.S. government defaulting on their debt is extremely unlikely. Keep in mind that the U.S. issues its bonds in its own currency. Therefore, if it ever had trouble making payments, it could always print more dollars. Of course, this leads us to the problem of inflation, which I feel is a much more immediate problem at the moment.

To give a little confidence to the markets, Moody’s Investors Service (another ratings agency) stated on May 27 that the U.S. government’s AAA rating is stable despite the country’s mounting debt. This gives some confidence to the markets, but no too much. The ratings agencies lost much of their credibility when they failed to alarm investors about the risky mortgage-backed securities that sparked the credit crisis.

How does U.S. government debt stack up to other countries? For the purpose of perspective it’s important to know this. To compare, we need to analyze debt as a percentage of gross domestic product (GDP). The table below shows the top 15 countries with the highest external debt as a percentage of GDP. External debt is the part of total debt in a country owed to creditors outside the country. You’ll notice in the table below that the U.S. is in better financial shape than many other developed economies, including the U.K.

Source: External debit information from The World Bank, GDP information from the CIA World Factbook. Figures quoted in U.S. dollars.

That is not to say there are no risks in the U.S. economy. The $787 billion economic stimulus package and the $700 billion bank bailout fund are straining resources. And many fiscal responsibilities, such as Social Security and Medicare, are still on the horizon. A U.S. credit rating downgrade is definitely possible, but not probable.

Bill Gross, manager of the world’s largest bond fund (PIMCO), believes that a downgrade in the U.S. credit rating could come in “at least three to four years, if that.” If we weren’t in a global recession, I could definitely see a ratings downgrade as imminent, but the U.S. is not alone its financial problems. Most countries are doing worse.

Another thing to keep in mind is that downgrading the U.S. would cause massive chaos in the markets. It would lead to a significant drop in the value of the dollar, which would be a severe problem worldwide, since the dollar is the reserve currency of central banks throughout the world. This leads many to question whether the ratings agencies would even have the courage to make such a bold decision.

There are more imminent issues than the unlikely downgrading of U.S. debt. The more immediate issue is inflation. The U.S. issues Treasuries in its own currency and can always print more money if it ever had problems making payments on its debt. But printing more money leads to inflation.

The government needs to sell a lot of Treasuries to fund its stimulus programs. Where will this money come from? As the foreign appetite for Treasuries slows down, the U.S. has no other choice but to print more money to fund these massive obligations. Inflation is the dark cloud hovering over markets right now.

Jeff Friedman is a Senior Market Strategist with Lind Plus. He can be reached at (800) 231-7811 or via email at jfriedman@lind-waldock.com.

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