Risks beyond downgrade

US fiscal position can lead to market dislocations

Fitch Ratings’ decision to downgrade the US debt didn’t have much effect on financial markets on Tuesday, although they fell on Wednesday. The rating action drew sharp reactions because practically no one in the financial markets doubts the US government’s debt servicing capabilities. US Treasury Secretary Janet Yellen, for instance, called it “arbitrary and based on outdated data”. Although the rating action may not affect financial markets significantly in the immediate short run, as was the case after Standard & Poor’s downgrade in 2011, some of the reasons highlighted by Fitch Ratings for its action should raise concerns. This is not to suggest that there is a risk of default, but the state of government finances in the US can actually lead to longer-term dislocations in financial markets.

In its communication, the rating agency, for instance, noted that the general government budget deficit was expected to rise to 6.3 per cent of gross domestic product (GDP) in 2023, compared to 3.7 per cent in 2022. This would be a result of weaker revenue, spending initiatives, and a higher interest burden. Fitch expects the general government budget deficit to increase to 6.6 per cent of GDP in 2024, and further to 6.9 per cent in 2025. Although the general government debt stock has declined from its peak, it is still significantly above the pre-pandemic level. In fact, the debt stock is more than 2.5 times the median AAA and AA-rated countries. Additionally, in the rating agency’s opinion, there has been a steady deterioration in governance standards over the past two decades, including in fiscal matters. Indeed, there have been concerns over the repeated political standoffs on the debt ceiling issue.

The fiscal position is unlikely to improve in the near term. The latest Congressional Budget Office projections showed that the US federal budget deficit would average 6.1 per cent of GDP over the next decade, significantly higher than the 3.6 per cent of GDP witnessed in recent decades. Consequently, the interest burden would double by 2033 to 3.6 per cent of GDP. A significantly higher budget deficit over the coming decade would mean that the US government would absorb more savings from the system, leaving so much less for the private sector. Given that inflation is running above target, a sustained higher fiscal deficit could keep interest rates elevated for longer than expected. This would have implications for global interest rates and capital flows. Higher interest rates in the US, along with other advanced economies, are making it difficult for several low- and middle-income countries to raise funds. Sustained higher interest rates, thus, would affect global growth. Higher interest outlay in the US Budget will also affect its ability to respond to macroeconomic shocks. Fitch, for instance, expects the US economy to slip into a mild recession later this year.

Despite the challenges on the fiscal front, it is fair to say that the US economy remains fairly dynamic and is supported by the most vibrant financial market, which should help overcome near-term challenges. However, its internal political fault lines and the evolving geopolitical conditions could affect recovery. A number of countries, for example, are exploring alternatives to the US dollar and dollar-denominated Western financial system. A significant fragmentation of the global financial system, as a result, could prove disruptive for both the US and the rest of the world.