DBRS Confirms AAA Rating with Stable Trend to the United States

DBRS, Inc. (DBRS) has today confirmed its AAA issuer ratings on the long-term foreign and local currency debt of the United States of America. The trend on both ratings is Stable. The ratings reflect the underlying strengths of the U.S. economy, which remains highly productive, diversified and flexible in response to external shocks. It also enjoys the benefits of scale as the world’s largest economy, at 21.7% of global GDP. Further supporting the ratings is the country’s institutional strength and the preeminence of the U.S. dollar as the world’s largest reserve currency, which facilitates low financing costs and funding flexibility. These attributes give the U.S. Treasury a high capacity to service debt, even during periods of investor risk aversion.

Since 2007, however, macroeconomic fundamentals have come under significant downward pressure. The chain of events triggered by the collapse of the housing market and an overleveraged private sector put severe stress on financial institutions, led to the global recession of 2008-2009 and contributed to a sharp increase in the fiscal deficit and public debt burden.

Furthermore, measures to restore health to the economy have significantly increased government contingent liabilities. The extraordinary policy measures taken by the Bush and Obama administrations to stabilize the housing and financial sectors and restore growth have yet to fully achieve their objective. The trade-off between the need to foster growth and employment on the one hand, and restore fiscal and debt sustainability on the other, is the central issue facing the incoming administration following the November 6, 2012 elections.

In 2012, the federal government deficit is expected to decline to 7.3% of GDP. Although this looks sustainable, general government debt (which includes state and local governments, and calculated on a calendar year basis) is expected to rise to 106.7% of GDP, well above those of other AAA-rated countries, and the absence of a medium term plan to reduce the deficit is worrying. In July 2011, the failure of U.S. political leaders to agree on whether to extend the expiring tax measures (favored by Republicans), and a series of generous entitlement programs (favored by Democrats) in return for raising the debt ceiling, led to a near-default. A default was averted when the Obama administration enacted on August 2, 2011 the Budget Control Act, which specified $917 billion (about 4.5% of GDP) of deficit reduction measures between 2013 and 2021. This raised the debt ceiling by $900 billion, one day before the stock of debt was estimated to reach the ceiling.

Congress was delegated the task of identifying an additional $1.5 trillion in measures by the end of 2012. If at least $1.2 trillion in savings is not identified, Congress will grant a $1.2 trillion increase in the debt ceiling, accompanied by automatic across-the-board spending cuts, or “sequester”, of $1.2 trillion, to be equally divided between security and non-security programs. The cuts would apply to mandatory and discretionary spending from 2013-2021, and include Medicare providers. Either the original measures identified by Congress or the automatic procedures will start to be implemented on January 2, 2013.

DBRS believes there are two fiscal issues that need to be addressed to put public finances on a more sustainable path. The first is that the United States faces a so-called fiscal cliff, which will kick in at the end of 2012. The fiscal cliff would occur if at the beginning of 2013 two tax cuts from the Bush era and several other tax provisions expire, and in the absence of policy action trigger a series of spending reductions. The increase in taxation and the reduction in spending would sharply lower the federal deficit. However, with a large output gap, the global economy slowing and unemployment still high at 7.8%, such a correction would likely have serious consequences for employment and growth.

The Congressional Budget Office (CBO) projects two distinct scenarios. A baseline scenario involves no change to current laws, with the fiscal cliff taking effect. The spending cuts and tax increases would reduce the deficit from $1,128 billion (7.3% of GDP) to $641 billion in 2013 (4% of GDP). Such a rapid adjustment would cause real GDP to decline by 0.5% between 2012 and 2013, and the unemployment rate to rise to 9% in the second half of 2013. Federal debt to GDP would peak at 76.6% in 2014, declining to 58.5% by 2022. This would eliminate about one-half of the deficit and stabilize debt to GDP, but the economy would be tipped back to recession.

The alternative – and more likely – scenario involves changes to current laws, in which all expiring tax provisions are extended, except for the payroll tax reduction in effect in 2011 and 2012; the AMT is indexed to inflation after 2011; Medicare payment rates for physicians’ services are held constant at the current level; and the sequester does not kick in except for caps on discretionary appropriations. Under this scenario, the 2013 deficit would be $1 trillion (6.5% of GDP), real GDP would grow 1.7% between 2012 and 2013, and the unemployment rate would remain close to 8% through the end of 2013. Federal debt to GDP would rise steadily, reaching 89.7% by 2022. The tradeoff in this scenario would be a much slower reduction in the deficit and a steady increase in debt to GDP, in exchange for an uninterrupted economic recovery.

The baseline scenario would place public finances on a more sustainable path. In contrast, the alternative scenario would provide more time for the housing market to recover, providing greater chances of a quicker return to full employment while shrinking the output gap. However, the continuation of a high deficit and rising debt ratio would then call for a viable medium term plan to stabilize debt to GDP.

DBRS also believes that placing public finances on a more sustainable, medium term path also involves addressing the longer term structural fiscal pressures associated with the aging and retirement of the baby boom generation. The number of people aged 65 or older will increase by approximately one-third between 2011 and 2021, causing this segment of the population to increase from 13% to 17% of the total population. After 2021, this percentage will increase even more. Furthermore, healthcare is becoming more expensive, and it is uncertain whether the 2010 health care legislation will offset this rise. Outlays for Social Security, Medicare and Medicaid in 2012 are already high at 44.4% of federal expenditures. According to the CBO baseline scenario, outlays are set to rise further, to 44.9% in 2013, and to 54.3% between 2013 and 2022.

DBRS expects that Congress and the administration will reach an agreement that incorporates some if not most of the CBO’s alternative scenario. It is unlikely that either party would risk allowing either such a large, front-loaded fiscal adjustment which impairs the recovery, or another impasse over the debt ceiling.

How the current and incoming administrations address fiscal policy will be important to DBRS’s ratings, since neither of the CBO’s scenarios allows for a strong recovery combined with a rapid correction in the deficit and an early stabilization in the debt ratio. Neither scenario would necessarily result in downward rating action. However, if the CBO’s baseline scenario occurs, placing public finances on a more sustainable path, DBRS would assess the impact of lower growth and employment. If the CBO’s alternative scenario materializes, allowing more time for the housing market to recover and a greater chance of a faster return to full employment, DBRS would assess the impact of a higher deficit on the debt ratio. Whatever the policy choice, failure to establish a viable medium term plan to stabilize debt to GDP could result in a Negative trend. Similarly, if there is another impasse over raising the debt ceiling, this could also result in downward rating pressure.

As the fiscal position is being resolved, of serious concern is that three years after the Great Recession GDP growth has averaged only 2.2%, well below the 3% average growth in the two decades prior to the recession. Furthermore, the labor market has yet to recover. This can partly be explained by a weak housing market. With most household debt in the form of mortgage debt, households are paying down debt and postponing purchases of durable goods. At the same time, tight credit conditions, partly owing to the tail risk of the Euro zone crisis on U.S. and global trade and financial flows, are perpetuating sluggish consumption growth and low private residential investment. To help jump-start private sector activity and a recovery in the housing market, the Federal Reserve has implemented unconventional monetary easing. The hope is that as the labor market recovers, banks will increase lending. Given the low levels of housing activity, increased monetary easing is likely to be supportive of growth. However, the uncertainty over fiscal policy continues to outweigh these other considerations.

Notes:
All figures are in U.S. dollars unless otherwise noted.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the U.S. Treasury, the Federal Reserve, the Office of Management and Budget, the Bureau of Economic Analysis, the Congressional Budget Office, the Bureau of Labor Statistics, the IMF, and the World Bank. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

Lead Analyst: Fergus McCormick
Rating Committee Chair: Alan G. Reid
Initial Rating Date: September 8, 2011
Most Recent Rating Update: September 8, 2011

For additional information on this rating, please refer to the linking document under Related Research.