The biggest news of all about Fitch’s downgrade of the U.S. credit rating, from AAA to AA+, is what didn’t happen.
Fitch’s rating action was a redux of the S&P downgrade exactly 12 years ago. The two firms define their symbols nearly identically. For Fitch, AAA is the highest credit quality and AA is very high credit quality. For S&P, AAA means the highest rating [we assign] and AA means very strong capacity to meet its financial commitments. Both use a plus indicates positioning at the high end of the AA bracket. Both rating actions were with respect to the same class of rating, the long-term government foreign currency Issuer Default Rating (IDR).
But the class of rating deserves more attention, if only to correct a misimpression circulated by a lazy media that the U.S. itself was downgraded. This did not happen. Nationally Recognized Statistical Rating Organizations (NRSROs) do not upgrade or downgrade countries (at least, not directly). They rate a borrower’s capacity to repay its debts in accordance with the contract.
IDR refers to the long-term (greater than one-year) foreign exchange claims-paying ability of the U.S. vis-à-vis global credit markets. Issuer means the rating is on the borrower—the U.S. government—not on an Issue—a particular series of debt. The U.S. is de facto a foreign currency issuer because its debt is denominated in USD, one of four freely convertible global currencies alongside Euros, Pound Sterling and Japanese Yen.
Although the rating actions were twelve years apart, they took aim at the same risks: weakening governance, difficulties in bridging the gulf between political parties over fiscal policy, failure to come up with a medium-term budgetary plan.
Here is the S&P announcement; and here is Fitch’s. The arguments were echoed a few days ago by Hank Paulson, who served as Treasury Secretary from 2006-2009, before the S&P downgrade. Paulson calledthe debt downgrade, while not an immediate worry, “a very important wake-up call” and said, “longer term, it’s a major concern.”
The day after Fitch’s rating action, Janet Yellen protested that the downgrade was “entirely unwarranted” in the face of a strong economy and a “flawed assessment” based on outdated data. Presumably by outdated data she meant that the debt ceiling bill had passed June 3. But Yellen’s perception may be outdated. People who decode credit rating agency rituals have learned that watch-listing and outlooks are the real credit actions. They are designed to give the market time to respond. The subsequent letter-grade change is a mere formality.
On May 23, Fitch put the US long-term IDR rating on Negative Watch citing these factors: debt ceiling brinkmanship at the eleventh hour; deleterious impacts if an agreement were not reached; and ongoing governance challenges for the U.S. And, on June 2, Fitch declared its intention to “resolve” the Negative Watch in 3rd Quarter, 2023. But they acted much faster, on August 2, before the 2nd Quarter ended—further indication that Fitch wanted its message heard above the din of denial.
Still the denial was forthcoming. Besides Yellen’s words, it can be heard in White House economic adviser Jared Bernstein’s comment that the timing made no sense, the decision, bizarre and arbitrary. To understand what a bizarre and arbitrary credit downgrade actually would look like, consider two other classes of rating that Fitch and S&P explicitly left untouched, which could wreak havoc on a country’s finances.
One is the country ceiling, which Fitch held firm at AAA in its May 23 press release. The other is short-term foreign exchange claims-paying ability, which S&P affirmed at A1+ (highest on the short-term rating scale) in its August 5, 2011 press release.
The country ceiling rating is based on the power of government to extract capital in accounts that belong to domestic entities it governs, if needed, to repay government bonds. If the government exercises this right, no borrower can be rated more highly than the country itself: the ceiling). But if investors do not want to take a chance on the domestic currency, the government needs to borrow in a convertible currency. The risk of default increases not because the government lacks funds, but because foreign exchange rates may move to a degree that makes structural default a viable option. Or, convertibility may cease altogether. NRSROs lower the country ceiling when such scenarios are imminent. Strong domestic companies will pay more or lose access to global credit, with severe knock-on effects down the domestic credit spectrum and into the local grassroots economy.
Country ceiling rating actions are how NRSROs downgrade whole countries.
The short-term sovereign rating is deeply connected to the payment system and structure. The U.S. government provides full faith and credit support to short-term funding functions ranging from national deposit insurance to national housing markets, commercial paper and the repo market. Once, in 1996, the issuer of another convertible currency was downgraded on the short-end: Japan. The result was catastrophic. It led to many market structural changes that ultimately set up the Global Financial Crisis of 2007-8.
Short-term rating actions on sovereigns that issue USD, EUR, GPB or JPY are how NRSROs downgrade the global economy.
Of course, for an NRSRO to lower the debt ceiling or short-term rating on the nation that prints dollars would be bizarre and arbitrary. The point is: neither of these rating actions were taken.
Here’s another thing that did not happen: Moody’s did not downgrade the U.S. long-term foreign exchange credit rating.
The why merits a separate blog. But I will close out this one by recalling my days at Moody’s, when Thomas Friedman caused consternation and uproar on the 11th floor of 99 Church (where Moody’s senior management once sat) by writing an Op Ed piece in the New York Times, Foreign Affairs; Don’t Mess With Moody’s.
In February 1996, he went on to say this to David Gergen on PBS:
“You could almost say we live again in a two-superpower world. There is the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful. “
Reflecting on Fitch’s rating action, it is obvious the real news is what did not happen. The US was not downgraded. Its country ceiling was not downgraded. Its short-term rating was not downgraded. And Moody’s has not exercised its nuclear option—yet.