Wayne Dass, Guest Writer

Dass

The severity of the current financial crisis in the United State has generated discussions in some quarters as to the possibility of the United States government being downgraded from its AAA status.

While the likelihood of such an event occurring in the short to medium term is low, it is not impossible.

Standard & Poor's current long-term rating on the US Treasury and its direct and guaranteed borrowings is AAA, the strongest rating on its scale.

Sovereign ratings

Only 19 of the 118 sovereigns rated by S&P, including the United Kingdom, France, Germany and Canada, share the AAA rating.

The outlook for all 19 sovereigns is stable. Notwithstanding the negative credit developments over the past year, S&P is of the view that the events are not dramatic enough to cause a revision of the rating or the outlook.

What, then, could cause a negative rating action on the US?

While S&P has been closely noting these negative credit developments over the past year, they still identify key underlying strengths in the US sovereign credit profile as follows:

High-income, highly diversified economy, with unusually flexible labour and product markets.

Fiscal flexibility, at least as favourable as that found in most other AAA-rated sovereigns.

The US dollar still being the key international currency, notwith-standing the pressures placed on it.

Openness to trade and capital flows.

A stable political system with strong, long-established institutions and transparency in policymaking.

Developments identified that could lead to a negative rating action include:

Worsening of the US fiscal position to a point where it would differ in a major way from those of the other AAA sovereigns.

The US dollar losing its key currency status.

Significant policy mistakes that put at risk in a material way the country's long-term growth prospects.

None of these developments seems likely in the short to medium term, but S&P has identified two specific risks that, should they materialise, would cause them to reconsider the AAA rating for the US.

Contingent liabilities, which will materially add to fiscal pressures in the US, are the financial upfront cost of maintaining aggregate financial system stability, should there be a deep and prolonged recession, estimated to add as much as 24 per cent of GDP to government debt; and the large and increasing unfunded liabilities of the Social Security and Medicare programmes.

In the case of the first risk, S&P's view is that a return to a stable banking industry in the US is at least a year away.

Macroeconomic forecast

Further, their current base-case macroeconomic forecast for the US is for a relatively long period of weak growth, in which real GDP should grow by 1.7 per cent in 2008, then dip to a low of 0.9 per cent in 2009, before recovering to 2.9 per cent in 2010.

S&P also sees US GDP gradually declining in the following years toward 2.5 per cent by 2017, as a result of slowing population growth tied to retiring baby boomers and other long-term factors.

With growth in credit linked to growth in the economy, the longer and deeper the recession, the more likely this contingent liability may be realised, at least in part.

Regarding the Social Security unfunded liabilities, though longer term in nature, the net present value of related future outflows are estimated at over 600 per cent of GDP.

Leading indicators

With recent decreases in interest rates and using updated inputs, projections are for an increase in related US net general government debt in the order of 200 per cent of GDP between now and 2050, raising debt levels for the US to those currently associated with speculative grade governments.

What could be some leading indicators of an impending negative rating action? S&P suggests some leading indicators as follows:

Degradation of the US fiscal profile to a point where it differs markedly from other AAA sovereigns, for example, year-over-year deficits that result in a persistent and material rise in debt per GDP.

Loss in key currency status of the US dollar, accelerated dollar depreciation, significant declines in the dollar's share of export and import invoicing globally, significant declines in official dollar holdings, and significant US Treasury borrowing in foreign currency.

A series of significant policy mistakes, such as persistent interference with the free flow of goods, services and capital across borders.

While on the surface most of these indicators may look unlikely at the moment, undue pressures on the US fiscal profile in a deep and prolonged recession scenario could prove to be its Achilles heel and cause a domino effect, spurring on the other indicators.

Wayne Dass is chief executive officer of ratings agency CariCRIS Limited. wdass@caricris.com