Investment Research General Market Conditions 1 August 11 Research US Further downgrade of US debt likely in 1 The recent years fast rise in US gross debt combined with a deterioration of economic outlook has resulted in concern about future fiscal sustainability. In response Standard&Poor s (S&P) have downgraded US sovereign debt to AA+ and Moody s and Fitch have put US on negative outlook. The President s current budget proposal involves a reduction in the budget deficit throughout the next decade. Nevertheless the deficit will persist, which contributes to further increases in US debt, and in ten years time the US gross debt ratio will reach 11% of GDP under the current budget. Because of the complex interrelationships between the budget and the economy, the budget estimates depend to a very significant extent upon assumptions about the economy. Hence changes in economic circumstances can worsen the situation about the US sovereign debt. In the paper we look at different scenarios for growth, interest rates and budget changes to see how sensitive the debt outlook is to these factors. Our analysis shows that a more severe downturn in economic growth as well as a drop in investor confidence resulting in higher interest rates could lead to a significant increase in the debt to GDP ratio. An economic downturn implies a dual pressure on politicians and in case the politicians succumb to the pressure from lower growth and abandon fiscal discipline it will have considerable effects on debt. Historical debt in percent of GDP 1 1 1 8 Historical values President's budget Main scenario 197 197 198 1988 199 1 18 Debt and deficit in 1 Deficit % of GDP (1) -1 Spain Denmark Finland Sweden Holland UK Austria Germany Source: Eurostat and Reuters Ecowin Ireland (deficit= -3.3) France US Portugal Belgium Italy Greece 8 1 1 1 Debt % of GDP (1) Based on the increasing economic uncertainty we believe Moody s and Fitch will follow the footsteps of S&P and downgrade US debt from its AAA rating. Moreover, a further downgrade from S&P to AA is likely in 1. This will add to financial uncertainty in 1. Is fiscal sustainability under threat? The financial crisis triggered a rising path for the US gross debt as it increased from around % in 7 to around 1% in 11. Despite the rapid pace of the rising debt, the current level is relatively modest compared with other major OECD countries. However, the future path for the debt seems a bit more concerning, and based on the recent fiscal consolidation plan S&P have downgraded the US sovereign credit rating to AA+, as they do not find the plan ambitious enough. In addition, economic growth seems to be weaker than expected in 11 and 1. This puts additional pressure on fiscal sustainability, due to the negative economic conditions significantly affecting the budget, which again affects debt negatively. Moreover, there is a risk that the economic concern will spill over to investor confidence and result in higher funding rates. This risk seems smaller at the moment, though, as Fed will try to compensate by keeping rates low for longer. All of these uncertainties about the economic situation place a twofold pressure on the politicians. On one side they wish to stimulate Primary balance in percent of GDP -1 Historical values President's budget 197 1977 198 1991 1998 5 1 19 Chief Analyst Allan von Mehren +5 5 1 8 55 alvo@danskebank.dk Assistant analyst Pernille Bomholdt Nielsen +5 5 1 8 9 pernni@danskebank.dk Important disclosures and certifications are contained from page 7 of this report.
economic growth but on the other hand they need to secure fiscal sustainability and preserve fiscal restraint. And the worse economic growth turns out the more spending cuts they need to put forward to get the deficit down as planned. Dynamics of the debt ratio The main recursive equation governing the dynamics of the debt ratio is 1 where is debt at the end of the period t, as a ratio to GDP at t, is primary balance (budget deficit excluding interest payments) in t, as a ratio to GDP at t and is defined as, 1 where is the nominal interest rate in period t; paid in period t on the debt stock outstanding at the end of t-1 and is the nominal GDP growth rate between t-1 and t. This debt accumulation equation implies, that the debt will increase, if the nominal interest rate on the debt stock exceed the growth in GDP. Hence a reduction in GDP growth or an increase in the nominal interest rate becomes a rolling snowball, as it increases the debt, which entails higher nominal interest payments, which again raises the debt and so forth. Further, a decrease in the primary balance will increase the debt. This implies that there is a twofold effect of a decrease in the GDP growth rate, as a reduction in growth affects the primary balance negatively through a reduction in taxable income growth, but also through increased spending as unemployment rises. Interaction between economic conditions and deficit In order to examine the implications of possible changes in economic assumptions we use the sensitivity estimates provided by The Office of Management and Budget (OMB). Based on a fixed budget policy, they provide a set of rules of thumb which we use to assess the impact on the budget of different GDP growth paths and interest rate scenarios. As the rules of thumb are based on a fixed budget policy, the fiscal policy will stay the same even though economic conditions change. Primary budget impact of lower GDP growth and higher interest rates Effect on primary budget deficit of 11 1 13 1 15 1 1 percentage point lower GDP growth for 1115, return to,1pp,33pp,33pp,33pp,33pp baseline growth in 18 1 percentage point higher interest rate, sustained in 111 -,pp -,11pp -,1pp -,15pp -,17pp -,19pp Source: US Office of Management and Budget As economic variables which affect the budget usually do not change independently of one another, it is assumed that the unemployment rate will be.5 percentage point higher for each one percent shortfall in the level of real GDP, compared with the baseline. This assumption implies a reduction in taxable income growth and hence an increase in debt. Other economic variables are held constant. 1 August 11
Main scenario: Lower GDP growth The Congressional Budget Office (CBO) projects the economic situation in the US based on the current budget proposal (The president s Budget) and estimates an increase in GDP growth rate from 3. % in 11 to 5.5% in 15 after which it slowly declines to a rate of.3% in 1. Main scenario: Primary deficit in % of GDP 7 9 11 13 15 17 19 1 Based on the recent disappointing growth prospects these assumptions look quite optimistic and our main scenario is that the growth rate will be lower than estimated under the 1 Budget. We consider two cases of lower growth in GDP each associated with a corresponding rise in the unemployment rate. GDP growth is pp lower compared with CBO s estimates from 11 to 15 followed by a gradually return to the baseline GDP growth rate in 18. -1 pp lower GDP growth 1.5% GDP growth A GDP growth rate of 1.5% until 15 also followed by a return to the baseline GDP growth rate over the ensuing three years. Main scenario: Gross debt in % of GDP The first case is seen as a bad but likely scenario, whereas the second setup primarily is used to measure the sensitivity of the debt and does not reflect our expectations. Under both scenarios the primary budget stays at a lower level during the normalization compared with the projection under the President s Budget. This is a consequence of lower receipts due to a lower growth rate and higher outlays due to a higher unemployment rate. Further, the interest payments on debt increases in these cases, and both of these effects contribute to a higher debt ratio compared to the baseline scenario. Consequently, the scenarios with pp lower GDP growth rate and 1.5% growth rate result in a debt projection, where gross debt in percent of GDP is at 13% and 13% in 1, respectively. Compared with CBO s estimate of the gross debt ratio of 11% in 1, the debt ratio is significantly affected by the lower economic growth rates. Even in the likely case, where economic growth is pp lower during 1115, there is a 38pp increase in the gross debt ratio from 1 to 1, and definitely not a stabilization at the current level. Risk scenario 1: Fiscal discipline not kept The analysis regarding lower GDP growth is made under the assumption that the government does not implement new fiscal stimulus measures to counter the lower growth rates, as the rules of thumb are based on a fixed budget policy. However, this is not necessarily a realistic assumption since unexpected downturns in economic growth, and attendant job losses, usually give rise to legislative actions to expand unemployment benefits, stimulate the economy with additional Federal investment spending and the like. This implies that the 1 Budget, which provides a path to lower medium-term deficits, could be overruled by stimulating fiscal policies in case of a downturn. Under the president Budget CBO estimates that the primary budget deficit will be at 9% of GDP in 11 declining to.% in 15 followed by a nearly constant level the ensuing five years. In order to estimate the debt ratio s sensitivity of a deviation from the 1 Budget we consider two cases, The primary budget is 3pp lower from 1 and onwards compared with CBO s estimates, hence there is a reduction in the primary budget deficit, but the politicians are not able to reduce it as much as estimated in the baseline scenario. 1 1 1 8 1.5% GDP growth 7 9 11 13 15 17 19 1 Main scenario: Interest payments in % of GDP 5 3 1 Risk scenario: lack of fiscal discipline: Primary deficit in % of GDP pp lower GDP growth 1.5% GDP growth 8 1 1 1 1 18-1 pp lower GDP growth 7 9 11 13 15 17 19 1 3pp lower Primary Budget Primary Budget at 11 level The government continues with a primary budget deficit at the same share of GDP as in 11. This is seen as a pessimistic and less likely scenario but made to illustrate what will happen if politicians do not reduce the budget deficit soon. 3 1 August 11
The effect of a higher primary budget deficit in percent of GDP affects the debt ratio directly, but it also affect it through an increasing interest payments in percent of GDP. Consequently, the gross debt ratio continues increasing after 11 and will reach a ratio of 175% of GDP in the scenario, where the primary budget is kept at the 11 level. The outcome is a bit more moderate under the 3pp lower primary budget, where the debt ratio reaches 1% of GDP in 1. Compared with the CBO projection of a debt ratio of 11%, there are major consequences for gross debt when the fiscal discipline weakens. However, there could be a positive second round effect of higher growth as a result of the economic stimulation. This is not taken into account here. Risk scenario: lack of fiscal discipline: Gross debt in % of GDP 18 1 1 1 1 8 3pp lower Pr imar y Budget Primary Budget at 11 level 7 9 11 13 15 17 19 1 Risk scenario : Drop in investor confidence trigger higher bond yields In our analysis US debt default unlikely, downgrade likely it appears that a downgrade would imply a moderate positive reaction in Treasury yields, as there was already a 5/5 probability of a one-notch downgrade priced in. Nevertheless, there is a future risk of a turn in investor confidence, which could send treasury yields and thereby funding costs markedly higher. Although probably less likely than the low growth scenarios it cannot be ruled out if confidence slips significantly as seen in for example several European countries. To some extent Federal Reserve will counter this by keeping rates low and possibly buying more treasuries. But some increase in bond yields could still take place and worsen the debt dynamics. CBO assumes that funding rates will increase rapidly over the next 1 years starting from a level of 1.9% in 11 reaching 3.8% in 1. However, a drop in investor confidence could result in further increases. We consider two different scenarios, Interest rates increase 1pp above CBO s estimate each year, which could be a consequence of further downgrades of the US sovereign debt or a drop in investor confidence. Interest rates increase with 3pp each year. This is seen as a less likely situation, which is mainly used to analyze the sensitivity of US debt to a drop in investor confidence. To estimate the effect of bond yield increases, it is taken into account, that only part of the debt will mature each year, such that the higher interest rates affect the economy gradually. 1 The two interest rate scenarios result in a debt ratio of 1% and 11% of GDP in 1, respectively. The higher debt ratio is mainly a consequence of a major increase in interest payments due to higher interest rates. Concerning the primary budget, the outlays are kept almost constant. However, there is a minor increase in revenues from the government account s security holdings as well as an increase in individuals income and financial corporations profits, which gives the government a higher tax income, thus affecting the primary budget and hence the debt ratio positively. Risk scenario: lack of fiscal discipline: Interest payments in % of GDP 7 5 3 1 Primary Budget at 11 level 8 1 1 1 1 18 Risk scenario: higher bond yields: Gross debt in % of GDP 1 1 1 8 Risk scenario: higher bond yields: Interest payments in % of GDP 3pp lower Primary Budget 1pp higher rates 3pp higher rates 7 9 11 13 15 17 19 1 1 9 8 7 5 3 1pp higher rates 1 3pp higher rates 8 1 1 1 1 18 1 The average maturity of marketable debt outstanding in the US is a little above 5 years, hence we use a 5 year rolling average as our interest rate estimate. 1 August 11
Interaction between the scenarios The three scenarios above highlights that there are a lot of uncertainties concerning the future path of the US debt. However, it is insufficient to consider each case separately. This follows because lower economic growth will increase the need for fiscal stimulation, hence it can result in the absence of fiscal restraint. A weakening in fiscal discipline puts further pressure on the future fiscal sustainability, which at some point in time could affect investor confidence negatively resulting in higher interest rates. As a consequence of higher funding rates economic growth will decrease and the economy has entered a negative spiral with increasing debt. To analyze a situation, where the independency between the three scenarios is taken into account, the three most likely cases above are combined. This implies a scenario which involves, Compared with CBO s estimates the GDP growth is pp lower from 11 to 15 followed by a recovery to the base-case level over the ensuing three years combined with a resulting drop in employment rate. The interest rates are 1pp higher than the assumption made by CBO, again taking account of the average maturity on the debt. The primary budget is 3pp lower compared to CBO s estimates from 1 and onwards before taken account of the secondary effects from GDP growth and interest rates. The composition of the three cases entails a higher deficit on the primary budget as it is assumed to be higher but also as a consequence of the lower growth rate in GDP and hence the higher unemployment rate. Further, the interest payments will be much higher compared with the baseline case under CBO, as the debt ratio is kept high, but also as a consequence of the drop in investor confidence. As a result of these aggregate effects, the debt ratio ends on 171% of GDP in 1. Compared with CBO s baseline case, where the debt ratio is 11% of GDP, this is a really bad outcome. Although the economy can end in this negative spiral, it is not certain that investors will lose confidence solely as a result of a weakening in fiscal discipline. Further there is a probability, that the fiscal stimulus can create economic growth, and probably stop the spiral. But it requires an increase in the primary budget deficit and hence a rise in debt ratio. The scenario serves to illustrate the snowball effect if the debt problems are not dealt with in time. Combined scenario: Primary deficit in % of GDP -1 7 9 11 13 15 17 19 Combined scenario: Gross debt in % of GDP 18 1 1 1 1 8 Combined scenario: Interest payments in % of GDP Higher rates, lower GDP growth and lower primary budget Higher rates, lower GDP growth and lower primary budget 7 9 11 13 15 18 8 7 5 3 1 Higher rates, lower GDP growth and lower primary budget 8 1 1 1 1 19 1 Moodys likely to remove AAA rating and S&P downgrade further to AA Our analysis show that a downturn in economic growth, higher interest rates or a deviation from fiscal restraint will all affect the US debt sustainability negatively. Especially the scenario with lower growth seems likely. For that reason, S&P, Moody s and Fitch have kept their outlook on negative, meaning that there is a high likelihood that the rating could be lowered. With a weaker growth profile than currently anticipated we find it likely that a higher debt trajectory will trigger a downgrade to AA+ by Moody s and Fitch and to AA by S&P during 1. A reduction in the rating by Moody s and Fitch will again add to financial uncertainty, and the impact from a downgrade by one of these rating agencies will be more comprehensive compared to S&P s first downgrade. This follows because many funds are only forced to sell AAA paper if more than one rating agency removes the AAA rating. Moody s has indicated that there would be a risk of downgrade if (1) there is a weakening in fiscal discipline in the coming year; () further fiscal consolidation measures are not adopted in 13; (3) the economic outlook deteriorates significantly; or () there is an 5 1 August 11
appreciable rise in the US government's funding costs over and above what is currently expected. We expect economic growth to be lower than predicted by CBO, which implies that unemployment will stay at a high level and this will lead to a higher debt profile than currently projected by CBO. The view on longer term growth prospects may also be downgraded as consensus may build that US is caught in a low growth trap similar to what Germany experienced following their housing bubble with relation to the reunification in the early 199 s. As a consequence it is likely, that Moody s and Fitch also downgrade the US debt. In addition S&P have stated that the rating could be lowered further to AA within the next two years if US cuts spending less than agreed to or other factors result in a higher trajectory for government debt. S&P have previously shown their willingness to downgrade more than once within a short period, as they downgraded Japan three times during a period of fourteen months in the beginning of the twenty-first century. With the outlook for longer term growth looking disappointing we expect another downgrade by S&P during 1. S&Ps three downgrades in Japan in early Source: OECD, Reuters Ecowin and Bloomberg A counterargument against a further downgrade from S&P or a remove of the AAA rating from Moody s and Fitch is political pressure. As 1 is election year both political opposites put pressure on the rating agencies not to downgrade. However, S&P s recent downgrade illustrates, that they do not succumb to political pressure, and we expect a disappointing growth trajectory to be sufficient to trigger further downgrades. As S&P attempt to look through the fluctuation of an economic cycle, the most remarkable thing about these downgrades is that they were completed during an economic downturn. Even though this is in contrast with S&P s attempt, the action can be justified, as a contraction will affect the primary budget, hence inculcating fiscal freedom enough to validate a downgrade. The same argument goes for the current cyclical fluctuation, and we expect S&P to downgrade further. 1 August 11
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