What Is Fitch’s Downgrade Of U.S. About?

Relevance: GS3- Indian Economy GS2 - Effect of policies and politics of developed and developing countries on India’s interests

(Source: The Hindu, 08/08/2023)

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Why in the news?

• Recently, global rating agency Fitch Ratings downgraded the U.S.A.’s rating from AAA to AA+, which was the first downgrade for the country since 2011.
• Fitch has justified the downgrade by citing the concerning fiscal deterioration, growing government debt, and erosion of governance as compared to similarly rated countries over the last 20 years.

What are the concerns expressed by Fitch?

• Governance: It observed a steady deterioration in the standards of governance over the last 20 years, including on fiscal and debt matters.
  • Despite the bipartisan agreement to suspend the debt limit until January 2025, repeated political standoffs and last-minute resolutions have eroded confidence in fiscal management.
• Fiscal structure: Unlike its peers, the U.S.A. lacked a medium-term fiscal framework and possessed a complex budgeting process.
  • Debt had increased successively between 2010 and 2020 due to severe economic shocks, tax cuts, and new spending initiatives.
• Deficit: The general government deficit i.e. balance of income and expenditure is expected to rise from 3.7% (2022) to 6.3% of the GDP (2023) as a result of cyclically weaker federal revenues, new spending, and higher interest burden.
• Interest burden: Over the next decade, the interest service burden will increase due to higher interest rates and rising debt.
  • According to the U.S. Congressional Budget Office, interest costs will double to 3.6% of the GDP by 2033.
  • Net interest costs reflect the cost to the sovereign for borrowing money at a specific period.
• Healthcare expenditure: The U.S.A. will have to spend more on the elderly absent fiscal policy reforms due to its aging population and rising healthcare costs.
• Vicious cycle: The rise in interest costs due to rising interest rates and national debt will restrict the scope for investment in priority areas amid the expiry of tax reforms and create a vicious cycle of further borrowing, servicing interest, and expanding debt.
• Recession: Tighter credit conditions, weakening business investment, and reduced consumption would result in a mild recession in Q4 of 2023 and Q1 of 2024 in the U.S.A.
  • The annual real GDP growth will slow to 1.2% in 2023 from 2.1% in 2022.

How will the downgrade impact India?

• Stock markets: Any major effect on the U.S.A.’s economy will impact the world market.
  • The BSE Sensex fell by over 1% to below the 66,000 level while other Asian markets such as Hong Kong, South Korea, Tokyo, and Australia fell by up to 2% following the downgrade.
  • Technology stocks which are reliant on the U.S.A. and Western markets were the worst affected.
  • Uncertainties about the US economic system will gradually increase in the future, applying pressure on the Indian equity market in the short term but gold markets are expected to be beneficial.
• Bonds: The downgrade can affect domestic and global financial markets as the U.S. Treasury bonds are considered a benchmark for safe-haven assets worldwide.
  • As a result of the downgrade, U.S. government debt could experience higher yields as investors demand higher compensation for perceived increased risk.
  • As a result, U.S. Treasury bond prices could fall due to investors selling them in pursuit of higher returns.
• Short-term effects: The US 10-year bond yield spiking above 4% and the dollar index rising to 102 are near-term negatives for emerging markets.
  • The negative knee-jerk reaction will be short-lived as global equity markets have been rising.
• Overall, the downgrade of the U.S.A.’s credit rating is likely to have a minor impact on the Indian market, as rating changes often come with certain repercussions.
  • However, experts suggest that the market is more likely to focus on other fundamental factors such as earnings, crude prices, RBI policy, and fund flows.

What steps has India taken to mitigate the impact?

• Foreign reserves: India has built foreign exchange reserves covering more than 18 months of imports and 118% of its external debt to act as a buffer against external shocks and exchange rate volatility.
• Capital flows: India needs to manage capital flows carefully by balancing their costs and beenfits as they may be influenced by global risk appetite and domestic factors.
• Diversifying trade: India needs to diversify its trade and investment partners to explore new opportunities such as the European Union, the United Kingdom, Japan, Australia, and the ASEAN amid lower interest from the U.S.A.
• Fiscal consolidation: Fiscal consolidation is necessary to counter the higher borrowing costs and lowered investor confidence associated with the US credit rating downgrade.
  • However, the country will have to continue spending adequately on health, education, infrastructure, and social protection while also improving its revenue mobilization, expenditure efficiency, and fiscal transparency.

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FAQs

MCQs

Question: Consider the following statements:

1. In India, credit rating agencies are regulated by the Reserve Bank of India.
2. The rating agency popularly known as ICRA is a public limited company.
3. Brickwork Rating is an Indian credit rating agency.

Which of the statements given above is/are correct? (UPSC CSE 2022)

(a) 1 and 2 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3