Testing the AAA boundaries

It’s time to forget the financial and macroeconomic crisis, and worry about the fiscal one.
So says Moody’s in the latest edition of its AAA Sovereign Monitor, which looks at eight of the countries rated AAA by Moody’s, but four of the largest in particular — France, Germany, the US and UK. Moody’s has to date only downgraded one sovereign (Ireland) so this is a rather timely publication given recent concerns over sovereign debt and ratings — concerns aptly summed up in the below, mostly downward-pointing, Moody’s chart:
Of course not all AAA ratings are created equal, according to Moody’s.
The ratings agency further divides its AAA ratings into three categories: resistant, resilient and vulnerable, the definitions of which you can view here.
As Evolution Securities’ credit analyst Gary Jenkins notes, in some ways the three categories they have for AAA’s are a bit like having a `stable’, `negative’ and `creditwatch’ — or `the good, the bad and the ugly’ within the AAA rating space. It’s worthwhile to note too, that all the big four rated-sovereigns are officially on `stable’ according to Moody’s, but they are not all `resistant.’ Ahem.
In particular, while France and Germany make it into the `resistant’ category, the US and UK do not.
Without further ado then, here is what Moody’s has to say about the UK:United Kingdom: A Resilient AaaInexorable deterioration of debt affordability as a long recession takes its tollThe UK economy entered the crisis in a vulnerable position, owing to the (overly) large size of its banking sector and the high level of household indebtedness. Both continue to weigh on economic performance. Net bank lending to the UK business sector has continued to contract through Q3 2009, and repairs to household balance sheets (i.e. the rising savings ratio) may weigh on demand for some time to come. Based on preliminary data, the UK’s GDP has fallen for the sixth consecutive quarter, resulting in a cumulative contraction of output by 5.9% so far from its peak. Other indicators, however, suggest that the UK economy has already started to expand again, and will continue to recover throughout 2010.The depth of the crisis has been mirrored by the ongoing deterioration of public finances (with gross debt/GDP having risen from 44% at the end of 2007 to an estimated 69% at the end of 2009). It also raises considerable challenges going forward, as the downward adjustment of potential output during the crisis will result in a recurrent shortfall in tax revenues, which, if not compensated by a parallel adjustment in expenditure, would leave the government with a permanent deficit. The structural public deficit, which was already in excess of 3% prior to the crisis, now stands above 10% of GDP, according to the European Commission. The result, as illustrated by the debt trajectory charts on page 13 << http://av.r.ftdata.co.uk/lib/inc/getfile/23606.jpg>>, is an inexorable deterioration of debt affordability in the short term under almost all foreseeable scenarios.
The good news here is that the UK has a high degree of debt financeability (the ability to raise debt without it substantially affecting the cost of the debt) helped by, err, QE-spurred demand for gilts and some cheap inflation-linked debt. As Moody’s puts it:Considerable debt financeability offers the government time to reactAgainst this background, the characterization of the UK Government as a “resilient” Aaa issuer is supported by a very high degree of debt financeability and an equally high assessment of debt reversibility.Over recent months, the UK Debt Management Office has issued inflation-linked gilts across the maturity spectrum at real yields close to or even below 0.5%. As this is a very low yield in comparison to the medium to long-term growth potential of the economy (hence trend growth in revenues), very favourable funding costs will (all other variables remaining equal) contribute to an improvement in debt affordability over time. Demand for gilts has also been supported by the Bank of England’s quantitative easing operations (with £181 billion of gilts purchased since March — about the same as total government issuance over the same period). This has been supplemented by regulatory pressure by the Financial Services Authority on banks to purchase government bonds to build up liquidity buffers. While both measures only generate demand temporarily, they contribute significantly to the ability of the government to borrow very large amounts on favourable terms. A high degree of financeability does not substitute for fiscal adjustment, but offers the government time to prepare and implement this adjustment.
Public consensus on the desirability of fiscal retrenchment suggests genuine capacity to repair the damageMoody’s assessment that the UK government exhibits a high degree of debt reversibility is supported by the trend over recent months towards an apparent consensus among the public that fiscal retrenchment (including cuts in expenditure) is both inevitable and desirable. This broad-based consensus is reflected in the stances of the UK’s three main political parties towards fiscal policy going forward. It effectively increases the room for fiscal manoeuvre of the government that will emerge after the general elections due to take place by June 2010, by which time economic recovery is likely to be more solidly anchored. While assumed capacity for fiscal adjustment currently supports the maintenance of the Aaa rating of the UK government, this assumption will have to be validated by actions in the not-too-distant future to continue to provide support for the rating.
The US, meanwhile, is looking at some rather different problems:United States: A Resilient AaaGDP growth is back, but how strong is it?The US economy returned to positive real GDP growth in Q3 2009, following negative growth in five of the previous six quarters. The annualized growth rate of 2.8% during Q3 was led by personal consumption, and there is a question about the sustainability of this trend given the situation of household balance sheets. Residential construction was also quite strong, and the large inventory of unsold homes indicates that this factor is likely to fade in coming quarters.The government’s stimulus plan appears to have been an important factor in the resumption of growth, and the initial impact was primarily through tax measures. However, infrastructure spending will continue into 2010. Nonetheless, it is uncertain whether the initial impact of the stimulus will wane. Overall, Moody’s expects the rebound from the recession to be relatively modest compared to the patterns observed following previous recessions. Real GDP growth of 2.0-2.5% in 2010 will undoubtedly help government revenues, but will not yet be high enough to make major progress in reducing the budget deficit.
Debt rising to new highs US federal government debt is rising rapidly.At the end of the last fiscal year (September 30), the ratio of debt to GDP had risen to 53.5% from 40.2% one year earlier. However, it is notable that the ratio of interest payments to government revenue declined from 10.0 % to 8.4%, despite the sharp rise in the debt outstanding, a clear indication that US debt financeability is strong. By our measure, discussed in the special focus article in this publication, it is the strongest of any country.However, under our baseline case, which relies on figures in the government budget, federal government debt and interest costs will rise considerably between now and 2012, with debt to GDP reaching 70% and interest to revenue (affordability) climbing to 13%. Under an adverse scenario, which Moody’s does not consider likely, debt affordability could become a problem as interest payments would exceed 18% of revenue - the historic high for this indicator that was reached during the 1980s. As the graphs on the following page indicate, such a scenario would also lead to a ratio of federal debt to GDP of around 80%, which would be by far the highest level since the Second World War.Recently, the announcement that Bank of America will redeem the $45 billion in government-owned preferred shares means that recoveries under the Treasury’s Capital Purchase Program (part of the Troubled Asset Relief Program), at about $115 billion, are now more than 50% of the amount initially purchased. Recoveries, of course, mean that debt issuance to finance the budget deficit is less than it otherwise would be.The forecast for general government debt (including state and local governments and certain pension liabilities), which we use for international comparison purposes, is somewhat better on the affordability front, with the ratio of interest payments to GDP remaining below 10% throughout 2010. This is comparable to the ratios for large European Aaa-rated governments.
Next Year: A Fiscal Consolidation Strategy?With the federal budget deficit at 10% of GDP in the previous fiscal year and a projected negative balance of 9.1% during the current fiscal year, it is clearly necessary to bring the deficit down to a sustainable level to avoid an unsustainable upward trajectory in debt ratios in the future. The latest budget documents show the deficit going down gradually to around 4% of GDP by 2015 and stabilizing at that level. Administration officials have said that the next budget, which will be presented in February 2010, will include measures to reduce the deficit to a lower level in order to prevent debt from reaching the levels implied by the current projections. A credible fiscal consolidation strategy would reduce the risk of higher interest rates and therefore a major deterioration in debt affordability that could come from a decline in confidence in financial markets. Without such a strategy, the federal government’s interest payments could come closer to those in the adverse scenario.
Which means the UK and US have just become the `bad’ bit in `The good, the bad, and the ugly’ sphere of AAA sovereign divisions.