During the summer of 2011, the US faced a credit crisis where it almost exceeded the allowable debt ceiling. This crisis which affected not only the US government but the US stock exchanges and beyond. Details and explanations about the event can be found on http://en.wikipedia.org/wiki/2011_US_debt_ceiling_crisis and through internet searches on the topic……
As a result of the US government’s extension of the debt ceiling, there was revaluation of the US government’s credit worthiness as assessed by Standard & Poors. Using some of the financial theories you learnt in Intro Finance and those reviewed in this class to discuss what the downgrade to the credit rating meant to the US and the reaction to this news by the market.
Debt ceiling refers to a cap on how much funds the US federal government can be indebted. Normally there is a limit of the amount the federal government is prohibited from incurring depending on the revenues collected. If the amount of expenses exceeds the revenues received, then a deficit budget is realized. Hence the shortfall can be paid for by the government through debt instruments. The amount to be borrowed is constrained by the debt ceiling which can only be raised using a vote by the congress. Back in 1917, the congress introduced the concept of debt ceiling which has then been used by the treasury as long as the total is kept at or under the approved limit (Reilly, 2011).
Impact of the downgrading credit rating to US and the market
The procedure followed in positioning the debt ceiling is distinct from the normal procedure of government operation financing. Debt ceiling raise does not have direct effect on the budget deficit. This year’s budget made a projection of tax collections and expenditures. Standard and Poor’s rating, was that US required $ 4 trillion cuts in deficits to provide the nation with a strong opportunity of not losing AAA-rating (Swann, 2011). Therefore, the government is likely to face various uncalled for repercussions which include;
The cost of borrowing by US might rise by $100 billion. The investors will maintain on being given a higher yield to obtain the treasury debt. This is what Standard and poor concluded a month ago. This because the downgrade will result into a tax raise as a result of increased borrowing costs. If the interests’ rates rise in general as prompted by a downgrade it will impact on the borrowing costs of the cities and the state at large. It will imply there is a possibility of bondholder’s risk of interest rate changes will be high as some bonds may be retracted before they mature. Corporations might run bankrupt as a result of high interests as the financial leverage will be too high to bear.
There will be a general rise of variable rates attached to government targets. If anyone would like to borrow using a variable rate from unpaid credit card balance to individual institution loans, the rates would rise if the prime rates are pushed higher. Similarly the rates of mortgage are likely to raise as well hence the cost of owning a home will be high. This will extend to the bonds that are backed by mortgage, as they will face downgrading. The impact to mutual funds will be a decline because they are the issuer of these funds.
The downgrading would see to pressure build up on money market mutual funds if the debt ceiling is not hiked up. There is no way the government can avoid paying debts owed to China, Japan and other major beneficiaries of U.S debt. Even if the treasury can avoid paying some of the bills some hard ones are inevitable and hence pressure to the federal.
If the credit quality of US goes below AAA rating by standard and poor, then the cost of imports and vacations will be more as the dollar value will deteriorate. The US exporters might however benefit from the weak dollar as a result of being paid more. From the capital structure theory it will be expensive to raise debts in US hence investors will be scared to venture into the country (Fried, 2011).
To sum up, the federal government has a huge task of hiking the debt ceiling to avoid the above named impacts. Lower credit rating might never be hiked up if the congress decides to maintain the debt ceiling at $ 1 trillion instead of the proposed $4 trillion in order to be on the safe side. This is because the US culture of spending is catching up with their budget as it has already hit 100% of the nation’s GDP.
Carla Fried, (2011), Top 6 Ways a U.S. Credit Rating Downgrade Could Cost Americans, CBS
Money watch, accessed on 06-10-2011
Nikola G Swann, (2011), United States of America Long-Term Rating Lowered To ‘AA+’ On
Political Risks and Rising Debt Burden; Outlook Negative, Standard and Poor’s
Sean Reilly (2011). “Budget chaos reigns: 2012, 2013 plans in disarray in wake of debt deal“.