U.S. Reaches Debt Deal: Is it Enough to Sustain AAA Rating?

On Tuesday, President Barack Obama signed a bill to raise the U.S. debt ceiling, preventing the nation from defaulting for the first time in its history.

The move came after key ratings agencies like S&P, Fitch and Moody's expressed concerns over the performance of the U.S. economy, which is crucial for the efforts of stabilizing the country's debt ratios.

The U.S. economy stumbled badly in the first half of 2011 and came dangerously close to contracting in the January-March period. The economy grew at a 1.3 percent annual pace in the second quarter, compared to the 1.9 percent analysts were expecting.

Additionally, growth for the first quarter was revised down to 0.4 percent from the previously reported 1.9 percent rise. As a result of this slower-than-expected expansion, economists' expectations for the fourth quarter dropped to 2.3 percent from 3.1 percent.

Under the latest deal, the U.S. will cut nearly $1 trillion over 10 years on discretionary spending and establish a bipartisan, bicameral Congressional committee that will identify an additional $1.5 trillion of additional deficit reduction by year's end.

The agreement passed by Congress provides for an initial increase of the debt limit of $900 billion and introduces procedures that would allow the limit to be raised further in two additional steps, for a cumulative increase of between $2.1 trillion and $2.4 trillion by the end of 2011.

The initial increase of the debt limit by $900 billion and the commitment to raise it by a further $1.2-1.5 trillion by the end of the year may have virtually eliminated the risk of a default.

But the key question is whether the raising of the debt ceiling is enough to keep the country's AAA rating.

This question assumes significance as the United States has been the world's dominant financial power for at least seven decades. The U.S. dollar is the reserve currency of the world and the debt of the United States became the collateral, which supported a wide variety of global financial instruments.

The U.S. has to keep its AAA rating at any cost to preserve its economic powerhouse status. If it fails, the world's reserve currency, its interest rates and its monetary policy cannot be tied to a nation that has lost financial control.

"One cannot keep buying U.S. Treasuries to protect against a U.S. Treasury crisis," Rochdale Securities analyst Richard Bove wrote in a recent note to clients. "The risks here are high. The most compelling one is that the U.S. will be forced to utilize its own resources to meet its own debt service costs. That will stress the economy as much as any tax increase might."

The U.S. may have temporarily evaded the risk of default, but the risk of downgrade and retaining AAA rating still remains. For now, both Fitch and Moody's have kept their "AAA" rating on U.S. bonds unchanged after the debt deal.

In Fitch's opinion, the agreement is an important first step but not the end of the process towards putting in place a credible plan to reduce the budget deficit to a level that would secure the United States' "AAA" status over the medium term.

Although the fundamental economic and financial underpinning of the United States' AAA status remains strong, the country needs to implement significant revisions to tax and spending policies to reduce the budget deficit that in turn will help to preserve its AAA rating.

Since America has $14.3 trillion of debt, more work lies ahead.

President Obama has hinted at some adjustments to Medicare, corporate taxes and tax payer subsidies to oil and gas companies.

"Since you can't close the deficit with just spending cuts, we'll need a balanced approach where everything is on the table. Yes, that means making some adjustments to protect health care programs like Medicare so they're there for future generations. It also means reforming our tax code so that the wealthiest Americans and biggest corporations pay their fair share. And it means getting rid of taxpayer subsidies to oil and gas companies, and tax loopholes that help billionaires pay a lower tax rate than teachers and nurses."

Fitch said the U.S., like much of Europe, must confront tough choices on tax and spending against a weak economic back drop if the budget deficit and government debt is to be cut to safer levels over the medium term.

On current trends, Fitch projects that U.S. government debt, including debt incurred by state and local governments as well as the federal government, will reach 100 percent of GDP by the end of 2012, and will continue to rise over the medium term - a profile that is not consistent with the U.S. retaining its AAA sovereign rating.

Moody's also voiced a similar opinion and has assigned a negative outlook to the rating. The agency said the risk of downgrade would trigger if fiscal discipline is weak in the coming year, further fiscal consolidation measures are not adopted in 2013 and the economic outlook deteriorates significantly.

Moody's expressed concerns over the idea of congressional committee and an automatic trigger as this framework is "untested."

"Attempts at fiscal rules in the past have not always stood the test of time. Therefore, should the new mechanism put in place by the Budget Control Act prove ineffective, this could affect the rating negatively," Moody's said in a statement.

Meanwhile, Moody's expects to see a stabilization of the federal government's debt-to-GDP ratio not too far above its projected 2012 level of 73 percent by the middle of the decade, followed by a decline. Such a pattern would also support a smaller interest burden as a percentage of government revenues than is now projected.

In addition, recent downward revisions of economic growth rates and the very low growth rate recorded in the first half of 2011 call into question the strength of potential growth in the coming year or two. Continued very low growth would make fiscal consolidation more difficult.

Finally, the US Treasury's cost of borrowing has remained low despite the recent political uncertainties surrounding the debt limit and the long-term fiscal outlook.

While the debt deal means the U.S. is unlikely to default, it is far from certain whether the plan agreed by the White House and lawmakers goes far enough in reducing the deficit to appease credit ratings agency S&P, which has threatened to remove the top-notch AAA rating for America.

S&P has placed its "AAA" long-term and 'A-1+' short-term sovereign credit ratings on the U.S. on CreditWatch with negative implications.

Moreover, repercussions of the deal will be felt for years to come and also set an interesting stage for 2012 presidential race when President Barack Obama seeks re-election.