Recently, Moody’s downgraded the U.S. credit rating—a move that, while met with a calm market response, signals a subtle decline in global confidence in America’s fiscal leadership.
- It is the latest downgrade of the three major rating agencies to lower the federal government’s credit, Standard & Poor’s downgraded federal debt in 2011 and Fitch Ratings followed in 2023.
- A downgrade in the rating indicates that the risk of default of the instrument is higher than what was earlier predicted.
About Credit Ratings
- A credit rating is an evaluation of a borrower’s ability to repay debt, issued by agencies like Moody’s, Standard & Poor’s, or Fitch.
- It reflects creditworthiness and helps investors assess default risk.
- Example: High rating (e.g., AAA) signifies Low risk and Low rating (e.g., BB or lower) signifies High risk
- Credit ratings are not a recommendation to buy, hold or sell a debt instrument.
- Types of Credit Ratings:
- Sovereign Rating: Assesses a country’s ability to repay its debt, influencing its borrowing costs and investor confidence.
- Corporate Rating: Evaluates a company’s creditworthiness and financial stability for raising funds.
- Bond Rating: Measures the risk of default on a specific debt instrument or bond.
Evaluation Of Credit Rating Agencies (CRA)
- In Depth Study: Ratings are based on a comprehensive evaluation of the strengths and weaknesses of the company fundamentals including financials along with an in- depth study of the industry as well as macro-economic, regulatory and political environment.
- Differing Criteria: Each credit rating agency may have its own set of criteria and different weight age for each component for assigning the ratings.
- Factors: Some of the common factors that may be taken into consideration for credit rating are Issuer Company’s operational efficiency, financials, competence and effectiveness of management, past record of debt servicing, etc.
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Reasons For The Downgrade In U.S Credit Ratings cited by Moody
- High debt-to-GDP ratio: Moody cited rising debt-to-GDP ratio as one of the main reasons.
- U.S. debt has surpassed 120% of GDP.
- Chronic fiscal slippage: There were persistent fiscal deficits of the US. The post-2008 era ushered in a new norm of emergency spending, first to rescue banks, then to stimulate recovery, and later to shield households from the pandemic’s chaos.
- Political Polarization: Inability to enforce fiscal discipline due to partisan gridlock, leading to frequent government shutdown threats.
- Loss of Confidence: The downgrade reflects weakening trust in U.S. institutions and long-term fiscal sustainability.
Global Implications Of The Recent Downgrade in US Credit Ratings
- Dollar Dominance at Risk: Central banks diversifying reserves into gold, euros, and digital currencies.
- Emerging Market Vulnerability: Higher U.S. Treasury yields could increase borrowing costs for countries like India.
- Historical Precedent: The 2013 “Taper Tantrum” showed how sudden shifts in U.S. monetary policy trigger capital outflows from EMEs (Emerging Market Economies).
- Serves as an Indicator: Emerging markets with heavy debt burdens and borrowing positions accompanied by low-growth cycles, like Brazil and South Africa too are already facing rising borrowing costs.
- Even developed economies, including Germany (debt-to-GDP at 62.5%) and Canada (at 110.8%), now operate under closer scrutiny.
India’s Fiscal Challenges
- High Debt Levels: India’s general government debt is projected to reach around 80% of GDP in 2025 (as per IMF estimates), significantly higher than the recommended threshold for emerging economies.
- This elevated debt level restricts the government’s fiscal space, making it difficult to respond to economic shocks or invest in critical sectors like infrastructure and social development without exacerbating fiscal deficits.
- Populist Spending: Pre-election freebies (loan waivers, power subsidies) strain budgets without boosting productivity.
- Structural Weaknesses:
- Low Tax-to-GDP Ratio (at 11%): India’s tax revenue as a percentage of GDP remains far below the OECD average (at 34%), limiting the government’s ability to fund development programs.
- This is due to a narrow tax base, tax evasion, and inefficiencies in tax administration.
- Judicial Delays in Insolvency Cases: The Insolvency and Bankruptcy Code (IBC), while a positive reform, has been hampered by prolonged legal disputes, leading to delays in resolving bad loans and discouraging private investment.
- Underinvestment in Critical Sectors: Despite progress in infrastructure (e.g., highways, railways), India still lags in logistics efficiency, education outcomes, and healthcare systems.
Implications of High Fiscal Deficit In India
- Crowding Out Private Investment: High fiscal deficits raise government borrowing, reducing capital for the private sector, raising interest rates, and depressing investments. (private investment-to-GDP is at around 20–22%).
- Distorted Credit Flows: Banks meet statutory liquidity ratio (SLR) norms by lending to the government, limiting credit to MSMEs and startups and therefore, stifling entrepreneurship.
- Reduced Developmental Spending: Over 25% of central spending goes to interest payments, leading to less funds for infrastructure, health, and education. This leads to weakening of long-term growth.
Way Forward for India
- Fiscal Discipline is Essential: India must avoid short-term populist measures that compromise long-term fiscal stability.
- Instead, the focus should be on sustainable growth policies, such as rationalizing subsidies, improving tax compliance, and prioritizing capital expenditure over revenue expenditure.
- Strategic Diversification: India needs targeted policies to develop export competitiveness and diversifying trade partners beyond traditional markets and strengthening regional FTAs. These will reduce its vulnerability to global shocks.
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