What is Debt Ceiling?◦ Also known as the debt limit, the debt ceiling is the amount of gross debt the federal government can have.◦ The US limit till July 2011 was $14.3 trillion, which the government surpassed on May 16, 2011.◦ During the recent global economic downturn, U.S. Congress voted to increase the debt ceiling to avoid the potential of a national default on our debt obligations.
What happens when a Countryexceeds its Debt Limit?◦ Default on outstanding sovereign debt would be a serious problem for the United States.◦ Default occurs when a debtor fails to pay interest or to repay principal on a debt obligation.
Why is the U.S debt so large? Government spending soared in the 2008 financial crisis and bills were passed to rescue the us economy Recession caused tax revenues to fall. With less revenue and more expenses, the deficit grew. To meet these shortfalls, the US government borrowed more money, adding to the national debt. In 2001 and 2003 George W. Bush signed into law tax bills that lowered the top marginal income tax rate from 39.6 % to 35 % This slashed the top capital gains tax rate from 20 % to 15 %.
Why is the U.S debt so large? Percentage of income that Americans are paying in taxes is at its lowest level since 1950 Wars in Afghanistan and Iraq swelled the deficit. Health care is another big cost: The amount that the US government spent annually on Medicare increased by 137 % from 1999 to 2009. According to the US treasury, the national debt has risen by more than $500bn each year since 2002.
Background and History of Debt Ceiling The US constitution stipulates that only congress can authorize the federal government to borrow money. Since 1962 congress has raised the debt ceiling 72 separate times, including 10 times in the past decade alone. A rule adopted in 1979 had allowed the House of Representatives to automatically raise the debt limit to whatever level the budget required. But in January 2011, the House voted to repeal this rule, requiring the House to hold a separate vote to increase the debt limit.
Background and History of Debt Ceiling When Obama took office in January 2009 in the midst of the biggest economic turndown since the Great Depression, US public debt stood at $10.6tn. This May, the current debt limit of $14.3tn was reached. The US Treasury can extend the August 2 deadline by exploiting various loopholes, such as postponing pension payments to federal employees. Most analysts say that even after August 2, the Obama administration has some flexibility to continue meeting their payments at least for a few more days.
COUNTRIES HOLDING USBONDS IN BILLIONS OF $ AS GRAND TOTAL ON JUNE 2011 $4499.21165.5 911 349.5 229.6 207.1 153.4 140.5 118.4 109.8 108.2 38.9 17
Basic Concepts Why does a country borrow? What is Debt Ceiling? What is its significance?
Financial Instability in the U.S Condition worse than Greece or any other Debt Laden European country Stock Market Crash Value of $ Decreases Unemployment – 9.2% (June 2011)
Why did it raise the Debt Ceiling? The U.S. could default on its Treasury bonds, but it may not. If it defaulted: *Serious Recession *Economic Reputation U.S. stock market will fall, so will global stock markets
Why did it raise the Debt Ceiling? U.S. credit ratings would be downgraded across the world U.S. interest rates would rise and the value of the dollar would fall Entitlement programs and military pay will face significant cuts
Political Instability The election of a Republican senator in Massachusetts The financial collapse of Dubai The near bankruptcy of various large states within the United States and four or five of the member states of the European Union Severe world currency fluctuations
Financial Challenges faced by FederalGovernment Controversy over raising the statutory debt ceiling Decline of Tax revenues significantly due to a severe recession Tax-policy choices, while expenditures have expanded for wars, unemployment insurance and other safety net spending The fiscal consolidation plan that Congress and the Administration recently agreed to falls short of what would be necessary to stabilize the governments medium-term debt dynamics
Experts voice Concern A group of 235 prominent economists, including six Nobel Prize winners and a former top White House economics adviser called on congressional leaders to raise the ceiling Do without attaching drastic and potentially dangerous reductions in federal spending In the worst case, could push the US back into recession
Implications of the raised Debt Ceiling The short-term fix comes with long-term potential problems. 1. Responsibility- Raised debt ceiling would tempt the government to continue borrowing money and spend beyond its means. Would continue to fail to address to the deficit. Would lose sight of the immediate and long term problems. 2.Collapsing dollar- Raised debt would devalue the dollar. The currency becomes riskier and less stable as we are more likely to default on the existing debt Also weakens the purchasing power and could cause dollar to lose its position as the world reserve currency.
Criticism towards the Government Congressional Republicans insisting on massive debt spending cuts and no tax hikes in order to raise Debt Ceiling Was straight away rejected by the liberals citing it would have adverse effects on the economy
Warning of a Downgrade by CRAs In June, Moodys followed suit, warning that if Congress did not quickly raise the debt ceiling above $14.3 trillion, the agency might reduce the debt rating S&P issued a research update putting the U.S. debt on a 90-day CreditWatch Fitch said that it would put U.S. debt on watch for downgrade in early August in the event that Congress fails to lift the federal debt limit before other stopgap measures are exhausted
Reactions by Credit RatingAgencies Three major Agencies Moody’s, S & P and Fitch Moody’s and Fitch maintained the US Credit rating to AAA S & P downgraded the US Credit Rating from AAA to AA+ Strong reactions all over the world
What does S & P do? United states based financial services company Publishes research and analysis on stocks and bonds One of the big three of CRAs Also has a unique criteria called the GAMMA score, known to evaluate corporate governance
Why did S & P downgrade the U.S? Review started more than two weeks before the August 2 deadline It was the deadline for politicians to raise the debt ceiling Raised the rating due to prolonged controversy over raising the statutory debt ceiling
Why did S & P downgrade theU.S? Lowered the rating due to rising public debt burden and their perception greater policymaking uncertainty Fiscal policy debate indicated that further near-term progress containing the growth in public spending, especially on entitlements, or on reaching an agreement on raising revenues is less likely than they previously assumed
Why did S & P downgrade theU.S?The U.S. debt-to-GDP ratio is at similar level to what Japans was at in 2001when it was downgraded from AAA to AA+ by S&P
Criticism for the Downgrade Rating Agencies continuously face flak as they wake up slow to financial risks Lehman and AIG which had AAA ratings up till the end are examples One of the biggest municipal bankruptcy debacle two decades ago, that of Orange County, had many bonds with stellar ratings till a couple of weeks before going bust Ratings often mislead investors
Criticism for the Downgrade S&P made a grievous and evident error in overestimating the debt by over a trillion dollars (double counting) The US economy is the largest (over $15 trillion in GDP) and the most varied. The economy has grown consistently and robustly over the last 60 years. US securities account for 40 per cent of total market capitalisation. At eight and seven per cent, Japan and Britain are distant second and third.
Criticism for the Downgrade Missed the sub prime mortgage crisis in 2007-2009 and is still being investigated about the role in the Mortgage crisis Being questioned about instances in which the company’s analysts wanted to award lower ratings on mortgage bonds but were overruled by other S&P business managers Even in the case of India, the S&P sovereign rating in May 1991 was actually higher than in 2001, a curious anomaly hard to explain.
Short term implications US bond markets not affected Forex reserves of foreign central banks is UST will not change as it is the deepest and most liquid bond market Mutual fund investment guidelines retain significant flexibility regarding the handling of this action
Short term implications The US banking system should not be forced to sell as well because the Fed has issued a guideline noting no change in risk weights Insurance companies are also unlikely to be forced to sell A single-notch downgrade should not lead to downgrades in the credit ratings of banks Yield-to-price rate on government bonds stable at 3.3817%
Long term implications The biggest impact will be through the effect on the USD as a reserve currency. A downgrade could increase diversification away from the USD. Heighten problems as many currencies pegged to the dollar Higher interest rates
Long term implications A one-notch downgrade would lead to an increase of 25bp in borrowing costs. But this is not a function of a specific rating action, but of the market downgrading the sovereign rating.
Post downgrade reactions First among the reactions globally was that of China. China bluntly criticized the United States after the S&P ratings cut to AA-plus, saying Washington had only itself to blame and calling for a new stable global reserve currency. France’s Baroin said France had faith in the United States to get out of this “difficult period.” The market’s reaction similar to what happened earlier this decade – nothing.
What’s ahead?• Real GDP growth• Economic growth• Job creation• Double-dip recession
Effect on India Lower commodity prices in the long term Strong rupee Help tackle inflationary challenges Fund flows (portfolio and direct investment) Growth differential with US will widen Interest rate differential will compress
The S&P Chairman Resigns Mr. Deven Sharma, the former Chairman of S&P, resigned less than a month after S&P downgraded the U.S According The Wall Street Journal says that his successor will be Douglas L. Peterson, currently the Chief Operating Officer of Citibank, N.A., Citigroups principal banking entity that operates in over 100 countries.
Why did Mr. Deven Sharma resign?Experts suppose that the reason behindMr. Sharma’s resignation is his agency’sconflict with the US authorities In early August, “Standard & Poor’s” –for the first time in history – lowered thelong-term credit rating of the USA from thetop “AAA” to “AA+”. “S&P” backed its decision with the factsthat the US state debt and the budget deficitare growing. Moreover, the agency predicted a furtherdecline of the US’s economic prestige.
S&P after Mr. Sharma’s Resignation Now, “Standard & Poor’s” is assuring that changing the director has nothing to do with the story with the US’s rating Still, the conflict with the US Department of the Treasury did lower the “Standard & Poor’s” rating in some points The authorities of several cities in have already refused to cooperate with “S&P” By appointing Mr. Sharma the scapegoat, the agency is trying to show that it is ready to recognize its mistakes, which is obviously a PR trick to have old clients back and to attract new ones.
The Road Ahead The U.S needs to do the following to get back its AAA rating: National Debt as a percentage of GDP must decrease from its current level of 74% Budget Savings and increases in government receipts must be greater The Congressional Joint Select Committee on Deficit Reduction, which is charged by November of this year to cut another $1.5 trillion, spread out over the next decade, would have to make major cuts in the largest entitlement programs.
The Road Ahead The U.S needs to do the following to get back its AAA rating: Reduce social programs: The government currently supports a long list of “underprivileged” Americans that goes beyond classic entitlements. One of the most visible of these is the unemployed population S&P made it clear that budget cuts alone are not sufficient but that taxes must be increased Reduce Defense budget: The Defense budget still supports large deployments of people and material overseas. Limit medical care: Aging is a significant burden on medical costs from Medicare.