Moody's Emphasizes the Importance of Debt Affordability and Debt Reversibility
On Monday, Moody’s Investor Service released its quarterly report (courtesy of Zero Hedge) on government debt held by large countries with the highest bond rating (the Aaa rating): France, Germany, the United Kingdom, and the United States (with notes on Spain and the Scandinavian countries). Moody’s and the other bond rating agencies have warned for months that the bond rating of a country could drop if governments do not begin to pay more attention to their burgeoning debt. While Moody’s notes that there is “no imminent rating pressure for Aaa Governments,” the risk of a downgrade continues to climb. Moody’s argues that:
- Growth alone will not resolve an increasingly complicated debt equation. Preserving debt affordability at levels consistent with Aaa ratings will invariably require fiscal adjustments of a magnitude that, in some cases, will test social cohesion.
- Tightening fiscal policy before private demand has become self-sustaining would involve the risk of putting growth on an even lower trajectory, thereby damaging a government’s main asset: its power to tax.
- Postponing fiscal consolidation much longer is no less risky as it would test the patience of the market – and of central banks. Although Aaa governments benefit from an unusual degree of balance sheet flexibility, that flexibility is not infinite. At the current elevated debt levels, a rise in the government’s cost of funding can very quickly render debt much less affordable – and potentially exert more abrupt pressure on the ratings.
Rather than looking at the debt-to-GDP ratio as the primary factor for assessing the potential for a government to lose its Aaa rating, Moody’s suggests another measurement: the ratio of annual interest payments required to maintain a government’s debt to its annual tax revenues. Moody’s argues that “debt affordability” is a better measure because how much flexibility a government has for other spending is determined by its past debt accumulation.
Moody’s emphasizes that there is no specific marker (although 10 percent is a marker that could be a warning sign) that would generate a downgrade of a country’s rating, rather the rating is subject to the debt affordability measure and the debt reversibility measure (a government’s ability to reverse the debt trend). In fact, Moody’s emphasizes this point, the rating "hinges on the credibility of the long-term fiscal adjustment plans” of a government and a country’s willingness to undertake fiscal consolidation.
We would only do so if we came to the conclusion that either the government was unable to restore affordability to a level consistent with an Aaa rating (the circumstances that led to Ireland’s downgrade in July 2009) or that the government chose to live with a permanently higher debt burden. Debt reversibility therefore provides a measure of the extent to which we would give a government the benefit of the doubt, if its finances were stretched but we believed its determination to correct the situation was unequivocal.
So, how does Moody’s assess the likelihood of a downgrade in the U.S. rating? According to Moody’s assessment of the debt projections in the Administration’s FY 2011 budget, the debt affordability measure would rise to nearly 18 percent by 2020 (roughly the rate from the 1980s, although Moody’s notes that the ratio then was due to high interest rates, rather than the size of the debt). If that measure actually reached those levels, Moody’s estimates that “there would be at some point be downward pressure on the Aaa of the federal government.” And while Moody’s notes the establishment of a fiscal commission, it argues that “the politics of actually implementing such reforms remain uncertain.”