Does the U.S. Have to Worry About Its Credit Rating?

With news Wednesday that credit default swaps on U.S. government debt have risen to a record level -- essentially meaning that there is growing nervousness about U.S. creditworthiness -- it's time to take a closer look. After all, many are newly worried about U.S.'s credit rating, especially the impact on the dollar if said credit is ever downgraded.

Country credit ratings -- usually called "sovereign" ratings -- are funny things. Not necessarily "ha-ha" funny either, more like "huh?" funny. I'll return to that in a moment, but I'll start by saying that the principle is straightforward: Credit rating agencies assign ratings to countries in much the same way they they do to companies. They look at capacity, cash flows, other debt, trends in all of the preceding, and generally the likelihood that a country will ever default. The outcome of that exercise is a letter rating that you can proudly post on your wall, or, better yet, take out on the capital markets when you're raising money as a country to do stuff. It drives domestic interest rates, especially in a relative sense, and, thereby, the exchange rate of your currency.

Fair enough, right? Well, it's not so simple. Credit rating at the country level is devilishly complex. For starters, it depends on the currencies in which your debt is denominated. If your debt is denominated in U.S. dollars and you don't, you know, own that currency, then you can get pinned to the wall and forced to default as your current depreciates and you run down foreign reserves. On the other side, if your debt is in your own currency you don't ever really have to default, as you can always just "print" more currency. Admittedly, bondholders don't like holding bonds of countries that have the habit of inflating their debt away, but that's their problem not yours.

So, back to the U.S. There is no doubt that the U.S. is busily upping its financial commitments across the board, from bailouts to banks to currency markets to wars. And that sort of thing catches up with you, as the widening in credit default spreads today shows. But U.S. debt is entirely denominated in U.S. dollars, so it's awfully tough to default. Granted, you could annihilate the currency, but that is different from having yours ears to pinned to the wall via debt denominated in another currency. That said, it is by no means certain that the U.S. will always get to denominate its debt in its own currency. It is plausible that we could see more Euro-denominated or even a post-floated Renminbi debt, which would change the calculus entirely.

Finally, and this is the "huh?" part of sovereign ratings. Many times, they just don't make sense anyway. The best example remains Japan, which has a lower credit rating than does Botswana, and is on par with Ukraine. Now, Botswana is a fine and improving country, and there is no doubt that Japan remains under a heavy debt load at the country level, but there is something seriously wrong with any credit model that puts Japan behind Botswana in the creditworthiness sweepstakes.

Comments

[GKM:]

The questions to ask are where are the major credit ratings agencies located (hint: in what country)? Will the ratings agencies pull their usual moves and downgrade only after it is patently obvious? Why am I asking rhetorical questions?

2008 Sep 17 05:30 PM

[NOWHEREMAN:]

The Ratings agencies were blamed for screwing up last year. They are making up for it.

The higher LIBOR goes the higher the uncertainty regarding US financial instability. At least thats how I view it.

Yesterday the Gulf States agreed to a pact forming a Monetary Union. They are now deciding on the composition of its currency. IMHO, the dollar won't be a large part of it.

2008 Sep 18 09:59 AM

[NOWHEREMAN:]

belay that last comment, 5 of 6 Gulf States but they won't act until 2010. Kuwait has already switched to a basket of currencies.

2008 Sep 19 12:29 AM

[Mr.G:]

"Admittedly, bondholders don't like holding bonds of countries that have the habit of inflating their debt away, but that's their problem not yours."
That pretty much says it all for me . The credit ratings arent made by agencies they are made by bond holders - Is anyone going to want to touch US debt after they inflate the debt by a trillion overnight , I dont think so and when the govt cant pay the old debts with the new debt that is when the trouble really starts -the US may never default on its debt but dont expect the dollar to buy anything for long because of it .

2008 Sep 19 12:03 PM

[zombi:]

I think that the ability of each country to take credit and to reimburse it later (principal + interest) depends on the ability of the economy to generate added value and to have positive cash flow. If the cash flow is negative and it is not able to generate added value to the economy the credit rating will reflect that situation, thus it is very correct that the credit rating of Botswana is way better that that of Japan (which currently bears a huge debt load).

2008 Sep 20 04:23 PM