In early August, Fitch Ratings, a leading credit rating firm, downgraded the long-term credit rating of the US government.
The agency—which lowered the US from the highest AAA classification to the notch lower AA+ rating—said the slight downgrade was due to a “steady deterioration in standards of governance” in recent decades on fiscal and debt matters, among other issues.
For its part, the US government objected to the decisions, with the White House issuing a statement expressing strong disagreement. Meanwhile, US Treasury Secretary Janet Yellen said the downgrade was “arbitrary and based on outdated data.”
So what exactly are sovereign credit ratings and how important are they?
What is a sovereign credit rating?
A sovereign credit rating is an independent judgment on a country’s level of creditworthiness. In other words, the rating assesses the level of risk associated with lending money to a government.
Oftentimes, lending money to a country comes in the form of investors or other governments purchasing government-issued bonds. These bonds are usually considered low-risk investments, but some governments may be deemed more or less likely than others to be able to meet their financial commitments.
Credit rating agencies quantify this risk to create a rating. Fitch Ratings, for instance, has produced sovereign credit ratings for 119 countries, according to the agency.
Fitch Ratings offices in London. Image: REUTERS/Reinhard Krause/File Photo
How are the ratings determined?
Private sovereign credit rating firms operate all over the world. However, three agencies are considered to be the most significant: Fitch Ratings, Moody’s Services and S&P Global Ratings.
Rating agencies take a number of factors into account when assessing a government’s creditworthiness. These indicators include the level of government debt, per capita income, GDP growth, the stability of financial institutions, inflation and default history, among others.
Regarding the downgrading of the US’ long-term credit rating, Fitch explained that the “repeated debt-limit political standoffs and last-minute resolutions have eroded confidence in fiscal management” and that “the government lacks a medium-term fiscal framework, unlike most peers, and has a complex budgeting process.”
“It is worth monitoring in the longer-term that Fitch cited the same reason—political tensions in Washington—as S&P did when they downgraded the US in 2011,” said Andre Belelieu, the World Economic Forum’s head of Financial Services Industries. “It is a dynamic that is not likely to improve in the near future.”
Rating scales differ between firms, but the top three agencies use alphabetical scales with AAA being the top level and C or D being the lowest. Pluses, minuses and numbers are also used to denote sub levels of creditworthiness.
At Fitch Ratings, a AAA rating is given in “cases of exceptionally strong capacity for payment of financial commitments” and in which “this capacity is highly unlikely to be adversely affected by foreseeable events.” A C rating, meanwhile, denotes that a “default or default-like process” and that a government’s “payment capacity is irrevocably impaired.”
Why are credit ratings important?
Sovereign credit ratings are important for governments who want to raise money by selling bonds in the international bond market.
A strong rating can attract investors and allow for cheaper borrowing. Conversely, a poor rating can make borrowing more expensive since the supposed risk is higher—or dissuade investors altogether.
The cost and level of borrowing can significantly influence a government’s ability to fund everything from infrastructure programmes to healthcare services. This makes sovereign credit rating especially important for developing countries.
“It has an influence on the cost of borrowing,” the United Nations Economic Commission for Africa noted in a statement last year. “Improving and maintaining good sovereign ratings is therefore essential for managing public debt and attracting investors.”
Sovereign credit ratings, however, are separate from assessments of private sector creditworthiness and other indicators of government stability and economic health.
“The downgrade of the US credit rating may have a slight impact on the economy and investors but is unlikely to cause widespread disruption or change the status of US treasuries as a safe investment,” Belelieu added.
Moreover, Fitch Ratings’ government downgrade did not impact the agency’s assessment of the US corporate environment.
The downgrade “will not trigger negative ratings actions for US non-financial corporates, since there are no direct linkages to the sovereign rating,” Fitch Ratings said.