Despite debt deal, US could still face a downgrade in its credit rating

Raising the debt ceiling may not be enough to keep rating firms from downgrading US credit from its coveted 'triple-A' rating. What would a downgrade mean for the US economy?

This week's bipartisan deal in Washington averts a worst-case outcome for financial markets, but it doesn't remove the risk that the US Treasury will see its credit rating bumped downward soon.

That's because the debt deal agreed by Congress and the White House – passed by Senate vote Tuesday after House approval the day before – offers only a partial fix to the nation's fiscal problems.

A credit downgrade from a rating firm like Standard & Poor's or Moody's would mean the US loses its pristine "triple-A" credit score. In effect, credit analysts would be saying that the risk of a default by the Treasury is a bit higher than it was last year.

What the debt accord announced on Sunday achieves: Congress's self-imposed cap on federal borrowing will rise enough to allow the government to pay its bills through the 2012 election. And it shows that Democrats and Republicans have been able to agree on sizable spending cuts, to reduce future federal deficits by about $2.1 trillion over the next 10 years.

What remains unsolved: Future deficits would still be high enough to push public debt higher as a share of the overall economy. The bipartisan negotiations also failed to make headway on the question of reforming entitlement programs, the key driver of future projected deficits. And a standoff between the parties on tax policy – where the elimination of some tax breaks could potentially help fund deficit reduction – left that issue for future debate.

In all, many finance experts say deficits would need to come down by about twice as much – $4 trillion over 10 years – in order to stabilize public debt and prevent it from harming economic growth.

The upshot: It's still possible that, even amid relief that politicians reached a deal, the US will see its credit rating marked down a notch.

The move would be more than just an embarrassment. It could impose some tangible costs to the economy, such as marginally higher interest rates throughout the economy. At the same time, the word "downgrade" should not be confused with "default."

A downgrade by Standard & Poor's from AAA to AA simply means that a rating firm believes US fiscal policy could use some improvement.

In the absence of a debt deal, finance experts say a sharper downgrade would have occurred, because the Treasury would have been placed in a difficult scramble to make good on its obligations – from interest on public debts to unemployment insurance and federal salaries.

Currently, the federal government has been borrowing about 40 cents for every dollar it pays out in spending.

The ramifications of a downgrade could include an uptick in interest rates and a hit to stock prices, among other things. But it's hard to know how big the changes would be. S&P doesn't set interest rates, after all. It just offers an opinion to investors and lenders, who are basing their decisions on a range of factors.

In the case, investors already know a lot about the fiscal position of the US.

An analysis by economists at the investment firm Goldman Sachs says a downgrade might have moderate implications for the US economy:

• Treasury interest rates would be expected to rise, but perhaps less than 0.25 percent on the 10-year note. A rise in Treasury rates typically ripples outward to affect mortgages, car loans, and other credit.
• Fears that some money-market mutual funds would feel compelled to shift away from Treasury debts, if those debts no longer had the top-tier rating, may be overblown. "We don't believe there is a significant risk of forced selling of Treasury securities due to regulatory constraints of investment mandates," the Goldman economists say. Similarly, they argue that impacts on so-called "repo" credit markets (short-term lending) would not be large.
• The stock market might see a drop of about 1 percent, judging by past instances of downgrades affecting Japan, Spain, and Canada in recent years.
• The value of the dollar in foreign-exchange markets might weaken "by as much as a few percent."

In turn, all those consequences could be negative for economic growth. The impact might be modest, but would come at a time of minimal forward momentum.

All these impacts are hard to guess in advance. On average, nations that enjoy triple-A ratings from S&P have interest rates about 0.75 percent lower than AA-nations on their 10-year government bonds, according to a tally by Third Way, a Washington think tank.

But the US isn't just any nation. Even after a downgrade, Treasury bonds would still be viewed by many investors as an ultra-safe investment.

So a downgrade isn't necessarily cause for panic, but a top credit score would be a nice thing to hang onto.