The US Must Focus On Lowering Fiscal Deficit To Overcome Uncertainties

in its May 16 announcement, Moody's Ratings downgraded United States’ ratings to Aa1 from Aaa. Moody's decision follows similar downgrades by S&P in 2011 and Fitch in 2023, leaving the United States without a single triple ‘A’ rating from the major credit rating agencies

The United States has always enjoyed a unique status as an advanced economy. The strong position of its dollar as the world’s largest reserve currency has ensured that a majority of international trade is designated in terms of dollar and the surplus foreign exchange reserves of other countries are held in the US by way of sovereign bonds.

It is also the largest destination in terms of majority share in world trade. The dollar as a currency plays an important and dominant role in international trade and the financial and forex markets. In fact, currency values of other nations get quoted in terms of its strength vis-à-vis the US dollar. The strength and vibrancy of the US economy is the guiding factor to ascertain the world economic growth. The economic, trade, financial and monetary policy of the US has a bearing on the global financial, equity, bond and currency markets. The other countries who are also yielding equal influence on global economic, equity, forex and financial markets are that of Europe, UK, China, Japan and India.

This unique strength is also reflected in the sovereign rating of Aaa, despite the large fiscal deficit as a percentage of GDP, which is much higher compared to other countries, which also enjoy a sovereign rating of Aaa. However, it is a fact that US can have a higher fiscal deficit as it could enjoy the trust of other countries, which place their surplus foreign exchange funds by holding US treasury bonds. This is helping strengthen the country and its dollar value.

This unique strength is likely to continue as currencies like Euro, Yen and CNY (Chinese yuan renminbi) yet to garner that unique strength even though there have been attempts to get alternative currency to act as reserve currency without much progress. The central banks of other countries have tries to diversify their investment into other currencies to bring about instead of having a single currency investment.

There have been efforts to invest the surplus in gold, whose demand has surged because of these.

There has been major trade policy shift by Donald Trump’s new administration like imposing reciprocal discounted higher tariffs to remove the US Trade deficit of $1.2 trillion. Even though it has led to a lot of uncertainty in international trade and retaliatory tariffs by some countries, particularly by China, which has led to trade war by more than 245 per cent tariffs. There has been a pause period of 90 days even though the base tariffs of 10 per cent have remained. There has been positive news that the US and China have had fruitful trade talks. A positive outcome is likely along with more than 90 countries having similar trade discussion actively considering mutually acceptable trade agreements with lesser tariffs and non-tariff barriers on both sides.

Give this situation, the US economy in the short term is likely to have a negative impact, although prices of commodities going high and supply chain disruptions. This may lead to inflation and unemployment amid a cloud of higher borrowings. These uncertainties also had an impact on the dollar index.

As a result of these uncertainties, in its May 16 announcement, Moody's Ratings downgraded United States’ ratings to Aa1 from Aaa. Moody's decision follows similar downgrades by S&P in 2011 and Fitch in 2023, leaving the United States without a single triple ‘A’ rating from the major credit rating agencies.

Moody's one notch downgrade is due to the more than a decade increase in government debt and interest payment ratio levels that are significantly higher than similarly rated sovereigns. Moody's concern has been highest fiscal deficit reaching nearly nine per cent by 2035, up from 6.4 per cent in 2024, driven by mainly interest payments on debt, rising entitlement spending and relatively low revenue generation.

Moody has also stated that federal debt burden may likely be 134 per cent of GDP by 2035 as against the 98 per cent in 2024. The ratings further add that without adjustments to taxation and spending, Moody's expect budget flexibility to remain limited, with mandatory spending, including interest expenses, projected to rise to around 78 per cent of total spending by 2035 from about 73 per cent in 2024. It further adds that if the 2017 tax cuts and jobs Act is extended, which is their base case, it will add around $4 trillion to the federal fiscal primary deficit (excluding interest payments) over the next decade. Concerns have been expressed in terms of federal interest payments absorbing around 30 per cent of revenue by 2035, up from 18 per cent in 2024 and nine per cent in 2021.

In spite of its significant economic and financial strengths, Moody believes that these no longer fully counterbalance the decline in fiscal metrics as regards the United States.

The current rating action is not likely to have any significant impact as the agency also changed its outlook from negative to stable noting that despite the United States poor record tackling rising government debt levels, the country “retains exceptional credit strengths such as the size, resilience and dynamism of its economy and the role of US dollar as a global reserve currency”.

The April Fiscal Monitor has called for countries to put their fiscal house in order as the rising global debt levels are likely to increase by 2.8 per cent this year more than twice the estimates for 2024-pushing debt levels more than 95 per cent of gross domestic product with public debt bearing 100 per cent of GDP by the end of the decade. It is therefore necessary for every country to be mindful of their fiscal position amidst heightened uncertainties and policy makers have to deal with complex tradeoffs between debt, slower growth and quality of spending and priorities of new spending pressures. There ought to be special plans to gradually reduce fiscal deficit as well as have fiscal buffers to meeti future uncertainties.

(The author is former Chairman & Managing Director of Indian Overseas Bank)