Effect of Debt Limit/Debate on Credit Rating of US - Research Paper Example

Running Head: EFFECTS OF DEBT LIMIT/DEBATE ON CREDIT RATING OF U.S The outline of the study is as follows: (a) Introduction...………………………………………...........................p 3 1.0 Brief history and Definition of Debt Limit..........................................p 3 (b) Discussion 1.0 Impact of Federal Default..................................................................p 4 2.0 Key Agencies of Credit Rating.............................................................p 4 3.0 Congress Legislations and impact of debt limit debate.................................p 5 4.0 Potential effects of debt limit on credit rating....................................p 6 (c) Conclusion.............................................................................................p 9 a) Introduction This paper will seek to provide an account of the potential effects of debt limit/debate on credit rating of United States. It will identify the key agencies and explain the process of credit rating. The research paper will attempt to analyze the impact of recent debates on the United States debt and current legislations. In Washington, the Government’s debt limit has been the focus of heated debate. This has been the case because Economists and Politicians argue that in order to be in a position to avoid economic disaster, the debt limit must be raised. Without due regard to the debt ceiling increase only providing temporary and a respite that is superficial, such a move is favored by those who give too much weight to the impact of the debt limit. Debt limit or debt ceiling can be defined as the legal limit on the total amount of gross debt that can be issued by the Federal government. In U.S. the debt limit has been raised seventy four times since 1962, which includes ten increases during the last decade. According to Pew Fiscal analysis Initiative’s ‘Fiscal facts: The U.S. Debt Limit’, the treasury reached the current limit of about $14.3 trillion in May. Since then, the government has taken measures to avoid more borrowings. According to the treasury, if the debt limit is not raised, Federal salaries, Social security checks or aids to state might be held back in order for the bondholders to be paid back. The government would still be in default if it was not possible to meet other financial obligations. b) Discussion If the President and congressional leaders fails to get a deal to raise the federal debt limit, the consequence can be failure of the government to be in a position to borrow in order to clear and meet its financial obligations. Policy makers of the federal government, opinion leaders, as well as the media puts focus on how the federal default might impact the national economy and afterwards, the global markets (Austin, 2010). The failure to link fiscal policies decisions to changes in the debt limit can be cited as a weakness in the process. Credit rating agencies when assigning a credit rating to sovereign nation’s debt considers a number of factors including the national economy strength, government debt overall level, monetary policies and budgetary framework. The debt limit has not compromised the US AAA credit rating but the credit rating agencies have raised concern about segregating the vote for increasing spending and revenue decreases that raises debt from the vote for additional borrowing. One of the agencies for credit rating attributed the delinking as a to have a negative effect and as weakness in the U.S. budgetary framework. Another suggestion from the second credit rating agency was anything that has potential to cause delay on timely federal debt redemption is viewed as negative. Back in year 1996, Moody’s Investors Service indicated that there was a possible downgrade for some treasury securities with the payments of interest coming due in the form of parts because the treasury had nearly exhausted all the options it had for managing debt near the debt limit. Some of the experts believed that the debt limit has contributed and served an important purpose in highlighting the growth of Federal debt (Langohr and Langohr, 2008). Budget resolution reflects aggregate decisions on fiscal policies and should be used to consider the implied level of debt by those decisions. The budget resolution serves the purpose of setting out the spending revenues level and debt for the current and next four fiscal years. Increasing the debt limit could tie spending and revenue decisions to the debt level effect of these decisions. It could not take into consideration increase in debt arising from an economic downturn. The congress enacted three legislations in 2008 and 2009 to respond to the crisis in financial markets and economic downturn. The Housing and Economic recovery act of 2008, the emergency stabilization Act of 2008 and the Recovery Act included a provision increasing the debt limit that was separate. Debt limit debates provided opportunities for both the president and the congress to take into considerations the implications of past fiscal policy decisions on borrowings by the federal government. The debate also played a role in budget enactment process agreements intended to decrease the growth of federal borrowing in future. The debt limit debate was however, believed to play a smaller role in fiscal policy discussions in recent year than it had in the past and given the already increasing attention to debt and deficits, debt limit is not expected to be needed in future to trigger debate over federal borrowing. Some risks were also associated with the debate such as the congress potential to delay or miscalculate the debt limit increase timing given the small amount of borrowing provided by the actions that were extraordinary. The federal government must borrow to make up for the shortfall, if the government does not collect enough revenue for its spending. Examples of Federal debt include securities such as bills, notes, and bonds, which are issued by the treasury and other agencies of the government. The debt limit or debate does not take control or limit the ability to run deficits or incur obligations by the federal government. It is just a limit on the ability to pay bills incurred. Debates surrounding the debt may raise awareness about the current debt trajectory on the Federal government. It may also provide congress with an opportunity which it can utilize to debate the decisions on fiscal policy that drives the trajectory (Docs.google.com, 2011). States and localities are not allowed to borrow money to close any shortfalls on the budget. All states are required by the constitution to balance their budgets by cutting spending and raise taxes to close the budget shortfalls. The local governments have also imposed substantial cuts to compensate for declining state aid and revenue from property tax. Securities from the treasury are backed by credit and also by full faith of the government of United States because of their perceived safety and thus treasury securities play a role that is critical in global financial markets. Treasury securities have an interest rate which can also be referred to as riskless rate. This rate serves the role of benchmarking in terms of the additional risks which many other financial instruments and assets are calculated. Rating agencies give treasury securities a bond rating of AAA or its equivalent because they are considered to be safe. Default by the Federal could lower the investors’ confidence in all government held assets. The Federal default could be disruptive to global financial markets and this cause the municipal market to be swept in the wreckage. Interest rates for municipal bonds have historically been tied to treasury securities closely and if the Federal government defaults, the borrowers of municipal debts would be affected by higher borrowing costs and an access to credit that is limited. United States downgrade would prompt review of local and states credit. United States default would thus make the municipal debt to be more attractive as the investors will search for assets that are attractive to replace the treasuries assets. Regardless of credit rating histories that are strong, some issuers of AAA rated state and local government securities might be downgraded. A lower rating would make borrowing more expensive for them and this might as well have consequences in their operations. The debt limit has intensified the effort to lower the $1.4 trillion federal deficit that is projected for fiscal year 2011. The budgets and borrowing of cities and states could be affected by measures being considered to be put by Washington to cut deficit. In the fiscal year 2012 proposals and also final appropriations for fiscal year 2011 had been significantly cut with regard to Community Development Block Grants. This program is designed to help improvement of housing options for low rate and moderate income families. Possible cut is also to Low Income Energy assistance Program which is aimed at providing grants to states in order to help with heating and cooling costs to the homeowners. Another proposal by the government is possible cuts in Medicaid. It the Federal state matching program that made up twenty one percent of states’ budget in fiscal year 2009. Currently, the government is contributing fifty six percent of the total costs of Medicaid. The result of some proposals is that states would pick up more of the tab or coverage cutting or cutting eligibility. Some proposals could be making it much expensive for local government and states to borrow money for infrastructure. The president and appropriators for the republican have proposed a cut that is significant to Drinking Water and Clean Water State Revolving Funds which are the source of capital to state funds that normally provides lending for improving infrastructure for wastewater and drinking water. There is a worry that exemption of federal tax on municipal bond that was newly issued could be scrapped off. This has been suggested by some deficit panels because over the next five fiscal years that is, 2012 to 2013, Office of Management and Budget estimates can cost the Federal government $230.4 Billion. The investors would hence demand returns that are better to buy municipal debt without the exemption and this makes borrowings for cities and states to be more expensive. Experts concerning Budget have advocated for the ending of the mortgage interest deduction or its modification. This proposal could carry a huge impact on localities and states through home prices that are lower, assessment and collections of property tax and spending of consumers. There could be a serious impact caused by a federal default on states and cities. Their borrowings and budgets could be constricted still in this time they are still feeling the Great Recession aftershocks. States and cities dependant on federal money means that they a vulnerable of the pain of cuts in the budget. Understanding on how cities and states are affected is crucial as policy makers in Washington debate the debt limit and federal deficits reduction options. Failure to increase the debt limit would result to United States defaulting on some of its loans and thus its credit rating would be adversely affected. Interest rates would rise because the lenders would be forced to charge a premium for the risk added by the possibility of default. However, raising the debt limit does not eliminate this threat and will continue being a threat if the government does not contain its debts and appending. If the government raises the debt ceiling but does not address the debt problem, the government borrowing will continue to rise and the demand for money in the loanable funds market rises consequently, raising the interest rates. To restore long term economic growth, the government must put in order structural reforms which include cuts that are dramatic in federal spending, entitlement programs restructuring, and realization that the economy is an ongoing product of hard work of the people. Meaningful steps must be taken to bring about economic recovery. c) Conclusion Failure to address the issue of raising the debt limit could lead to serious and negative outcome in the treasury market. It can also lead to negative consequences on the ability of United States to finance Federal debt at the lowest cost over time. It can create uncertainty in the treasury market. Some of the action taken by the treasury to manage the debt amount near the debt limit such as reducing the size of auctions, can be a compromise to the certainty of supply that Treasury relies on to help it achieve over time the lowest borrowing costs. The uncertainty caused can in turn, raise the federal debt cost of financing (Irving and Engel, 2011). Growing debt burden projections have raised concern both in congress and the public. The federal government’s long term fiscal challenge issue can be addressed by well designed budget processes and metrics. The prevailing design of the debt limit does not facilitate debate over specific spending proposals or over specific tax proposals and their effects on the debt. The uncertainties created can cause disruptions in the treasury market and in turn, causing higher borrowing costs. In order to avoid disruptions to the treasury markets and to help inform the debate on fiscal policy in a manner that is timely, there should be considerations by the congress to better link debt limit decisions with decisions on spending and revenue. References: Austin D. (2010). Debt Limit: History and Recent Increase. Diane Publishing. Docs.google.com. (2011). The debt ceiling debate. Retrieved: 21st September 2011 http://docs.google.com/viewer?a=v&q=cache:1um0YmBxMksJ:www.pewcenteronthestates.org/uploadedFiles/Pew_debt_ceiling.pdf+Effect+of+Debt+Limit/Debate+on+Credit+Rating+of+US&hl=en&pid=bl&srcid=ADGEESjL4PosdCkOUJhDAQl519FdNJFAlUv_BiveEoEg9fI4dz5gIf88vZcnwegtyQdsCjuNUKAMCfjrGH42ZxC9rwzlqGawfR4oRIvJSDZQWJAe39MYNb8rKvaEwBcXU0KXTNh5Zp1H&sig=AHIEtbQdDywIXfcbyB7Rs8Es9TgwLijH9w Irving, J. Engel, T. (2011). Debt Limit: Delays Create Debt Management Create Debt Management Challenges and Increase Uncertainties in the Treasury. Diane Publishing. Langohr, M. Langohr, T. (2008). The rating agencies and their credit ratings: what they are, how they work and why they are relevant. Illustrated. John Wiley and sons Levit, R. (2011). Reaching the Debt Limit: Background and Potential effects on government Operations. Diane Publishing. Read More