UPDATE: S&P Affirms Ratings on U.S.; Outlook Stable

On June 6, 2014, Standard & Poor's Ratings Services affirmed its 'AA+' long-term and 'A-1+' short-term unsolicited sovereign credit ratings on the United States of America. The outlook on the long-term rating remains stable.

RATIONALE

The sovereign credit ratings on the U.S. are supported by the resiliency and diversity of its economy, its institutional strengths, its extensive economic policy flexibility (including its management through the 2008-2009 global financial crisis, particularly its innovative monetary policy), and its unique status as the issuer of the world's leading reserve currency. A higher degree of political brinksmanship in recent years--that complicates the policy decision-making process, resulting in a somewhat weaker ability to enact reform--constrains the ratings. The general government debt burden has doubled since 2007. Although it is projected to hold steady over the next several years, we, along with many other observers, expect the general government debt burden to rise toward the end of the decade absent measures to raise additional revenue and/or cut nondiscretionary expenditure.

With a per capita GDP of US$54,750 for 2014, the U.S. ranks 14th out of the 129 sovereigns that Standard & Poor's rates in terms of income level. The breadth and depth of the U.S. economy, coupled with a track record of proactive policymaking at the depth of the recession, underpin the recovery since that time. The level of real GDP is 11% higher than its nadir in second-quarter 2009. Although the recovery has been subpar compared with previous rebounds, it has occurred from the deepest economic downturn since 1929. The pace of the U.S. rebound also compares favorably with those of its advanced economy peers. Long-term potential growth, however, has declined, in our view. It is likely to be closer to 2% rather than 2.5%, reflecting aging demographics (which contribute to labor force participation being at a 36-year low) and diminished labor productivity gains over the past decade compared with the postwar average.

However, over the next several years, we expect real GDP growth of 2.5%-3.5%. This growth rate is supported by a revival in manufacturing due to competitive labor costs and the lower cost of natural gas stemming from increased shale gas production. In addition, deleveraging in the U.S.'s household sector is more advanced than it is for European peers, and the U.S. banking system has bolstered its financial strength more through raising capital than deleveraging. Compared with prior years, we expect less fiscal drag at the federal, state, and local government levels (together, the general government) in the near term. As economic and labor market conditions have improved, the Federal Reserve has begun a slow process of normalizing monetary policy. Long-term unemployment, while down, remains high, at more than twice that of prerecession levels, and with its concentration in the young and the old, poses a policy concern.

The U.S.'s policymaking and political institutions tend to be transparent and accountable. The checks and balances of the U.S.'s system of government have generally generated a stable backdrop for economic prosperity and the free flow of information, notwithstanding the recent budgetary debates. Unparalleled economic data in terms of timeliness and coverage are readily publicly available. A strong civic society, political stability, respect for property rights and the rule of law, and success as a driver of innovation have supported economic prosperity and underpin the U.S. dollar's status as the world's premier reserve currency.

This reserve currency status affords the U.S. significant flexibility in its external accounts. Taking into account the key reserve currency status, as well as the degree to which the U.S. has supplied liquidity around the globe in recent years, our political and economic analysis suggests that the U.S. has unparalleled external liquidity. The external analysis is complicated by the dominant reserve currency role. Whereas the ratio of external debt, net of liquid assets, averaging about 360% of current account receipts (CAR) during 2014-2017, is high compared with the ratios of most sovereigns, the overall net external liability position of the U.S., at 195% of CAR over this same period, is much lower. In addition, the debtor position may be overstated, considering currency issues, composition considerations, and the difficulty of recording multinational activity of U.S. private companies in offshore centers.

Valuation effects on the U.S.'s external assets and liabilities, including derivatives, dominate the external stocks vis-à-vis the balance of payments cash flows. The current account deficit declined to 2.3% of GDP as of 2013 from a prerecession 2006 peak of 5.8% of GDP, and we expect it to remain around this level. Prospects for ongoing shale gas and oil production could turn the U.S. from a net energy importer to potentially a net energy exporter. In October 2013, domestic production of crude oil was higher than imports for the first time since 1995. The significant increase in natural gas
production--with the U.S. the largest natural gas producer in the world--will support natural gas exports.

At the outset of the 2008-2009 recession, the Federal Reserve Bank acted promptly and innovatively to staunch the collapse in credit. It provided exceptional support to broker-dealers, commercial paper issuers, mutual funds, large insurance companies, U.S. offices of foreign banks, and foreign central banks, to name a few. These operations have since been wound down. At the same time, the Fed has supported monetary conditions through balance sheet expansion, having reached the zero bound in interest rates in 2008. The Fed's holdings of government securities and mortgage-backed securities rose to $4.1 trillion (24% of GDP) at the end of May 2014 from $741 billion in December 2007 (5% of GDP). In our view, the Fed will likely begin to rein in its balance sheet only after the first hike in the federal funds rate (which could be in the second quarter of 2015). In preparation for this normalization, the Fed has developed its tools to manage the process, including paying interest on bank reserves and expanding the list of eligible counterparties for reverse repurchase transactions. We believe inflation expectations are well-anchored, as evidenced by the yields on 10-year TIPS (government inflation-linked notes).

The stability and predictability of U.S. policymaking and political institutions, while high, have weakened in recent years, in our view. We find that the political impasses have impeded more effective policymaking compared with some of the U.S.'s other peers. This is underscored most recently by the simultaneous acrimonious debates in October 2013 about raising the debt ceiling and shutting down the government. As we expected, a last-minute compromise was struck, but we find the repeated shorter-term nature of political fiscal calculations and deal-making to be negative credit factors.

That said, some agreements have been struck. Both parties reached across the aisle to conclude The Bipartisan Budget Agreement (BBA2013) in December 2013. BBA2013 provided partial relief from the automatic sequestration of discretionary spending in fiscal 2014 and fiscal 2015 (by a combination of higher revenues, spending reductions, and extending sequestration beyond its previous end date by an additional two years); the agreement on overall discretionary spending levels should facilitate funding appropriation through fiscal year-end Sept. 30, 2015. The same was done to avoid the so-called "fiscal cliff" in December 2012 as both parties passed the American Taxpayer Relief Act (ATRA2012), making permanent some expiring tax cuts and allowing high-income tax cuts to expire.

However, more ambitious steps to stem rising medium-term fiscal pressures do not appear to be in the offing. Although both parties agree on the need to lower the government debt burden, the discussions about how this might be achieved are acrimonious. In the near term, including the run-up to the presidential elections in 2016, we do not expect entitlement or tax reform to advance. We believe that renewed debate over the debt ceiling could resume after the midterm elections in November 2014 under certain scenarios. While we expect the discussions about the debt ceiling to be ultimately resolved as they have been, we still see risks that these debates entail.

Against this backdrop, we see that the fiscal position of the U.S. has, in fact, improved from 2009 on a flow basis, namely a decline in government deficits. The improvement is part cyclical and part structural following from policy decisions: namely implementation of the Budget Control Act of 2011 (BCA2011), ATRA2012, and BBA2013.

Under our criteria, our primary fiscal metric on the flow side is the change in general government debt. The change in debt results mostly from yearly deficits but also from off-budget activities, such as net lending. The general government deficit (as stated in the National Income and Product Accounts on a calendar-year basis) has declined by half, to 5.9% of GDP in 2013 from 12% in 2009. Most of this improvement stems from the federal government, due to cyclical improvements in revenue, the rescinding of the temporary reduction in social security contributions, higher tax rates on high-income earners, and expenditure restraint due to caps that the BCA2011 imposed. The change in general government debt also includes such items as the increase in direct student loans (that has averaged about 0.8% of GDP a year) and the imputed interest cost of unfunded pension obligations (about 1% of GDP a year).

With the rebasing of GDP in 2014, the ratio of net general government debt to GDP is about 80% of GDP. Given our growth forecasts and our expectations that credit conditions will remain subdued, thus keeping real interest rates in check, we expect this ratio to remain stable through 2017, at which point it will begin to deteriorate again without a policy response. We view contingent liabilities emanating from the U.S. financial system as limited, as our criteria define the term.

OUTLOOK

The stable outlook incorporates our view that there is less than a one-in-three likelihood that we will change the ratings over the next two years. We do not see material risks to our favorable view of the flexibility and efficacy of monetary policy. We believe U.S. economic performance will match or exceed its peers' in the coming years. We expect the external position of the U.S. on a flow basis will not deteriorate.

The 'AA+' rating already factors in our view of the lesser ability of U.S. elected officials to react swiftly and effectively to public finance pressures over the longer term in comparison with officials of some more highly rated sovereigns, including the prospect for repeated divisive debates over raising the debt ceiling. We expect these debates to conclude without provoking a sharp discontinuous cut in expenditure or in debt service. However, some measures taken in extremis to address a debt ceiling impasse could be construed as a default under our criteria, such as unilaterally extending debt maturities, even if for short periods. Of lesser consequence, we see some risks that continued improvement in economic performance could lead to complacency in addressing the nation's medium-term fiscal challenges. Less likely than complacency but more consequential for the rating, a deliberate relaxation of fiscal policy without countervailing measures to address the nation's longer-term fiscal challenges could lead to a downgrade.

We could raise the rating to 'AAA' if we see additional evidence of bipartisan efforts that signal a lower degree of political brinksmanship around fiscal policy decisions, coupled with a general government debt burden decline more pronounced than we currently expect. This could result from implementation of bolder medium-term fiscal policy measures or a more robust growth trajectory.

KEY STATISTICS

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