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Earlier this month, Fitch Rating Service downgraded the United States’ long-term foreign-currency issuer default rating from AAA to AA+. The current administration condemned the downgrade and blamed the previous administration, while the opposing party more or less hailed the downgrade. We suspect identical narratives would prevail if the party in executive power were flipped.
We were curious about how Fitch rates debt issued by sovereign nations. According to its recent press release, Fitch derives its sovereign debt ratings from an in-house statistical model that uses historical data on 18 economy-wide variables. In other words, Fitch analysts plug in real-world data for each nation’s economy to a model, and the model generates a rating. However, an in-house committee often adjusts the rating to “reflect factors within its criteria that are not fully quantifiable.”
From the press release, we get a sense of the process. The United States’ general government debt-to-GDP ratio is 112.9%, well above the median of 39.3% for AAA-rated countries and 2-1/2 times higher than the median of 44.7% for countries rated AA+. If Fitch used only this measure, America’s credit rating would be much lower. But the general government debt-to-GDP ratio is one of only 18 variables in the formal model, and the company considers other factors.
The press release notes, “Several structural strengths underpin the United States’ ratings. These include its large, advanced, well-diversified and high-income economy, supported by a dynamic business environment. Critically, the U.S. dollar is the world’s preeminent reserve currency, which gives the government extraordinary financing flexibility.” Since the U.S. dollar is a reserve currency, central banks and financial institutions hold large amounts of dollars for international transactions. Being a reserve currency lowers the U.S. government’s borrowing costs.
The press release does not indicate how much these strengths affect the 18-variable model or how much they are incorporated in the post-model adjustment. Fitch did state that it did not adjust this year’s rating from the outcome implied by the basic model.
The top-line story is that the Fitch downgrade emerged from its perception that there “has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters” in the United States.
We agree with this assessment. Increased partisan bickering undermines confidence in the country’s fiscal integrity. That our political leaders are spending their energy either contesting or gloating over the timing of Fitch’s pronouncement confirms its accuracy.•
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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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