The US and the UK are moving closer to losing their AAA credit ratings as the cost of servicing their debt rises, according to a Moody’s Investors Service report.

US: The ratings agency says  the pattern of growth and the high rate of unemployment raise the question of how strong the recovery will be going forward. The federal government budget assumes a 2.7% real growth rate in 2010, with private forecasts slightly higher. This figure is less than the average growth rate during the ten years up until 2007, which included a mild recession following the bursting of the “high-tech bubble.” During the same ten years, personal consumption rose at an average annual rate of 3.6%, and it appears unlikely to match that rate in the near term. Ultimately, the ability of the US economy to grow more rapidly and, therefore, for government revenues to contribute to fiscal consolidation, will have to depend on a revival in the growth rate of consumption. The need for fiscal consolidation, a poor (but stabilizing) housing market, and low capacity utilization that affects the level of business fixed investment all indicate that other areas of the economy are unlikely to provide strong growth impetus.

In the budget announced in February for fiscal year 2011, the administration estimates that the federal deficit in the current fiscal year will rise to 10.6% of GDP, the highest level since 1946. For the second consecutive year, total revenues are estimated at 14.8% of GDP, down from 18.5% in 2007 and a recent peak of 20.6% in 2000. The 2009-2010 level of receipts as a proportion of the economy is the lowest since 1950. While this revenue drop shows the severe effects of the recession (and tax reductions that formed part of the stimulus package) on the government’s fiscal position, the exceptionally low level of revenue also indicates that there is room for increasing revenues once the effects of the recession recede.

Expenditures also are setting post World-War-II records, with the current year showing a peak of 25.4% of GDP and FY 2011 only slightly lower. The high levels of expenditure in these two years represent stimulus spending as well as peak spending for defense, although the latter is lower as a percentage of GDP than during the decades from 1950 to 1990.

Moody's says the very high deficit in the current fiscal year will bring federal government debt to 64% of GDP, according to the budget estimates, compared with 40% two years earlier. Because of the drop in revenue, the ratio of debt to revenue will reach 430%, more than double its level at the end of FY 2007. Nonetheless, for the time being the affordability of the much larger debt has not deteriorated, with the ratio of interest payments to revenue falling to 8.7% in the current year from a recent peak of 10.0% in FY 2008. During the period through 2013, this ratio should rise but remain well below levels reached during the 1980s, according to the budget.

At the general government level (including state and local governments), a measure used for international comparison purposes, the level of debt in relation to GDP will rise to 92% at the end of the current year before reaching 101% by 2013. While this is a very high level, the affordability of the debt, with interest/revenue at 10% in 2013, will just breach the bottom of the reversibility band. Nonetheless, both federal and general government affordability is growing more vulnerable to any shift in market confidence that would lead to higher interest rates than assumed in these projections.

UK:  Moody's says a muted pace of recovery creates downward risk for debt affordability. The risk is that tax receipts recover more slowly and less fully than initially envisaged. This would accelerate the ongoing deterioration of government debt affordability as captured by the ratio of the cost of servicing the debt to government revenue. The relatively low level of public debt at the start of the crisis (44% of GDP for gross debt) created fiscal space and allowed the government to counter the rise in private savings in the form of very large public deficits. This fiscal space is currently being used to the full and public debt is rising rapidly. Under current government projections, it is projected to stabilise at around 90% of GDP in the coming years. The risk, if tax receipts fail to recover quickly enough, is that debt rises even further.

As the level of debt rises, affordability becomes increasingly sensitive to the government’s cost of funding. So far, the government has benefited from favourable market conditions, with the UK Debt Management Office generally issuing long-term debt at yields that have remained below the long-term nominal growth potential of the UK economy. The ratings agency says the extent to which the purchase of £198 billion of gilts by the Bank of England in the context of its quantitative easing policy (£4 billion in excess of the total amount of gross gilt sales by the UK Debt Management Office over the same period) has distorted prices in favour of the government is debatable. If the initial IMF estimate of 40-100 bps is broadly accurate, however, the discontinuation of these purchases, announced by the central bank on 4 February, creates upside risk to yields. At a minimum, it exposes the government more directly to market scrutiny. Despite the long average life to maturity of public debt in the UK, debt affordability to a level that, if it were maintained over time, would not be consistent with a Aaa rating.

Moody's says against a background of stretched debt affordability, the Aaa rating of the government therefore relies on an assessment of high debt reversibility, i.e. a strong ability on the part of the government to restore its debt to more affordable levels through resolute action. The question here is less when fiscal retrenchment ought to start, but rather how credible it is that sufficient retrenchment will eventually take place. A loss of confidence in eventual fiscal tightening by markets (causing yields to rise) or by consumers (resulting in rising precautionary savings) could each complicate the adjustment.

Current UK government projections assume a fall in total managed expenditure from 48% of GDP to around 43% of GDP over the next five years. They also assume a gradual rise in the tax-revenue-to-GDP ratio from approximately 33% to 35.3%. Moody’s believes that there are margins on both sides to generate additional budget resources if required. Such additional efforts would not be out of line with historical precedents and would be politically feasible, in a context where the public support to fiscal consolidation remains strong in our view.