By Dennis Shen, Senior Director, Sovereign and Public Sector

Scope’s baseline scenario has been for the Federal government to suspend (or raise) the debt ceiling at the 11^th hour. President Joe Biden and congressional leaders are scheduled to meet this week amid signs discussions are making progress. But sticking points remain and the approval process through Congress is anything but straightforward.

While any given debt-ceiling episode such as the present iteration is more likely than not to be ultimately resolved, repetition of such severe episodes raises risks in the long run. Such acute risk during severe debt-limit crises may be incompatible with credit risks characteristic of an AA-rated borrower.

Each debt-ceiling crisis creates financial-market instability. Recurring debt-ceiling crises have resulted in phases of debt repayment distress for the Federal government and dependence on last-minute congressional actions to ensure repayment of debt in full and on time. A technical default in 1979 furthermore debunks the notion of debt-ceiling stand-offs being inevitably resolved on time.

Debt-limit risks are a unique vulnerability of the United States’ creditworthiness

The non-negligible possibility of temporary non-repayment of debt during specific and severe debt-limit episodes constitutes a unique vulnerability among the United States’ highly-rated sovereign peer group.

Positioning at the front end of the Treasury curve for the period straddling a possible early June X-date – the day when extraordinary measures are exhausted – highlights market concerns about the outcome of present debt-ceiling negotiations. The spread between one-month and five-year Treasuries remains near a record high of about 235bp, from -133bp on average in 2022. The cost of insuring against US sovereign default also hit multi-decade highs: one-year credit default swap spreads are about 150bp from 14bp at the start of 2023 and above levels from the 2011 debt-ceiling crisis.

Under any scenario where the X-date is surpassed, (a short) technical default becomes more likely (even if such default would nevertheless not remain our baseline). A contingency plan could be used to prevent short-run failure to pay. In 2011, a never-used contingency blueprint was drafted that included payment delays to agencies, contractors, Social Security beneficiaries, and Medicare providers. The President could also consider invoking the 14^th Constitutional Amendment. However, such unprecedented measures each hold meaningful consequences and could face legal and/or constitutional challenges.

Treasury Secretary Janet Yellen suggested it would be better for the US legislature to permanently remove or reform the debt ceiling. Any such step – even if unlikely – could re-anchor the credit ratings.

Federal deficits to stay higher than normal

The credit standing of the United States is challenged by several factors beyond the debt ceiling. Challenges include governance hardships of a divided nation; economic and banking-system risks as the Federal Reserve completes its rate-tightening cycle; comparatively elevated government debt; the economic and fiscal implications of an ageing population; and external-sector vulnerabilities.

Risks to financial stability also reflect decreased liquidity in Treasury markets. Vulnerabilities have emerged this year following the failure of several regional banks. Although swift and prudent intervention from authorities prevented spread of the crisis to other segments of the financial system, financial-stability risk is expected to remain a theme in the coming years.

Unless there is significant spending reform as part of the resolution of the current crisis, Federal deficits will likely stay higher than “normal” over coming years. Budget deficits reduce the space the Treasury has to take emergency action in meeting government spending obligations during debt-limit crises – raising associated risk. Treasury cash reserves dropped to USD 155bn by 8 May 2023 versus USD 964bn a year before (Figure 1). Treasury reported only USD 88bn of remaining extraordinary measures as of 10 May, from an originally-authorised USD 333bn.

Figure 1. US Treasury deposits at Federal Reserve Banks, General Account (USD trn)

Source: Federal Reserve, Scope Ratings

Scope expects the United States’ general government deficit to grow to 6.2% of GDP this year before stabilising around a 7% average over 2024-28 (compared with a 4.8% average of 2015-19). This projection accounts for deficit-raising policies adopted recently, such as the student loan forgiveness programme, spending pressures from an ageing population, as well as higher debt-servicing costs as debt is refinanced at higher rates.

US government debt ratio to rise gradually

Because the average maturity of US Treasuries is a moderate 6.1 years, annual government gross financing requirements are meaningful: 32% of GDP this year before averaging 28% during 2024-28. The improving US general government debt-to-GDP ratio is expected to start reversing this year, as debt edges up to around 122.2% this year from 121.7% in 2022, and to 135% by 2028. Persistent deficits outweigh the favourable effects of continued economic growth and higher inflation for longer.

Read Scope’s 5 May rating announcement on the United States.

Contributing Writer: Keith Mullin

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