US Credit Downgrade: Implications for Indian Investors

The US always pays its debts – this popular belief has come to question lately.

Fitch Ratings, one of the important credit rating agencies alongside Standard & Poor’s & Moody’s, downgraded the US’s credit rating to AA+ from AAA on August 1, 2023.

Here we understand why the US was downgraded and what it means to Indian equity investors.

Why the downgrade?

First things first – When a company or a government gets a credit rating, it predicts the likelihood of debt repayment by them.

The rating downgrade signals that the finances have worsened, and lending to that company or the government has become riskier. When the US’s sovereign rating was downgraded from the highest credit rating of ‘AAA’ to ‘AA+’, which is one notch lower, it implies the same.

Like companies seeking funding for their operations and expansions, governments borrow, too, for several reasons, including spending on public projects and providing financial assistance to individuals and businesses to boost economic activity and create jobs.

Over the years, the United States has accumulated a significant amount of debt. It also breached the ceiling limits set for itself to avoid any defaults. So, they reached a point where they had to make fresh borrowing to finance previous borrowings.

On 1st August 2023, Fitch Ratings downgraded the country’s ratings citing that the US government’s fiscal deficit (managing expenses & income) is deteriorating with growing debt and governance issues.

After this announcement, many US officials and public policy commentators criticized Fitch’s decision saying that it did not make sense.

Whatever is said and done, the downgrade happened. The US will now rank below a few high credit-rated countries – Germany, Singapore, and Australia. 

However, note that this rating is not permanent. If the rating agency believes in the future that the US’s finances have improved, they could upgrade to AAA again.

Consequences

The downgrade signals that lending to the US government has become riskier.

This should increase their borrowing cost as investors want to get compensated for higher risk. This must theoretically reflect in the upward movement of yields on government securities (also known as US Treasuries).

As the yields go up, bond prices fall; there is an inverse relationship between yields and bond prices.

As US treasury rates are the benchmark to other lending rates, the interest rates in the economy are expected to go up as well.

Because of higher interest rates, stocks could tumble. Why? Because bonds could become attractive compared to equities. Further, companies’ profitability could also come down due to higher interest costs. There could also be slow down in the fresh investments by corporates, which could eventually result in a weaker economy.

Well, this is all what the theory says. To what extent it plays out depends on many other factors.

In fact, since August 1, 2023, when the downgrade happened, the 10-year US treasury yields went up from 4.03% to 4.25% (as on September 15, 2023). On the other hand, the S&P 500 index, the most commonly followed index in the US, was down by 1.5%. 

By the way, remember, the fall in bond prices and stocks as mentioned above, may not be necessarily due to the downgrade. It could be due to other factors as well. 

Impact on the Indian stock market

They say, “when the US sneezes, the world catches a cold.”

Generally, the first thing you notice after any disturbance or disruption in the US or anywhere in the world is foreign outflows from emerging markets, including India. This increases market volatility in the short term.

If the US economy becomes weak, the Indian export market could also be affected which will result in profitability of India Inc. 

But this downgrade doesn’t seem to be so serious. Here is one of the top voices in the economics and fund management space in the US- Mohamed El-Erian, President at Queens’​ College, Cambridge said on LinkedIn, “this announcement is much more likely to be dismissed than have a lasting disruptive impact on the US economy and markets.”

Global markets are interconnected and understanding how events abroad impacts India is important. But this is not the only factor. 

The Indian markets have been on sideways for about a month after the downgrade, but seems to have gained traction after that (yet to see if there are any long-term implications). 

As of now, Moody’s is the only agency that maintains a AAA rating. If you wonder about India’s rating, it has Baa3/BBB- rating, just a notch above junk status. The Indian Government has been pitching for a rating upgrade for sometime now.

Anyways, in the face of such uncertainty and volatility in the stock market, staying long-term in the market is considered a good strategy for most investors.

After all, both Indian and US markets and economies have come a long way since the US’s first downgrade in 2011 by S&P. Equity has been a proven asset class to deliver inflation-beating returns in the long-run.