What happens if US credit rating drops? Other countries offer clues.

Credit ratings aren't the only determinant of interest rates. AA-ranked Japan pays lower interest rates than any AAA-ranked nation. So what makes the difference?

A downgrade in America's credit rating is now a distinct possibility. That's true even if politicians in Washington reach a deal to raise the nation's debt limit while curbing federal deficits.

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Credit-rating firms are focusing not just on whether a deal gets done, but also on the uncertain outlook for the nation's future fiscal health. The debt plans currently under consideration don't rise to the level of the "grand bargain" needed to stabilize the national debt at an economically safe level.

But even if a rating downgrade occurs, that doesn't automatically mean financial catastrophe.

Consider the contrast between nations that have the strongest rating ("AAA") from Standard & Poor's and nation's that are one notch down, at AA. Often it's hard to tell, from their interest rates, which is which.

Canada enjoys a triple-A rating, and bond investors currently demand an interest rate of 2.93 percent (as of earlier this week) on its 10-year government bonds. Chile's 10-year bonds are rated lower, at AA, yet have an interest rate of 2.92 percent.

So a slightly lower credit score doesn't necessarily push interest rates dramatically higher. In fact, AA-rated Japan sports a lower yield (1.09 percent) on its 10-year bonds than any nation in the triple-A camp, according to a recent tally by the group Third Way.

One reason for the seeming anomaly: Interest rates are driven by a variety of factors that affect investors, not just the rating from S&P or another firm. The propensity of families in Japan to buy bonds from their government is one example.

This doesn't mean US policymakers shouldn't strive to keep the best rating possible on US debt. Overall, the triple-A countries had average interest rates of 2.98 percent, substantially lower than the double-A average of 3.75 percent. That's real extra money that taxpayers of those lower-score nations have to pay every time their governments go out to borrow.

Also, a credit downgrade can have effects that go beyond interest rates.

The rise in borrowing costs can cause stock prices to fall (often about 1 percent on the day of a downgrade, according to Goldman Sachs). A downgrade could also have similar negative ripple effects for other credit ratings (such as some municipal bonds), for the foreign-exchange value of the US dollar, and economic growth.

At the same time, the impact of a downgrade shouldn't be exaggerated. Unless the US actually defaults on some of its debt (including being late in making payments), the impact of a downgrade for credit markets might be modest ? a disturbance rather than a financial panic.

An event of actual default by the Treasury would be a different and more difficult story.

The government's credit rating would be downgraded more severely, and investors would respond with greater worry, financial analysts say

"There's no guarantee the United States would return to its current top-level rating once it was out of default," wrote investment firm Charles Schwab in a comment to clients.

To some extent, the rattling of investor faith could last for years.

America is in a much stronger fiscal position than Greece, but that Euro-zone nation has become a cautionary tale of what can happen when investor trust implodes. Despite bailout aid from the European Union, the fear of some type of default or investor-unfriendly debt restructuring has driven Greece's credit rating down to a CC and interest rates up to 25 percent, even on relatively short-term debts (two-year government bonds).

Rating firms including Moody's and Fitch as well as S&P have put the US on notice that a downgrade could be near.

The immediate concerns about US creditworthiness are essentially two-fold.

• First, in the short term, will Congress allow more borrowing, by lifting a self-imposed debt ceiling? If not, then the ability of the Treasury to pay the nation's bills comes into doubt.
• Second, is the US taking steps to correct long-term imbalances in the federal budget? If not, then a wide gap between spending and tax revenue appears poised to persist, causing an unsustainable rise in public debt.

The first is obviously the most urgent of the issues, but the credit scorekeepers want to see progress on both fronts.

Source: http://rss.csmonitor.com/~r/feeds/csm/~3/tHlLTsC_fHY/What-happens-if-US-credit-rating-drops-Other-countries-offer-clues.

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