news & analysis credit in depth

MOODYS.COM

20 SEPTEMBER 2012

NEWS & ANALYSIS Corporates 2

» Diesel Price Hike Is Credit Positive for India's State-Owned Oil Companies

Banks 3

» New Prudential Measures in Hong Kong Are Credit Positive for Banks

Insurers 5

» HCSC’s Alliance with Blue Cross and Blue Shield of Montana Would Be Credit Positive

Sovereigns 6

» Latvia's Revenue Performance and Loan Prepayment Strengthen Its Creditworthiness

US Public Finance 7

» Federal Budget Sequestration to Include Build America Bond Subsidies; Credit Negative for US Municipal Issuers

» Wisconsin’s Act 10 Ruled Unconstitutional; Credit Negative for Local Governments

CREDIT IN DEPTH Outlook for the US Government’s Debt Rating 10

Budget negotiations in 2013 will likely determine the direction of the

US government’s Aaa negative rating. If those negotiations lead to

specific policies that produce a stabilization and then downward trend

in the ratio of federal debt to GDP over the medium term, the rating

will likely be affirmed and the outlook returned to stable. If

negotiations fail to produce such a plan, we would expect to lower the

rating, probably to Aa1. The maintenance of a Aaa with a negative

outlook into 2014 is highly unlikely unless certain conditions prevail.

RECENTLY IN CREDIT OUTLOOK

» Articles in last Monday’s Credit Outlook 19

» Go to last Monday’s Credit Outlook

Discover Weekly Market Outlook, our sister publication containing

Moody’s Analytics’ review of market activity, financial predictions, and

calendar of economic releases.

NEWS & ANALYSIS Credit implications of current events

2 MOODY’S CREDIT OUTLOOK 20 SEPTEMBER 2012

Corporates

Diesel Price Hike Is Credit Positive for India’s State-Owned Oil Companies

On 13 September, the Indian government

The initiatives are credit positive for India’s state-owned oil refining and marketing companies,

including

(Baa3 stable) increased the retail sales price of diesel by

about 12% or INR5 per liter ($14.5 per barrel), and limited sales of subsidized liquefied petroleum gas

(LPG) to six 14.2-kilogram cylinders per household. The higher retail price reduces the government’s

fuel subsidy, whose up-front costs are paid for by state-owned oil companies.

Indian Oil Corporation Ltd. (IOC, Baa3 stable), and state-owned upstream oil companies,

including Oil & Natural Gas Corporation Ltd. (ONGC, Baa1 stable). The increased retail price will

lower the total amount of the fuel subsidy by about INR200 billion for the remainder of the current

fiscal year ending in March 2013. We now expect the fuel subsidy for the year to be INR1.7 trillion

versus our earlier estimate of INR1.9 trillion.

Still, the subsidy will be 23% higher than the INR1.4 trillion for the previous fiscal year. The

government usually distributes subsidies to state-owned oil refining and marketing companies with a

lag of up to six months. In the interim, companies such as IOC need to raise money to cover the cost

of the subsidy.

Based on our revised estimate for the fuel subsidy, we now expect IOC’s debt balance for the fiscal year

to be INR1.0 trillion, compared with our previous estimate of INR1.1 trillion. As a result, IOC will

save interest costs of about INR5 billion.

On the whole, the company’s retained-cash-flow-to-debt ratio for the year is likely to improve

marginally, by about 100 basis points, although it will still remain below 10%.

The price revision will also lower ONGC’s expected share of the subsidy increase by about INR65

billion, which will consequently lower its expected revenue and EBITDA declines by the same amount.

We expect ONGC to share about 32% (same as the last fiscal year) of the total subsidy for the full

fiscal year, which means that the company’s share of the subsidy burden will still be about INR540

billion for the current fiscal year versus INR445 billion a year ago.

The increase in the retail diesel price is the first since June 2011. Since then, import parity prices,

which are used as a reference to calculate the subsidies, have risen by nearly 25% because of higher

international diesel prices and the depreciating rupee. But the near double-digit domestic inflation and

the political consequences of pushing through unpopular reforms have kept the frequency of price

hikes low.

If the government rolls back a part of the hike, as some coalition partners and members of opposition

parties have demanded, the decline in subsidies will be smaller. The total amount of the fuel subsidy

will exceed our estimate if the rupee continues to depreciate or international diesel prices increase

further.

Vikas Halan Vice President - Senior Analyst +65.6398.8337

[email protected]



Banks

New Prudential Measures in Hong Kong Are Credit Positive for Banks

On 14 September, the Hong Kong Monetary Authority (HKMA), Hong Kong’s de facto central bank,

announced a new round of countercyclical prudential measures for property mortgage lending that go

into effect immediately. The HKMA’s new mortgage measures are credit positive because they mitigate

the risk that stepped-up monetary easing in the US will lead to further fund inflows into Hong Kong’s

already inflated property sector and further expose Hong Kong banks to a housing bubble.

The HKMA introduced the new measures (Exhibit 1) in response to the US Federal Reserve’s 13

September launch of its third round of quantitative easing (QE3), which entails the purchase of agency

mortgage-backed securities and a pledge to hold policy rates at current ultra-low levels through mid-

2015.

EXHIBIT 1

New Prudential Measures in Hong Kong

New Measures Related to Borrowers with Multiple Properties under Mortgage

Lower the debt servicing ratio (DSR) limit to 40% from 50%; and the maximum stressed DSR limit to 50% from 60%

Lower the loan-to-value (LTV) limit to 30% for property mortgage loans assessed based on the net worth of mortgage applicants

Lower the applicable LTV limits by another 10 percentage points for property mortgage loans to mortgage applicants whose income is derived mainly from outside Hong Kong

For All Property Mortgage Loan Applicants

Limit the maximum loan tenor to 30 years for all property mortgage loans

Source: Hong Kong Monetary Authority

The HKMA’s response to QE3 shows its determination to reduce the risks to Hong Kong banks from

another upswing in the local property market. Hong Kong runs a currency board system that pegs the

Hong Kong dollar with the US dollar. As a result, the HKMA is passive in terms of the monetary

policy leverage it can use to influence domestic liquidity and has to align its policy rates with current

near-zero key US interest rates. Negative real interest rates, historically high employment in Hong

Kong,1 and demand from non-resident purchasers have led to a 90% increase in property prices in

Hong Kong between the end of 2008 and third-quarter 2012 (see Exhibit 2). The introduction of a

prior round of macro-prudential measures in mid-2011 chilled market sentiment, but both housing

transactions and prices have rebounded for most of this year. The HKMA timed its latest decision to

preempt any QE3-triggered exuberance from extending this rebound further.

� The most recent unemployment rate was a record low 3.2% in June 2012. Total employment has been rising steadily since

mid-2010 to 3.68 million in June 2012.

Sherry Zhang Associate Analyst +852.3758.1392

[email protected]

Sonny Hsu Vice President - Senior Analyst +852.3758.1363

[email protected]



EXHIBIT 2

Private Property Price Index

Source: Rating and Valuation Department, Hong Kong Government

Given the HKMA’s limited ability to determine policy interest rates, its latest measures focus on the

following:

» Reducing the debt servicing ratio (monthly loan repayment divided by monthly income) to 40% from 50% for borrowers with multiple mortgages. We expect this reduction, coupled with the introduction of a maximum limit on mortgage tenors of 30 years, to help limit excessive leverage and improve borrowers’ ability to meet repayment obligations when interest rates eventually rise.

» Reducing loan-to-value (LTV) ratios for borrowers with multiple mortgages to 30%. Such a reduction would be far lower than the current average LTV ratio of 55% for all newly underwritten mortgages and will reduce demand from property investors, who pose higher credit risks than owner occupiers.

Given that the QE3 announcement amounts to a confirmation that current excessive liquidity

conditions will persist at least until 2015, we cannot rule out the risk of further house price

appreciation. However, the HKMA seems determined to ensure that banks’ exposure to an eventual

price correction will have a limited negative effect on the banking system by discouraging their

participation in financing high-risk, speculative transactions and by adding to the collateral buffers for

transactions they do participate in. Hang Seng Bank Ltd. (Aa2 stable; B/aa3 stable)2 and Standard

Chartered Bank (Hong Kong) Ltd. (Aa3 stable; B-/a1 stable) have the greatest commercial and

residential real estate exposure relative to their common equity at around 4x, compared with 1x-3x for

other Hong Kong banks, and therefore should benefit the most from the new measures.

2 The bank ratings shown in this report are the bank’s deposit ratings, its standalone bank financial strength rating/baseline

credit assessment and the corresponding rating outlooks.

50

70

90

110

130

150

170

190

210

Dec-06 Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10 Dec-10 Jun-11 Dec-11 Jun-12



Insurers

HCSC’s Alliance with Blue Cross and Blue Shield of Montana Would Be Credit Positive

Health Care Service Corporation (HCSC, financial strength A1 stable) on 17 September announced it

would ally with Blue Cross and Blue Shield of Montana (unrated). An alliance would be credit positive

for HCSC because it will leverage its operating platform and administrative capabilities outside of its

existing geographical markets.

We believe the announcement indicates a likely pattern of smaller healthcare insurers seeking

partnerships with larger insurers such as HCSC as the cost of new technology and administrative

requirements become burdensome for companies that lack scale.

HCSC, the fourth-largest health insurer in the US, is one of a handful of BlueCross BlueShield

(BCBS) plans that has the capability to provide the support and technology that smaller BCBS plans

require. In addition, HCSC has a history of successful acquisitions and mergers with other insurers,

namely the BCBS plans in Texas, Oklahoma, and New Mexico. If the proposed alliance, which is

subject to regulatory approval, results in HCSC eventually acquiring BCBS of Montana, we do not

envision a material change in HCSC’s credit profile because of the relative small size of the Montana

plan (272,000 members) versus HCSC (13.4 million members). However, the additional earnings and

geographic diversity would improve HCSC’s risk profile.

We do expect that there will be other similar transactions as small regional plans come to terms with

the financial commitment required to keep pace with changing information processing technology and

evolving regulatory standards. This includes the transition to International Classification of Diseases,

Tenth Revision (ICD-10) coding for claims systems, and investments to develop products and

administrative capabilities required for participation in the insurance exchanges under the healthcare

reform law.

Operating as a not-for-profit, HCSC is in a unique position to attract partnerships with other not-for-

profit Blues because regulatory hurdles are likely to be lower compared with combinations involving

for-profit insurers, which would likely entail a conversion to a stock company. Regulators recently have

been less receptive to such conversions, reflecting their concern that profit motives would result in

higher health insurance premiums for consumers. Additionally, the ability for joint marketing of

products under the BCBS brand is a distinct motivating advantage for smaller BCBS plans to seek a

partnership with a larger BCBS plan such as HCSC. Currently, there are approximately 30 regional or

single-state unaffiliated not-for-profit BCBS plans in the US.

Steve Zaharuk Senior Vice President +1.212.553.1634

[email protected]



Sovereigns

Latvia’s Revenue Performance and Loan Prepayment Strengthen Its Creditworthiness

Last Thursday, the government of Latvia (Baa3 positive) passed a supplementary budget for 2012,

focusing on increased social benefits made possible by higher-than-expected revenues. A second year of

strong economic growth has increased fiscal flexibility, which also allowed Latvia to make a

prepayment last Friday on its loan obligation to the International Monetary Fund (IMF). The

continued fiscal prudency and decrease in general government debt strengthens Latvia’s

creditworthiness.

The Latvian economy grew by 5.9% in the first half of 2012 versus the same period a year-ago,

according to Latvijas Statistika, the strongest growth in the European Union so far this year. Stronger

domestic demand, particularly first-half investment growth at close to 30%, built on the 5.5%

economic growth of 2011. Recovering private consumption grew 6.3% in the first half, boosted by

positive economic sentiment and improving labour conditions. As a result, the government has revised

its growth estimates for 2012 to 4% from its earlier 2.5% estimate.

Economic growth has increased revenues by approximately 1.8% of 2011 GDP, which returns the

government to its pre-crisis revenue intake. The gain has prompted the government to increase

expenditures, but at the same time reduce its overall budget deficit target. Expenditures increased by

5%, compared with the original budget, and largely benefit the Ministries of Health, Culture and

Welfare and Education, relieving some of the social pressures built up after three years of significant

austerity measures. The additional revenues also allowed the government to revise its budget deficit

target for 2012 to 1.9% of GDP from 2.1% of GDP. We believe that this new target is achievable.

The revenue outperformance also allowed a prepayment of €211.1 million to the IMF last Friday.

Latvia borrowed €1.16 billion from the IMF under a Stand-By Arrangement in late 2008. Latvia is still

scheduled to repay an additional €163 million this year, after which it will have completed 45% of the

total repayment of its IMF loan. The prepayment eased the government’s debt burden to 43.5% of

GDP in 2012 from an earlier expected 44.5%, and improved its debt affordability because the early

payment will lower interest charges due to the IMF.

Cyril Audrin Associate Analyst +44.20.7772.5328

[email protected]

Alpona Banerji Assistant Vice President - Analyst +44.20.7772.1063 [email protected]



US Public Finance

Federal Budget Sequestration to Include Build America Bond Subsidies; Credit Negative for US Municipal Issuers

Last Friday, the White House Office of Management and Budget (OMB) detailed the programs and

cuts that will be implemented if federal budget sequestration takes effect in January 2013.

Unexpectedly, the plan called for reducing interest subsidy payments related to Build America Bonds

(BABs), which is credit negative for the US municipal sector.

US municipalities issued approximately $200 billion of BABs and similar securities in 2009 and 2010.

Cutting the subsidy effectively reduces revenue for BABs issuers and other similar subsidy programs.

However, the effect on the ability to pay debt service is mitigated to the extent that most general

obligation bond issuers budget to pay full debt service without accounting for receipt of the interest

subsidies, and most revenue bond issuers did not pledge the subsidies to bondholders. Instead, they use

the subsidy to offset debt service costs once the subsidy is received. We expect a minimal amount of

financial strain for those issuers if they do not receive the full federal subsidy.

Some issuers, however, rely on timely receipt of the federal interest subsidy to complement another

revenue source in order to make full debt service payments. These issuers may need to make budget

adjustments or draw on a debt service reserve (if one was established) to mitigate a reduced federal

subsidy. Some issuers included extraordinary mandatory redemption provisions in their BAB issuances,

triggered by reductions in federal subsidy amounts, which they may now have to consider.

Whether the subsidy is reduced or not, the timing of the BAB subsidy’s receipt continues to be a

potential credit challenge in certain circumstances. The federal government treats the interest subsidies

as tax refunds, which issuers must apply for within a specific time frame relating to debt service

payment dates. Administrative error or weak management practices could cause the subsidy to be

received late. The federal government also can offset or withhold the subsidy when it has claims against

the issuer.

The Build America Bond program was implemented in 2009 as part of the American Recovery and

Reinvestment Act (ARRA). The US federal government pays 35% of the taxable interest cost of a BAB,

in most cases through a subsidy remitted directly to the issuer. Appealing to non-municipal bond

investors, many BABs are structured more like taxable corporate bonds, not like typical municipal

bonds. There was a total of $181.2 billion of BABs issued until the program expired at the end of

2010, lowering borrowing costs by $20 billion, according to the US Treasury. There were also $14.9

billion of similar Qualified School Construction Bonds (QSCBs) issued in which the federal

government subsidizes 100% of the interest cost.

OMB’s announcement includes preliminary estimates of program cuts the US government (Aaa

negative) would make as part of the sequestration required by the Budget Control Act of 2011. It

reflects a 7.6% reduction in subsidy payments for BABs, QSCBs, and similar Qualified Zone Academy

Bonds and Qualified Energy Conservation Bonds in federal fiscal year 2013, or $322 million. The

announcement does not describe the mechanics of how or when the reductions would be made if

sequestration is implemented. Including the subsidies in sequestration’s cuts reflects a notable shift for

the federal government. It created the BAB program to spur municipal issuance and full and ongoing

subsidies for as long as bonds are outstanding was expected. Nonetheless, reductions to BAB subsidies

were a risk we highlighted in our 2009 methodology Credit Aspects of Build America Bonds

Nick Samuels

.

Vice President - Senior Credit Officer +1.212.553.7121

[email protected]



Top 25 Issuers of Build America Bonds ($ millions)

State of California 13,183

City of New York 4,430

Metropolitan Transportation Authority 3,790

New York City Municipal Water Finance Authority 3,458

Bay Area Toll Authority 3,275

New York City Transitional Finance Authority 3,263

State of Illinois 3,245

New Jersey State Turnpike Authority 3,225

American Municipal Power-Ohio 2,908

University of California 2,838

Commonwealth of Massachusetts 2,791

Los Angeles Unified School District 2,642

Municipal Electric Authority of Georgia 2,620

New York State Dormitory Authority 2,582

Los Angeles Department of Water and Power 2,215

State of Texas 2,206

University of Texas 1,701

Commonwealth of Pennsylvania 1,667

State of Washington 1,659

City of San Antonio 1,659

State of Connecticut 1,633

Texas Transportation Commission 1,500

City of Chicago 1,448

County of Clark 1,154

State of Utah 1,145

Source: US Treasury



Wisconsin’s Act 10 Ruled Unconstitutional; Credit Negative for Local Governments

Last Friday, a Dane County, Wisconsin Circuit Court judge ruled that certain provisions of

Wisconsin’s Act 10 are unconstitutional. Act 10, which took effect last year, prohibits non-public-

safety local government employees from collectively bargaining over any element of salaries and

benefits other than base wages, the increases in which are limited to growth in the Consumer Price

Index (CPI). Ultimate repeal of these Act 10 provisions would be a credit negative for Wisconsin (Aa2

stable) local governments because it would materially restrict their budgetary flexibility at a time when

budgetary challenges show no signs of letting up.

Act 10 legislation took effect in June 2011 as part of the state’s 2011-13 biennium budget. The Act 10

provisions allowed many Wisconsin municipalities to curb growth in personnel expenditures because

they were freed from labor contracts that included the municipality’s agreement to fully fund the

employee contribution of pension and health insurance plan costs. The Act 10 limitations on collective

bargaining effectively absolved municipalities from the duty to fund employee’s share of pension and

health insurance plan costs for all non-public-safety employees.

Prior to passage of Act 10, most Wisconsin cities, counties, villages, and school districts regularly

negotiated the terms of salary and benefit packages with public safety and non-public-safety employee

unions. Local governments with labor contracts already in effect upon the implementation of Act 10

were required to wait until those contracts expired in order to take advantage of the budgetary relief

provided by Act 10. Still, many Wisconsin local governments have already realized significant savings

during the past year.

Last week’s court ruling stated that Act 10 violated the equal protection clause of the state constitution

by creating separate classes of workers and treating those classes unequally. A federal appeal is expected

to be heard in late September. On 17 September, the Wisconsin State’s Attorney General announced

his intention to request that the ruling be put on hold, thereby keeping Act 10 enforceable throughout

the appeals process. If the hold is granted, it is unlikely that the ruling would affect local governments’

fiscal 2013 operating budgets. However, if the ruling is upheld and Act 10 is ultimately overturned,

Wisconsin cities, counties, villages, and school districts would lose an effective tool to manage

personnel expenditures that account for a high portion local government spending. If continued

revenue pressures accompany a repeal of Act 10, we would expect the financial profile and the credit

quality of some Wisconsin local governments to weaken during the next several years.

Rachel Cortez Vice President - Senior Analyst/Manager +1.312.706.9956

[email protected]

Kathryn Gregory Associate Analyst +1.312.706.9962

[email protected]

CREDIT IN DEPTH Detailed analysis of an important topic


Update of the Outlook for the US Government’s Debt Rating

The US government’s bond rating remains unchanged at Aaa with a negative outlook. The direction of

the US rating and its outlook will most likely be determined by the outcome of budget negotiations

during the course of 2013. In particular:

1. If those negotiations lead to specific policies that produce a stabilization and then downward trend in the ratio of federal debt to GDP over the medium term, the rating will likely be affirmed and the outlook returned to stable.

2. If those negotiations fail to produce a plan that includes such policies, we would expect to lower the rating, probably to Aa1.

3. The maintenance of the Aaa with a negative outlook into 2014 is highly unlikely unless the method adopted to achieve debt stabilization involved a large, immediate fiscal shock with a resulting unstable economic situation. Such a shock could come from the so-called “fiscal cliff.” In such circumstances, we would await evidence that the economy could rebound from the shock before considering a return to a stable outlook.

It is difficult to predict when in 2013 Congress will conclude negotiations that result in a budget

package. The Aaa rating, with its negative outlook, is likely to be maintained until the outcome of

those negotiations becomes clear.

It is also worth noting that maintaining the rating outlook assumes a relatively orderly process for the

increase in the statutory debt limit. The debt limit will likely be reached around the end of this year,

and the government’s ability to meet interest and other expenses out of available resources would likely

be exhausted within a few months. Under these circumstances, the government’s rating would likely be

placed under review after the debt limit is reached, but several weeks before the exhaustion of the

Treasury’s resources. We took a similar action during the summer of 2011 after the debt limit had

been reached.

SUMMARY OF UPCOMING TAX AND SPENDING MEASURES

At the beginning of 2013, a number of important changes in US fiscal policy will occur unless there is

new budget legislation before that time. Previously legislated, these changes affect both revenues and

expenditures. If all the changes actually occur (an event sometimes referred to as the “fiscal cliff”), they

would very likely result in a recession and higher unemployment during 2013. As a result, there is a

strong incentive for legislators and the administration to modify tax and spending policies before the

end of 2012 or during 2013. We expect that policymakers will take action at some point, but the

content of any potential fiscal measures is highly uncertain, given the national elections on 6

November and the unknown political dynamics afterward.

The following important measures go into effect at the beginning of calendar 2013 under existing law.

Because the fiscal year begins on 1 October, the changes will affect only three quarters of the 2013

fiscal year.

1. Individual income tax rates will rise for ordinary income, capital gains, and dividends. In addition, certain tax credits will shrink and the alternative minimum tax (AMT) will affect a larger number of taxpayers. The Congressional Budget Office (CBO) estimates that total revenue from

Steven A. Hess Senior Vice President +1.212.553.4741 [email protected]

Atsi Sheth Vice President - Senior Analyst +1.212.553.4873 [email protected]

Bart Oosterveld Managing Director - Sovereign Risk +1.212.553.7914

[email protected]



individual income taxes will rise from 7.2% of GDP in fiscal 2012 (which ends 30 September) to 9.0% in 2013 and 9.4% in 2014, the first full fiscal year the new tax levels would be in effect.3

2. The Social Security payroll tax paid by employees will rise from 4.2% of income to 6.2% (on income up to $110,100), resulting in total social insurance taxes (also including Medicare) going from 5.5% of GDP in 2012 to 6.0% in 2013 and 6.2% in 2014.

Primarily because of these two tax increases, but also due to a number of smaller measures, the CBO estimates that total government revenue will rise from 15.7% of GDP in 2012 to 18.4% in 2013 and 19.6% in 2014, a rise of about 4% of GDP in just two years.

3. An automatic reduction in discretionary spending in 2013 and a cap on spending growth thereafter that were included in the Budget Control Act of August 2011 will, together with other measures including a reduction in payments to physicians for Medicare and the expiry of extended unemployment benefits, result in total spending falling from 22.9% of GDP in 2012 to 22.4% in 2013 and 21.9% in 2014.

The steep increase in revenues and the spending reductions/caps, if actually implemented, would result

in the budget deficit falling from 7.3% of GDP in fiscal 2012 to 4.0% in 2013 and only 2.4% in

2014. The 4.9% reduction in the deficit over two years would be unprecedented since the end of the

Second World War and is what has been referred to as the “fiscal cliff.” It would result in government

debt as a percentage of GDP peaking in 2014 and declining thereafter. The economic effect of this

fiscal scenario would be a recession, with the CBO estimating a drop of 0.3% in real GDP during

calendar 2013.

Under an alternative scenario in which current tax rates were extended, the AMT was indexed for

inflation, and the mandated reductions in spending did not occur (“business as usual”), the deficit

would be reduced by considerably smaller amounts, to 6.5% of GDP in 2013 and 5.6% in 2014.

Economic growth would remain positive, but government debt would continue to rise as a percentage

of GDP.

Over the next decade, the deficit would decline to very low levels under the baseline scenario (see

Exhibit 1), being 1.0% of GDP or smaller from 2016 onward. Under the alternative scenario,

however, it would remain above 4.0% of GDP.

3 Congressional Budget Office, An Update to the Budget and Economic Outlook: Fiscal Years 2012 to 2022, August 2012



EXHIBIT 1

The CBO’s Baseline and Alternative Scenarios for the Federal Budget Balance (Percent of GDP)

Source: Congressional Budget Office

Over the next decade, the baseline scenario shows that revenues would rise to more than 21% of GDP

(see Exhibit 2), while expenditures would fall from their recent peak before beginning to rise again by

end of the period. In the alternative scenario, revenues would rise less steeply, and expenditures would

end the decade only about one percentage point below their peak during the financial crisis.

EXHIBIT 2

Federal Government Revenues and Expenditures under Two Scenarios (Percent of GDP)


How do these scenarios compare to historical experience? Over the 50 years through 2010, federal

government revenues averaged 18.0% of GDP, while expenditures averaged 20.4%. Furthermore, until

the disruption to federal finances brought about by the financial crisis in 2008-09, they did not show

too great a variation from these levels, as illustrated in Exhibit 3. The highest year for revenue was

2000, when it reached 20.6% of GDP, and the lowest year was 2004, when it fell to 16.1%. Thus, the

CBO’s baseline would be a departure from the historical pattern, particularly in the case of revenue,

which would rise to over three percentage points above the 50-year average in relation to GDP.

Expenditures would also depart from their historical patter, but to a lesser degree.

-12

-10

-8

-6

-4

-2

0

2

4

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Fiscal Balance (Actual) Fiscal Bal. CBO Baseline Fiscal Bal. CBO Alternative

14.0

16.0

18.0

20.0

22.0

24.0

26.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Revenue (Actual) Expenditure (Actual) Rev. CBO Baseline

Exp. CBO Baseline Rev. CBO Alternative Exp. CBO Alternative



EXHIBIT 3

Historical Revenues, Expenditures, and Fiscal Balance (Percent of GDP)

Source: Office of Management and Budget

On the expenditure side, the peak year was 1983, at 23.5% of GDP, while the lowest level was 17.2%

in 1965. Therefore, the alternative scenario would differ significantly from the historical pattern

primarily on the expenditure side, with the average level of expenditures being near the highest level

recorded during the five decades before the financial crisis.

During the same 50-year period, the budget balance averaged a deficit of 2.4% of GDP, with the

highest pre-global financial crisis deficit of 6.0% of GDP recorded in 1983. At 1.2% of GDP, the

deficit under the CBO baseline would be half the historical average over the next decade and even

lower during the second five years. The alternative scenario would result in an average deficit of 5.0%,

or double the historical average.

In evaluating the long-term stability of any fiscal scenario, the comparison to historical experience is

useful, especially since the size of the US federal government has remained fairly stable over a long

period. The financial crisis of 2008-09 was a significant departure from this stable pattern, so the

question becomes whether this departure is the beginning of a permanent shift or will there be a return

to the historical pattern. One argument is that, because of the aging of the US population, upward

pressure on entitlement spending will gradually increase the size of government unless there is

significant reform of entitlement programs, which form the bulk of what is termed “mandatory”

spending. No such reforms are considered in the CBO’s scenarios, which are based on current law or

historical practice.

Reform of entitlement programs, through revenues, expenditures, or both, would add stability to any

long-term fiscal plan, in that entitlement programs are not part of the annual appropriation process

and are much more difficult to change. As shown in Exhibit 4, mandatory spending has risen in recent

decades to well over half of total federal spending, and its proportion is projected to continue to rise

unless there are reforms in Medicare, Medicaid, and Social Security.

-40

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-20

-10

0

10

20

30

40

50

1930

1932

1934

1936

1938

1940

1942

1944

1946

1948

1950

1952

1954

1956

1958

1960

1962

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1968

1970

1972

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1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

Fiscal Balance Revenues Expenditures



EXHIBIT 4

Mandatory Spending Is Largest Part of Total (Percent of total spending)

Note: Projections come from the 2013 Budget

Source: Office of Management and Budget

DEBT TRAJECTORIES DIFFER SIGNIFICANTLY

The debt trajectories resulting from the two CBO scenarios are quite different, with the ratio of federal

debt to GDP peaking in 2014 and declining afterward to less than 60% in the early 2020s in the

baseline scenario but rising to about 90% during the same period in the alternative scenario (Exhibit

5).4 Neither of the sets of policies underlying these trajectories is likely to be adopted. However, the

scenarios provide a framework for analyzing the future debt trajectory, which is one of the most

important factors determining the rating outlook. If we believed that a debt trajectory such as that in

the baseline scenario were likely, the probability of an eventual return to a stable outlook on the Aaa

rating would rise. If we considered the alternative scenario more likely, a downgrade of the rating

would be more probable. Thus, the actions of policymakers in terms of long-term fiscal measures at the

end of the year or in early 2013 will be important determinants of how we deal with the rating

outlook. Including reform of entitlement programs would add to the long-term stability of any fiscal

plan.

4 In this Special Comment, we consider only federal government debt rather than general government debt. The latter

includes state and local government debt, which as a percent of GDP was about 20 percentage points higher than federal

government debt at the end fiscal 2011. This measure is used to make comparisons with other sovereigns.

0

10

20

30

40

50

60

70

80

90

100

Discretionary Mandatory Net Interest



EXHIBIT 5

Federal Government Debt Trajectories under the Two Scenarios (Debt as a percent of GDP)


ALTERNATIVE PROPOSALS

The CBO scenarios are a starting point, but they are not actual policy recommendations. There are,

however, a number of actual budget proposals available. Three of the most prominent proposals are

briefly discussed below. They differ significantly in the outlook for government revenues and

expenditures over the coming years.

1. The Obama administration budget. The budget produced by the Obama administration in February and updated in the August Mid-Session Review5 would produce a debt trajectory in between the CBO’s two scenarios, with the ratio of debt to GDP in 2022 at 75%, near the mid-point between them. The proposed budget includes the expiration of the so-called “Bush tax cuts” for those families with incomes of more than $250,000 ($200,000 for individuals) and a reduction in the ability of upper-income taxpayers to use various tax deductions. The administration estimates that these provisions would increase revenues by $80 billion in fiscal 2013 and by increasing amounts over the coming decade. Partly as a result of this rise in revenue, revenues during the coming decade would average 19.1% of GDP, somewhat higher than the 18.0% historical average and showing a gradual upward trend during the 10 years. Expenditure would also be higher than the historical average, at 22.4% of GDP. There are no significant reforms of entitlement programs proposed beyond including the provisions of the Affordable Care Act that have already become law. This act includes provisions that would attempt to limit the growth of federal outlays through cost control.

2. The budget passed by the House of Representatives. The House of Representatives passed a budget on 29 March that projects somewhat lower revenues as a percentage of GDP but much lower expenditures than the administration budget.6 This budget will not go beyond the House, and so actual implementation is unlikely. However, if the Republicans win the presidency in the coming elections, something along these lines would be a possibility, depending also on the results of Congressional elections.

Comparing the Obama administration’s and the House of Representative’s budgets, the differences are

clear, as shown in Exhibit 6. The administration would have higher expenditure and revenue levels, on

5 Office of Management and Budget, Fiscal Year 2013 Mid-Session Review, August 2012 6 House Budget Committee, House 2013 Budget

30

40

50

60

70

80

90

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Federal Debt CBO Baseline CBO Alternative



average, over the next decade compared with both the House budget and historical averages. The

biggest difference between the two proposals is the level of expenditure.

EXHIBIT 6

Revenue and Expenditure in the Administration and House Budgets Percent of GDP)

Sources: Office of Management and Budget, House Budget Committee

3. The Fiscal Commission Proposal. Another prominent budget plan is that of the National

Commission on Fiscal Responsibility and Reform (also known as the Simpson-Bowles commission), a bipartisan group commissioned by the president to make recommendations on measures to reduce the deficit over time. This commission presented its proposals in December 2010,7 so the economic baseline from which their projections derive is not comparable to those of either the administration or House budget proposals. With this caveat, the revenue projections for the 2013-20 period are consistently higher than either the Obama administration’s or House’s budget proposals, averaging 19.7% of GDP. Expenditure levels for the same period would be between the two other proposals but somewhat closer to the administration budget, averaging 21.8% of GDP. The commission proposes a number of changes to the way the Medicare program is managed aimed at controlling costs. It also goes further in entitlement reform in proposing long-term reforms to Social Security, including gradually raising further the full retirement age and a gradual increase in the maximum income subject to the payroll tax.

Even though both revenues and expenditures are higher than in the House budget, deficits and the

resulting debt trajectory are closer to the House budget than to the administration budget. However, if

the proposed package were implemented starting now, it is likely that, because the starting debt level is

higher than that assumed in 2010, the ending point would also be somewhat higher.

7 National Commission on Fiscal Responsibility and Reform, The Moment of Truth, December 2010

14.0

16.0

18.0

20.0

22.0

24.0

26.0

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Revenue (Actual) Expenditure (Actual) Rev. Admin.

Exp. Admin. Rev. House Exp. House



EXHIBIT 7

Differing Debt Trajectories over the Coming Decade (Ratio of Debt to GDP; percent)

Sources: Congressional Budget Office, Office of Management and Budget, House Budget Committee, Fiscal Commission

ECONOMIC CONDITIONS ALSO AFFECT OUTLOOK

Fiscal policy actions will be the most important determinant of the debt trajectory over the coming

decade; without such actions, a downward debt trajectory appears unlikely. However, the economic

outlook is another key determinant that affects revenues as well as spending. The economic

assumptions used in the various debt projections differ somewhat as to real GDP and inflation. The

CBO has lower real GDP growth than the administration budget. Likewise, it is lower in terms of

nominal growth, which is the most important determinant of government revenues. The House

budget used an earlier CBO baseline for its economic assumptions.

These forecasts have a strengthening of real growth during the middle of the decade from its current

pace of 1.5%-2.0%, a factor behind the declining deficits and debt trajectories. By the end of the

decade, the projections assume that real growth reverts to its long-term potential of near 2.5%,

somewhat below the average for the previous 50 years. The lower potential growth rate results in part

from population aging.

Real GDP growth in 2013 differs significantly, however, between the CBO baseline and the

administration budget. Because the baseline assumes that the “fiscal cliff” actually occurs, it shows a

decline in real GDP for the calendar year. If this decline were truly temporary and long-term growth

returned as the CBO projects, then it would not necessarily alter our view of economic strength.

However, it would raise the question of whether the policies that produced the recession would be

viable over the long term.

50

60

70

80

90

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

CBO Baseline CBO Alternative Administration Budget

House Budget Fiscal Commission



EXHIBIT 8

Underlying Growth Scenarios (Annual percent change in GDP)

Sources: Congressional Budget Office; Office of Management and Budget

-1

0

1

2

3

4

5

6

7

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Nominal Growth Rate Admin. Nominal Growth Rate CBO

Real Growth Rate Admin. Real Growth Rate CBO

RECENTLY IN CREDIT OUTLOOK Select any article below to go to last Monday’s Credit Outlook on moodys.com


NEWS & ANALYSIS European Sovereign and Bank Crisis 2

» Bank Supervision Proposals Would Be Credit Positive for Weaker Euro Area Governments

» German Court’s Ruling on European Stability Mechanism Is Credit Positive for Euro Area

» Troika’s Approval of Portugal’s Revised Bailout Terms Is Credit Positive

Corporates 6

» BP’s Sale of Gulf of Mexico Assets to Plains Moves it Closer to its Disposal Target

» Plains’ Leverage Is Set to Balloon with $6.1 Billion Deepwater Expansion

» Potential EADS-BAE Merger Is Complex and Far from Assured, but Credit Positive

» Chesapeake’s Asset Sale Solidifies its Debt Reduction Plan

» Wyndham’s Acquisition of Shell Vacations Is Credit Positive

» Brazil’s Electricity Tariff Reduction Is Credit Positive for Industrials

» Metso’s Proposed Extra Dividend Is Credit Negative

Infrastructure 14

» Brazil’s Electric Utility Concessions Will Be Renewed at Much Lower Tariffs, a Credit Negative

Banks 16

» Citigroup’s Charge for Decline in Value of Morgan Stanley Joint Venture Is Credit Negative

» Increase in Unbanked Households Is Credit Positive for Alternative Financial Services Providers

» BNP Paribas’ Reduction of Banca Nazionale Del Lavoro’s Funding Is Credit Positive

» Russian Central Bank’s Funding Increase to Banks Is Credit Negative

» New Central Bank Discount Window Is Credit Positive for UAE Banks

Insurers 24

» AIG Reaches Another Credit Positive Milestone Through Treasury Sell-Down to Minority Stake

Sovereigns 26

» Fed’s Monetary Move Is Credit Positive for US Government

» China’s Foreign Investment Protection Agreement with Canada Is Credit Positive

» India’s Reform Announcements Buoy Market Sentiment More than Sovereign Credit Profile

US Public Finance 32

» Central Falls’ Bankruptcy Without Default Is Credit Positive for It and Other Stressed Rhode Island Cities

Accounting 35

» Draft Update of International Hedge Accounting Rules Is Positive for Investors

» Proposals to Improve Auditor Reports Are Positive for Investors

RATINGS & RESEARCH Rating Changes 39

Last week we downgraded Panasonic, Samson Investment, the State of

South Australia, 24 securities from 12 Irish RMBS transactions, and 47

securities from 32 Portuguese ABS and RMBS transactions, and

upgraded Desenvolve, Ecuador, and Poudre Valley Health Care

(Colorado), among other rating actions.

Research Highlights 48

Last week we published on Asian corporates, US homebuilders,

Canadian corporates, Mexican accounting rules, Brazilian corporates,

US pharmaceutical services, US coal, US broadcasters, UK banks,

Canadian banks, US life insurers, the US government, the European

Union, non-US regional and local governments, US higher education,

and US RMBS, among other reports.

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