|The threat will hurt the economy as it recovers from the worst recession since World War II [GALLO/GETTY]
Standard & Poor's (S&P) has threatened to downgrade the United States' prized AAA credit rating unless the Obama administration and Congress find a way to slash the yawning federal budget deficit within two years.
S&P, which assigns ratings to guide investors on the risks involved in buying debt instruments, slapped a negative outlook on the country's top-notch credit rating, on Monday.
It said there is at least a one-in-three chance that it could eventually cut it.
A downgrade, which would leave Germany and France with a higher rating, would erode the status of the United States as the world's most powerful economy and the dollar's role as the dominant global currency.
If investors start demanding higher returns for holding riskier US debt, the rise in bond yields would crank up borrowing costs for consumers and businesses.
That would threaten to hurt the economy as it recovers from the worst recession since World War II.
"This new warning highlights the need for the US to take better control of its fiscal destiny if it is to avoid higher borrowing costs and maintain its central role at the core of the global economy," said Mohamed El-Erian, chief executive at PIMCO, which oversees $1.2tn in assets and has a short position on US government debt.
Major US stock indexes fell by more than 1 per cent on the day.
Longer-dated government bond prices initially fell but recovered to post solid gains as falling stocks took over as the main driver for price action in the Treasury market. Bond prices frequently trade inversely to stocks.
Although the dollar rose as more immediate fiscal problems in Greece hurt the euro and supported some US assets, it is down about 5 pertcent against major currencies in 2011.
S&P's move, coupled with record low US interest rates, will do little to make it more attractive, said Kathy Lien, director of research at GFT.
"Even though I don't think an actual downgrade would occur, in this very sensitive or vulnerable time for the US dollar, it's enough to spook investors from holding or buying dollars," she said.
The threat of a downgrade raises the stakes in the struggle between President Obama's Democratic administration and his Republican opponents in the House to get control over a nearly $1.4tn budget deficit and $14.27tn debt burden.
The White House last week announced plans to trim $4tn from the deficit over the next 12 years, mostly through spending cuts and tax hikes on the rich.
However, Congressional Republicans want deeper spending cuts and no tax increases.
The deficit problem has become crushing since the financial crisis of 2008. Now for every dollar the federal government spends, it takes in less than 60 cents in revenue.
A budget deficit running at nearly 10 per cent of output and expected to grow will likely further swell a public debt load that's already more than 60 per cent of the country's gross domestic product.
"Because the US has, relative to its AAA peers, what we consider to be very large budget deficits and rising government indebtedness, and the path to addressing these is not clear to us, we have revised our outlook on the long-term rating to negative from stable," S&P said.
Even so, Austan Goolsbee, the top economist at the White House, downplayed S&P's move, telling CNBC on Monday it was a "political judgment" that "we don't agree with".
Moreover, some of the United States' biggest creditors moved to shore up confidence in its sovereign debt on Tuesday.
Asian nations have amassed trillions of dollars in US government bonds through recycled export earnings, and have a vital interest in maintaining their value. So it was no surprise that officials were keen to play down the danger.
"The United States is tackling fiscal issues in various ways, so I still think US Treasuries are basically an attractive product for us," Yoshihiko Noda, Japanese finance minister told reporters.
Japan's reserves stood at $1.12 trillion at the end of March, the bulk of which is thought to be in Treasuries.
Even that pile is dwarfed by China's $3 trillion in reserves, and again much of that is believed to be in US government debt.
Other large holders of US debt include the United Kingdom, oil exporting nations in the Middle East, Brazil, Hong Kong, Russia, Taiwan and Canada.
Treasury prices did indeed prove resilient on Tuesday, though that did not stop stocks markets from skidding across Asia, where investors were already worried that Greece may be on the verge of restructuring its debt.
Some on Wall Street also downplayed the immediate impact.
"If a corporate entity had the same kind of unsustainable leverage problems, it would have been downgraded long ago," said Robert Bishop, chief investment officer of fixed income at SCM Advisors in San Francisco.
"But from the standpoint of the sovereign, being on outlook negative is not the end of world," he added. "Japan, for example, is a double-A credit."
S&P downgraded Japan's rating earlier this year for the first time since 2002, saying Tokyo had no plan to deal with its mounting debt burden.
But unlike the United States, almost all Japanese debt is held by domestic investors. That means the country need not depend on foreigners for financing.
Some investors even hoped that S&P's threat may put pressure on the White House and the US Congress to reach a compromise on measures on deficit reduction, as a failure to clinch a deal could lead to government shutdown as the US is expected to hit the current debt ceiling by May 16.
"The gap between the two sides seems immense but this warning of a rating downgrade might help them reach an agreement," said Arihiro Nagata, manager of foreign bond trading at Sumitomo Mitsui Banking Corp.
That was a sentiment echoed by a source familiar with managing South Korea's foreign exchange reserves, which currently top $291 billion.
"I think this is a good development in a sense that this will eventually help spur efforts in the United States to improve its fiscal health," said the source.
In India, sources with direct knowledge of the matter said the central bank was not considering diversifying due to a lack of credible alternatives to US debt.
The Reserve Bank of India keeps more than 60 per cent of its offshore holdings in US Treasuries and around 30 per cent in euros.
"After S&P's threat of downgrade, the US debt has in fact rallied. Global markets are thinking of buying back US debt now," one of the central bank sources said. "Where is the alternative to diversify? European and Japanese debt are worse."