This is the second of three columns that take off from Moody’s downgrade of the US Treasury. The first column introduced the event, sketched a rudimentary theory of the lift provided to the US Treasury’s credit by the reserve role of the dollar, and distinguished sovereign risk from country risk (McCauley 2025).
This column confronts the theory with empirical analysis of sovereign ratings. The history of economists’ inferring the recipe for the rating agencies’ secret sauce is only a generation long. During much of that time, the data did not confess the role that fiscal deficits or debt must play in sovereign ratings. Ten years ago the data did, under sustained interrogation, confess. But the relationship found ten years ago sits uneasily with a US Treasury rated Aa1/AA+/AA+ by Moody’s, Standard and Poor’s (S&P), and Fitch, respectively. This column then sketches the different ways that the rating agencies conceive of the boost that the dollar’s reserve role gives to the US Treasury’s rating. They seem to arrive at a common destination by different routes.
Government debt burden and sovereign ratings: Central bank empirics
The odd truth is that for almost 20 years after the 1996 New York Fed article by Richard Cantor (now Vice Chair of Moody’s Investor Services, Inc.) and Frank Packer (now at the Bank for International Settlements (BIS)), “Determinants and impact of sovereign credit ratings” (Cantor and Packer 1996), economists had a hard time finding a role for fiscal deficits and debts in the Moody’s, S&P and Fitch sovereign ratings. Yes, Cantor and Packer accounted for 92% of the cross-sectional variance in ratings with per capita income (positive), inflation (negative), external debt (negative), and a recent default dummy (negative). This may seem ho-hum, but this reverse engineering has scored big in the academic body count, with no less than 2,150 citations. But Cantor and Packer found “surprising... the lack of a clear correlation between ratings and fiscal ... balances.”
Eighteen years later at the BIS, Claudio Borio and the self-same Frank Packer revisited the issue (Borio and Packer 2004). The fiscal variable, this time a stock rather than a flow, performed no better after a generation.
Look at the last line in Table 1 (here truncated). See the woefully insignificant coefficient on public debt/GDP. Zilch. Nada. Rien de tout.
Table 1 Foreign currency sovereign rating regressions of Borio and Packer
Source: Borio and Packer (2004).
Does the sovereign rating-public debt burden work in theory but not in practice? Marlene Amstad, now chair of the Swiss Financial Markets Authority (Credit Suisse undertaker (Perotti 2023) and UBS scourge) and the self-same Frank Packer tried breaking governments into two groups – advanced economies, and emerging and developing economies (Amstad and Packer 2015). The burden of government debt as measured by the ratio of interest payments to government revenue emerges as a significantly negative influence on the sovereign rating.
Figure 1 Sovereign forex rating falls with less affordable government debt
Source: Amstad and Packer (2015).
So the fisc does play a role in sovereign ratings. That said, the differential treatment of advanced and emerging market economies in the right-hand panel of Figure 1 passes the interocular impact test with flying colours. Does this reflect the rating agencies’ and market participants’ realistic appreciation of a domestic version of ‘debt intolerance’ (Eichengreen et al. 2007) or something more sinister?
Amstad and Packer (2015) report a regression in which an intercept dummy is found to be insignificant, and boldly proclaim:
the use of a multivariate estimation framework considerably reduces the “penalty” for the EME [emerging market economy] designation. In fact, when the variables discussed above are accounted for, the impact of the dummy for EME designation is much lower (less than one notch) both before and after the crisis, and statistically insignificant [italics added].
Does this mean that concern over a possible bias against emerging market economies by the major rating agencies that one frequently reads in both the financial press and among policy-informed economists (Bartels and Weder di Mauro 2013) is unfounded? At the risk of wonkiness, the right-hand panel of Figure 1 suggests that the right test for a significant difference in the relationship of ratings to debt affordability would allow the downward slope to be steeper as well as the intercept with the y-axis to be higher for advanced economies as opposed to emerging market economies.
“Support is not found for the hypothesis of bias against emerging market economies,” summarise Amstad and Packer with Popperish care (Hoyningen-Huene 2022). However, neither is support found for there being no bias.
We need to see a joint test for the equality of intercept and slope in the right-hand panel of Figure 1. The pair of parameters for advanced economies may jointly differ significantly from that for emerging market economies, without either being separately significantly different.
Back to the real world, the downward slope in the right-hand panel of Figure 1 carries an implication that is far from benign for Alexander Hamilton’s successor, Secretary Bessent. This is not the happy-go-lucky world of Figure 2 in the first column in this series (McCauley 2025). As Fitch noted almost two years ago:
The interest-to-revenue ratio is expected to reach 10% by 2025 (compared to 2.8% for the 'AA' median and 1% for the 'AAA' median [CBO (2025) now projects 18.7% for 2025] due to the higher debt level as well as sustained higher interest rates compared with pre-pandemic levels... The CBO projects that interest costs will double by 2033 to 3.6% of GDP [CBO (2025) now projects 4.1% of GDP in 2035].
Have another look at the right-hand panel of Figure 1. Locate 15% on the horizontal axis, and trace up to the red least squares line. Oops!
As normal bond yields repopulate the stock of US Treasury debt at successful auction after well-covered auction, the US Treasury is barrelling to the right (Figure 1, right-hand panel). The US Treasury bond market is the locus of the real Great Replacement (Bergmann 2025), as bonds carrying coupons of 4%+ replace ones with lower coupons. It puts the US Treasury’s credit on a highway to hell.
Does the dollar’s reserve role confer an exorbitant privilege? Raters’ view(s)
With that clarification of the “what,” let us turn to the “why.” Moody’s gives the US Treasury credit for the dollar’s global reserve role. McKinsey, a veritable font of ad populum fallacies, holds that the dollar’s role confers cheap debt on the US Treasury (McKinsey Global Institute 2009).
Or rather, according to Stephen Miran, Chair of the White House Council of Economic Advisers (Miran 2024), the US Treasury’s
borrowing advantage... may reduce the price sensitivity of borrowing. In other words, we don’t necessarily borrow substantially cheaper, but we can borrow more without pushing yields higher. This is a consequence of the price inelasticity of demand for reserve assets, and the flip side that we run large external deficits to finance that reserve provision.
But is this conventional wisdom (Galbraith 2010) correct?
As noted by Nangle in FTAlphaville, Moody’s cites the dollar’s reserve role in putting extra weight on the US government’s interest to cash flow (the latter either government revenue or GDP) ratio (‘debt affordability’). It puts correspondingly less weight on the government’s ‘debt burden’ (either debt to government revenue or debt to GDP). In principle, the interest to cash flow ratio has much to recommend it – it is one of the best, if not the best, single predictor of corporate default (McCauley et al. 1999), for instance. But anyone who watched house macroeconomists in the 1980s present the results of large econometric models into which ‘add-factors’ had been introduced can recognise the persuasive power of presenting priors as results. And Nangle, for one, could not see how even this tailored re-weighting suffices to achieve the required ‘fiscal strength’ rating for the US Treasury.
S&P has a different means to the same end of giving the US Treasury credit for the dollar’s reserve role. For this agency, the reserve role of the dollar, and that of the Japanese yen, the British pound, and perhaps some day,
China’s yuan renminbi boosts the sovereign in the “external assessment”:
47. Sovereigns with a reserve currency.
A sovereign in this category generally benefits from a currency (which it controls) that accounts for more than 3% of the world's total allocated foreign exchange reserves based on the IMF report "Currency Composition of Official Foreign Exchange Reserves." Demand for the debt of these sovereigns tends to rise in periods of global economic stress (flight to quality)... [italics added]
The European Catch-21 is that parenthetical, which “disses” Federal Reserve independence. Scroll down to paragraph 63:
Specific considerations for members of monetary unions
63. Each sovereign belonging to a monetary union receives an external assessment based on its individual external position... and depending on the currency of the union. This is because the external liquidity and balance sheet situations of members of a monetary union may vary greatly, even though they all share a common currency and common capital markets. However, although the currency of a monetary union as a whole may be a reserve currency, individual members of the union would be treated as if the currency was just actively traded because they do not control the common currency alone [italics added].
That’s right, European readers. Under this criterion, the German Federal Republic in 1997 would have benefited from the Deutschmark’s 13.1% share of global foreign exchange reserves, according to IMF data. Now this borrower does not benefit from the euro’s 20% share. Nor does any other sovereign in the euro area. On this view, the treaty-based independence of the ECB was in principle bad news for the average rating of the euro area sovereigns, at least insofar as reserve currency status supported that average. In practice, the German Federal Republic was and remains Aaa-rated.
Perhaps this is another reason to wonder about Europe’s strategic autonomy. Bartels and Weder di Mauro (2013) might have another reason to ask: “A rating agency for Europe? A good idea?”. However, it is easy to understate the cost and uncertainty of outcome entailed by such a project.
According to S&P, euro area sovereigns only benefit from the rating uplift arising from “active trading” of their single currency. This is defined as more than 1% of global foreign exchange turnover as measured by the Triennial Survey of the BIS.
Thus the euro does for euro area sovereigns no more than the Chinese yuan renminbi, the Australian dollar, the Canadian dollar, the Swiss franc, the Hong Kong dollar, the Singapore dollar, the Swedish krona, the Korean won, the Norwegian krone, the New Zealand dollar, the Indian rupee, the Mexican peso, the New Taiwan dollar, and the South African rand (in that order of currency turnover according to the BIS) do for their respective governments.
Fitch hangs the uplift provided to the US Treasury’s credit by the reserve role of the dollar on a couple of hooks. When Fitch downgraded the US Treasury almost two years ago, it opined, “Critically, the U.S. dollar is the world's preeminent reserve currency, which gives the government extraordinary financing flexibility.” In its principles of sovereign ratings, Fitch states:
Macroeconomic policy flexibility and credibility
...Countries with currencies that exhibit reserve-currency characteristics enjoy exceptionally strong financial and policy flexibility....
External finances...
Reserve-currency flexibility–The variable for RCF captures the reality that countries whose currencies have a significant role in global official foreign-exchange reserve portfolios are less likely to experience funding stress, reflecting stable demand for assets denominated in their currency. For countries (such as the US) with exceptionally strong reserve-currency flexibility, these assets tend to be a destination for safe-haven capital flows in times of market stress [March 2020? McCauley 2024]. RCF benefits fiscal as well as external financing flexibility as the majority of reserve assets are government bonds and RCF therefore tends to increase external demand for a country’s sovereign debt, but Fitch categorises the variable in its External Finances section of the SRM. The RCF indicator is based on hard data (from the IMFCOFER database) so as to avoid subjective judgements.
So yes, the rating agencies privilege the US Treasury owing to the reserve role of the dollar. Do market participants agree? This is the subject of the next column.
Author’s note: I thank Claudio Borio and Frank Packer for discussion.
References
Amstad, M and F Packer (2015), “Sovereign ratings of advanced and emerging economies after the crisis,” BIS Quarterly Review, December.
Bartels, B and B Weder di Mauro (2013), “A Rating Agency for Europe? A good idea?”, CEPR Discussion Paper 9512.
Bergmann, E (2025), "The Strategic Exploitation of Conspiracy Theories by Populist Leaders", Genealogy 9(2): 41.
Borio, C and F Packer (2004), “Assessing new perspectives on country risk”, BIS Quarterly Review, December.
Cantor, R and F Packer (1996), “Determinants and Impact of Sovereign Credit Ratings”, Federal Reserve Bank of New York Economic Policy Review 2(2).
CBO – Congressional Budget Office (2025), The Budget and Economic Outlook: 2025 to 2035.
Eichengreen, B, R Hausmann and U Panizza (2007), “Currency Mismatches, Debt Intolerance, and Original Sin: Why They Are Not the Same and Why It Matters”, in S Edwards (ed.), Capital Controls and Capital Flows in Emerging Economies: Policies, Practices, and Consequences, University of Chicago Press.
Galbraith, J K (2010), The Affluent Society and Other Writings, 1952-1967, Library of America.
Hoyningen-Huene, P (2022), “Revisiting Friedman’s 'On the methodology of positive economics'('F53')”, Methodus 10(2).
McCauley, R N (2024), “The Offshore Dollar and US Policy”, Federal Reserve Bank of Atlanta’s Policy Hub No. 2-2024.
McCauley, R N (2025), “Downgrading Uncle Sam, not America”, VoxEU.org, 24 June.
McCauley, R N, J S Ruud and F Iacono (1999), Dodging Bullets: Changing U.S. Corporate Capital Structure in the 1980s and 1990s, MIT Press.
McKinsey Global Institute (2009), “An exorbitant privilege? Implications of reserve currencies for competitiveness”, Discussion Paper.
Miran, S (2024), A User’s Guide to Restructuring the Global Trading System, Hudson Bay Capital.
Perotti, E (2023), “The Swiss authorities enforced a legitimate going concern conversion”, VoxEU.org, 22 March.
