NEW YORK - March 15, 2010 - The U.S. and the UK have moved substantially closer to losing their AAA credit ratings as the cost of servicing their debts rose, according to Moody’s Investors Service.

The governments of the two economies must balance bringing down their debt burdens without damaging growth by removing fiscal stimulus too quickly, Pierre Cailleteau, managing director of sovereign risk at Moody’s in London, said in a telephone interview.

Under the ratings company’s so-called baseline scenario, the U.S. will spend more on debt service as a percentage of revenue this year than any other top-rated country except the UK, and will be the biggest spender from 2011 to 2013, Moody’s said today in a report.

“We expect the situation to further deteriorate in terms of the key ratings metrics before they start stabilizing,” Cailleteau said. “This story is not going to stop at the end of the year. There is inertia in the deterioration of credit metrics.”

The pound fell against the dollar and the euro for the first time in three days, depreciating 0.8% to $1.5090, while the dollar index snapped a four-day drop, adding 0.3% to 90.075.

The U.S. government will spend about 7% of its revenue servicing debt in 2010 and almost 11% in 2013, according to the baseline scenario of moderate economic recovery, fiscal adjustments in line with government plans and a gradual increase in interest rates, Moody’s said.

Under its adverse scenario, which assumes 0.5% lower growth each year, less fiscal adjustment and a stronger interest-rate shock, the U.S. will be paying about 15% of revenue in interest payments, more than the 14% limit that would lead to a downgrade to AA, Moody’s said.

The UK is likely to spend 7% of revenue servicing debt this year and 9% in 2013, rising to almost 12% under the adverse scenario, Moody’s said.

Financing costs above 10% put countries outside of the AAA category into a so-called debt reversibility band, the size of which depends on the ability and willingness of nations to reduce their debt burden by raising taxes or reducing spending. The U.S. has a 4 percentage-point band, while the UK has a 3 percentage-point band.

“Those economies have been caught in a crisis while they are highly leveraged,” Cailleteau said, referring to the level of private and public debt as a percentage of gross domestic product. “They have to make the required adjustment to stabilize markets without choking off growth.”

The U.S. would be the most affected under the adverse scenario, as the only country that would face a downgrade, Cailleteau said. The company’s baseline scenario assumes that all current AAA sovereigns will keep their ratings over the next three years, he said.

“On balance, we believe that the ratings of all large AAA governments remain well positioned, although their ‘distance-to- downgrade’ has in all cases substantially diminished,” Moody’s said in the report.

None of the current AAA rated countries are likely to lose their ratings, said Peter Chatwell, a fixed-income strategist at Credit Agricole CIB in London.

“This report is a warning shot to governments, setting out the line that they can’t cross with their budgets,” he said.

While the U.S. is likely to benefit from economic growth more than other AAA nations, weak public consumption is likely to weigh on GDP this year, the ratings company said.

“The pattern of growth and the high rate of unemployment raise the question of how strong the recovery will be going forward,” Moody’s said. “The ability of the U.S. economy to grow more rapidly and, therefore, for government revenues to contribute to fiscal consolidation, will have to depend on a revival in the growth of consumption.”

The U.S. economy will grow 3% this year and in 2011 after contracting 2.4% in 2009, according to the median estimate of economist forecasts compiled by Bloomberg. Unemployment will average 9.6% this year, up from 5.8% in 2008, and will fall to 9% next year, based on the median estimate.

Sales at U.S. retailers unexpectedly climbed 0.3% in February, compared with a median forecast for a 0.2% contraction, the Commerce Department said on March 12.
“The emphasis of the market, and our own, will move increasingly away from public finance developments in 2010, towards medium-term consolidation plans and the credibility thereof,” Moody’s said.

Achieving the fiscal consolidation necessary to avert a downgrade will test “social cohesion” and may involve rewriting the “social contract” between governments and their people, Cailleteau said. “People have to decide what level of pain they are willing to accept to have a healthy economy.”

UK Prime Minister Gordon Brown has clashed with opposition leader David Cameron over the timing and speed of budget cuts as they prepare for an election that must be held by June 3.

The opposition Conservatives argue that the government should come to grips now with the budget deficit, while Brown’s Labour Party says it’s too soon to remove fiscal stimulus.

“Although the economy is now growing, recovery is still in its early stages and remains very fragile,” Brown told business leaders in London on March 10. “We’re not going to withdraw the stimulus until the recovery is assured.”

The UK economy, which emerged from its longest-ever recession last quarter, is forecast to expand by 1.2% this year after a 5% contraction in 2009, according to median economist estimates compiled by Bloomberg. Unemployment will average 8% this year and 7.9% next year, the estimates show.

“The question here is less when fiscal retrenchment ought to start, but rather how credible it is that sufficient retrenchment will take place,” Moody’s said.