Financial Times

Tough decisions for the 'Untied States'

Monday, July 19, 2010

Government debt problems are plaguing individual American states and could be as much of a threat as the issues facing some eurozone countries, according to reports emerging from the US.

Whole cities have been declared bankrupt or have been forced to outsource public services, and some of the US’s biggest states are grappling with eye-watering budget deficits which can rival those of Greece, Spain or Portugal.

Investment management firm T Rowe Price warned recently the US may soon be “forced to make painful fiscal decisions” in order to shore up the dollar, reduce debts and control inflation. High taxes and spending cuts may soon be the order of the day in the US as much as they are here in the UK and Europe.

While US concerns are nothing new, it is only during the past few weeks that individual states have started to grab the headlines. For example, California is attempting to deal with a $19bn (£12.6bn) budget deficit. The combined funding gap across all 50 states is expected to reach $112bn by June 2011, according to a report by the Financial Times.

Frances Hudson, global thematic strategist at Standard Life Investments, says 40 per cent of the problems being experienced by the dollar is down to just four states – Illinois, New Jersey, New York and California.

“Most of the states are in deficit, but those four are in serious trouble,” she says. “A good part of the US stimulus package was, in effect, just transfers from federal government to the states. Once they started to withdraw stimulus measures, then the position of state finances was thrown back into sharp relief.”

Legally, states cannot run deficits, so action must be taken to plug budget gaps, but this is proving to be a difficult task. In the fallout from the financial crisis, many states have found income from taxes has been reduced due to rising unemployment. Latest figures from the US Department of Labor indicate that 14.6m people were unemployed at the end of June. Foreclosures are also on the increase, meaning property taxes are also suffering.

While here in the UK the recession is already spoken about in the past tense, California is only on its way into one. Governor Arnold Schwarzenegger is reluctant to raise income taxes, but is lacking many other options – a wider-ranging sales tax is likely, which could apply to all service-based transactions.

Ms Hudson says the size of California – with a population of 36.9m and bigger in landmass than Portugal and Greece combined – may mean it can work its way out of debt. However, she says that a debt-to-GDP ratio of 29.9 per cent will make any recovery very problematic. Even with some degree of central support, credit ratings for individual states have been hit. Ms Hudson says that just a few years ago states could raise cash easily by issuing municipal bonds, but now that the financial sector has “had its fingers burned” it is a lot less willing to lend money. Recent downgrades will not have helped the situation.

While Greece has obviously suffered the most, being downgraded four notches by Fitch from A- at the beginning of December 2009 to BBB- on April 27, 2010, it is rated only marginally lower than California (A-).

Illinois has recently been downgraded by Fitch after it failed to significantly address its budget shortfall. According to research by Standard Life Investments (SLI), the state’s debt is equal to 24.7 per cent of its GDP. One of its main problems – shared with many other US states – is a shortfall in funding for the state pension scheme.

Stock-picking fund managers regularly reassure investors that economic problems faced by countries do not necessarily impact directly on the companies based there, but Ms Hudson believes economic difficulties in US states “are definitely starting to impact public services”.

She adds: “This includes health, education, public sector salaries and public sector jobs. If you start cutting police forces because you can’t afford to pay them, then there are social implications as well. At the same time they have to try and attract businesses to come and employ people, and give incentives for them to do this.”

All this does not necessarily mean that Europe is in a good position – there are still major question marks about the future of the euro, and Germany is starting to buckle under the strain of propping up the ailing Greek government deficit. However, this must be put in perspective and advisers must do their research before relying on the traditional ‘safe havens’ – such as the US – without question. While it retains its AAA rating and status as reserve currency, beneath the surface all is far from tranquil.