Moody’s warned yesterday of a credit rating downgrade to junk for the US state of Illinois.

The background

The state hasn’t had a full year budget for the last 2 years because of disagreement over spend/revenue plan between its Republican Governor Bruce Rauner and Democratic-controlled legislature. Rauner’s pro-business policies of tax cuts and cost cuts in worker compensation plans did not gel well with the Democrats who felt that the policies would hurt the middle class. After two years of stalemate, Illinois is now expected to have a budget. Moody’s had earlier warned the state to pass a budget or face rating downgrade. However, it appears that the state might face a downgrade despite the budget, as the rating agency questions the lack of long-term solution to fix the state’s financial mess

Mass exodus unlikely

While a drop to the junk status might trigger a sell-off of the bonds causing bond prices to drop, a mass exodus by the investors is unlikely. It is expected that the state’s biggest bondholders are unlikely to exit immediately and might avoid stress selling their holdings.

But the cost to state economy would be huge

A junk rating would significantly increase borrowing costs for the state. It would impact the government’s ability to continue with public spending like federal aid for universities, medical and pension aids.Tax hike to generate state revenues would hurt individual and business incomes. Investments into the state would eventually suffer as people and businesses move out of the state in search of better prospects.

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