GLOBAL FINANCIAL MARKETS OP-ED
US’s potential risk of a debt default amid regional banking woes could add to a perfect storm
Signs of economic strain in the face of a year of steep rate hikes have been long in coming. But the regional banking crisis and its potential contagion effects aren’t the only things we need to worry about. The potential breach of the US government’s debt ceiling in a matter of months could add to a perfect storm for global financial markets.
American investor Ray Dalio describes the US bank failures as a “canary in the coal mine early-sign dynamic” – and he may well be right in seeing these as a forewarning of what he calls a self-reinforcing debt-credit contraction.
But it’s not just the potential fallouts from ultra-hawkish monetary policy that are a problem. It’s also the looming threat of a government debt default after the US government reached its debt ceiling in January – a major potential risk event for global financial markets.
Since the debt ceiling was reached earlier this year, the US government has relied on various “extraordinary measures” to meet its financial obligations, but these are only expected to tide government finances over until about June. Thereafter, if the Democrats and Republicans haven’t reached an agreement to lift the debt ceiling, which has happened many times before, the government is unable to raise further funding from the financial markets.
In that event, the government will face several unpalatable options, the worst of which would be a sovereign debt default that would shake the global financial markets and severely undermine the US’ status as the financial safe haven of the world.
The US has reached its debt ceiling many times in history and has come close to breaching it on a few occasions before an agreement was reached in Congress. According to the Peterson Institute for International Economics (PIIE), Congress has permanently raised, temporarily extended or revised the definition of the debt limit 78 times since 1960, most of which occurred under Republican presidents.
The closest example of what could lie ahead this year is the 2011 debt ceiling standoff between House Republicans and President Barack Obama, which resulted in an eleventh-hour agreement to reduce expenditure. Though the debt ceiling was increased and the prospect of a debt default averted, Standard & Poor’s downgraded the US’s credit rating for the first time in history, a decision that is estimated to have increased the government’s cost of funding that year by $1.3-billion.
The rating agency specifically cited the political brinkmanship and inability to agree on raising the debt ceiling in a timely manner as reasons for downgrading the credit rating to AA+ from AAA. The PIIE says: “While default was narrowly avoided, the surrounding chaos sparked the most volatile week for financial markets since the 2007-09 financial crisis.”
This year the stakes are much higher because the global economy is in a far more precarious position, and financial markets are on edge.
The Fed is in a tough bind, committed to fighting inflation but cognisant of the financial stresses emerging, as reflected in the collapse of two regional banks and heightened fears that these would lead to a broader financial liquidity crisis. These prompted the government to step in and guarantee the depositors’ funds of the failed regional banks.
Right now, President Joe Biden is insistent on negotiating a clean deal with the Republicans that does not include the stiff spending cuts the party is demanding in return for their agreement to raise the debt ceiling. Says the PIIE, “The administration is adamant about opposing anything that normalises the use of the threat of default as a bargaining chip.”
However, his unbudgeable stance means there will be exceptional market volatility as the so-called X-day nears, and, in a worst-case scenario of the debt ceiling being breached, the consequences will be disastrous not only for the US but also for the rest of the world.
Treasury has several options that vary in severity if they can no longer access global bond markets for funding after the debt ceiling has been breached – the last of which would be to default on its government debt repayments in the global bond market. The Brookings Institution notes that Treasury had a contingency plan to cope with the same scenario in 2021, which gives a good indication of the options available to them if, as it says, the debt limit were to bind this year.
Treasury would continue to pay interest on Treasury securities and, as these matured, would pay the principal by auctioning new securities for the same amount. In this event, no debt default would be in the offing. It would also delay payments to agencies, contractors, Social Security beneficiaries and Medicare providers. The Brookings Institution estimates that non-interest federal spending would have to be cut by about 20% in an average month depending on the revenue inflows, which vary month to month and could rise to 35% or more.
The institution outlines a worst-case scenario in which the Treasury is forced to delay interest or principal repayments on US debt: “Such an outright default on Treasury securities would very likely result in severe disruption to the Treasury securities market, with acute spillovers to other financial markets and to the cost and availability of credit to households and businesses. Those developments could undermine the reputation of the Treasury market as the safest and most liquid in the world.”
UBS’s editorial team, in their analysis of the impact of the US debt ceiling debate on financial markets, says the most probable scenario is that Congress reaches an eleventh-hour compromise “within days or hours of the deadline”.
However, they caution that investors should be prepared for a period of volatility as the deadline approaches and say the possibility of a failure to reach an agreement cannot be discounted and that this would result in “abrupt financial market distortions”.
Hopefully, sanity will prevail and the politicians won’t take it down to the wire, recognising the gravity of a US economy already at risk of other economic dislocations emerging in response to the shift, within just a year, from a zero-rate to a 5% interest rate economic environment.
And for the rest of the world, their decisions matter because, as the adage goes, “when the US sneezes, the rest of the world catches a cold”. BM/DM