Stock markets around the world have been in sell-down mode, as jittery investors hold their breath over the potential consequences of the US government technically defaulting on its debt obligation.
At stake here is US$14.3 trillion worth of government debt and politicians from the United States have been scrambling to work out a deal before Aug 2.
The last vote on Speaker John Boehner's proposed bill has been delayed as not enough ayes have been mustered to see the bill passed. His bill calls for an increase in the debt ceiling but must be linked to spending cuts.
Many think allowing the United States to technically default its loans would be financial insanity, but the scale of problems in the US has seen the big rating agencies threaten a rating downgrade. Moody's and Standard & Poor's have put the US debt rating on their ratings watch but downgrades by smaller agencies from a AAA rating to a AA rating took place this month.
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| The US dollar is losing its value due to the debt crisis. — EPA |
Although the situation in the United States is unlike Greece or other parts of Europe that are reeling from a debt problem, the US government debt is nonetheless still sizeable.
The size of the US GDP was US$14.7 trillion as at 2010 and the size of government debt to GDP is close to 100%. The strength of the US economy and its position as the world's largest economy offers it latitude most other countries will not have but there are still limits to what investors will feel comfortable with.
A technical default will not mean the US Government will not be able to honour its debt obligations but it will have to go through irregular channels to do so.
Reports have suggested that the Obama administration will have at its disposal different tools to go skirt around the repayment issue. The US government could sell assets, prioritise payments, invoke the 14th Amendment and get the US Federal Reserve to pay off the government bills.
“But even if the debt ceiling is raised and an immediate default avoided, the magnitude of the fiscal austerity that awaits the US if it is to restore sanity to the public finances is daunting,” says Citigroup in a report.
Citigroup says that given the small near-term likelihood of a deal that would put the US back on the path towards fiscal sustainability, a near-term downgrade of the US to at least AA is therefore likely.
It feels the consequences of a moderate downgrade are likely to be far less damaging than a default but it will still be substantial, including increasing funding costs for the US sovereign, many related public entities and many related or unrelated private companies.
“A downgrade would also further reduce faith in the US dollar as an international currency and store of value and in US Treasuries as an international risk-free asset,” says Citigroup.
“It is hard to see how the US can overcome the unavoidable fiscal challenges without either experiencing a sovereign debt and US dollar crisis or a recession caused by significant fiscal tightening, or both.”
Economists feel that a cut in the US debt rating would bring dire repercussions to the US financial system.
“Estimation showed that a 50 basis point increase in US Treasury rates will add an additional US$75bil each year on taxpayers,” says MIDF Research Sdn Bhd chief economist Anthony Dass in a note this week.
Bank of America Merrill Lynch believes a solution to the debt problem will be in two stages. The first is a smaller upfront deal where US$50bil to US$100bil is trimmed from the deficit over the next decade and a comprehensive deal will be passed either at the end of the year or early next year.
“The comprehensive deal would include both tax and entitlement reform and cuts to discretionary spending. However, our concern is that policymakers struggle to come up with a credible longer-term plan before year-end, particularly since it is an election year.
“This would mean we could face the risk of another debt ceiling crisis and ultimately rating agency downgrades. With this plan, we believe the debt ceiling will be raised before Aug 2, but probably by only US$500bil to give Congress six months time to write and pass the new legislation.
“Any agreement to raise the debt ceiling by a much larger amount in the future would likely be conditioned upon passage of the more comprehensive legislation,” it says.
Any economic impact will be dependent on the composition of the deficit reduction plan.
“The ongoing fiscal uncertainty will only be a moderate restraint on growth, but near-term cuts will have a more serious drag. As a rough rule of thumb, for every US$100bil extra cuts next year we would anticipate cutting 2012 GDP growth by 0.7%,” it says.
The cut in the deficit would mean long end rates of Treasury bonds would likely rise but the direction of the dollar will depend on downgrades by the rating agencies.
Downgrades in the US debt rating would mean a weaker dollar in the longer term as foreign investors would be less likely to hold US debt.
For Malaysia, the stronger ringgit would be beneficial to importers and would facilitate more investments by Malaysian firms.
“Lowering import cost of inputs and capital will facilitate firms' transformation from labour to capital intensive production. It will raise productivity and profits and result to higher wages and more vibrant labour market with a larger pool of highly skilled workers,” says Dass. “Higher wages in turn will boost domestic consumption and spur non-tradable sectors' performance. It will re-orientate the economy from trade-dependent to domestic demand driven.” (The Star Online)
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