Is a US default unthinkable? Think again
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Emerging Markets

Is a US default unthinkable? Think again

US policymakers have clearly shown themselves to be standing ready to support the financial system, whatever the cost. But the price to be paid could be nightmarish — a default of the United States itself.

EM staff


The risk of inaction today outweighs the ill-effects tomorrow of efforts to stave off global financial meltdown. So goes the emerging consensus among financiers and policymakers alike: authorities should aim to overshoot rather than fire short in organizing bailouts of their financial systems and institutions - and worry about mopping up later.

But in doing so, are governments throwing caution to the wind—and at what price?

When the dust settles, public finances will have changed markedly for the industrialized nations. That will have an impact on ratings in terms of rank ordering; it may also have an impact on absolute levels.

As the financial crisis places unprecedented strain on public balance sheets, a fiscal time bomb across G7 economies — including the US, Europe and Japan — has begun counting down. The effective blanket guarantees of the financial system, together with new plans for massive government spending to jumpstart growth, at the very least raise the spectre of sovereign ratings downgrades among rich countries. Even more startling, the risk of sovereign default among G7 members can no longer be ruled out.

The $300bn bail-out of Citigroup this week forced the US government to say, in effect, that it will now provide whatever capital is needed to support the financial system. It also weakened residual ideological resistance associated with bailing out certain sectors of the economy.

Yet as a result of the US bailing out of its financial and, possibly, non-financial sectors — while mooting a ramp up in public spending to reflate the economy — it is no longer inconceivable that government debt could lose it its triple-A credit rating. This fact alone is significant — but if it happened it would fundamentally reshape the global investment landscape, since global asset prices are, for now at least, benchmarked against US Treasuries

This is no idle speculation. Gross US public debt has reached about $10.6 trillion this year, or just shy of 70% of GDP. October’s rescue legislation increased the government's debt limit to more than $11.3 trillion from $10.6 trillion. The additional borrowing could push the national debt well past the 70% mark, the highest since the immediate aftermath of World War II, when the US was still paying off war debt.

The US government’s funding needs are likely to be of the order of $3 trillion over the next three years; and a budget deficit of several trillion dollars over the next few years would set alarm bells ringing about the sustainability of US public debt. If the US defaulted, the results would be catastrophic for the global financial economy, possibly bankrupting the entire system.

The facts from US treasury markets do not augur well. Investor anxiety about how the cost of rescuing banks and carmakers will affect US government debt dynamics has reached unprecedented heights.

While nominal bond yields have declined, the credit risk component of US treasuries has been on an upward trajectory since last year. The cost of insuring against a US government default has risen by 25 times in little over twelve months. Similar trends are evident in the UK and German government bond markets.

This week, spreads on 10 year US treasury credit default swaps hit record wide levels, increasing to 49.8 basis points on Monday from 49.3 basis points at Friday’s close, according to the credit data company CMA DataVision. Five year treasury CDS widened to 43.5 basis points versus 43.0 basis points last Friday, a day which itself saw a 20% rise in the risk premium.

CDS spreads have nearly doubled from levels seen two months ago after the collapse of Lehman Brothers. Before the financial crisis, default risk premiums on US government debt were in the single digits. Meanwhile overall funding costs for the US government are edging up, even as interest rates head south.

The central question is whether the rest of the world will continue financing the US. The sovereign’s financing needs are soaring at a time of reduced international liquidity and declining current account surpluses in Asia. China was a willing financier when the US was buying its goods, but now with its exports to the US falling, Chinese authorities find themselves instead supporting its financial system. Despite the recent “flight to quality,” sharp gains in long term US government bond prices are not likely against this backdrop.

But a hint that US sovereign debt could lose its coveted status may yet trigger a sharp reversal by Chinese and other major buyers — a scenario that would also see the US dollar collapse in short order, and could conceivably imperil the entire fiat currency system.

The hope is that US government debt will remain attractive to domestic and international investors because of the enormous breadth and depth of treasury markets. But the signals from today’s markets are, at the very least, alarming.

Of course, the second the US government finds it can’t borrow what it needs at any price — and the treasury bubble bursts — the US authorities would print more dollars to meet their financial obligations. The result, which could engender an era of hyperinflation, would be cataclysmic for the world economy. But even if the treasury market holds up, the medium term risks have hardly gone away.

And in any event, the case for objective ratings of US sovereign debt remains undiminished.


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