Thursday, October 28, 2021

5 Ways US Debt Defaults Will Resonate Through the Global Economy

US lawmakers have less than three weeks to prevent a default on the country’s sovereign debt by raising the limit on the amount the Treasury Department can borrow. Failure to do so would result in the United States willfully defaulting on its loans for the first time in history.

So far, economists’ estimates of how much the US economy would suffer in the event of a default triggered by bitter conflict between congressional Democrats and Republicans have been widely reported.

An estimate by Moody’s Analytics earlier this month predicted that in the long-term default scenario, the US would be hit by a recession, with GDP falling by about 4%. Some 60 lakh jobs will be lost, raising the unemployment rate to 9%. The resulting stock market sell-off would wipe out $15 trillion in household assets. In the short term, interest rates will rise, and in the long term, they will never return to pre-default lows.

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But losses from a US default will not be absorbed in the United States itself. US The securities issued by the U.S. have been so reliable for so long that they are considered essentially risk-free in the financial markets, and are used to short a large number of financial contracts around the world.

“The US Treasury market is the world’s anchor asset,” said Jacob Kierkegaard, senior fellow at the Peterson Institute for International Economics. “If it turns out that the asset is not truly risk-free, but it could actually default, it would basically explode a bomb in the middle of the global financial system. And that would be extremely messy.”

A man wearing a protective mask walks past an electronic stock board showing Japan’s Nikkei 225 and the New York Dow index at a securities firm in Tokyo on September 29, 2021.

immediate result

In the event of a default, it is generally assumed that there will be a widespread sale of Treasury securities, known as Treasuries. This would be for a number of reasons – from individual investors panicked to default, to companies that had collateralized loans with treasuries being forced to replace lenders with more secure ones.

The sell-off would make it more expensive for the US to borrow in the future, raising interest rates in the United States and causing the dollar to fall in value against other world currencies.

Here are five ways those influences will resonate through the global economy.

decreased global trade

If a default plunged the US into recession, US consumers and businesses would reduce the amount of goods and services they could buy from outside the country.

While this will affect almost all countries to some degree, emerging market countries that rely on exports to the United States for most of their income will be particularly hard hit.

A potential devaluation of the dollar would have a similar effect – making it more expensive for US firms to buy supplies abroad, resulting in even less tradeoff.

Dollar economies will suffer

The US dollar is a common currency in most parts of the world. Some countries have adopted it as the official currency, while in others it exists alongside a local currency that is often “denominated” to the dollar to keep its value stable.

In the event that the dollar declines in value by default, countries with highly dollarized economies will lose the purchasing power of existing currency stocks.

“Emerging markets will suffer greatly because they will not have a domestic currency that is very reliable,” Kierkegaard said.

business contract affected

Around the world, many cross-border transactions require that they be settled in US dollars. In normal times, this is seen as a practical way to ensure that sudden fluctuations in the value of the local currency do not dramatically harm one party in a future transaction.

A sudden and sharp drop in the value of the dollar would mean that individuals and companies expecting to pay on existing contracts in dollars would effectively receive less than expected for their goods and services.

More sophisticated trade contracts may include anti-default clauses that require the agreements to be renegotiated in the event of a default that reduces the value of the reserve currency. While this would keep both parties to a contract as a whole, it would also be complicated and slow down many transactions.

Clients buy and sell money at the currency exchange office in Istanbul, Turkey on September 27, 2021.

Clients buy and sell money at the currency exchange office in Istanbul, Turkey on September 27, 2021.

Capital flows away from America

One of the long-standing economic advantages of the United States is that it is a magnet for global capital. When the global economy is strong, investors want growth funnel money for US firms. When times are bad, investors take refuge in the US Treasury. Either way, global markets are directing capital into the US

But when interest rates rise for the wrong reasons — because investors don’t trust the US government to pay their debts — that system breaks down.

The result is that to some extent, asylum-seeking investors will be more cautious about assuming that Treasury securities are the go-to investments to protect the value of their assets. The logical step for them would be to start directing at least some of their investments into securities issued by other governments and denominated in different currencies.

new reserve currency

A side effect of those new capital flows could be a challenge to the dollar as the world’s “reserve currency.”

A reserve currency is money held by a country’s central bank and large financial institutions for domestic companies to facilitate global trade, to meet international debt obligations, and to influence domestic currency exchange rates, among other reasons.

The dollar’s stability since the end of World War II has made it the major global reserve currency. This has generated a sustained global demand for the dollar, making it possible for the US government to borrow at lower interest rates than other large countries.

The United States’ global competitors, including China and Russia – but even allies such as the European Union – have suggested for years that it would be better if the dollar’s dominance was not as absolute as it is.

There has been little movement to remove the dollar in recent decades, but a setback like a default on US debt allows some countries to hedge their bets by taking other currencies such as the euro or renminbi as an addition to their reserve holdings. can persuade.

“If you are China or, for that matter, the euro area, you want to replace or replace the dominant role of the dollar in the global economy with the renminbi or the euro,” Kierkegaard said. “You couldn’t ask for a better thing.”

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