When American schoolchildren learn the key dates in their national history, probably the best known is July 4, 1776 – when the 13 colonies declared independence. Less celebrated but also significant was January 8, 1835 – the first and only time that the US government had zero debt.
Times have changed since then. In the ensuing 176 years, national debt has been run up to over $14.29 trillion, hitting the ceiling imposed by Congress. And if Congress doesn’t vote to raise that ceiling before August 2, something rather disturbing might occur: the American government could default on its bonds.
Ratings service Moody’s has already indicated that this would lead to a downgrade of the country’s top credit rating, which in turn would mean US Treasuries no longer represented ‘risk-free’ instruments. Given the T-bill is a pillar of the world’s financial architecture, a US government bond downgrade could then spark waves of selling in other asset classes.
That has plenty of policymakers concerned about a financial panic, including US Treasury Secretary Geithner who has already made plain his fears to American lawmakers.
But perhaps the country most worried about the possibility of default is China, currently the biggest holder of US government debt.
What are they saying in Beijing?
Editorial coverage has been extensive, with signs of growing concern.
“Of all the creditors of the US government, the most anxious is undoubtedly the Chinese government,” concurs newspaper CBN.
“I think there is a risk that the United States may commit debt default,” Chinese central bank adviser, Li Daokui told the Global Times last month. “The consequences of this are very serious. I really hope they do not play with fire.”
Shen Jiru at the Chinese Academy of Social Sciences (CASS) went further, telling the Global Times that any breach in US debt repayment would see it become “a target of the world’s public criticism” and “cause disorder of the entire international financial system”.
The dollar would depreciate substantially, commodities like oil and iron ore would rise in price and stock markets would fall. “The whole world will be overwhelmed,” Shen warns.
The Economic Information Daily also predicted a chain reaction if America’s two political parties cannot reach a compromise by mid-July. In the event of a default in early August “a dollar sell-off will occur around the world – first financial institutions will sell, then small countries, then big countries.”
That would be a bleak outcome for China, the newspaper warned. Of its $3.19 trillion of foreign exchange reserves, $1.16 trillion is held in US Treasury bonds. These will depreciate quickly, as a result of the credit downgrades and a falling dollar.
Worse, it believes the Federal Reserve would respond to the crisis with a further bout of quantitative easing, adding to China’s inflation woes. Global demand would be hit as the US leads the rest of the world into a stagflationary environment. “A great depression is inevitable,” the EID warns.
The International Finance News also foresees “a new round of capital markets panic”, adding that the Chinese banks will be in the firing line too as their own US Treasury portfolios fall in value – a major concern given their rising exposure to bad debts at home (fuelled by a local government lending binge, see WiC110).
So is a default likely?
It remains such a doomsday scenario, that the Chinese media thinks it is doubtful, particularly as it would be a self-inflicted crisis (induced less by external events and more by political bickering in Congress).
Back to Shen Jiru of CASS (quoted earlier): “The US will not dare to commit a debt default and so the end result will be a bipartisan compromise.” Over the past few days the moves to find that compromise have gained momentum, with President Obama calling emergency negotiations.
However, talks between Republicans (who control the House) and Democrats (who control the Senate) have stalled over some major differences, and the debt ceiling won’t be increased unless a deal is done to cut the budget deficit.
Both sides agree on the need for the deficit to fall; just not on how to do it or by how much.
Obama favours a $4 trillion reduction over a decade (“It’s not going to get any easier. We might as well pull off the Band-Aid; eat our peas,” he says). His Democrats want increased taxes to pay for $1 trillion of the deficit reduction.
Senate Minority leader Mitch McConnell, a Republican, told Fox News on Sunday: “We’re not going to raise taxes in the middle of this horrible economic situation.” His party want to see deficit cuts funded entirely through reduced spending. Indeed, to avoid any suggestion of tax rises lead Republican negotiator John Boehner has scaled back his ambitions to $2 trillion in cuts (an amount calculated to win some political capital, but perhaps without derailing his party’s bid to win the White House and Senate next year).
Complicating matters is the Republican fringe, the so-called Tea Party movement. They are holding out for even deeper spending cuts and appear oblivious to Geithner’s warnings of how financial markets might be paralysed by a default.
In fact, it looks like they’d rather default than give way on their electoral agenda to eliminate trillions of government spending. A bit like the Y2K bug, they seem to believe an August 2 default would be a non-event.
(The attitude is a surprise given the Tea Party camp is so keen on the Constitution. They of all people should know the 14th amendment forbids the federal government from defaulting on its debt, points out TIME magazine.)
American business is worried too, and 470 executives representing companies like Alcoa and Procter & Gamble signed a letter urging Congress to raise the debt ceiling. They wrote on Monday that the alternative would throw markets into “disarray… this is a risk our country must not take”.
Could the unthinkable happen? According to the Wall Street Journal, Obama has expressed confidence that Congress will act in time. But by Tuesday negotiations had “spiralled downwards”. The White House and congressional leaders had “dug in on their positions,” wrote the Journal.
As WiC went to press, the latest twist was a new plan hatched by McConnell and cautiously endorsed by Senate majority leader, the Democrat Harry Reid. “In a sign of disarray within his own party and increased pessimism about the potential for a deal,” reports the Financial Times, McConnell suggested a mechanism that would allow Obama to raise the debt ceiling – even if no agreement had been reached on deficit cuts.
But fellow Republicans have already voiced dissent. Steve King, a representative from Iowa, has likened it to “putting the fox in the hen house” by abrogating any leverage to cut spending; and Boehner has said the idea won’t pass the House. Meanwhile, Moody’s yesterday cited a “rising possibility” the ceiling would not be raised in time, and said it was now reviewing a possible downgrade of the US government’s debt.
Changing Chinese attitudes…
Even if the US doesn’t default in the next couple of weeks, all the talk that it might do so has focused minds in Beijing.
Over the past two years Premier Wen Jiabao has publicly worried about the size of China’s US debt holding, as well as its potential to decline in value. Accordingly, there has been a conscious move this year to diversify reserves – buying more Japanese government bonds, as well as from governments in the eurozone (good luck with that, the US Treasury might well respond). In the first four months of the year, it is estimated China’s reserves rose $200 billion: of that $150 billion went into non-US dollar assets.
Back in April, China’s central bank governor also admitted the nation’s foreign exchange reserves had exceeded a reasonable level. Many interpreted that as code for ‘we have too much exposure to US debt’. According to the Shanghai Evening Post, governor Zhou Xiaochuan told an international forum that another alternative to buying more US Treasuries was for China to direct its savings surplus to emerging market economies. These are the growth spots, he said, but lack capital for development.
Liu Shengjun, vice president of CEIBS Lujiazui International Financial Research Institute agrees that China holds “excessively large numbers of US Treasury bonds”. In an interview with the National Business Daily he suggested China buys more commodities instead.
Of course, the other big trend in moving away from the dollar is to conduct more trade in the Chinese currency, the renminbi. In the past year this process has accelerated. But realistically, most of China’s cross-border trade in goods and services will be priced in dollars for the foreseeable future.
But as the New York Times points out, in the meantime the Chinese will use their creditor status as a source of diplomatic leverage.
The newspaper comments: “One senior American Treasury official noted the other evening, as his colleagues engaged in the giant game of default chicken, that sooner or later whatever agreement goes through the House and the Senate will have to pass muster, at least informally, in the Great Hall of the People. ‘You know how the generals always say that when it comes to our strategy in Afghanistan, the enemy has a vote?’ he asked. ‘Well, when it comes to borrowing a few trillion dollars, the Chinese have a vote, too.’”
The deficit, it notes, gives China the right to criticise American spending policies. And the Chinese seem to think so too. This week the Shanghai Daily reported that the chief of general staff of the People’s Liberation Army told his counterpart Admiral Mike Mullen that the US should cut defence spending.
Chen Bingde said at a joint news conference: “I know the US is still recovering from the financial crisis. Under such circumstances, it is still spending a lot of money on its military and isn’t that placing too much pressure on taxpayers?”
And yesterday, China got explicit with its concerns. Foreign ministry spokesperson Hong Lei told a briefing that Beijing hoped the US would “act more seriously and effectively” to resolve the debt ceiling issue.
“ ‘Worried’ China warns US against debt downgrade” headlined the South China Morning Post.
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