The consequences of a US debt default

The consequences of a US debt default

It’s down to the wire. The US government is just a few days away from default, as warring politicians have not yet come to an agreement to raise the borrowing limit of the federal government.

US Fed chairman Ben Bernanke has already warned that a failure to structure a bipartisan agreement could push the world’s largest economy into a major crisis. The equity markets have not panicked as yet, perhaps in the hope that a deal will be in place at the 11th hour, but the price of insuring against a US default in the market for credit default swaps has touched a record high. The shadow of the US debt crisis has emerged at a time when Europe is already battling fiscal woes in its peripheral countries.

We doubt the world economy will blow up next week, even though the US government is expected to run out of money on 2 August. The first hit could be taken by everybody who receives monthly payments from the government, from soldiers to pensioners. There will be personal pain rather than financial calamity. Non-essential services could be next — libraries, museums, national parks etc., could see deep budget cuts. The state of Minnesota has already seen a government shutdown this month thanks to a local fiscal crisis.

What should really concern us is if there is a third stage, when the US government defaults on its bond obligations. The impact could be truly calamitous, perhaps on a par with what happened in September 2008 after the implosion of investment bank Lehman Brothers.

However, the big worry right now is the impact of a downgrading of US debt by the global credit rating agencies, which have already warned about the eventuality. The US is the largest issuer of triple-A debt in the world, the issuer of the global currency and most bond prices around the world are benchmarked to the yield on US treasurys. There could be huge portfolio adjustments across the world if the US loses its top-notch rating.

An eventual default could send bond and currency markets into a tizzy, with money fleeing to other AAA-rated securities issued by countries such as Germany and into currencies such as the Swiss franc and the Australian dollar. Indian balance sheets could get hit if US interest rates spike, but those who have borrowed in dollars could benefit if the rupee appreciates.

At worst, there could be a mad rush of money into safer physical assets such as gold, metals and oil, exacerbating inflation.

So the worst-case scenario is some way off. But the current brinkmanship in American politics is not a pretty sight at all.