U.S. lawmakers have less than three weeks to avert a default on the country’s sovereign debt by raising the limit on the amount of money the Treasury Department can borrow. Failure to do so would result in the United States purposely defaulting on its debts for the first time in history.
By now, the extent of the damage that economists predict the U.S. economy would suffer in the event of default triggered by bitter conflict between Congressional Democrats and Republicans has been widely reported.
An estimate from Moody’s Analytics earlier this month predicted that in a prolonged default scenario, the U.S. would slide into recession, with the Gross Domestic Product falling by almost 4%. Some six million jobs would be lost, driving the unemployment rate up to 9%. The resulting stock market sell-off would erase $15 trillion in household wealth. In the short term, interest rates would spike, and in the long term, they would never fall back to pre-default lows.
But the damage from a U.S. default would not be contained to the United States itself. Securities issued by the U.S. have been so trustworthy for so long that they are treated as essentially risk-free in financial markets, and are used to underpin a vast number of financial contracts worldwide.
“The U.S. Treasury market is the world’s anchor asset,” said Jacob Kirkegaard, a senior fellow with the Peterson Institute for International Economics. “If it turns out that that asset is not actually risk free, but that it can actually default, that would basically detonate a bomb in the middle of the global financial system. And that will be extremely messy.”
In the event of a default, it is generally assumed that there would be a broad sell-off of Treasury securities, known as Treasuries. This would happen for multiple reasons — from individual investors being spooked by the default, to companies that had collateralized loans with Treasuries being forced to replace them with something the lender sees as more secure.
The sell-off would make it more expensive for the U.S. to borrow in the future, driving up interest rates in the United States and driving down the value of the dollar against other world currencies.
Here are five ways those effects would echo through the global economy.
Reduced global trade
If a default drove the U.S. into recession, U.S. consumers and businesses would reduce the amount of goods and services they purchase from outside the country.
While this would impact virtually all countries to some extent, emerging market countries that rely on exports to the United States for much of their income would be particularly hard-hit.
The expected devaluation of the dollar would have a similar impact — making it more expensive for U.S firms to purchase supplies overseas, resulting in trade being reduced even further.
Dollarized economies would suffer
The U.S. dollar is a common currency in much of the world. Some countries have adopted it as the official currency, while in others it exists side-by-side with a local currency that is often “pegged” to the dollar to keep its value stable.
In the event that a default drove down the value of the dollar, countries with highly dollarized economies would see the buying power of existing currency stock diminished.
“Emerging markets would suffer greatly from this, because they wouldn’t have a domestic currency that’s very credible,” said Kirkegaard.
Business contracts affected
Around the world, many cross-border transactions carry requirements that they be settled in U.S. dollars. In ordinary times, this is seen as a practical way to be sure that sudden swings in the value of a local currency don’t dramatically disadvantage one party in a transaction that is to be settled in the future.
A sudden and sharp decline in the value of the dollar would mean that individuals and companies anticipating payment on existing contracts in dollars would effectively be receiving less than they had expected for their goods and services.
More sophisticated trade contracts may contain anti-default clauses that require agreements to be renegotiated in the event of a default that drives down the value of a reserve currency. While this would keep both parties to a contract whole, it would also complicate and likely slow down many transactions.
Capital flows away from the U.S.
One of the economic advantages the United States has long enjoyed is that it is a magnet for global capital. When the global economy is strong, investors seeking growth funnel money to U.S. firms. When times are bad, investors seek shelter in U.S. Treasuries. Either way, global markets are directing capital into the U.S.
But when interest rates go up for the wrong reason — because investors don’t trust the U.S. government to pay its debts — that system is broken.
The result is that to some degree, investors seeking shelter would be more cautious about assuming that Treasury securities are the go-to investment to protect the value of their assets. The logical move would be for them to begin directing at least some of their investments to 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 in order to facilitate global trade for domestic companies, to meet international debt obligations, and to influence domestic currency exchange rates, among other reasons.
The stability of the dollar has made it the dominant global reserve currency since the end of World War II. This has generated constant global demand for dollars, making it possible for the U.S. government to borrow at lower interest rates than other large nations.
The United States’ global competitors, including China and Russia — but even allies, like the European Union — have for years suggested that it would be better if the dollar’s dominance were not as complete as it is.
There has been little movement to unseat the dollar in recent decades, but a shock like a default on U.S. debts could persuade some countries to hedge their bets by taking on other currencies, like the euro or renminbi, as additions to their reserve holdings.
“If you are China or, for that matter, the euro area, you have been wanting to replace or supplant the dollar’s dominant role in the global economy with either the renminbi or the euro,” said Kirkegaard. “You couldn’t ask for a better thing.”your ads here!