Spectre of US default looms

Debt negotiations in the US were hit by further complications last night.  Republican leaders abandoned a vote on plans to increase the debt ceiling after failing to secure enough votes to get the plan approved. The failure has now given US politicians 4 days before the date put forward by Treasury Secretary Tim Geithner as the time by which any deal needs to be completed and the government is able to make payments both to it own citizens and foreign creditors. If any deal fails to materialise and the US misses a coupon payment, a technical default would have occurred and the question is what does that mean for the world economy and the US dollar. Firstly, it would massively hurt the financial credibility of the worlds largest economy pushing up short and long term real interest rates, and would be the equivalent of poking its largest creditor, China, in the eye.

Secondly, any default would lead to a huge adjustment in the value of the Dollar, which would be reinforced by the almost certainty of the Fed embarking of QE3 to offset the forced reductions in governmental spending. But any estimates of what would happen if the US did miss an payment on its debt are really best guesses. We are in unchartered territory in terms of the potential effects on the world economy, particularly the inter-bank and repo lending markets which could according some economist be affected more by a US technical default than in the aftermath of the Lehman Brothers failure.

The US problems would have large ramifications for the European debt markets, since if the safe haven of the US cannot meet its obligations, who can? The recent problems in Spain and Italy would be amplified and may lead eventually to those countries requiring some sort of bail-out. However since money would have to flow somewhere and place would have to have deep capital markets and relative stability, the Euro may benefit from the US problems. Sterling may also benefit from the turmoil against the Dollar since the UK also has large capital markets, but that may not be a good thing since weaker Sterling is part of the policy the Bank of England has been pursuing in rebalancing the UK economy away from consumption.

Report by Alistair Cotton.