Potential Impact of the US debt Crisis

It is hard to switch on a TV or pick up a newspaper that does not have blaring headlines of the coming crisis of a US debt default. However, to what degree is this over-played by the media and what would likely be the real impact if the senate doesn’t agree a deal by the 2nd of August?


Likelihood of a default

It would seem pure madness that the House of Representatives could allow a sovereign default by the USA over a relatively minor issue of simply increasing the debt ceiling. However, as one commentator put it these tea party republicans are like mad rabid dogs. It is entirely possible for them to not only take it down to the wire but go way past it.

However, all would not be lost. The 2nd of August deadline imposed by the treasury is something of an artificial barrier imposed to try to focus the minds of congress on actually doing something. The US actually reached its debt limit in March of this year. The US has been running since March without borrowing due to higher than expected tax receipts. It is entirely possible for the US to continue meeting debt payments after the 2nd of August; it will simply just have to stop paying US federal employees.


Impact of the Current Crisis

It is highly unlikely that the US will default. The US is one of only two countries in the world - the other being the United Kingdom - to have never committed a sovereign default. It would seem inconceivable that congress and more importantly the US Treasury could let this record slip. However, the main impact of this crisis is likely to be on the US credit rating. Unless a long term cuts and tax increase program on the order of $5 trillion can be agreed then the US will lose its AAA credit rating.  S&P have already stated that the US may lose its AAA rating “within 90 days”.

It now seems certain the US will experience a credit rating drop. The main question is what will the impact of this be? The primary impact to note, will be the effect of higher interest payments on servicing US debt. At present the spread between AAA and AA is around 0.5%. 0.5% would be a significant impact on a government with more than $14 trillion in debt. However, the US tends to issue debt on a long term basis of 30 years plus. This means that only a small part of the debt will have to be re serviced each year at the higher rate.

Looking at current spreads, US debt is already beginning to be priced at AA levels. Many AAA rated companies already pay lower yields than the US treasury. This means that the impact on the bond market of a rating downgrade would be relatively contained.

The main impact on investments would be the fact that a number of institutions rely on US government bonds to back transactions. These investments must be AAA rated under current investment rules. However, these rules can be changed and have been in the past. Japan had its credit rating cut earlier this year to AA- only the fourth highest level and Japan currently pay just over 1% on its borrowings.

The main impact would be on the US dollar. With a rating default not to mention the panic that Washington is installing in foreign investors such as China, the US dollars days as the reserve currency are numbered. The only thing holding the dollar up at present is the lack of an alternative with the Yen, Euro and Sterling all facing their own problems. However, this will not continue to be the case. All the nations behind the other major currencies seem committed to international stability while the US congress seems to be completely oblivious to the rest of the world.

To summarize, the US is highly unlikely to actually default, either by hook or by crook the treasury is likely to continue paying interest payments of US bonds. However, it now seems certain that the US will have its credit rating cut. This is not necessarily the end of the world. Much of the impact of a rating cut has already been priced in. However the greatest impact is likely to be on the US dollar which will lose all credibility as a reserve currency.