INSIGHT: Default lies not in our stars but in ourselves

28 July 2011 15:41  [Source: ICIS news]

By Joe Kamalick

US edges closer to defaultWASHINGTON (ICIS)--US manufacturers this week warned that the nation’s economy is hostage to a fiscal policy war whose casualties could include skyrocketing interest rates, a new recession and death of the dollar as the international reserve currency.   

Daniel Meckstroth, chief economist at the Manufacturers Alliance, lamented that “Once again, politicians are engaged in a high-stakes standoff that effectively bets the US economic recovery in a match to control the direction of fiscal policy”.

Republicans and Democrats in Congress along with President Barack Obama have been struggling for weeks to come up with a mutually acceptable plan to raise the limit on the federal government’s authority to borrow money - known as the debt limit or ceiling.

By law, the US Treasury Department may not issue bonds or otherwise borrow money in excess of the debt limit set by Congress. The current debt limit is $14.3 trillion (€10,01 trillion).

Because the US government’s income from tax revenues and fees covers only about 60% of its daily $10bn in outlays, the Treasury Department must borrow money on international financial markets to cover the balance - some $4bn daily.

But the Treasury’s ability to borrow more money - to pay federal programmes and meet interest payments on earlier debt - is expected to reach the $14,3 trillion ceiling on or about next Tuesday, 2 August.

It is a crisis not of external origin but of our own unmaking, the inevitable consequence of spending more than we earn. With apologies to The Bard, the looming default lies not in our stars but in ourselves, that we are spendthrifts.

Even if Republicans and Democrats on Capitol Hill can work out an agreement to increase the debt limit before next Tuesday, the US government’s triple-A credit rating is already seen to be at risk.

Majority Republicans in the House of Representatives and Senate Democrats and President Obama have been engaged in duelling press conferences, each blaming the other as the clock ticks down toward default without any resolution at hand.

Meckstroth suggested that the edge-of-disaster debate could run through Sunday or Monday. He recalled that “Back in April, congressional leaders and the Obama administration came to an agreement on the 2011 federal budget less than one hour before a government shutdown”.

But a default would be far more serious and consequential than a temporary federal government shutdown.

“A short suspension of principal or interest payments on the Treasury’s debt obligations,” said Meckstroth, “would cause severe disruptions in financial markets and the payments system”.

Because banks, money market mutual funds, and many  other financial institutions use the liquidity of short-term Treasury securities to manage cash needs, he explained, “a default would suddenly make the market value of Treasury securities difficult to determine, potentially destabilizing the financial sector and creating panic”.

Even if a default is avoided at the 11th hour, and depending on how the debt limit is raised, the US government’s credit rating may very well be downgraded, which Mekstroth warns “would hasten the decline of the dollar’s role in the international financial system”.

A ratings downgrade, or indeed outright default, would “call into question the status of Treasury securities as a safe haven for foreign investors”, he said, noting that more than one-third of federal debt is held by foreign governments, the largest being China and Japan, among many others.

A US default or ratings downgrade would not only trigger a new US recession, it could re-ignite global recession and even trigger a severe multi-year depression.

Analysts at High Frequency Economics (HFE) warned that a US default or credit downgrade would sharply reduce the value of Beijing’s central bank holdings, and if the US - China’s top trading partner - drastically cut spending, China too could slip into recession.

“We have no doubt the world economy would fold with it,” HFE said.

The capital intensive US chemicals industry could be hit hard in a US default or even just a credit rating downgrade.

Larry Sloan, president of the Society of Chemical Manufacturers and Affiliates (SOCMA), said that as long as the political logjam over raising the US government’s borrowing authority persists, the greater the threat to the nation’s credit rating and the overall economy.

“A less than stellar credit rating on our sovereign debt will trickle down to higher interest rates on everything from capital improvement loans to revolving credit,” Sloan said.

As a consequence, chemical companies and other industrial firms that depend on outside funding for capital improvements or major equipment purchases “could feel the brunt”, he said.

“In addition, those firms with investments tied up in the market - and these days who isn’t - could be negatively impacted by a faltering Dow Jones Industrial Average (DJIA),” Sloan added.

He noted that Greece’s sovereign debt woes of the past six months have already adversely affected the Dow index and other US stock markets from time to time.

If the US were to fail to raise its debt limit by next Tuesday, “imagine what the US default would do to the markets”, he said.

“I would suspect that that borrowing costs will likely increase in the short term, maybe not a lot but by something,” if the US misses the debt ceiling deadline, Sloan said.

“And this would then cause companies to hold off on new investments, and this clearly would then trickle through the economy and could result in a true ‘double-dip’ recession if foreign markets sense that there is no clear resolution in sight,” he said.

Among other consequences, a US default or even a credit rating downgrade would put downward pressure on the US dollar.  That might make US exports more competitive in foreign markets, Sloan noted, but it also would increase the cost of US imports, including for raw materials that many US chemical companies need.

“The cost of raw material imports could far outpace any export boost resulting from a cheaper dollar, and profitability would suffer,” Sloan said.

If the US goes into default or its credit worthiness is downgraded, “What if foreign countries start to lose faith in their US reserves and demand payback now?”

“And what if foreign markets start demanding greater assurances from US suppliers that they too will not default?” Sloan said.  “There could be additional restrictions imposed on us by our export markets to counter the weaker dollar’s export-boosting benefit.”

But, he added, no one can really say what might happen if the US were to go into default or simply has its credit rating downgraded.

“This would be the first time in our history that our nation’s credit rating is downgraded,” he said, “so we are in uncharted territory.”

 ($1 = €0.70)

Paul Hodges studies key influencers shaping the chemical industry in Chemicals and the Economy

By: Joe Kamalick
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