US debt ceiling crisis could spiral if deal not struck by Thursday

Without resolution, not only would US growth suffer but dollar's status as reserve currency could also be questioned

Thursday (17 October) is a critical day for the markets, because if the US government does not manage to increase the debt ceiling, then the chances of a default by the US government increase. With a fractious Congress, a debt ceiling crisis may not be resolved by Thursday. So far markets are not even factoring in such a possibility, but if this happens, the world markets are in for a lot of turbulence. 

 

The US Treasury has a debt ceiling of $16.7 trillion, which it hit on May 19, 2013, and since then the US government has been using various methods to make payments and issue debt papers. Lawmakers need to arrive at an agreement and hike this ceiling if the US government has to pay salaries. If the debt ceiling is not increased by October 17, then the US could default on these payments and interest commitments. The Economist says that even though the US Treasury has $30 billion in cash, it will still struggle to make large payments, which are coming up. On October 23, $12 billion in payments are coming up for Social Security and $6 billion as interest payout on its debt on 31 October. Apart from this, it will need another $67 billion to pay salaries of bureaucrats and soldiers. Citigroup on the other hand believes that the real deadline for a settlement is 1 November. 

 

Most market experts believe that a quick resolution is difficult and if the US defaults technically or delays payments, then the markets would question the political stability and dollar's status as a reserve currency. According to Robert V DiClemente at Citi Global Ecoonmics Research, says: "If US creditworthiness and political stability are questioned because of sequential technical defaults stemming from political dysfunction, global investors may want to shift to alternative currencies." Also if a debt ceiling is not raised and budget cuts continue, then the US could be headed for a prolonged period of economic weakness, which would have a cascading effect across the globe. Other turmoil in the currency markets, the great rotation to US bonds, which had started some time early this year, may also come under pressure as unwinding may begin in a relatively tighter liquidity conditions. 

 

The markets are so far of the opinion that a US debt default is unlikely and which is why there is no visible sign of any stress, even though markets want the crisis to be resolved. Senior currency strategist Sacha Tihanyi at Scotia Bank said a failure to come to an agreement on the debt ceiling constrained sentiment in Asian trading on Monday. With the onset of the Budget battle and the US shutdown has pushed Treasuries down yet again. Economists in the US believe the failure to raise the debt limit could lead to a rapid and sharp economic downturn if not reversed quickly. 

 

So what does this mean for emerging markets like India? While the debt ceiling deadline is crucial to markets, the bigger issue that emerging markets face is the issue of the gradual rollback of its quantitative easing programme. According to Goldman Sachs, the US Federal Reserve's decision not to taper its fiscal stimulus is nothing more than a short respite for EM assets but quick reversals are likely given the fundamental challenges in many emerging market economies. 

 

One of the key factors that contributed to the rise in Em assets and currencies was the money that flowed into these assets after developed countries adopted loose monetary policies. Countries like India benefited immensely from this and corporates increased their overseas borrowings, while export oriented countries built up forex reserves by increasing exports. With the US Fed looking at reversing its loose monetary policy stance, flows to countries like India will be affected. 

 

Dominic Wilson, chief markets economist and co-head of global economics research at Goldman Sachs says Dominic Wilson: There are three main implications for emerging markets. The first is that the extraordinary performance of EM assets over the last decade is unlikely to be repeated. Second, if you look out over the next two or three years, EM assets are probably going to face more challenges, both on an absolute and on a relative basis compared to developed markets, which has already been true for a while. And thirdly, differentiation between different parts of the emerging market universe is going to become relatively more important." As far as India is concerned, Goldman Sachs Tushar Poddar expects the RBI to hike repo rate by 100 bps by March 2014.