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US debt default ‘looks unlikely’: IG analyst

Experts warned of a ‘stock market meltdown’ should debt budget negotiations continue to drag on.

us debt default impact stock forex asia economy global ceiling Source: Bloomberg

What is a national debt default?

The latest headlines of the US potentially defaulting on its bills has brought national debt defaults to the forefront again.

A national debt default happens when governments are unable or unwilling to pay off outstanding bills.

There are several common causes of debt defaults, including:

  • Chronic economic stagnation (Venezuela, 2017)
  • High debt accumulation (Greece, 2012)
  • Political instability (Sri Lanka, 2022)
  • Financial mismanagement (Argentina, 2020)

In the case of Argentina, the government was unable to pay back the principal amount and interest earnings to local and foreign bondholders for matured bonds that had been issued as part of debt restructuring plans made following a default in 2001.

As seen with Argentina, governments may struggle to pay back dividends during recession and high inflation. This could result in lower credit ratings and interest rates, which then makes it even harder for governments to borrow additional funds from the bond market to pay off existing arrears.

US debt default: will it get to that stage?

The US Treasury Department has stated that it would likely run out of cash to pay outstanding bills as early as 1 June 2023, barring a debt ceiling lift. Treasury Secretary Janey Yellen’s latest letter on 15 May 2023 also reiterated the unlikelihood and imprudence of a debt ceiling raise.

‘We have learned from past debt limit impasses that waiting until the last minute to suspend or increase the debt limit can cause serious harm to business and consumer confidence, raise short-term borrowing costs for taxpayers, and negatively impact the credit rating of the US,’ she wrote to the US Congress.

In 2011, the US Congress agreed to increase the debt ceiling (the amount of outstanding debt that the government can legally have) just two days before the deadline, or X-date. Following that, Standard and Poor’s downgraded the US government’s credit rating for the first time in its history, from AAA to AA+. The US dollar and S&P 500 index then tanked, while Treasuries rallied.

Axel Rudolph, IG senior market analyst, says that unlike most developed countries, the US sets a ceiling on how much it can borrow. And because the US government spends more than it takes in, ‘lawmakers must periodically raise that cap’, which some US politicians view ‘as a negotiating opportunity that sometimes leads to a deal being made close to the wire’.

US President Joe Biden, however, has stated that he is ‘confident’ that there will be an agreement on the cap and that the US ‘will not default’.

Mr Rudolph is also optimistic that a US default could be avoided, as the issue of the US debt ceiling will ‘likely’ be resolved as ‘it always is in the end’. ‘The only question is when,’ he adds.

What are the consequences of a US default for financial markets?

Nonetheless, a short-term spike in stock market volatility may be seen while negotiations continue. ‘A US credit downgrade or stock market meltdown could occur if debt ceiling negotiations were to drag on for weeks into June, however,’ says Mr Rudolph.

Following the 2011 debt ceiling lift, the global stock market experienced a rout (with major Asian and European benchmarks falling over 3%) while commodities (such as gold) also suffered heavy losses.

This latest default, if it does get to that unfortunate stage, is expected to wipe out stock prices by at least a fifth, according to Moody’s Analytics.

How will a US default impact Asian economies and markets?

Based on how interconnected the global financial markets are, there is no doubt that a debt default by the US will have widespread implications on the rest of the world, including Asia, according to IG Asia market strategist, Yeap Jun Rong.

On a broader scale, a default may lead to loss of confidence in the US, which could ‘mean potential capital outflows from Asian economies, which are already perceived to be of higher risks than the US during normal times’, says Yeap. Consequently, Asian equities may plunge, while currencies will face sharp depreciation.

Asian economies also tend to be ‘very dependent on external demand for growth’, including the US, which has been a ‘major trading partner’ to the region.

‘If credit conditions in the US tighten because of a debt default, businesses may face a difficult time seeking funding for expansion. Consumers will cut back on spending, which would restrict economic growth and magnify the risks of a recession,’ he adds.

A US recession will negatively affect demand for Asian exports, which would lead to a recession among trade-dependent Asian economies. Singapore, in particular, ‘would be more vulnerable to a US recession, considering its heavier dependence compared to its regional peers’, says Yeap.

This information has been prepared by IG, a trading name of IG Australia Pty Ltd. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients.

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