Their debt, our woes: 30th July Financial Express

The Greek tragedy, which turned out to be quite a farce, is not an isolated instance of distortion in the financial markets. Uncle Sam appears to be the imminent threat today with President Obama striving to have the debt limit of $14.3 trillion enhanced. A payment of $29 billion in interest is due in August. Given the size of the US debt problem, the PIGS story appears to be merely a short tale in an epic of indebtedness. Now, whether or not the limit is enhanced will be more of a political issue with the President having the right to bypass Congress as a last resort. But, more importantly, the fact that the US government can default highlights the fact that the global financial system is not really stronger even after emerging from the crisis of 2008. Lehman and Bear Stearns were institutions that shook the financial markets, but a US government default will damage the credibility of the sole superpower and anchor currency.

A US government default will mean that all holders will have to reconsider their options. The outside world holds around $4.5 trillion of the total debt, which is a little over 30% of the total. Clearly, they would get jittery at this prospect and the country likely to be affected the most would be China, which holds $1.16 trillion. China and the US are now symbiotically bound. If the US defaults then China’s holdings get affected. However, the US cannot afford to default because it will then find it difficult to find buyers for its debt in the future, for which China is a major customer. A fall in the value of these reserves will mean losses to be written off that can be quite substantial. A lower value of reserves will compress money supply, which, in turn, will mean pressure on interest rates. Higher rates impact investment and growth.

The second constituent of the market that would be affected will be the pension funds, provident funds and insurance companies that have to perforce invest in triple-A-rated paper. Any erosion in value would mean a withdrawal, which, in turn, will mean large-scale selling of treasuries that will spur up interest yields in the market. Lastly, this panic will affect around $4 trillion of treasuries that are held as collateral in the futures market—repo, OTC derivative, etc. A default will induce a haircut on these values, leading to a tailspin the market.

The issue may be seen as being more of a political dilemma where the Republicans want an expenditure cut as against Obama who would like to see taxes increased. This impasse has meant that the financial markets remain on the edge. Various packages are being spoken of in terms of expenditure cuts and the rating agencies are intransigent about anything less than $4 trillion in debt to retain the triple-A status.

What does this mean for the world? Even in case a default is eschewed, there will be a certain loss of credibility in the dollar and the global system will have to look for alternatives. Currently, with the dollar being the anchor currency, the US has the prerogative to follow the policy of benign neglect to supply dollars to the world where there is belief that the currency is strong. However, now with doubts being raised, we have to look at another currency. The euro was to be the alternative but given the entanglements with the debt crisis and the existence of a common currency has inextricably put the better performing nations in a compromising position. The euro tangle is one where no one can let the rogue nations sink as it would affect every bank’s and hence nation’s balance sheet.

The recent restructuring of Greek debt turned quite farcical. In the new package, Greece borrows 35 billion euros and buys 30-year bonds, which will be worth 100 billion euros on maturity, which is used to repay the investor. WSJ has estimated that the total loss for EU banks can be around 14 billion euros. This comes shortly after the stress tests were carried out by the European Banking Authority that found only eight banks to be deficient in capital (maintaining core tier-1 capital of 5%) out of a set of 90 banks, but surprisingly did not take into account the most vital stress test of Greek default.

The situation is hence quite fluid for the financial markets. While credibility is the main factor, the implications for global growth are compelling. An overall slowdown in global growth as well as trade cannot be ruled out, as the onus will be more on the emerging nations to provide an impetus. Countries like India and China, which have been the bastions of growth in the past, are trying hard to fight inflation and deflate their economies. In such a situation, growth prospects appear to be muted.

But, on the positive side, we can see this entire process being part of a cleansing process where nations will put their fiscal balances in order. Keynesian pump priming, which worked in 2008 and 2009, has to be reviewed now as it also means building debt, which can shake the edifice of credibility as well as future growth. These episodes should be lessons to be imbibed as we work on modifying, if not creating, a new global financial order against the background of the financial crisis that started with Bear Stearns in 2008 and culminated with Uncle Sam’s sorrows.