US Debt Default May Be Unlikely But India Has To Be Ready With Precautions

By Anjan Roy

The global financial circles are agog with speculation about the prospects of the US government defaulting on its payments. This is because the two major parties in America have so far failed to agree on raising the ceiling of US government borrowing.

This is currently at $25 trillion. The Biden  government has exhausted its current authorised borrowing limit. It cannot raise more borrowing unless the ceiling is raised. The global financial newspapers and players are discussing nothing but the implications of a possible US government default.

What is holding back the simple trick of raising a borrowing ceiling? As usual, this is local politics of United States of America between the Republicans and the ruling Democrats. Republicans are arm twisting the Democratic Administration to adopt some of their policies for spending cuts —amounting to some $4trillion— which the ruling party and president Joe Biden is steadfastly refusing.

But how does the silly US domestic politics is any concern    to the outside    world ?It does, and a default could make a world of difference. The entire present applecart of global financial stability could get disrupted in case of a default by the US government. It will roil the entire global financial markets and could make pricing of financial products nearly impossible. That would give rise to stock market crashes and erratic capital flows across borders.

Should this unlikely event reach the Indian shores and those   of other countries making economies vulnerable? Yes, it would. In the same way that we are affected by the global financial meltdown in 2008-09, or the way Indian rupee lost its ground —from arguing 44 to a dollar to over 55 in a matter of a few months— in course of the US Federal Reserve’s so-called tater tantrums in 2011-12. What could be the intensity of the economic turmoil that can follow a US government default?

Some experts have said it could be so severe that the financial melt down of the 2008-09 could look like a “tea party”. Ironically enough, the first victim of the US default and debt crisis has already suffered — the G7 summit. US president had to cut short his participation at the Hiroshima G7 meet and flew back to Washington after which the QUAD Summit slated in Australia had to be abandoned.

Some people can say it is good to not let government borrow. Families also follow prudence and avoid borrowing to meet expenses. After all, the old English proverb says, cut your coat according to your cloth.

But if prudence is good for families, if a government follows this dictum it is recipe for total economic disaster. How, let us see in our Indian case.

The government of India borrows money to pay for its expenses. It really goes on borrowing and never repays its borrowings in full. It borrows to repay its old debts and interest on them. The government borrows by issuing its securities — the government bonds and securities. These are picked up by commercial banks mostly and other investors as well.

These bonds and securities are said to be risk-free assets and the interest rate on them determines the entire interest rate architecture for the whole economy. Any variations in the interest rates could make situation a hell for the banks, unless they have properly guarded their investments.

Now, to see how important these are just refer to two recent bank collapses in the USA. The Federal Reserve had increased its policy interest rates. Variations in interest rates cause the values of securities and bonds —including the government ones— go up or down. This is because the stocks of government securities are not just held by the banks. They ae constantly traded in the financial market to meet funds requirements of banks.

When the central bank raises or lowers the policy rates, the discount or premium on existing bonds and securities goes down or up. This is the mechanism through which banks’ balance sheets are affected.

Two American banks —Silicon Valley Bank and First National Bank— had exposure to US government treasuries, which suffered in value as the US central bank had raised its interest rates stages. At a critical point following a rate hike, these banks had to reckon the losses they had suffered because on interest hikes. Their balance sheets had become so weak as such they could no longer survive as independent banks. US government had to step and assuage their depositors that their deposits were safe and would be paid back.

So the government bonds —called Treasuries in US— and interest rates were the Lynch pin on which the entire financial structured rested. Any doubts about its robustness could be disaster for the whole financial world. Those must remain rock solid and this is one reason why an increasing portion of the finial sector is veering round to the public sector. That, of course, is a different topic calling for detailed examination.

But for the present purpose, any default by the US government will shake that faith in the US treasuries as the ultimate rock solid financial asset. The entire pricing of the financial assets —be that a corporate stock, the treasuries issued by other governments, bonds or any other instruments— would become uncertain in a  way. Markets will start discounting whether Japanese would falter, Britain, Germany and who not.

Default by the US government will mean that the US treasuries’ value would become a matter of doubt. Mind you, our care of foreign exchange reserves —$560 billion— itself would become uncertain as the Lon’s shape is placed in US treasuries. Stock markets would tumble, interest rates would come to be adrift, funds would flow in different unforeseen directions.

Would this really happen? No very, very unlikely. But the mere speculation itself is sending shudders. US president is speaking to the US House speaker to   find a solution. Both are doing some hard bargaining and in the end should work out a formula.

But if does happen, how could India be immediately affected. We will be hurt mainly through the financial channel. FII investments would all on a sudden fly out. That will affect the stock market and the rupee exchange rate. The prices would go up. US would be thrown into a recession and its GDP will shrink. It will affect our exports and international liabilities.

But as a large country with   big domestic reservoirs of economic strengths, India  will be able to remain afloat. After all, our domestic economy could be insulated fairly quickly and keep chugging along.   But still. Vigilance is needed and our finance ministry officials are certainly monitoring closely the developments in Capitol Hill to be ready with precautionary  measures, if needed. India has already learnt lessons from 2008-09 financial crisis and the follow up thereafter. (IPA Service)

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