Five ways U.S. defaults resonate in the global economy

US lawmakers have less than three weeks to avoid default on the country’s sovereign debt by raising the limit on how much the Treasury can borrow. Otherwise, the United States will deliberately default for the first time in history.

To date, there have been numerous reports of the extent of the damage economists predict the U.S. economy will suffer in the event of a default caused by a fierce conflict between Democrats and Republicans in Congress.

Moody’s Analytics estimated earlier this month that a prolonged default scenario would put the United States into recession and reduce GDP by almost 4%. About 6 million jobs will be lost and the unemployment rate will reach 9%. The resulting stock market sell-off will wipe out $ 15 trillion in household wealth. Interest rates will skyrocket in the short term and not return to pre-default lows in the long term.

However, damage caused by defects in the United States is not included in the United States itself. Securities issued by the United States are so credible that they are considered inherently risk-free in financial markets and are used to support the large number of financial contracts around the world.

“The US Treasury market is a global anchor asset,” said Jacob Kierkegaard, senior researcher at the Peterson Institute for International Economics. “If it turns out that the asset is not really risk-free, but could in fact be the default, it would detonate a bomb in the middle of the global financial system, and it’s very embarrassing. ”

On September 29, 2021, at a brokerage in Tokyo, a man wearing a protective mask walks in front of an electronic board displaying the Nikkei 225 in Japan and the Dow in New York.

Immediate benefits

When defaults do occur, it is generally expected that there will be a widespread sale of treasury securities called treasury securities. This happens for a variety of reasons, ranging from individual investors tricked by defaults to companies forced to replace government bond-backed loans with what lenders see as safer. ..

The sale will make the United States more expensive to borrow in the future, raise U.S. interest rates, and lower the value of the dollar against other world currencies.

Here are five ways in which these impacts can be reflected in the global economy.

Declining world trade

If defaults drag the United States into a recession, American consumers and businesses will reduce the amount of goods and services they buy overseas.

This will have some impact on virtually all countries, but emerging countries that depend on exports to the United States for a large portion of their income will be particularly affected.

The expected devaluation of the dollar has a similar effect. Trade is further reduced as US companies spend more money to buy goods abroad.

The dollarized economy will suffer

The US dollar is a common currency in many parts of the world. Some countries use it as the official currency, while others coexist with the local currency, which is often “pegged” to the dollar to stabilize its value.

If defaults devalue the dollar, countries with heavily dollarized economies will experience a decline in the purchasing power of existing currency stocks.

“Emerging markets will suffer a lot because they don’t have very reliable national currencies,” Kakegard said.

Commercial contract concerned

Many cross-border transactions around the world must be settled in US dollars. This is generally seen as a practical way to ensure that sudden fluctuations in the value of the local currency do not pose a significant disadvantage to a party to a transaction that will be settled in the future.

The sudden and sharp drop in the dollar’s value means that individuals and businesses that expect to pay in dollars for existing contracts are receiving considerably less than expected for goods and services. It means you are.

More sophisticated commercial contracts may include default prevention clauses that require the contract to be renegotiated in the event of a default that depresses the value of the reserve currency. This can complicate and slow down many transactions as both parties maintain the entire contract.

Customers buy and sell money at a currency exchange office in Istanbul, Turkey, September 27, 2021.

Capital flows out of the United States

One of the economic advantages that the United States has long enjoyed is that it attracts global capital. When the global economy is booming, growth-seeking investors invest money in American companies. When times are tough, investors seek refuge in US Treasuries. Either way, the global market is directing capital to the United States.

But if investors don’t trust the U.S. government’s debt repayment and interest rates rise for the wrong reason, the system breaks.

As a result, to some extent, investors seeking shelters will be more cautious when they assume that government bonds are a reliable investment to protect the value of their assets. The logical decision is for them to start channeling at least part of their investment towards securities in different currencies issued by other governments.

New reserve currency

The side effect of these new capital flows could be the challenge of the dollar as a global “reserve currency”.

A reserve currency is money held by a country’s central bank or a large financial institution to promote global trade by domestic firms, meet international debt, and influence domestic exchange rates.

The stability of the dollar has made it the dominant global reserve currency since the end of World War II. This has created a constant global demand for the dollar, allowing the US government to borrow at interest rates lower than those of other great powers.

He has long suggested that the US’s global competitors, including China and Russia, but even allies like the European Union, should not have less complete control of the dollar.

There has been little movement to free the dollar in recent decades, but shocks such as US defaults have led some countries to use other currencies such as the euro and the renminbi in addition to reserves. Then I started to hedge my bets.

“If you were in China, or even in the eurozone, you wanted to replace or want to replace the dominant role of the dollar in the global economy with the yuan or the euro,” Kakegard said. “I couldn’t ask for better. ”


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