The US government had been shuttered for more than two weeks, and investors around the world, including those in emerging markets, have been watching the impasse and beginning to plan in the event of a default of US government debt. Late Wednesday, the US Congress agreed to a short-term extension of the debt ceiling until February and set the stage for the government to reopen. However, a definitive, long-term solution to the nation’s debt issues was still not reached and we could see a repeat of the political dysfunction.
The debt ceiling is the limit on the total amount of debt that the US Department of the Treasury can issue to the public and to federal agencies. That ceiling had been hit, and the US borrowing authority would have lapsed on October 17 unless action was taken to increase it. If Congressional lawmakers failed to raise the debt ceiling, the US could, for the first time in history, have faced a default on its obligations– including to international investors such as China and Japan. According to the Congressional Budget Office, the country would likely have run out of money to pay all of its bills, including benefits, salaries and interest, before month-end, if a deal was not struck this week.
While the immediate threat of default has passed, the US fiscal problems have been tabled, not resolved. Of course, a major US debt shock would impact markets around the world, but I think it would be temporary. As is the case in all such market crises, I believe there should be opportunities for some and losses looming for others.
In my opinion, it is very unlikely that the US would default on its foreign debt in particular. First, there could be extra funds in the government budget which could be found to meet current interest payments. In addition, government leaders of both parties would be reluctant to allow that to happen because it would end the ability of the US to borrow at low rates. There is an additional US national security issue: by having the US dollar as the world’s main reserve currency and its main trading currency, the US global reach and security is enhanced with the ability to restrict and monitor international money flows and facilitate sanctions against countries.
If the US government faces a future debt crisis (default), the immediate response would likely be high volatility in markets around the world. However, I believe predictions of a “meltdown” are probably exaggerated since the world today is highly diversified. Even though the major global currency is the US dollar, many transactions are carried out in euro and increasingly in China’s renminbi. I also think these continued issues in the US could likely change investment allocations around the world, with less emphasis on holding US dollars and more diversification into other currencies as well as other assets. Global trade could change, with more trade being settled in other currencies such as the euro and RMB. In addition, precious metals and other rare collectables could rise in USD value.
From my point of view, the problems the US is now facing with its budget and the discussion of the (very unlikely) possibility of the default could be an inadvertent positive for some emerging market countries over the long term because outflows from US Treasuries could go into other markets. It could incentivize investors who are heavily invested in US debt and the US market generally to have second thoughts about putting too many of their eggs in an uncertain US basket and lead them to diversify their investments more globally. Such a portfolio could include greater allocations to emerging markets. The US has a high debt-to-GDP ratio1, slow growth and limited foreign reserves. In contrast, relative to the US, emerging markets generally have much lower debt to GDP ratios, more foreign exchange reserves and much higher GDP growth rates.
As the late Sir John Templeton once said, “to avoid having all your eggs in the wrong basket at the wrong time, every investor should diversify3.”
1. Federal debt held by the public is now about 73 percent of the economy’s annual output. Source: US Congressional Budget Office, September 2013.
2. As of December 31, 2011. Sources: Bloomberg LLP, FactSet. © 2013 FactSet Research Systems Inc. All Rights Reserved. The information contained herein: (1) is proprietary to FactSet Research Systems Inc. and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither FactSet Research Systems Inc. nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
3. Diversification cannot guarantee profit nor protect against loss.