Will US default on debt, set dangerous precedent?

16:47, July 08, 2011      

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The dispute between the Obama Administration and the U.S. House of Representatives around whether to raise the 14.3-trillion-U.S.-dollar debt ceiling has become even more intense. U.S. treasury securities will face at least a "technical default" risk if the two sides fail to reach a consensus by Aug. 2.

Currently, both sides are trying to use this "technical default" risk to coerce each other into submission. Although these are differences between the policies of different U.S. domestic political institutions and different political parties, the results will bring a major impact on the global financial system.

The United States, as the issuer of the global currency, has locked the interests of global creditors in a domestic political struggle. Even though the two sides reached a consensus before the deadline, the United States has set a bad precedent of ignoring the global economy and the interests of creditors in other countries based on its own policy.

In fact, the gross national debt reached debt ceiling as early as May 16, setting a record high in 60 years. This resulted from years of a debt-driven consumption policy adopted by the United States.

In accordance with past practice, the While House can always obtain Congressional authorization to raise the debt ceiling. Congress has raised the debt ceiling 16 times since 1993. In response to the plea from the White House to raise the debt ceiling before the upcoming general election, the Republican Party, which controls the House of Representatives, has added some new legal obligations requiring the government to cut the federal spending by 2 trillion U.S. dollars over the next 10 years without a tax increase.

For the Obama administration, accepting such a condition could mean that Obama will lose his re-election in 2012. On the other side, if Congress does not grant the debt limit increase authorization on Aug. 2, the government will theoretically fail to pay the due debt interests (the earliest interest payment to creditors will be due Aug. 15).

As a result, the Obama administration will have to suspend pension payment to domestic retirees and cease interest payment to foreign creditors. Evidently, this will lead to a catastrophic consequence that both the United States and the global financial market cannot bear. Nevertheless, the White House and Congress are both using this catastrophic consequence as a means to force the other side to submit.

Although international financial credit rating institutions have already issued clear warnings about the risk concerning the U.S. national debt and the transaction volume of CDS that is an indicator of default risk in the financial market has considerably increased, the chance is very slim for the United States to face a similar sovereign debt crisis as Greece.

First, latest statistical data shows that investors are still interested in purchasing newly issued U.S. national debt. Second, “technical default” will not prompt central banks of various banks, primary overseas holders of U.S. national debt, to dump the U.S. debt they hold.

Foreign holders of U.S. debt are faced with a real risk. Since the U.S. political parties only consider their own interests and dare to ignore the interests of foreign creditors, it is highly possible that the United States will damage the interests of foreign creditors for its own political, economic, or security interests some day.

In other words, it may use the debt default to threaten other countries. This is a terrible systematic risk hidden in the current international financial system. The U.S. debt crisis has posed a real dilemma for foreign creditors. They either have to endure the immediate enormous financial risks brought about by the U.S. debt default, or hold more U.S. debt at their peril.

At the same time, the U.S. debt crisis served as a wake-up call to China, the largest foreign holder of Treasury bonds. China should stop increasing its already massive foreign exchange reserves, and be alert of the national financial security risks in excessive holdings of U.S. dollar assets.

In the post-global financial crisis era, there is a growing international consensus that the U.S. dollar-centered international currency system should be reformed as soon as possible. Getting rid of the dollar will not only serve the interests of creditor countries, but also ensure the stability and sustainable operation of the international financial system.

By Li Xiangyang, the director of the Institute of Asia-Pacific Studies under the Chinese Academy of Social Sciences and the article is translated by People's Daily Online.

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