Debt ceiling chatters: How will it impact the USD?

If the US government defaults on its debt, it would be unable to issue new debt and pay its bills.

The total US debt ceiling stood at $31.4 trillion as of January 2023.

By Amit Pabari

“We don’t have a trillion-dollar debt because we haven’t taxed enough; we have a trillion-dollar debt because we spend too much.” – Ronald Reagan

What is the debt ceiling?

To run the show, the US government must either earn or borrow, and when the spending exceeds the earnings, government depends on borrowings. The “Debt ceiling/Limit” was created by the US Congress in 1917 to set the maximum amount of outstanding debt the US government can incur. As on January 2023, the total US debt ceiling stood at $31.4 trillion and the government has run a deficit averaging nearly $1.3 trillion every year since 2001, meaning it spends more money than it receives in taxes and other revenue. As the US government debt hit this level in January, now the government cannot legally borrow any more money. To make up the difference, it must borrow to continue to finance payments only that Congress has already authorized by both Republicans and Democrats. 

How many times has it raised the ceiling and suspended rise leading to crises?

The US government debt has increased under every single president since 1929. So far, the debt ceiling has been raised more than 100 times. Well, there were times when it suspended to raise the same which sort of led to a crises-like situation.

In 2011, 

  • The US reached a crisis point of near default on public debt and suspended the rise in the limit. The delay in raising the debt ceiling led to its first downgrade in the US credit rating, a sharp drop in the stock market, and an increase in borrowing costs. 

Another one in 2013,

  • This time when the ceiling was reached again, the Treasury adopted extraordinary measures to delay a default. These measures included suspending investments in individual retirement funds of federal employees, the Civil Service Retiree’s and Disability Fund, the Postal Service Retiree Health Benefits Fund, etc. 

That apart, the debt ceiling was suspended in 2015, 2017, and 2019, but in all these years it was upwardly revised post a few months of suspension. 

What happens if the US Government defaulted on its debt this time? What is the probability of it? 

By hitting the limit and failing to pay interest payments to bondholders, the US would default leading to lowering its credit rating and increasing the cost of its debt. As the limit has been hit, the Treasury would simply delay payments if funds could not be raised through “extraordinary measures” and the debt ceiling was not raised. These measures could essentially be fiscal tools that curb certain government investments so that the bills continue to be paid. However, these options could be exhausted by June. 

What is at stake? 

Post exhaustion of its extraordinary measures and running out of cash, it would be unable to issue new debt and pay its bills. As the US government runs in deficits, the size of its debt shall increase every year, and so do the costs of servicing it. And, if it cannot borrow any more money, the Government will stop being able to cover all of its costs.

A default on its obligation could plunge the globe into a financial crisis and the impact would be as given below:

The markets

Americans’ investments would take a direct hit and the stocks could witness a huge sell-off. According to estimates, nearly $12 trillion in household wealth could be wiped out.

The Costs

If a default occurs, US Treasuries yields will inevitably rise due to sell off which could be led by downgrading the bond ratings by the watchdogs. Also, as the interest rates on loans, credit cards, and mortgages are based on Treasury yields, the cost of borrowing money and paying off debt would rise over and above the increased costs the citizens are already facing from the Fed’s rate hikes.

The Economy

An economic downturn couldn’t be ruled out if default took place, which would prompt a spike in unemployment in a fragile time when the nation is already dealing with rising interest rates and stubbornly high inflation. If the default lasts for about a week, then close to 1 million jobs would be lost, including in the financial sector, which would be hard hit by the stock market declines. Due to this, the economy would contract by nearly half a percent. And if it lasts beyond that, the damage would be even more.

Looking at the previous episodes, the US Congress has generally raised the ceiling before the measures have been depleted. However, currently in exchange for votes to raise the debt ceiling, the Republicans are calling for drastic spending cuts with an intention to dilute the Democrats’ agenda, which the Democrats are not agreeing to. If the Congress does not act to raise the debt limit, federal spending would have to fall, or taxes would have to rise significantly.

Impact on US Bonds and Dollar

On the bond side, the spread on US five-year credit default swaps which gauges the risk of default – widened to 50 basis points, 1 year’s swaps widened by 100 bps, hinting towards the upcoming selloff which could arise driven by any default or delay in payment.

Well, the creditworthiness of US treasury securities has always increased the demand for dollars, which is contributing to their value and status as the world’s reserve currency. Any hit to confidence in the US economy, whether from default or the uncertainty surrounding it, could cause a sell-off in the US bonds and thus weaken the dollar in the long-term perspective.

However, if we take a closer look at the momentum of DXY in the past decade, with the rising of the ceiling, the fiat has risen by an average of 2.30% from 1 month before the raise to one month after the rise in the ceiling in a particular year. Therefore, in the current scenario, if the past trends are to be considered wherein the US will hit the debt ceiling by 1st June, from the current value of USD which is around 101 levels, it should rise to over 103 by July.

(Amit Pabari, MD, CR Forex. Views expressed are author’s own. Please consult your financial advisor before investing.)

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First published on: 09-05-2023 at 11:44 IST