An unnecessary disaster spawns market fears


  • Business
  • Saturday, 19 Oct 2013

THE focus of concern of my last column (Oct 5) was how to identify and best manage risk emanating from the great growth deceleration in emerging Asia in the face of “Abenomic” expansionary thrusts and threat of QE (quantitative easing) tapering by US Fed which resulted in a massive withdrawal of funds from Asian markets.

As I write on Oct 16, the threat of fiscal impasse is upon us. Already, US government has been shut down for 16 days and in just another working day, US Treasury’s Oct 17 deadline to raise the debt ceiling (US$16.7 trillion) will pass. At this late hour, US politicians are still grappling with how to re-open the shuttered government and avoid a potentially calamitous failure for the first time to service on time the nation’s debt obligations. The standing of the US (trust in the US signature) is at risk. Five years after the 2008 crisis, the debt stand-off has plunged markets into uncertainty, a showdown not dissimilar to the 2011 brush with calamity.

Many readers have asked why this was allowed to happen; and asked to be better informed of the implications of such madness, which for even the most knowledgeable are just too vast and dynamic to fully fathom. Some scary views from experts: “…would wreak havoc in the world economy and financial markets” (JP Morgan Chase); “would trigger failures in collateral markets” (Pimco, world’s largest bond manager); “would be negative, very negative for US economy and world economy” (European Central Bank); “utterly catastrophic” (Deutsche Bank); “would be at risk of tipping, yet again, into recession” (IMF); “would be a disastrous event for the developing world, and that in turn will greatly hurt the developed economies as well” (World Bank); and “consequences for the market are dangerously unpredictable” (Sifma, a US lobby group for financial firms trading in Treasuries). How did this come about? I should explain.

Why so?

The answer can be traced to the radicalisation of the US Republican Party. Senator H. Reid (Senate majority leader) attributes it to “the emergence of a banana Republican mind-set.” I am told the core group orchestrating the impasse and fiscal standoff comprises 20-30 most conservative Republicans in the House of Representatives (mostly from the South, Midwest and Plains states) who have gained strength and prominence with its ultra-conservative Tea Party wing.

New York Times columnist N.D. Kristof likened this group to the infamous “Gang of Four” who ruled China during the hard-time communist isolation years of the 1970s. He labelled this hard-core group (and its sympathisers): “Gang of 40”, who has since forced government to shut down and is now flirting with a debt default without any appreciation of its catastrophic consequences. Economics Nobel laureate Paul Krugman outlines its psychological profile best by quoting from T. Mann and N. Ornstein’s ’12 book, It’s Even Worse Than It Looks: “an insurgent outlier – ideologically extreme; contemptuous of the inherited social and economic policy regime; scornful of compromise; unpersuaded by conventional understanding of facts, evidence and science; and dismissive of the legitimacy of its political opposition.” Krugman concludes: “They are also deeply incompetent.” I should add that such politicians are not unique to the United States. We do also find them all over Asia.

Debt armageddon

Most of US government is closed for business, first in nearly two decades. Europe has yet to fix its broken currency regime while Japan is evolving at walking pace. China is decelerating. The other BRICS (Brazil, Russia, India and South Africa) keeps faltering. They all don’t seem to change. Yet, none of these has dimmed the resurgence of political brinkmanship in the United States.

The situation could yet worsen if Congress fails to raise its borrowing limit by Oct 17, raising the chilling prospect of a default, starting with Treasury bills (TBs). Alternatively, the Treasury could be forced to balance the budget abruptly (as it can no longer borrow), requiring savage spending cuts (equivalent to about 4% of GDP) which could send the US (and with it, the world) into recession. The current situation is strange and tense.

Unfortunately, it’s not about the inability of the US to pay its bills. It is self-inflicted political dysfunction that makes them unwilling to do so. Fears for the solvency of the US have begun to hit the market; investors again fear collateral damage. With Congress stuck in a highly partisan deadlock (with the President insisting no negotiations on the debt ceiling and Republicans insisting on defunding or delaying Obamacare – the Affordable Care Act – as a condition to break the impasse) financial markets are not pleased.

The dollar has weakened and US stocks have now fallen. The Dow Jones rose nearly 3% towards the end of last week and was only marginally lower on Monday (Oct 14). The mood is queasy. Stock markets in Asia have been mostly resilient, with mixed performance last week. But there are already signs of investors and banks moving out of US dollar even as yields on short Treasuries rise. One-month TBs briefly traded above 20 basis points (only 36bp a week earlier). Amid anxiety over near-term finances, US debt that is due within a month has risen well above those for similar bonds that don’t mature for another six months.

Given what’s at stake, expectation was for a much stronger reaction. After all, Wall Street’s “fear gauge” (the Vix index) has yet to react in a significant way. It’s not that markets have become desensitised to political turmoil. I think investors are just lulled by previous experience of similar wrangling in 2011 and 2012 which ended in agreement. The bet is that, this time too, sanity will eventually prevail.

“A debt default cannot happen” concluded J. Dimon, CEO and chairman of JP Morgan Chase. But there will be significant damage if it really happens. Still, political brinkmanship is intense. It would appear neither side is prepared to default. After all, the House did vote 407-0 on Oct 5 to provide back pay to all furloughed federal workers once the shutdown ends. But neither side is ready to settle as yet either. What’s worrisome now is not just whether US would default but also, can US be relied upon in the future not to jeopardise the “extraordinary privilege”, as a French minister once put it, of borrowing cheap in the world’s most trusted currency.

The impact

It is important to understand that the entire global financial architecture rests, to a large extent, on the US dollar (as reserve currency and anchor intervention currency in global money and forex markets) and US TBs. Treasuries are important because (i) all other assets are valued relative to TBs; (ii) TBs are regarded as havens – they are supposed to be a riskless; (iii) TBs are the most liquid (markets for them are deep and broad) – as good as cash; (iv) TBs act as sterling collateral for borrowers to put up to secure short-term financing; (v) TBs carry no “cross-default” provisions – unlike bank loans, missing a payment on TBs does not automatically place other TBs in default.

The US TBs market, with a value of US$11.6 trillion, is bigger than the government bond markets of Germany and UK combined. US government will reach its borrowing limit on Oct 17 when Congress will need to approve new borrowing to avoid running out of cash. Its budget is in deficit, equivalent to about 4% of GDP. Cash flow requires this financing gap to be bridged. Government has hovered just below the US$16.7 trillion limit since end-May, using various extraordinary measures to free up cash to meet payment obligations. Treasury has about US$30bil in working cash, which would be used up in a few days. Republicans are demanding a one-year delay (or scale-back or funding cut) of Obamacare before they agree to lift the ceiling. The President has refused to negotiate stating that since all spending were approved by Congress, it has to honour its obligations. Setting such a precedent would be dangerous. The worst case scenario? Default is unprecedented. It will cause investor alarm and possibly send TBs yields sharply higher, raising the cost of public debt, imperilling the tepid economic recovery and triggering a global financial meltdown. In practice, about 30% of US government payments will be missed. This is most serious indeed.

There is precedent for a government shutdown. The 1995-96 experience provides a guide for how lost government output will affect the economy. If the period is brief, it will likely shave 1.4-percentage point off 4Q’13 GDP for a 4-weeks shutdown. It’s tiresome but manageable. If it really persists, Washington will be paralysed, condemned to chronic uncertainty. But fight over the legal borrowing limit is much more troublesome since repercussions of a default are both global and unpredictable. It is a major blow to confidence and threatens the stability of financial markets because of the role played by TBs as conduits of liquidity for the entire system. Simply put, a default would undermine investors’ belief that US always makes good its debt. The direct impact would be a sell-off of short-term TBs (which has already started) with knock-on effects on equities and US dollar. About US$1.5 trillion of TBs are outstanding at end 2Q’13. The secondary impact is just as serious.

TBs are the collateral of choice in both the US$2.6 trillion “bilateral-repo” market and the US$1.8 trillion “tri-party repo” market, both important sources of overnight funding. Already, some US banks would rather not take TBs maturing Oct 24 or Oct 31 as collateral for loans and trades. The Hong Kong future markets now only accept TBs with less than one year maturity as margins for futures’ contract with a discount (or haircut) of 3% to their value (against 1% previously). These are signs of losing confidence.

Frankly, damage to the economy is impossible to quantify. Quantitatively, it can really hurt. Experience of the 2011 debt-ceiling stand-off near-miss provides an indication. That June, economists polled by the Wall Street Journal had estimated 3Q’11 GDP to grow by 2.3% – the real outcome was 1.4%. This time we will have damage caused by both the shutdown and debt-ceiling stand-off. Already Gallup’s consumer confidence index has dropped as sharply over the past month as in 2011, which definitely hurts small business, household wealth and stock market values, with serious ramifications for lending and economic recovery. This time (not unlike Aug 2, 2011), Congress has again strayed to the edge. The further along the road the impasse goes, funding gets tighter while the need for cash grows more urgent. And the drag on the economy intensifies. After all, 3Q’13 growth was only 2% and inflation is so low, the economy risks collapsing into deflation. Estimating the precise impact is difficult but economic evidence is clear about the direction of the effects: a large and persistent financial shock brings in its wake a slower economy and higher unemployment than otherwise would be the case.

Analysts talk of a 90% probability that there won’t be a default. If there is only a 10% chance of default, the problem shouldn’t exist at all since it’s the politicians’ job to compromise off small probabilities! But if it does happen, the damage would be extremely adverse. My guess is that by the time this column is published, the debt ceiling impasse would be history. As I write, there appears to be an emerging pact in the Senate to reopen government through Jan 15, 2014 and permit the Treasury to borrow normally until Mid-February 2014 to ease the dual crisis. Postponement is just kicking-the-can-down-the-road. It just buys time. Solves nothing.

What then, are we to do?

The debt ceiling was first introduced to make it easier to finance the First World War (WWI). Before 1917, each new bond issue had to be approved. Since more borrowing does look profligate, voting became partisan – voting against the president of the “other” party became orthodoxy, as Obama did against Bush. Horse trading is order of the day in deal making. Nothing unusual here. But brinkmanship has since evolved to become counterproductive, even catastrophic. The 2011 debt ceiling fight did hurt the economy. Now Republicans intimidated (insisting to trade-off Obamacare for a deal) but the president is standing firm and so far, refuses to bow to “extortion.” So policy uncertainty has become no better than in WWI, and this makes investors and businesses nervous and unhappy.

This episode, if it does come to pass, will derail the fragile recovery in Europe, make-worse the ongoing deceleration in emerging economies, and serves to remind us that the world remains seriously connected with the American economy. Unlike economic risks, which is hard enough but which can be analysed, political risks like this one is really difficult to handicap. We just don’t know what’s going to happen. It also reminds us of the risks emanating from over dependence on a single dominant reserve currency, and the urgent need for international monetary reform.

Postscript: As expected, by the Oct 17 dateline, US Congress passed the bill to (i) fund government so that it can reopen until Jan 15, 2014, (ii) extend Treasury’s borrowing authority to enable it to borrow beyond its current US$16.7 trillion debt ceiling until Feb 7, 2014, and (iii) force Congress to commence negotiations for a long-term budget with a Dec 13 dateline. It was signed into law on early morning Oct 17. Rating agency Standard & Poor’s estimated that the 16 days government shutdown cost the US economy US$24bil, shaving at least 0.6% off 4Q’13 GDP. The Dow Jones index rose sharply (up over 600 points) over the past week amid optimism to resolve the impasse. Asian markets opened with a sign of relief. So, the political process cycle resumes. Uncertainty returns.

No one knows what’s going to happen in the spring of 2014.

>  Former banker, Tan Sri Lin See-Yan is a Harvard educated economist and a British Chartered Scientist who speaks, writes and consults on economic and financial issues. Feedback is most welcome; email: starbiz@thestar.com.my.

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