US debt default: The knowns – and unknowns – unnerve the globe

As they watch the US budget crisis unfold, presidents, policymakers, and ordinary savers across the globe are united by a single fear: that a chaotic US default on its sovereign debt would throw the world economy into a tailspin just as it is shaking off the effects of the 2008 crisis.

In Europe, a US default would sabotage the continent’s nascent economic recovery after years of austerity, local bankers say.

In Asia, it would carve tens of billions of dollars off the value of the US Treasury bonds that China and Japan hold, and lead to a collapse of the world trade on which their economies depend, analysts predict. 

In Mexico, which sells 78 percent of its exports to the United States, economic chaos north of the border would be fatal to its prospects of greater prosperity any time soon, businessmen warn.

The effects would be felt everywhere should Congress not authorize an increase in the US debt ceiling so as to make interest payments, and if US Treasury securities were deemed to be in default as a result.

“It’s going to impact the whole world, not just countries having significant geographic or economic interaction with the United States,” Mexican President Enrique Peña Nieto warned fellow attendees at the APEC summit in Indonesia on Monday.

Chinese deputy Finance Minister Zhu Guangyao was equally blunt at a press conference in Beijing Monday, insisting that “safeguarding the debt is of vital importance to the economy of the US and the world.

“That is the United States’ responsibility,” he said, urging Washington to take steps before Oct. 17 to forestall a default.

Threat to the 'Asian Giants'

Few countries have more to fear from the potentially calamitous consequences of a US debt default than Asian giants China and Japan.

They are the two largest US creditors, holding nearly $2.5 trillion in US Treasury bonds between them. They are also the second- and third-largest economies in the world, with much to lose from the collapse of world trade that experts warn could follow a default-induced freeze in global credit markets.

The threat of a US default comes at a pivotal moment in Japan’s economic recovery under Prime Minister Shinzo Abe, who took office last year promising to pull the country out of its deflationary spiral. He has presided over three straight quarters of economic growth as exporters benefited from a sharp fall in the value of the yen, boosting their profits overseas.

Japan’s recovery could be undermined, though, if a debt crisis in the US prompts investors to drop the dollar and head for the “safe haven” of the yen, in turn driving up the value of the Japanese currency. That would make Japanese goods more expensive abroad and thus harder to export. On Tuesday, the yen rose to an eight-week high.

Fragility in Europe 

Europe is also beset by fears that a debt default would weaken the value of the dollar, thus making the euro – and eurozone exports – more expensive. For a continent just beginning to creep out of a lengthy recession whose second largest trade partner is the United States, that could be disastrous.

“A default would be most unwelcome for Europe,” says Mark Wall, co-head of European economics at Deutsche Bank in London. “Europe has reached a position to start a recovery but it is very fragile.”

That is especially true of southern European countries such as Spain, Italy, Portugal and Greece, where recovery is much slower than in other parts of Europe. They are even more dependent on stronger exports to offset the negative effects of record unemployment and slumping consumer demand.

“The only dynamic factor in Europe is improving foreign demand,” points out Matteo Cominetta, an economist with HSBC in London. That demand, all over the world, would drop if the global economy was throttled by the sort of credit squeeze and consumer reticence that followed the 2008 financial crisis.

Equally grave, says Mr. Cominetta, would be the rising interest rates that a default would spark. “Most of Europe is not in a position to absorb higher rates with this initial recovery,” he warns.

Emerging market vulnerability 

If Europe is vulnerable to events in the US, Mexico is even more so – tightly bound as its economy is to its northern neighbor.

“Slow growth in the United States means slow growth … if not recession in Mexico,” says Deborah Riner, chief economist for the American Chamber of Commerce in Mexico.

The uncertainty that a US default would engender would be especially damaging to countries such as Mexico, Ms. Riner says, because investors will be looking for safe havens, not the higher returns that some developing countries have offered in the past.

“If investors are concerned about risk, they are going to put their money in the safest thing they can get,” says Riner. “I don’t think it’s going to be emerging markets.”

The safest thing investors could find has traditionally been a US Treasury bond, and China owns $1.28 trillion worth of them, according to the latest US figures, more than any other foreign holder.

That puts Beijing in a difficult spot. It has accumulated the world’s largest hoard of foreign reserves, about $3.5 trillion, by exporting more than it imported year after year, and because the Chinese government bought exporters’ dollars from them in a bid to keep the Chinese currency, the RMB, competitively low.

Beijing then invested those dollars in US Treasury bonds, the easiest and safest place to put them. “China is joined at the hip to the dollar and to the US debt market, which is the only place large enough to absorb all the dollars they have accumulated,” says Patrick Chovanec, chief strategist at Silvercrest Asset Management in New York and former professor at Tsinghua University’s School of Economics and Management in Beijing.

“They are along for the ride,” he adds, “wherever that ride leads.” 

Justin McCurry, Andrés Cala, and David Agren contributed reporting from Toyko, Madrid, and Mexico City.