US Debt And The Financial Crisis

Written by admin on July 29th, 2011

dynamics can be handled by the U.S. without difficulties (deflation is a more apparent issue now), credit risk growth can be barely managed. The U.S. debt has been growing much faster than the economy has, so the investors may be unwilling to get interest revenues which do not reflect actual level of risk. Let us consider the dynamics in the U.S. cost of borrowing.

The U.S. interest rates have been decreasing since 1994. Thus the U.S. debt has become cheaper along with its overall growth. This proves confidence in the U.S. economy. At the end of 2008 when the financial crisis became apparent investors rushed to buy out American treasury bonds in hope to preserve their savings. That caused the rates of return to fall down to 2%.

The current U.S. dollar value has almost reached its historical minimum. Obviously, this means higher investment risks. The U.S. is a net importer meaning that its imports exceed its exports, and it finances the trade deficit by external borrowings and investments. One of the characteristics of a strong and opened for foreign investments economy is a strong currency. Weak dollar risk implies that the interest of foreign investors to the U.S. assets may diminish, causing the U.S. to lose important means of trade deficit financing.

Another current threat to the U.S. dollar is appearance of alternative world reserve currencies. In January 2011 the Bank of China began direct sales of RMB to the U.S., while the Chinese Yuan was traded on the MICEX in Russia December 15 of 2010. The fact that the Yuan has started to be subject of international transactions, shows that China has been implementing competent foreign and domestic economic policies. By promoting its currency, China has become more integrated into the world monetary system. At the same time, China has been shifting the core drivers of its economic growth towards domestic consumption (from exports and infrastructure). In 2010, it was actively discussed that China had overtaken Japan in respect to the size of its economy. If we take Purchasing Power Parity for calculations, the size of the U.S. economy is .62 trillion, the size of the Chinese economy – .08 trillion, the size of Japan’s .31 trillion, according to the International Monetary Fund data. Thus, in terms of real purchasing power, China’s economy has been ahead of Japan’s economy for a long time. Indeed, the Chinese GDP per capita is far lower than that of Japan. However, a country as a world leader and guarantor is not solely defined by the GDP per capita value, but by the absolute size of its economy and its ability to influence international relations. China has been realizing this strategy with honor, although the full convertibility of the Yuan’s has not been achieved yet. Another important competitor to the U.S. dollar is Euro, as the EU’s economy and the U.S. economy are comparable in size. Thus, the U.S. dollar is being stalked.

The question of choice of the most appropriate international reserve structure is being actively discussed by all countries. At present, more than a half of current reserves are denominated in the U.S. dollars. The theory suggests that a structure of reserves should depend on the country trade partners. For instance, given that 30% of the total country’s international trade and investments are made with China, 30% of reserves should be held in Yuan. This theory hasn’t found a practical application though for a number of reasons, like non-convertibility of currencies; political risk, etc. Reduction of the dollar-denominated reserves by countries would have dire consequences for the dollar, as the U.S. treasury bonds are included into international reserves of many countries.

Thus, we have considered the U.S. investment risk factors. They may not present any threat if taken separately, but create discomfort for the international community if taken altogether. The worst case scenario would be the U.S. default on its debt. Let us consider this scenario.

It is unlikely that anyone could see a point when American creditors may lose patience, say, a month prior to that. The famous investor Warren Buffett has confirmed that the system can remain in such a state for indefinite time. A factor triggering the U.S. default may be just “a spark” that would cause a domino effect, like, for instance, treasury bonds withdrawal by a large international creditor. Crises are likely to start when there is a circumstantial evidence of something being wrong, and to be triggered by a spark, causing a further cascade of events, including those of a psychological nature. For example, while the global oil demand fell by no more than 5% following the recent crisis, the price of oil fell by more than 3 times. This is the psychology of the market.

If the U.S. declared a default, the world would suddenly lose trillions of dollars. International reserves denominated in dollar would depreciate, while international capital flows would plunge into chaos until the situation is resolved. Today, the probability of the U.S. default is small due to the fact that nobody is interested in it. For example, China is the largest holder of U.S. treasury bonds and could lose more than half of its foreign exchange reserves denominated in dollars. At the same time, we can observe China has actively started to invest reserves in real assets: gold and securities of companies around the globe. China Investment Corporation was created to manage a part of the international reserves of the country. During the ten months of 2010, China imported over 200 tons of gold, which is five times the volume of purchases of the precious metals made by the country for the full year of 2009.

The consequences for the U.S. in case it declares default would also be sharp budget shrink; social programs cuts and falls of living standards of all layers of the society, especially those who are financially dependent on the state. The dollar would be devaluated and lose status as a world currency; investment in the country would sharply decrease. Outbreak of inflation would be possible, and the U.S. would do their best to preserve national wealth, even at an expense of growth. But in the long run, America will survive. The future of the global economy is Technology, and the U.S. Technology will persist even in case of default. Thus, even if it had lost the status of the world monetary power, America would have remained the technological power. Such scenario would stipulate a launch of a new era in the U.S. economical and political development.

The recommendations to investors, holding assets in the U.S. dollars, are as follows:

• Monitor growth of the federal budget deficit and national debt of the United States
• Monitor the dynamics of demand for U.S. treasury bonds from major foreign creditors, primarily China
• Track yield on the 10-year U.S. treasury bonds, watching for the rates to reach 5% or more
• Make investment portfolio diversification; invest globally by buying stocks and bonds of U.S. corporations, looking for international companies with the U.S. sales share which does not exceed 25-30%.

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