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– mars 2024

On January 13th 2023, Janet Yellen – the Secretary of the US Treasury – sent a letter to Kevin McCarthy, the Speaker of the US House of Representatives. The tone of this correspondence was somewhat grim. Indeed, as per the 2021 Consolidated Appropriation Act, the US statutory debt limit had been increased to 31,381 trillion USD. She gave January 19th as the deadline for Congress to vote on the expected increase of the debt limit, thus preventing the United States from defaulting on its obligations.

As no legislative traction was obtained from this first communication, a new one was issued the following week, on the day of the said cutoff. In this latest writing, the Secretary of the US Treasury urged Mr. McCarthy and the Congress to perform their “constitutional responsibility” and agree on raising the threshold without further ado. This is, in fact, a rather straightforward action Congress is accustomed to doing since 1917, as part of the US government’s rather unusual borrowing needs validation mechanism.

She added having had no other choice but to start resorting to costly and temporary “extraordinary measures” (consisting of mere accounting tweaks), buying Congress another few months before a default would be deemed inevitable. Having recently changed from a democratic to a republican majority, both parties within the House of Representatives are currently embroiled in a dispute whereby Republicans – contrary to Democrats – intend to condition this particular vote to sizable yet undefined decreases in government spending.

This quarrel has induced substantial inertia within Congress and brings the US on the brink of a debt failure by the day. Such an outcome would yield a cataclysmic event with a paramount impact on the US and consequently, on the welfare of global financial stability.

An archaic yet American exception

The notion of the statutory debt limit, i.e. the limit defining the extent to which the US government may borrow, was first introduced in 1917, as the then Congress decided to bestow upon the Treasury Department, the ability to issue bonds as a financing mechanism. At that time, the US was about to enter WWI and wanted to streamline its spending validation process instead of having to vote each time a new project was presented.

A few years later, the Treasury Department took over the payment of federal spending as well as the issuance and management of the US debt up to a limit that is frequently reviewed and established by Congress. This legislative arrangement has, since its first occurrence, led to approximately 100 debt limit raises and 5 decreases.

As the US borrowing needs evolved through the years (due to wars, infrastructure, and social related spending such as federal salaries, Medicaid, and pandemics), it now seats at 38 trillion USD with 1 trillion USD of fixed annual expenditures. These figures put the US in second place of the countries with the highest debt-to-GDP ratio (behind Japan) and the latter is expected to more than double by 2050.

Implementing a debt ceiling approach as a way to control a country’s borrowing capacity isn’t really something unheard of and a few have tried in the past. Indeed, Australia put one in place back in 2007 amidst a period of great budget unbalance. The system was used for a few years before it was simply rescinded in 2013 because of the way it vastly hindered Australia’s ability to face its own obligations and to borrow funds to finance its spending accordingly.

In the rest of the western world, Denmark chose to implement a somewhat similar debt limit system in the late 1990s, however, its mechanism is rather different. While the Danish Government indeed fixes a limit concerning its borrowing capacity, in order to avoid what is witnessed today in the US Congress floors, the Danes decided to set their limit purposely so high that it has never been reached.

Other European countries such as Germany or Poland adopted a “debt brake” system. Instead of a defined ceiling amount, this logic fixes the limit of incurred debt to a calculated percentage of their GDP (60% for Poland and approximately 33% for Germany).

So, what is all the fuss about?

Well, the USD is the preferred currency when it comes down to international trade and some even refer to it as “the world’s reserve currency”. According to the IMF, the US dollar covered about 60% of the world’s total foreign reserves in 2022, the Euro was at 20% and the renminbi represented only 3%.

A country such as the US has reached this type of coverage thanks to the current size of its economy, its geopolitical strength, and its ability to face its financial obligations, such as its debts. Take one of these criteria off the equation and a negative financial domino effect arises. In fact, since its creation, the US has never defaulted yet the tensions surrounding the inevitable and frequently recurring ceiling raise debate have been more and more dramatic during the course of the last decade.

For example, 2011 saw a fierce deadlock between Barack Obama and a Republican Congress over the vote and although a deal was found 2 days before the deadline, the global economy felt the tremor of this commotion. Investor confidence had fallen by 22%, and the US economy registered a loss of about 1 million jobs, raising the unemployment rate to 9%. In addition, US Stock markets reacted by dropping to 17%. Both Standard & Poor’s and Moody’s swiftly reflected their skepticism on the sustainability of the long-term US public finances and changed their rating from AAA to respectively AA+ and Aa1.

In Europe, most banks held (and still hold) a sizable amount of US government debts and thus faced potentially significant losses. Furthermore, the increased uncertainty regarding the US financial standing caused mayhem in the markets. A majority of investors sought safer assets and massively sold a variety of stocks. Indices like the CAC40, the FDAX, and the FTSE 100 registered important losses.

In the event of a potential debt default (which would truly be a “self-inflicted wound”), major economists and analysts have already projected an average loss of 6 million US jobs and a dismal 7% hit on their GDP. Such a dark outlook will not fail to, once again, create great economic tensions at the global level, should it come to occur.

A schadenfreude for China

China has always made it clear that it is ambitious for the renminbi to replace the USD as the world’s currency. Although it has ways to go to achieve this goal, its economy is still going strong and seats as the world’s second-largest economy by nominal GDP, in 2022. Furthermore, after registering a disappointing 3% growth in 2022 compared to 8,4% the previous year (partly due to the pandemic aftermath), the perspectives for 2023 are looking somewhat better. In addition, the communist republic is the second country in the world that owns the most US debt (approximately 13,48%, corresponding to 1082,2 billion USD), behind Japan (14,88%) but before the UK (11,96%), Belgium (4,58%) and Luxembourg (4,3%).

In the case of a default, these countries would thus tend to be the biggest beneficiaries as interest rates paid to them would mechanically rise. Moreover, the induced decrease in investor confidence in the US creditworthiness will open the door for other nations like China to argue that their economic system (and consequently their government structure) provides more stability and generates less risk for investors, therefore reigniting the eternal debate on capitalism vs communism.

Keeping the debt ceiling as-is or simply electing to revoke it is part of a vast debate. Indeed, at its genesis, Congress intended to provide the Treasury department with some autonomy in order to increase the government borrowing capacity, up to the predefined debt limit rather than incrementally do so. However, through the last decade, this mechanism has seemingly brought the US (and the rest of the world) to the thread of many financial crises. The current and recurrent standoff in US Congress has brought forth ever-increasing support in favor of overturning the 106-year-old congressional procedure. Indeed, Janet Yellen, herself, said so, not hiding her contempt towards an obsolete and harmful measure that holds the stability of
the financial world hostage, time and time again.

Roger Ferguson Jr, former vice chairman of the board of governors of the U.S. Federal Reserve, endorses such a view and considers that is high time for the US to rid itself of such a potentially devastating tool “bringing the country to the precipice of default every few years”. If it were to be so, the current House ofRepresentatives majority, would lose the most important weapon in their current arsenal to bend the Democrats to their political agenda, thus adding even more uncertainty regarding an abolishment.

Challenges for the years to come

In conclusion, we can certainly state that in recent years, much has been done in favor of the emerging climate-related risk policies. The first results are slowly being achieved, as can be seen from the attention the topic has received and the number of financial and non-financial institutions engaged in it. In any case, there is still a long way to go, and much remains to be done.

In this regard, a persistent problem in the development of models and policies is the lack of data and their quality. Central banks and the supervisory authorities must encourage all stakeholders to develop data extraction and modeling techniques that will allow for consistent testing to understand how to tackle climate risks.

World-leading banks must be prepared to include climate stress tests within their risk management systems. Increasingly, large financial institutions are relying on experienced consulting firms that can gather the necessary data for the creation of climate-related risk assessment models, both for internal management purposes and in anticipation of future policy developments.

By Willy N. ANNICETTE Senior Manager at Square Management


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