Can Asia Escape If US Debt Is Downgraded Or There Is A Default?

For Asia, the deepening debt troubles in the West are like a giant asteroid on a collision course too big to dodge or ignore and yet difficult to pinpoint where the worst damage will be done. With roughly US$3 trillion of reserves held in the form of US Treasury debt more than US$2 trillion in China and Japan alone Asia would be directly exposed to a US debt downgrade or default.

The sheer size leaves Asia with nowhere to hide.

“Where could these investors go to put that amount of cash to work? Answer: nowhere,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.

Government officials in Asia said in interviews that there was little they could do but wait and hope for the best as Washington struggles to find a politically palatable agreement by Aug 2 the date the US Treasury said it would run short of money to pay bills to avoid a default and satisfy ratings agencies.

A man looks at falling US dollar and euro values against the yen in Tokyo. — EPA

Some officials sounded more worried about risks emanating from Europe, where debt fears have spread beyond Greece, Ireland and Portugal to a much larger economy, Italy.

“Holding onto Treasuries could cause some capital losses in case of a downgrade, but we could live with it,” said a senior Japanese government official who spoke on condition of anonymity because he was not authorised to speak to the news media about contingency planning. “We have no problems investing in sub-AAA-rated bonds,” the Japanese official added. “Besides, what else should we buy by selling dollars? Euros? Would that be a safer investment than the dollar?“

Japan's worry is that the yen would strengthen against the dollar or euro if debt troubles worsen, which would hurt Japanese exports and constrain economic growth.

The biggest concern for Asia would be a global panic, similar to what followed the bankruptcy of Lehman Brothers in 2008. Although Asia fared better than the United States or Europe in that episode because its banks had little direct exposure and its public finances were healthy, a US default today would be a direct hit.

Not only would the region's Treasury holdings be at risk but investors would most likely pull money out of emerging markets, too, even though their growth prospects look healthier than those in many of the advanced economies.

Banks that count on Treasury securities for ultra-safe reserves might have to curb lending or sell riskier assets to bolster capital.

A US debt downgrade could also have wider repercussions. Funds that invest only in AAA-rated debt would be forced to sell. The ratings agency Moody's has put 7,000 US municipal bond issues on review because they have direct links to US debt.

Asian financial markets could take a beating as well. The Federal Reserve chairman Ben S. Bernanke pointed out last week that Treasury securities were often used as collateral, so a default could throw the entire financial system into “chaos,” as he put it.

Foreign exchange markets in Asia look particularly vulnerable because many investors bet with borrowed money. Individuals can easily obtain foreign exchange trading accounts allowing them to bet US$100 for US$1 they put up. That cushion could be quickly wiped out in the case of a US default.

Chris Krueger, a research analyst at MF Global in Washington, said that as of last Friday he saw a 40% chance that Congress would fail to raise the US debt ceiling by Aug 2. But despite the potential for massive upheaval, several Asian policymakers said they had no formal contingency plans for that possibility.

The South Korean finance minister, Bahk Jae-wan, said on Friday that his country was not drafting plans for how to cope with a US default, believing that American lawmakers would eventually work out a solution.

Financial markets appear to have drawn the same conclusion. The yield on 10-year US government bonds is under 3%, indicating investors still see them as a haven.

But for both the United States and Europe, the biggest impediment to resolving debt troubles is political, not economic. That makes it even trickier to predict the outcome.

A fallback plan gaining momentum in the United States would avert a default by allowing President Barack Obama to raise the country's borrowing limit before the Aug 2 deadline. - Reuters