Recent policial infighting in Washing has re-ignited the debate about a US debt default. While it’s unlike that the US will default on its debt, the threat of a default is enough to terrify investors and traders all over the world.
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Even though lawmakers seem to have settled the latest debt ceiling debate kicking the can down the road is nothing new in Washinton. Senate leaders from both parties on Wednesday reached a deal to raise government spending and take other steps meant to curb Capitol Hill budget squabbling, although the deal calls for much higher spending and only extends the government’s debt ceiling to March 2019.
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Previously, the Treasury Department has warned that without an extension in borrowing, the government could run out of funding by the beginning of March. The deal is expected to increase government spending by nearly $300 billion over two years, which, following the recent tax cut, will only pile further pressure on Washington's strained finances.
A default or even downgrade of the US' credit rating would have a substantial impact on not just debt holders but the broader financial system in general and possibly the world.
US financial institutions would suffer a heavy impact as many of these institutions hold Treasuries as collateral. Life insurers would be some of the most heavily impacted. According to credit ratings agency Moody's, if the US were to be downgraded, "It is unlikely that any property/casualty insurer would remain rated more than two notches above the sovereign, or any life insurer would remain rated more than one notch above the sovereign due to substantial investment exposure to the sovereign (including sovereign-linked/sensitive instruments), or shared fundamental economic drivers."
Central counterparty clearing houses will also feel the brunt of the downgrade as, according to Moody's, "Central counterparty clearing houses have very high dependency between their creditworthiness and that of the US, especially through their extensive use of US Treasurys as collateral resources." The Depository Trust & Clearing Corporation’s central counterparty clearing houses risk "being downgraded by the same magnitude" following a default event according to Moody's.
There would also be far-reaching impacts outside the US. The US is the most significant shareholder in eight multilateral development banks including IBRD, International Development Association, Asian Development Bank, Inter-American Development Bank, International Finance Corporation, European Bank for Reconstruction & Development, Inter-American Investment Corporation and North American Development Bank, and it is the second-largest shareholder in African Development Bank. Moody's notes that while the direct impact on these entities from a US downgrade might be limited, the smaller entities, with strong ties to the country could suffer from less-established access to capital markets.