Sitting on Debt Dynamite

25 Mar

Glancing through Mankiw’s blog, I came across a startling fact- the US govt is expected to cumulatively borrow $9.3 trillion over the next decade. To put that into perspective, India’s GDP stands at about a trillion USD. Roughly thus, the US govt will borrow an amount equal to one India GDP every year.

US Fiscal Deficit

US Fiscal Deficit

The Congressional Budget Office, an independent body which has a mandate to provide the congress with “objective, nonpartisan, and timely analyses to aid in economic and budgetary decisions on the wide array of programs covered by the federal budget”, also estimates that the national debt to GDP ratio in the US would exceed 82 per cent by 2019, which is double the last year’s level.

National Debt to GDP

National Debt to GDP

The US fiscal deficit is expected to be $1.85 trillion in the present fiscal. The US GDP approximately stands at $14 trillion. That would put the current fiscal deficit at about 13 per cent of the GDP.  The only time the US government ran a deficit as large as this was before World War II.

The situation is startling indeed. And has resulted in some very uncomfortable questions doing the rounds. The venerable US govt treasury bills, branded the ‘safest asset in the world’, suddenly does not seem so safe now. The possibility of the US govt defaulting on its debt  is now at least being considered if not expected.

The foreign holding of US treasuries has throw in another aspect. Look at the pie chart below-

Foreign Ownership of US Treasuries

Foreign Ownership of US Treasuries

Around 28 per cent of the outstanding US treasuries is owned by “Foreign and International” entities – read this as the central banks of countries like Japan, China and India. And the spiraling US debt has made at least one creditor nation wary of the “safe investment” branding.  China, which recently surpassed Japan as US’s largest creditor (China holds $696 billion in U.S. treasury debt, more than Japan’s holdings of $578 billion. Foreign holdings of U.S. Treasury debt in the previous year stood at $3.1 trillion), expressed concerns regarding the ability of the US government in meeting it’s debt obligations. Wen Jiabo, the Chinese premier, recently said that China is “worried” about its holdings of  US treasuries and wants assurances from the US that the investment is safe. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets,” Wen said at a press briefing in Beijing.

I am still finding it difficult to digest the above. Nobody questions the safety of US treasuries. Or so I believed. The situation has come to this pass that a developing nation, one-fifth the size of the US economy, is counseling the US administration to honor it’s debt obligations!! The future holds very important questions in light of the above. Is the appetite for US treasuries falling? If yes, what implications does this hold for the US government in raising finance to get it’s economy out of recession? What are the implications for the value of the dollar-the world currency? And lastly, which asset will now take the place as the “safest asset in the world”? Questions worth pondering on…

Published by Ravi Saraogi

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4 Responses to “Sitting on Debt Dynamite”

  1. Aashim March 25, 2009 at 9:10 pm #

    Well m surprised too but dont think the US govt was plannin to finance itself by selling these treasury bonds to get out of recession or was it?

  2. informedinvestors March 26, 2009 at 3:45 am #

    Well Aashim, treasury bills will be a very important source for the expenditure of the US govt. The govt is not banking on say tax revenues to spend more as it is cutting down taxes to give fiscal stimulus to the economy.

    If you see the first figure of the post, you will see that the fiscal deficit is projected to increase from a little over $400 billion in 2008 to more than $1.85 trillion in 2009. Such a massive increase in fiscal deficit is a direct outcome of the US govt launching stimulus packages in response to the sub prime.

    The government will also try to reduce its administrative expenditure, might tweak a little here and there, but there is only so much you can do through this route.

    Moreover, if you see the first figure again, the US govt was already running a deficit when the sub prime happened. The US government’s revenue was not sufficient to pay for it’s expenditure even before the sub prime happened!!!!

    Add to this tax cuts, and it is difficult to see what other than debt can finance US govt’s increased expenditure.

  3. Anand March 26, 2009 at 8:39 am #

    Some Facts suggesting doom for the US:

    GDP (purchasing power parity):
    $14.58 trillion (2008 est.)

    Public debt:
    60.8% of GDP (2007 est.)

    Current account balance:
    -$568.8 billion (2008 est.)

    Debt – external:
    $12.25 trillion (30 June 2007)

    $700 billion relief package.
    $500 billion guranttee for Freddie Mac and Fannie Mae.
    About $130 billion for AIG.

    It is evident that the the US is in a big mess. However, I do not expect the dollar to lose its shine in the next decade. This line of reasoning is based on the following points:

    1. Even today majority of world trade is done in dollars

    2. Almost 75% of the total foreign exchange reserves of the world economy is in dollars.

    3.US still remains the most preferred destination of FDI.{$2.22 trillion (2008 est.) }

    Thus given these facts it is in interst of the other nations of the world to ensure that the value of the dollar does not fall. So even when there is a speculative attack on the dollar some country, say Germany, Japan, UK, etc will intervene to enure that the dollar stays healthy.

    However, if the US does not clean up its mess over a period of time it is quite likely that the hegemony of the dollar will be broken as trade will be done in a currency other than the dollar. Also if that happens the dollar will remain no more a preferred currency to stock up foreign reserves.

  4. informedinvestors March 28, 2009 at 4:46 pm #

    @ Anand: I couldnt agree with you more. In the short term it is difficult to see the dollar hegemony collapse. However, as you said, if the US does not get its act in order, the dollar may well begin to fall apart.

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