Fixing latest US debt ceiling crisis needs compromise from Biden and House Republicans

Much like 2011, a Republican-controlled House is trying to force a Democratic president to cut federal spending in exchange for averting a government shutdown
Now, though, House Speaker Kevin McCarthy must not only forge compromise with US President Joe Biden but also radical elements in his own party

Tai Hui

Published: 9:30pm, 3 Mar 2023

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The United States is one of the few countries in the world whose level of government issuance is limited by its lawmakers. The US federal government debt ceiling has been raised or suspended close to 100 times, usually without much debate.

However, the current political climate in the US could mean the path to lifting the debt ceiling and avoiding a government default could be bumpier than investors would prefer.

In mid-January, Treasury Secretary Janet Yellen warned that the US federal debt would reach its legal limit by January 19. This does not mean the government runs out of money straight away. It still has around US$300 billion in deposits parked in its account with the US Federal Reserve and is expected to start receiving tax revenue in April.

There are also other accounting methods the government can deploy to meet its funding obligations. In February, the non-partisan Congressional Budget Office estimated that these measures should allow the government to avoid a default in the next five to eight months.

As the largest government bond market in the world, and with US Treasuries being one of the most important financial assets for the global financial system, a government default would create shock waves around the world. Interest rates of US dollar corporate bonds around the world are often referenced to US government bond yields. Wild swings in these reference rates would affect companies’ funding costs.

The experience of the UK gilt market crisis last September also serves as an important reminder that the use of investment structures or derivatives could lead to unintended consequences to the broader market or economic activities when these benchmarks swing more than usual.

US dollar bulls could be skating on thin ice

The US was uncomfortably close to default in 2011, when the Republican-controlled House of Representatives demanded president Barack Obama cut government spending in exchange for an increase in debt ceiling. This episode led to the ratings agency Standard & Poor’s to downgrade its US sovereign rating from AAA to AA+ while the two other main ratings agencies, Moody’s and Fitch, retained their AAA ratings.

Credit ratings are important since many institutional investors – such as pensions, insurance companies, banks or sovereign wealth funds – might not invest in bonds below a specified credit rating. They would have to look for alternative assets if a country’s sovereign rating is downgraded below their defined thresholds.

The US Treasury Department building is seen in Washington, DC, in January this year. With US Treasuries being one of the most important financial assets for the global financial system, a US government default would create shock waves around the world. Photo: AFP

That said, with US Treasuries being such an important asset in the financial system, it would be difficult to look for an alternative with similar market size, depth and liquidity.

Fast forward to 2023 and there is a palpable sense of déjà vu. The House of Representatives is once again under the control of Republicans who are demanding a Democratic president reduce the deficit. Meanwhile, the White House wants the Congress to discuss spending cuts without holding the debt ceiling hostage.

It is important to stress that raising the debt ceiling under a divided government has been a norm. Since 2001, the debt ceiling has been raised or suspended more than 20 times, often when the government was divided. Moreover, every politician should already know the economic and financial catastrophe that would occur if the US government defaults.

Hence, the most logical outcome is for the Congress to eventually pass the motion after some horse-trading. After all, politics is about negotiation and compromise. This is also the most likely outcome.

Investors are concerned that the possible black swan of a government default might not come from conscious decisions but from a failure to coordinate. Although the Republicans control the House with 222 seats out of 435, this is a slim majority.

US House Speaker Kevin McCarthy delivers remarks on the debt ceiling outside his office on Capitol Hill in Washington on February 6. Photo: Reuters

It would only take a handful of dissentients from within the party to block the debt ceiling being raised. The fact that Kevin McCarthy needed 15 rounds of voting to be elected as House speaker, instead of the single round that is usually required, reflects the divisions within the Republican Party.

Not only do the House and US President Joe Biden need to find a middle ground, Republican House members will also need to come to an agreement. This could mean a bumpier road than usual, which would add to the complicated macroeconomic landscape of higher interest rates and weaker growth this summer for investors.

Tai Hui is chief market strategist for the Asia-Pacific at JP Morgan Asset Management