August 3rd, 2011
01:34 PM GMT
How did Europe react to the U.S. debt deal?
The U.S. debt ceiling deal has been signed into law but European stocks fell amid fears around the country’s economic recovery and its ability to avoid a major credit downgrade.
The debt debate revealed the country’s political intransigence and threw more doubt over the world’s recovery, already struggling to deal with the financial crisis in Europe.
Questions are now being raised around the damage caused to the reputation of the U.S. Treasury and currency markets as the world’s safe investment haven.
How has the U.S. debt debate impacted Europe?
In the past Europe could have benefitted from being a safe haven for investors concerned about the U.S. However the eurozone is neck-deep in its own crisis and problems across the Atlantic proved a distraction rather than providing any sort of benefit.
Spooked investors instead looked beyond the two currency giants, pushing up the value of commodity currencies such as the Australian and New Zealand dollar and safe haven currencies like the Swiss franc and Japanese yen.
The value of U.S. Treasuries – or the country’s debt – has remained largely steady, showing it is still an asset of choice for investors due to its liquidity and status.
The value of U.K. Gilts did lift slightly through the debt debate, showing some investors were moving their cash into the British market. The value of European debt, particularly in the eurozone’s troubled economies, remained under pressure.
An ongoing issue facing Europe and the U.S. is the trading relationship. The European Union is the largest economic trading partner of the U.S., with $560 billion in goods changing hands last year. That relationship may have been damaged by the political instability.
The U.S. crisis also crystallized problems facing countries attempting to deal with huge debt burdens. The U.S. could pay its bills but it was stymied by politics. Conversely, political will in the eurozone is ensuring support for member countries which can’t pay the bills.
What if a major ratings agency downgrades the U.S.?
A major ratings agency could strip the U.S. of its coveted triple A credit rating, despite the debt deal being done.
Market participants are deeply concerned one of the big three agencies - Moody’s, Fitch Ratings and Standard & Poor’s – could move to downgrade U.S. debt. Following the debt deal, Moody’s lowered its outlook on the country’s debt to negative, while keeping it at its AAA rating.
Chinese agency Dagong Global Credit Rating Company has downgraded the debt to A, while U.S. agency Egan Jones has downgraded it to double A plus.
Further downgrades may mean investors including countries – China and Japan being the biggest players – banks and pension funds could move to offload their U.S. investments. However, a downgrade of U.S. debt would likely be small and sell-off limited as investors remain highly sensitive to risks in other parts of the world.
A default on the country’s financial obligations – threatened if the U.S. did not pass its last minute debt deal – would be far more serious. Beyond the psychological shock, which would likely create panic in the markets, investors could be forced to take write-downs on the value of their investments, which can in turn create a domino effect of financial instability.
So what exactly is the U.S. debt ceiling?
The debt ceiling is effectively the U.S.’s credit card limit, and the money is used for spending requirements such as defence, security, social security and healthcare.
The U.S. hit its $14.3 trillion ceiling on May 16, but Treasury Secretary Timothy Geithner shuffled money around to avoid going through the limit.
The debt deal agreed on Sunday night will raise the ceiling by between $2.1 trillion and $2.4 trillion. After deep cuts are enacted, it will be increased by another $1.2 trillion. The increases should cover the Treasury’s borrowing needs until 2013.
The country’s lawmakers needed to meet an August 2 deadline to avoid default on the U.S.'s obligations.
Why was the ceiling created?
Before WW1, the U.S. Congress, made up of the House and the Senate, had to approve all borrowings. In 1917, Congress decided to put a limit in place instead. The ceiling has since increased exponentially, from $395 billion in 1970 to $4.1 trillion in 1990 to $14.3 trillion now, and an estimated $16.4 trillion – $16.7 trillion by the end of the year.
The ceiling is usually raised as a matter of course but this time the deep political divide between Republicans and Democrats on how to make cuts and raise funds led to the stalemate.
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