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Saturday, 16 July 2011 00:00
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 It’s unbelievable but with just about two weeks left before the US government defaults on its repayment obligations, US policymakers continue to play ducks and drakes. So, when their first warnings some months ago didn’t work, credit rating firms like S&P were forced to issue another warning, saying there was a 50:50 chance US government debt would be downgraded. It is true the credit rating agencies don’t deserve to be taken seriously given their abysmal record of both getting it wrong and colluding with companies, but surely US lawmakers can see what their actions are likely to cause. The US is the benchmark against which almost all securities are measured and any rise in its risk-metric will get multiplied manifold as it gets transmitted across the financial system. Which makes you wonder whom certain Republicans are referring to when they say that a technical default will send out a powerful message.

 

Even though the world will heave a massive sigh of relief when, and if, an agreement is reached on raising the debt ceiling, the real issue is that there is no credible plan to reduce the debt in the long-run. Indeed, an analysis of 45 episodes of deleveraging since the 1930s by the McKinsey Global Institute makes it conclude that such episodes of reducing debt-to-GDP by 25% can take 6-7 years and “will exert a significant drag on GDP growth”.

Things look even worse across the Atlantic, and while the Greek tragedy is yet to unfold in its entirety—the Germans continue to refuse to finalise the bailout till Greek bondholders take a haircut—the fears of Italy getting sucked in look far more real, at least to bond markets where spreads are widening. Italy, of course, is considered too big to bail, with its debt-to-GDP ratio even higher than those of Portugal and Spain. And the weekend’s crisis is yet to unfold. At the time this comment was written, the results of the European stress tests were still not in, though experts suggested that 10 of the 91 banks to be tested would come up short of the tier-I capital requirement of 5%—one German bank even withdrew from the test. As the IMF put it ever so tactfully in its note for the meeting of the G20 deputies a few days ago, downside risks have risen.

 

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