US Debt ceiling – What is it all about?

One of the most talked about news doing rounds in the world economy in the last month has been the US debt ceiling. US is the biggest economy of the world with $ 14.6 trillion of GDP. Nearest competitor China is at $ 5.8 trillion i.e less than half of that of USA. Still credit rating agencies gave a deadline of August 2 to decide on the debt ceiling issue failing which credit rating on select US Government bond would have been lowered. Amid a lot of discussions and debates, Obama Government could pass on the bill for raising the debt ceiling. Amid all this, I thought, what is this issue of debt ceiling, and why is it important?

I came across this nice one pager on US Debt ceiling, which explains in simple and brief manner regarding the issue. It says,

Why reaching a deal before 2nd August was so important?

If the debt ceiling were not raised by August 2, the U.S. would have defaulted on some of its obligations. Some of these obligations were interest payment on the treasury bonds, social security check, medicare and medicaid payments and federal salaries. Default on the US debt could have meant higher borrowing cost. Foreign investors like China and Japan and other countries altogether holding nearly half of outstanding Treasury debt, could have reduce their purchases of Treasuries on a permanent basis, and potentially even sell some of their existing holdings which woul d have undoubtedly led to an increase in the treasury borrowing costs. As nearly all interest rates use U.S. Treasuries as a benchmark if these rates would have climbed, then the interest rates for products like mortgages, personal loans and credit cards would have increased as well.

Though the plan has been passed, the report discusses the impact of this issue on the economy, dollar and gold, it says –

The plan seems to be fallible in the long -run, thus, dollar might gain strength in the short-run (also due to flight to safety) but remains weak in the intermediate to long -term. Currencies like yen, swiss franc are expected to exhibit strength while INR might remain range-bound. The yields in the US bond markets are expected to go up with the debt rating still under review with Moody’s.

This paper makes a good read for knowing the potential impact of this move on the economy given the ongoing situation in Euro region, growth prospects of US economy and its relation with other emerging economies.

Also would like to share with you this small picture which summarizes the effect on stock markets nicely. (Image courtesy Mr Vivek Bajaj, Kredent)

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