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Will USA default on their debt?
By Davorin Sadar of Markssin
WSJ - Washington Is Quietly Repudiating Its Debts (August 22, 2008; Page A15) was an article that made me sit down and write my personal view of US “debt problem”. Consecutive USA governments are not by themselves guilty of accumulating more than 9.5 trillion of outstanding treasuries. Japan, Asian Tigers, and later China helped with its build-up. If we take, for example, a case of Japan we quickly find why Japan is the biggest buyer of US denominated assets: Japan is net exporter. If they want to purchase raw materials and energy for their production, they need to import those using US dollars. When they sell them abroad, they get dollars, many times the value of raw materials and energy. Their homeland suppliers and workers they need to pay in yen. Therefore, they have to sell US dollars to buy yen. If they sell a lot of dollars the price of yen in dollars tends to go up. If the price of yen in dollars goes up, the price of Japanese exported goods in US dollar terms tend to increase. If they become too expensive, nobody buys. If nobody buys we have a recession. To keep the dollar price of yen (USD/JPY exchange rate) low, Japanese have to sell yen for dollars and store dollars in their vaults or to lend them. Natural borrower of US dollars is US government. Everybody likes to lend to solvent borrowers. When US government borrows, the US immediate buying power is higher than it should be exactly for the amount borrowed. USA was the engine of growth for the whole Asia for more than 20 years. USA dutifully paid all of its debts at maturity. National debt in 2008 represents more than 60% of yearly GDP. Is USA financial system in danger? In my opinion, already the administration of Bill Clinton (the guy that has leaded the nation between Bushes) prepared emergency exit strategy. "In January, the U.S. Treasury finally auctioned the first in a new series of inflation-indexed securities. With their penchant giving new products cute names, Wall Street professionals have started calling these notes TIPS, an acronym for Treasury Inflation-Protected Securities." Wrote William F. Ford in ABA Banking Journal, Vol. 89, 1997. Today, on August 22nd 2008 the yield difference on 30 year treasuries is 4.47% for regular bonds against 2.04% for TIPS (Source: Bloomberg). TIPS are composed of two parts: inflation-connected interest rate and real interest rate. While with regular treasuries yields are fixed regardless of inflation rate, TIPS pay out inflation adjusted amount. The higher the inflation the bigger the payout on coupons at maturity. From cash flow perspective regular bonds are worth less when inflation is high. TIPS do not lose value if inflation rises. I choose TIPS against regular bonds 5 out of 5 times. In early eighties we have already seen rampant inflation of over 15% in the USA. We can see it coming again. When (I did not say if) inflation picks up, the Fed lets it go until it rises above 10%. All markets rise, except commodities and bonds. Oil prices fall to 50$ a barrel (this is still 500% more than 10 years ago, when it fell to 10$ in December of 1998! - Source: WTRG Economics), and 30 year treasuries’ prices (at 3% coupon to yield 15%) drop to 20% of their nominal value. Source: Bond Yield Calculator. What does a smart government do? A smart government in a series of auctions issues heavily demanded TIPS for about two trillion US dollars and slowly and quietly buys back regular bonds for 20 cents on a dollar, thus replacing 9.5 trillion in bonds with 2 trillion in outstanding TIPS. And who cares about the guy making a buck out of 50 cents! Technically, US government would not repudiate the debt, although the effect seems much the same. Some creditors most likely would not be happy. One of the consequences might be a change in structure of foreign reserves. While now about 63% of 6 trillion of global foreign exchange reserves are held in US dollars, 27% in euro and 10% in all other currencies together, after an operation of “Debt wiper” euro would gain to the expense of US dollar. US dollar would fall against all majors (from 75 where it is now to 50 or even below). Asian economies would have to write of substantial amount of reserves, but the development that they have achieved in the last quarter of a century probably outweighs the costs incurred. We would probably exit the stagflation times stronger than ever, ready to make another inflationary bubble, hopefully something not already seen.
This intel first appeared on: http://rurzag.wordpress.com/2008/08/24/will-usa-default-on-their-debt
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There has been a couple of comments on major TV channels about the US NOT being the sole ecomonic power house anymore in the World. After this the other countries with "Credit" (US is a debtor country and poor) will take more control of their financial stability. The USA is finished as a sole power house in the World's Global ecomony. It is the beginning of the end of USA dominance in World's Financial Affairs. I do like your article. Cheers
David Jackson
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This intel was contributed by Rurzag
Rurzag
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