Debt default would mean financial crisis round two

New Zealand banks get about a third of their funding from the international credit markets which would be affected by a US debt default. Photo / APN

If the United States Government were to default on its debt, what would it mean for us?

No one knows for sure.There is no real precedent. But it would not be pretty.

Sovereign debt defaults have typically been because governments have borrowed heavily in foreign currencies and the exchange rate has turned sharply against them, or because interest rates on their debt have spiked to insupportable levels.

Neither is the case with the US. It borrows in its own currency and at yields of around 3 per cent it is hard to see any risk of default priced into US Treasuries.

But without a deal to raise the debt ceiling, the US Government would find itself at least 40c in the dollar short of being able to pay its bills. It runs a deficit of US$125 billion a month.

Even if it prioritised meeting the interest payments on its existing debt and thereby avoided a technical default, interest rates on existing US Government debt would climb.

American borrowers generally would face higher rates - the last thing their economy needs right now.

And so would the rest of us, because risk aversion in financial markets would spike.

Credit rating agency Standard and Poor's said on Thursday the risk of a payment default is small, but if it occurred the consequences would not be limited to the United States.

"This hypothetical scenario could look similar to the fall of 2008, when a loss of investor confidence and a flight to quality brought the global funding markets to a temporary standstill," it said.

The trouble is, a "flight to quality" has traditionally been a flight to US Treasuries - seen as the safest securities of all because they are backed by the full faith and credit of the US Government.

A US debt default would be an insane thing to do, says David Mayes, professor of finance at Auckland University Business School and a former chief economist at the Reserve Bank.

"A normal default is because you are insolvent. The US Government isn't. It would just be a legal barrier to the ability to pay and all they would have to do is remove that barrier and they have got the means to pay."

The fallout would depend on how long people expected it to last.

"If they think it is a day or two, the system will be able to go on," he said.

"But if people think they are really not going to do anything it is hard to know what would happen - no one has been that stupid before. But a lot of transactions would come to a halt."

In short, a credit crunch.

US Treasuries are used by banks to meet their capital adequacy requirements.

If their value were to fall sharply, banks' ability to lend would shrink as well, quite apart from any general effect of such a crisis on the confidence of borrowers and lenders alike, says Westpac chief economist Dominick Stephens.

Regulatory changes have meant New Zealand banks are less reliant on short-term offshore funding than they were during the global financial crisis.

But they still get about a third of their funding from that source.

If international credit markets were to freeze the banks could find it impossible, or prohibitively expensive, to roll over their existing funding from those sources.

In that case the Reserve Bank could act as lender of last resort, allowing banks to borrow from it on the security of slices of their loan books.

The greater impact on New Zealand is likely to be through the real economy. A US recession would be virtually inevitable and if the global financial crisis of 2008 is any guide, commodity prices would plummet.

But so would the New Zealand dollar because in times of elevated risk aversion money drains away from peripheral economies like ours.