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Will Obama force a haircut on bondholders?

Kingshuk Nag
What happens if the US government fails to raise the debt ceiling, which is already set at an imposing figure of $14.2 trillion by August 2 this year? Haircuts apart from an impending global economic disaster would be inevitable. Incase you are about to fix an appointment with your barber the coming month, just hold on. Haircuts here basically mean the losses incurred by US bond holders in case the Fed defaults on its debt.
The debt ceiling, created in 1917, is a cap on the amount of debt the US government can borrow and fund its expenses. It was created to control the spending habits of the US government and since 2001, the ceiling has been increased 10 times to the present $14.2 trillion. While almost everyone in Capitol Hill agree that the debt ceiling needs to be increased, the problem lies in the conditions attached to it. Republicans vowed that they won't vote for an increase in debt ceiling if spending is not slashed by 40 percent and the democrats have also persisted for an equal rise in taxes for the debt ceiling cap to be slashed.
President Barack Obama had also promised in his first budget that he would cut deficits in half by 2013 and with public debt at its highest levels in the last 50 years, raising the cap would be contrary to what Obama promised.
So how did the US manage to burden itself on a huge pile of debt worth trillions of dollars in the first place? Back in 2001, the US owed $5.8 trillion and in just 10 years, the number grew by $9 trillion to the present $14 trillion worth of debt. The stratospheric rise
in debt was mainly contributed due to the wars in Iraq and Afghanistan, which cost the exchequer $1.3 trillion. Not only the wars but also the tax cuts during George Bush's presidencyhurt the US by a further $1.5 trillion.
Obama however kept government spending under control and the economic stimulus package to revive the US economy post recession cost the US debt to rise by over $800 billion. This figure however seems pale in comparison to the massive tax cuts, war costs and overdue interest that were incurred during the Bush regime.
On July 23, the most unpalatable situation took place when John Beuhner, the most influential republican in Congress, walked out of White House in a meeting with the president and the decision of raising the debt ceiling hung in balance. The US has about a week to decide and any failure to reach an agreement within August 2 will put the US economy in doldrums for good.
Both Standard and Poor's and Moody's have put the US debt ratings under review and have hinted for a possible downgrade due to the delay in reaching an agreement on raising the US debt limit. As a consequence, investors are already shorting on US 30 year treasury bonds as concerns rise over the country's ability to repay its debts.
If the debt ceiling is not increased, the confidence in the US treasury notes considered the closest equivalent to cash and the trust in US being the world's most bankable borrower would be squashed almost immediately.
Back in 1998, when US credit rating agency Moody's downgraded Japan's AAA rating, the Japanese yen tanked to its lowest
level in six and a half years along with a fall in the prices of government bonds. If a similar situation confronts the US, the already weakened dollar would sink to its lowest levels and lead to higher inflation due to cheaper imports. The falling dollar would also cause American companies to shell out more money in foreign investments or acquisitions due to loss of the greenback's purchasing power.
Of the $14.3 trillion in US debt, almost $5 trillion in the form of US treasuries rated AAA
until now is held by foreign countries. China holds $1.5 trillion and Japan holds $1 trillion of these debts. If China, Japan and other countries were to abandon their holdings as a result of a default, the cost of borrowing for the US will rise and increase the burden of the already burdened American taxpayer.
A 50 basis points increase in treasury rates will cause an outlay of $75 billion a year for the American taxpayer. Interest rates will rise across the board as investors look for greater returns due to the higher risk they are betting
on. As a result, businesses that have been enjoying low interest rates due to Fed's QE2 policy to revive the economy will have to foot a higher bill on loans taken at floating rates and thus, discourage the investment climate in the country.
With the rise in borrowing costs, the US will have to pay a higher interest bill on the outstanding debt it already owes to its creditors and that again would be a drain in the country's weak fiscal condition. Standard and Poor's also indicated that even if the US were able to go forward with raising the debt cap, it might downgrade the US rating to AA+ if $3 trillion spending cuts were not enforced.
On the other hand, the US might deliberate not raising its debt limit and choose the creditors it might want to pay on an immediate basis. The US might consider clipping social security benefits, medicare benefits or military costs but with Obama gunning for a second presidential bid, doing away with populist measures can hurt him badly in 2012. However, if he chooses to dishonour interest payments on US treasuries held by China and other countries, the world economy might head for a tailspin.
The US government is within days of losing its AAA rating that it has held on to since 1941 and the only way to avert it is by ensuring the debt ceiling limit is raised before August 2.
Obama has to make some tough decisions and we thought being the president of the world's most powerful economy is easy.
The writer is a banker and can be reached at kingshuk_nag001@yahoo.com