U.S. Debt Ceiling Crisis: Lesson for India?

Abstract

The U.S. is on the verge of an unprecedented default as the White House and Congress disagree over increasing the debt ceiling, which was breached in January 2023. This article explains the debt ceiling crisis and its potential implications for India. It demonstrates that a U.S. default could impact India’s financial markets and foreign trade and destabilise the economy. This is because the U.S. Dollar (USD) is the world’s reserve currency, and U.S. Treasury Bonds are a part of India’s foreign debt. This article also suggests that India’s way forward is to move away from a U.S.-driven international financial system to a multi-currency international system through the example of the Special Vostro Rupee Accounts (SVRAs).

Keywords: Debt Ceiling, U.S., Foreign Trade, Financial Markets, Reserve Currency, Special Vostro Rupee Account

Introduction

The world waits in anticipation as proposals to raise the U.S. debt ceiling have been put on hold after Janet Yellen, the Secretary of the U.S. Treasury, warned that the country could default on its debts. The possibility of the U.S. defaulting could collapse the global economy because it relies on the consistency and dependability of the U.S. financial instruments. This paper attempts to understand the debt ceiling, trace the timeline of the current debt ceiling crisis, the implications and the way forward for India.

What is the Debt Ceiling Crisis?

The debt ceiling refers to the amount of money the U.S. government can borrow to pay for its services. Every year, the U.S. government receives revenue and incurs expenditures greater than the revenue, leading to a deficit. Over the past decade, this deficit has ranged from $400 billion to $3 trillion, and the leftover deficit at the end of the year gets added to the existing debt (Aratani, 2023b).

To finance the debt, the U.S. Treasury issues securities like the U.S. government bonds that it repays with interest. However, the Treasury can issue securities only till the debt ceiling. Once this is breached, the U.S. Treasury adopts ‘extraordinary measures’ to continue making payments. However, the Treasury can make these payments only until the so-called ‘X-date’ when all the cash will run out. The ‘X-date’ depends on the inflows and outflows of the U.S., and Congress must raise the debt ceiling before the ‘X-date’ to prevent a default (Edelberg & Sheiner, 2023). Since 1960, the debt ceiling has been increased 78 times- 49 times under Republican administrations and 29 times under Democratic administrations (Aratani, 2023b). The last time the U.S. came close to default was in 2011 when President Obama and Congress were at loggerheads over spending cuts. Republican demands were accepted, and the debt ceiling was raised three days before the deadline for default (Aratani, 2023a).

2023 Debt Ceiling Crisis: Timeline

On January 19, 2023, the U.S. reached its debt ceiling of $31.4 trillion. Since then, the U.S. Department of Treasury has adopted ‘extraordinary measures’ to keep the debt from binding. On April 26, the Republicans passed a bill in the House of Representatives raising the debt ceiling by $1.5 trillion conditional to a $4.8 trillion in spending cuts over ten years. However, the Democrats have refused to discuss spending cuts (Aratani, 2023b).

In a letter to Kevin McCarthy, Speaker of the House of Representatives, Janet Yellen said that the Treasury would “be unable to continue to satisfy all of the government’s obligations by early June, and potentially as early as June 1, if Congress does not raise or suspend the debt limit before that time” (Yellen, 2023). The June 1 deadline is crucial for the U.S. economy because the U.S. could witness a catastrophically historic sovereign default if the White House and Congress fail to reach a consensus on increasing the debt ceiling by then (Aratani, 2023b).

Consequences of Defaulting for India

There is uncertainty regarding the potential consequences for India if a U.S. default occurs, given its unprecedented nature. However, in a letter to Kevin McCarthy, Janet Yellen mentioned that the inability to repay the debt would spell “irreplaceable harm to the U.S. economy, the livelihoods of all Americans and global financial stability” (Aratani, 2023b). Some of the possible consequences of a potential U.S. default on India are the following:

Financial Market Volatility

Experts believe that the shock of default would impact the financial markets — stocks, bonds, mutual funds, and derivatives — before spilling into the broader economy. Stocks could plummet, expecting a broader economic downturn. Investors could withdraw money from the market when interest rates rise to maintain access to short-term funding. The banking industry might become more cautious about making new loans. (Stein, 2023). The bond markets would tremble when existing Treasury bonds prices decline due to increased yields on new ones, particularly ones closer to the X-date (The White House, 2023). Moreover, the credibility of the U.S. Treasury might suffer from a downgrade in the country’s credit ratings, making investing in the U.S. less appealing (Snell, 2023).

Moody’s Analytics has estimated that stock prices may fall by roughly 20%, while the White House estimated a 45% decline. Businesses would likely halt expansion — driving stocks down even more. In 2011, the last time the U.S. came close to default, major stock indices fell by around 20% (Stein, 2023).

However, Anuj Gupta, Vice President of Research at IIFL Securities, is optimistic that Foreign Institutional Investors (FIIs) buying in the Indian stock market will unlikely be affected in the short run. According to him, the chances of a U.S. default are minimal, and the market is bracing itself for either acceptance of the debt ceiling or printing new currency (Manohar, 2023). However, the Indian stock market will see some level of correction.

Impact on Foreign Trade Due to a Weakening Dollar

The demand and value of U.S. dollars depend on the creditworthiness of the U.S. Treasury assets. Any decrease in investor confidence in the American economy could lead them to sell US Treasury bonds, devaluing the dollar. (Berman, 2023). The fear of not being paid back on time due to default would make holding U.S. Treasury securities less desirable, decreasing the demand for dollars globally. Investors might reduce their dollar holdings due to weakening government dollar purchases. This would raise volatility in the dollar’s value relative to other currencies and decrease liquidity (Lovely & Russ, 2023).

The International Monetary Fund (IMF) suggests that a dollar depreciation affects commodity prices in the world market by encouraging the demand for items priced in dollars, making commodities a more attractive investment option for foreign investors compared to dollar-denominated assets, and stimulating a monetary policy that encourages foreign demand for commodities (Elwell, 2012). Should the dollar depreciate, the rupee is likely to appreciate in response. This could lead to an increase in imports and a decrease in exports, worsening the trade balance while possibly reducing inflationary pressure (Fan, 2002).

Economic Problems with U.S. Bonds and USD as Reserve Currency

U.S. government bonds are crucial for the global financial system because of their safety. U.S. Treasury Bonds serve as reserves for everything from foreign nations’ central banks to money market funds. Any financial instrument whose value relies on Treasury bonds could experience volatility and uncertainty after a debt ceiling breach due to a rapid price reduction. Breaching the debt ceiling could drive the U.S. bonds’ value down, hurting the foreign exchange reserves of many nations (Stein, 2023).

As the world reserve currency, the USD provides the U.S. with tremendous economic benefits. It stabilises the demand for dollars and reduces the forex risk U.S. companies face in international transactions. Moreover, the U.S. faces lower debt-service costs or default risk and lower costs for foreign debts due to the foreign central banks’ willingness to hold dollar assets. If the USD depreciates, it risks losing its reliability as a world reserve currency. The Euro is the closest to the USD as a principal reserve currency, which holds about 20.4% of the global forex reserves as opposed to the USD’s 58.36%. However, the size and stability of the dollar asset markets, along with the sovereign debt crisis in the European states and the power of ‘incumbency’ of the USD, may not contribute enough to help the euro overtake the USD as the principal reserve currency (Elwell, 2012). Therefore, a fall in the value of U.S. bonds and the USD possibly losing its status as the world’s reserve currency is terrible news for India, which holds foreign exchange reserves of $599.53 billion for the week which ended on May 19 (Reserve Bank of India, 2023).

Way Forward for India

As the current international system revolves around the USD, switching to an alternate system is unfeasible for India in the short run because there are not enough viable alternatives in the international financial and economic system. However, India could work towards creating a ‘multi-currency’ international financial system that would not be too dependent on the USD’s movements.

Some positive steps have already been taken in this direction. The RBI set up the rupee trade settlement mechanism in July 2022 to attract other countries. Russia was the first to start foreign trade owing to the sanctions placed on it due to the Russia-Ukraine war. Countries like Sri Lanka, Bangladesh, and Myanmar have commenced trade, and Cuba, Luxembourg, Tajikistan, and Sudan have started Special Vostro Rupee Accounts (SVRAs). Meanwhile, the RBI has approved the Vostro accounts of Sri Lanka and Mauritius (Sharma, 2023)

Furthermore, the RBI has permitted banks from 18 countries including the United Kingdom, Israel, Germany, Russia and Singapore- to settle payments in INR through SVRAs, moving away from USD dependence. India aims to use the SVRAs to trade directly in INR rather than hard currencies like USD or Euro. Generally, countries pay in a foreign currency – mostly the USD- for importing and exporting goods and services. This means a buyer in India would have to first convert the rupee into USD to pay the foreign seller, who would then convert the USD into his currency. Both parties pay conversion costs and incur risks of fluctuating foreign exchange rates (Sharma, 2023). Using an SVRA will help overcome these obstacles.

A Vostro account allows countries to obtain an invoice for goods and services made in Indian rupees, provided the second party has a Rupee Vostro Account. When an Indian buys from a foreigner in rupees, the Vostro account will be credited with the amount. The account will be debited when the Indian exporter needs to be paid for goods exported, and the money is credited to the exporter’s account. To open an SVRA, a foreign bank may contact an Authorised Dealer (AD) bank in India, which will then request RBI approval. Once the approval is granted, the SVRA in the Indian AD bank by the foreign bank will be operational. The trade between the two parties can then be settled in INR, and the exchange rate between the currencies can be established by the market (Sharma, 2023).

Although this is an encouraging development, there have been very few transactions in the Vostro accounts. India is still buying Russian oil in dollars. Moreover, India does not allow full capital account convertibility, fearing a short-term mass exodus of capital and massive exchange rate volatility. In contrast to the USD’s 88%, the euro’s 31%, the yen’s 17%, and the pound sterling’s 13% daily average shares in the entire turnover of the foreign currency market, the rupee’s stake is just 1.6%. Therefore, India still has a long way to go.

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Conclusion

The centrality of U.S. financial instruments in the international financial system cannot be denied. However, countries, including India, cannot place their entire economic and financial stability on the domestic political developments in the U.S. The tensions surrounding the U.S. debt ceiling crisis are a testimony to this. Therefore, India should slowly move from the US-driven international financial system towards participating in or initiating a multi-currency international financial system.

References

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B R Neeraj

B R Neeraj is a fifth-year undergraduate in the Department of Humanities and Social Sciences, IIT Madras, pursuing an Integrated M.A. in Development Studies. His academic interest lies in International Relations, particularly India’s foreign policy, its influences and consequences. He is also interested in history, primarily Indian and Military History, and International Economics, focussing on India’s external trade.