The U.S. Debt Ceiling | Barita Insights | March 7, 2023

Introduction
In its simplest terms, The Debt ceiling is the limit on how much the US Government can borrow. The US treasury essentially pays the country’s bills by collecting revenue from taxes. When spending exceeds the income collected, this leads to a deficit, which is covered by the issuance of government fixed-income securities. However, The United States Congress has imposed a cap on the nominal value of securities the treasury can issue. If borrowings were to dry up, then payments such as social security, medical care benefits, and near-term interest on national debt would be at risk. The US is currently at its ceiling of $31.4 trillion US dollars, which has some market participants worried about a potential debt crisis. Notwithstanding, the US over the last few decades has come close to hitting this limit, but congress has always raised this ceiling, thus allowing the treasury to issue new securities. In 2011 congress came close to exhausting the treasury’s spending capacity, which led to the US national debt being downgraded for the first time in its history, moving from AAA to AA; with the downgrade being attributed to political risk. Since 2011 the ceiling has been lifted a total of nine times (2011-2021). Given that Government spending is at an all-time high, outpacing the increase in revenue, the US is expected to run a deficit of US$1 trillion in 2023, which has garnered attention on the topic of the US outstanding debt.

Will the U.S. Avoid default?
The US Treasury secretary Janet Yellen, in January 2023 stated that with current cash on hand and ‘extraordinary measures’, the treasury can remain under the debt limit until June 2023. When the treasury utilizes extraordinary measures it – suspends reinvestments of government funds; suspends new investments of civil services, disability, and postal services retiree health funds, while redeeming existing ones; and suspend reinvestments held by the Exchange Stabilization Fund. The breach of the debt ceiling could occur between July and September. If the debt ceiling is breached, the US will not be able to issue more government debt, which would cause the treasury to cut back spending in other areas such as federal programs. Eventually, it will not be able to pay interest on this debt or social security instruments, resulting in a sovereign default. It is important to note that the US has never defaulted on its debt throughout its history.

As the issue of the debt ceiling looms going into summer 2023, congress has two primary options – the first being to raise the ceiling, which it always has, or to remove the ceiling altogether. The conversation surrounding the debt ceiling amongst congress in recent times has been used as a means of political leverage, with the Democratic Party having the belief that the decision to lift the ceiling should be bipartisan, while the Republican party believes that there are better ways to navigate how the US deals with its debt, with a view on strategic spending cuts.

As mentioned earlier, the US experienced a downgrade in its credit rating in 2011 as the decision to raise the debt ceiling came at the doorstep of the US defaulting. Investors and economists are worried that the same dynamics will come into play once again, as the republican party remains undecided on the issue. We will most likely see negotiations finalize as the window narrows towards the deadline. If a decision is not made at that time, the US could potentially default, which would be catastrophic for global markets. A default would precipitate a downgrade in the nation’s credit rating, leading to higher borrowing costs. As the benchmark cost of borrowing increases, mortgages, other loans and fixed-income securities would also see higher interest rates. Retirement, insurance, and other funds as well as foreign individual and institutional investors globally holding US treasury bonds would suffer, and federal programs would most likely see a slowdown or near shutdown. This may have negative implications for the dollar as investors search for an alternative safe haven during the fallout. . Also, as government spending declines, aggregate demand would fall, eventually cascading into higher unemployment, likely resulting in broad-based economic turmoil along the way. The Republican party however has stated that a default on the national debt is not an option, leading there to be some confidence that the ceiling will either be raised or abolished and potentially accompanied by budget cuts.

Conclusion
Government debt usually increases exponentially in a period where significant spending or investment is needed in the economy. The Covid-19 pandemic prompted the creation of government stimulus packages to provide relief throughout the crisis. During the pandemic, the US spent a total of approximately USD 5 trillion on individual relief packages which contributed to the US debt total over the past three years. The US has the fourth highest debt-to-GDP (~128%) amongst developed nations, coming in behind Japan, Italy, and Greece. The US government has long been regarded as one of the highest quality credits, with the most liquid fixed-income market globally. Despite this, the 5-year US Credit Default Swaps (a credit derivative used to hedge default risk) has risen ~86% in the last six months. This comes on the backend of investors increasing concerns about default and implications for the US currency. Despite the political tottering between parties, both parties are likely aware and in agreement with the domino effect a sovereign default would create and will likely find a favourable short or long-term solution regarding the country’s debt capacity.