Central Banks Gaming Out U.S. Default as Deadline NearsSimon Kennedy, Jeff Black and Jennifer Ryan
Central banks have begun making contingency plans on how they would keep financial markets working if the U.S. defaults on the world’s benchmark debt.
Policy makers discussed possible responses when they met at the International Monetary Fund’s annual meetings in Washington over the weekend, said officials who spoke on condition of anonymity because the talks were confidential. The discussions continued as policy makers headed home.
“Because in the past it’s always been sorted out is absolutely not a reason to fail to do the contingency planning,” Jon Cunliffe, who joins the Bank of England as deputy governor for financial stability next month, told U.K. lawmakers yesterday. “I would expect the Bank of England to be planning for it. I’d expect private-sector actors to be doing that, and in other countries as well.”
The initial response from the world’s central banks would likely echo their actions after the collapse of Lehman Brothers Holdings Inc. in 2008. Back then, policy makers pledged they would provide ample liquidity, eased the collateral they lent against and boosted dollar swap lines with each other to ensure supply of the currency.
The $12 trillion of outstanding U.S. government debt is 23 times the $517 billion Lehman owed when it filed for bankruptcy on Sept. 15, 2008.
“The bank has at its fingertips a range of tools to ensure the system operates properly, that liquidity conditions remain normal in all sorts of eventualities,” Bank of Canada Governor Stephen Poloz told reporters in Washington on Oct. 11. He declined to talk about specifics.
Central bankers would have had a chance to discuss the threat of default when U.S. Federal Reserve Chairman Ben S. Bernanke hosted a lunch of counterparts on Oct. 12 during the IMF meetings.
Time is running short for U.S. lawmakers as they try to end a stalemate that risks pushing the nation into default if the government’s borrowing authority isn’t raised before Oct. 17. Senate Democratic and Republican leaders were working yesterday on the details of an accord that would prevent the nation from breaching the debt ceiling and end a partial government shutdown now entering its 15th day.
“We’ve made tremendous progress,” Senate Majority Leader Harry Reid, a Nevada Democrat, said yesterday as the chamber adjourned, adding that he hoped a deal could be announced as soon as today. His Republican counterpart, Senator Mitch McConnell of Kentucky, said there was “substantial progress.”
While policy makers from Japan to Saudi Arabia have expressed faith in the ability of the U.S. to pay its bills, a default would put the world in uncharted territory.
Central bankers have spent the past six years expanding their toolkit for dealing with a financial crisis that began in August 2007 when tremors in the U.S. subprime mortgage market began reverberating worldwide. That turmoil deepened with the Lehman failure and was then extended by Europe’s fiscal woes.
“You want the plumbing of the financial sector to keep working even with the main benchmark in default,” said Rob Wood, an economist at Berenberg Bank in London and a former official at the Bank of England. “You want to avoid a firesale of U.S. assets.”
The Fed opened what eventually became 14 swap lines in December 2007 to provide the global financial system with dollar liquidity as the subprime mortgage crisis stirred doubts about the quality of assets on bank balance sheets around the world. They were boosted as markets froze the following year.
The swaps were closed in February 2010 and re-opened three months later amid a squeeze in dollar funding due to the euro area debt crisis. Last December, the Fed extended the lines with the Bank of Canada, Bank of England, the European Central Bank and the Swiss National Bank until February 2014. The swaps allow the central banks to borrow in dollars from the Fed and then auction them at home.
With less room to cut interest rates now than in 2008, when major central banks did so in unison, a U.S. default would prompt officials to first focus on pumping cash into the financial system, said Stewart Robertson, an economist at Aviva Investors Ltd in London, which has about $438 billion under management.
“There are other measures they can take, such as easing liquidity strains,” Robertson said. “They might actually find that easier than after Lehman. At that time there was really a worry about who was holding billions and trillions of toxic waste. With this, you know more what’s happening.”
Sri Lanka unexpectedly cut its two main interest rates by 50 basis points today to protect economic growth from the risk of a U.S. default. Congress’s failure to clinch an agreement has been “very, very difficult for us to understand” and “something we will really fret about in the next few months,” central bank Governor Ajith Nivard Cabraal said in a Bloomberg Television interview today.
“Even if the U.S. were to get their act together and get past the debt ceiling, I think the fact that the global economy has been put under so much stress, is something that many policy makers would not forget,” Cabraal said. That’s going to lead to “various changes in the way central banks will perceive the safety and quality of investments,” he said.
While they could utilize swap lines and keep accepting Treasuries as collateral, central banks would probably hold back on easing monetary policy because they would bet the U.S. would quickly end the default once markets turned volatile and recession loomed, said Wood of Berenberg Bank.
“It’s only if you think the default will be extended and politicians won’t react enough that you would engage in significant monetary policy,” he said. “Would you buy oodles more bonds if you expected lawmakers to act?”
To be sure, not even the world’s most powerful central banks have the weapons to counter the potential fallout of even a so-called technical default, finance executives say.
“It will be like putting band-aids on a gaping wound,” Deutsche Bank AG co-Chief Executive Officer Anshu Jain said at a panel discussion hosted by the Institute of International Finance in Washington on Oct. 12.
Jain said the bank’s analysis of the consequences of even a “technical default” found that “there are aspects to that which are irrevocable.”
“Once you miss payment on U.S. Treasury debt, we don’t want to go into all of it but I’ll give you a little taste,” said Jain. “Things like tri-party repo, the underpinning of the collateral system, there are legal ramifications which we believe are probably incurable.”
JPMorgan Chase & Co. CEO Jamie Dimon said at the same event that his bank has calculated it probably processes about six or seven billion dollars a week in benefits such as Social Security, food stamps and veterans benefits. “We were going to fund it, despite the fact that we weren’t being paid by the government, because those people have to eat,” Dimon said.
A default, however, would be tougher to prepare for, he said.“You don’t know the effect and the ripple effect of that through money market funds, people start drawing down revolvers, people don’t know if collateral is good,” he said. “We can’t have a debt default.”
For those reasons, global financial policy makers maintain that a default is unlikely.
“It’s unthinkable that an agreement won’t be found,” European Central Bank President Mario Draghi told reporters in Washington. Japanese Finance Minister Taro Aso told Bloomberg Television’s Sara Eisen that “there’s no other way than for the U.S. government itself and the U.S. Congress to sort it out.”