Posted in Finance Articles, Total Reads: 3879
, Published on 21 December 2011
Today, globalization connects every country, whether developed or developing-- economically, socially, and technologically. Hence, poor economic health of one country can affect other countries in many ways. All countries need to support the affected country for fast recovery and maintaining balance in the world. Similar situation is currently being faced by USA, wherein, USA’s economic growth is slowing down and this is forcing world’s biggest economies to think about it. Decade 2000 started as a nightmare for the US, with only 2001 being the year of USA trade surplus USA and rest all years till now USA is contributing to its debt through trade deficit. After 2008 recession, the poor economic conditions of USA have aggravated. Recession showed the complex relationship between USA and the various USA economic powerhouses like European Union, Japan, China and UK. It also left world’s best economists with some conundrums such as why world economies have to pray for USA’s fast recovery, how these economies survival depends upon the healthy growth of USA, will USA lose its currency supremacy, who in future will drive the world economies, can USA come up with some solution, what will be the future of other economies and the list goes on. These questions have no answers as of now, but just opinions are available. In order to build an opinion on some of the above questions, we must analyze the current situation of USA economy … the history, sources of funds, spending areas and implications of total USA debt.
Currently, when Europe is dealing with the Greece debt crisis by Germany and France agreeing to bailout Greece, there can be another “to be” future debt crisis which has attracted the attention of people in recent days – raising national debt ceiling by USA to $2.1 trillion and USA debt to GDP ratio which reached about 96%. USA defined “ceiling” for the first time under Second Liberty Bond Act of 1917 to give more flexibility to finance USA involvement in World War 1. USA defined an aggregate limit on the total amount of bonds that it can issue. The modern debt limit, in which an aggregate limit was applied to nearly all federal debt, was substantially established by Public Debt Acts. USA has time and again tinkered with the debt ceiling limits to be able to fund its goals like social security, education, healthcare and defense expenditures which constitute the major chunk of Govt. spending for many decades.
Current total USA debt is $14.5 trillion which is 96% of its GDP. USA government total debt has been broadly classified into two categories – Public debt and Intragovernmental holdings. Public debts further comprises of debts raised from institutions, investors, foreign countries (governments), state and local governments and the likes. Intragovernmental debts are supported by government trusts like Social Security Trust fund.
Figure below shows breakup of current USA debt and its holdings by various USA institutions (trillion $)
Source: Department of treasury/Federal reserve board
$5.6 trillion are Intragovernmental holdings which are about 30% of total holdings of USA total debt and $8.3 trillion are private holdings which constitutes the rest of 70% of total USA debt. Out of $8.3 trillion, $4.2 trillion are held by government of foreign nations.
Figure below exhibits the distributions of USA bond holdings by foreign countries (in trillion $)
Source: Department of treasury/Federal reserve board
Major contributors of the total USA debt by foreign countries are China $1.16 trillion, Japan $0.9 trillion, UK $0.3 trillion, Brazil $0.2 trillion and the like.
Reasons for mounting of USA debt:
Now an important question arises why USA debt is increasing year after year? Annual revenue of USA government from taxes collected from people, corporate, and other incomes is around $4.5 trillion and expenditures of about $6.1 trillion so a fiscal deficit of about $1.6 trillion. USA Govt is in this state of deficit for past 10 years hence mounting the USA debt to current $14.5 trillion.
Table below exhibits the govt spending and the fiscal deficit for year 2011
Since 2004 there has been consistent rise in Defense Spending and that has been the sector where maximum spending had been done, because of the Afghan War and Iraq War. Also, USA major spending is in healthcare sector which accounts for 25% of the USA annual revenues.
Implications for increasing USA debt ceiling
Annually, USA govt pays $0.43 trillion as interest payments (3.3% yields) for the debt which is around 10% of the revenue that USA govt collects. Also, with increasing USA debt and its chances of default in future, the demand of T-bills that the USA govt issues decreases. Hence, all the private investors and foreign governments expect a higher rate of interest on USA T-bills and debt bonds. This may ultimately increase the obligations of interest payments by USA govt in future. Also, with such high debt to GDP ratio of US, the rating of USA has already been decreased from “AAA” to “AA+” by S&P. This has already signaled investors of USA debt bonds to resist investing in it and instead transfer their holdings to safer investments like GOLD. Weakening of USA Dollar due to any present or future crisis like 2008 recession leads to huge exchange rate related losses to the foreign investors. Hence, there is always a concern for USA regarding the funding of future fiscal deficit.
Impact of USA’s surmounting debt on foreign economies
What if there is default by USA in future? How will it impact all the developed countries like Japan, UK and Russia? Japan, a country with a very high 2.25 as debt to GDP ratio has stable domestic savings, healthy current account surplus USA and low concentration of foreign source funding. As of 2004, USA takes up 22.7% of Japanese exports, and supplies 14% of its imports. United States- Japan Treaty of Mutual Cooperation and Security also strengthen their relations. But, when earthquake and Tsunami hit Japan this year it lead to a loss of $200 billion and also with unstable future of USA economy, Japan might think to strategically divert its USA investments to other uses. This might impact the trade relations between the two countries, again might hamper the growth of the USA as whole. United Kingdom, another major investor in USA T-bills and Govt. bonds has a long history of good relations with USA. UK’s biggest importer is USA, again UK disinvesting from USA bond market may hamper its export growth but at the same time UK has to minimize its investment exposure in USA. This trade-off has to be balanced by the UK and if any future USA crisis happens then it can lead to huge loss of exports from UK.
China is one of the fastest developing economies of world. It has investments worth $1.2 trillion in USA bonds (nearly 10% of Total USA debt). China’s net export to USA is $270 billion and USA is one of the major importer of China. China would never like country like USA to default and lose on a major chunk of income. This is one of the reasons why china invests heavily in USA bonds. Also, China is in a strong position to dictate terms to USA regarding the valuation of Yuan in comparison to the USA Dollar. China can threaten USA to sell the bonds if USA goes for under-valuation of Yuan. In future, if there is a default by USA economy, China stands to lose huge amount of its investments and also the support for Yuan which has currently maintained the position of China in world as leading exporter of goods. Brazil another fast developing country, having $0.2 trillion exposure in USA bond market, is the 8th largest exporter to USA. Again, we can perceive the repercussions of USA default on Brazil’s investments and revenues.
Possible steps USA can take to curb the deficit
What the USA Govt. can do to reduce the fiscal deficit, generate surplus USA and hence overall decrease in total debts? USA has to cut-down its spending on defense by withdrawing some of its forces from countries like Japan, Afghanistan and Iraq. Also, USA can make people save more by reducing the Govt spending on health expenses. Obama has an opportunity to increase revenues in the future if he opts to allow tax cuts enacted under George W. Bush to expire as scheduled in 2013. Even if Obama lost his re-election campaign next year, he could veto legislation to extend those cuts before leaving office - raising $3.5 trillion as revenues from Taxes. But, there is a trade-off here. In order to repay debt, if taxes are increased, real income of people decreases and leading to decrease in the growth of the overall economy. Hence, USA Govt. should gradually increase the taxes. Another issue that USA Govt. should address is that of unemployment. After recession, unemployment in USA has increased and Govt. gives unemployment benefits of about 1% of revenue to people. Also, there is a decrease in the revenue (taxes) due to unemployment (-3.3% of revenue). So, if USA Govt. addresses the issue of unemployment than it can actually increase their revenues and decrease its fiscal deficit. Another step the USA Govt. can take to reduce the impact of the total debt is USA Dollar currency devaluation which will reduce the actual debt on the govt. But, this will lead to huge losses to foreign govt. and hence again a strategic decision is required to choose between reduction of debts and its foreign relationships.
All in all, it can be said that USA economy is under tremendous USA pressure and timely measures need to be taken in order to avoid the double-dip recession.