The US Government is battling with potential economic commotion as they hit the debt ceiling and here’s how it will affect investors in Australia.
Even though it is occurring on the other side of the world, the impact of the US debt ceiling is expected to affect the Australian market, both directly and indirectly while the US remains a central economic powerhouse.
What is a debt ceiling?
The US debt ceiling is a legal limit on the amount of national debt the US Treasury can accumulate. It restricts the government’s ability to borrow more money to pay for expenses that have already been approved and appropriated. While it doesn’t directly limit government deficits, it prevents the Treasury from fulfilling financial obligations once the limit is reached.
Similar to other governments, the US government relies on tax payments to fund operations and keep the economy running, but there is a limit on how much they can spend, and how much they can tax. To bridge the gap, the government borrows money and accumulates debt as a result and the Treasury department is restricted by Congress in how much it can borrow. These debts need to be repaid with interest, increasing the overall repayment amount.
The US reached its debt ceiling on 19 January 2023, which sparked a debt-ceiling crisis and a debate within Congress over government spending and the national debt. To handle the situation, Treasury Secretary Janet Yellen implemented temporary “extraordinary measures.” which could be exhausted as early as 1 June 2023, but this date was later pushed to 5 June. If the Government exhausts its funds, it would face the choice of defaulting on bondholder payments or cutting funds owed to various companies mandated but not fully funded by Congress. Both scenarios could lead to a global economic crisis. Additionally, if the federal government were unable to issue new debt, it would have to balance its budget by imposing budget cuts that, in total, would equal 5% of the size of the American economy.
Debt ceiling outcome
There were disagreements in the US Capitol about increasing the debt ceiling between the House of Representatives and the White House. In general, the Democrats believe an increase to the debt ceiling is non-negotiable and an obligation of Congress, but Republicans are adamant they will not agree to raise the limit unless the Democrats also agree to spending caps, which the White House hasn’t ruled out.
In case of no agreements reached, the US Treasury will have to prioritise what payments to make from its tax receipts, but there would also be major flow-on effects for financial markets. It would not only lead to a recession in the US, but it would also spark another financial crisis.
On Wednesday 1 June night (Thursday AEST), the House passed a bill to raise the US debt ceiling, which prevented a historic default on bills. This agreement, reached between President Joe Biden and House Speaker Kevin McCarthy, extends the borrowing limit until January 2025. The bill also includes government budget provisions for the next two years and introduces certain policy changes, like increased work requirements for federal food assistance.
How would the debt ceiling affect investors in Australia?
Investor Confidence: Heightened uncertainty caused by the US debt ceiling debate can impact Australian retail investors, as they may become more cautious and conservative in their investment strategies. This will potentially lead to reduced trading activity and slower market participation or shift towards safer assets, thus affecting market liquidity and overall investment activity.
Interest Rates: If the US debt ceiling issue triggers significant market disruptions, it would cause the global interest rates to rise. Changes in interest rates can influence borrowing costs for Australian businesses and consumers. Those invested in companies with high reliance on borrowings should be conscious that interest rate payments on borrowings will have a trickle down effect to finance expenses and higher cash outflows.
Interest Rate-Sensitive Sectors: If the debt ceiling crisis leads to a default or a downgrade in the US credit rating, it could potentially increase borrowing costs and interest rates. Interest rate-sensitive sectors, such as real estate, construction, and highly leveraged companies, may face challenges as financing becomes more expensive.
Government Contractors: If the US government experiences a funding shortfall due to a debt ceiling crisis, it may affect government contractors and companies heavily reliant on government contracts. Delays or cuts in government spending can impact their revenue and profitability.
Economic Impact: The US debt ceiling debate and potential financial instability can have broader economic implications such as indirectly affecting the performance of Australian companies and industries. While safe-haven assets such as gold, high-quality government bonds, and currencies like the Swiss franc or Japanese yen might be minimally impacted, slower economy will impact employment levels, income growth, profit-making activities, an overall conditions for most businesses in Australia, which then will influence the cycle of consumer spending with individuals being more cautious about discretionary expenses.
The financial market will be disrupted with declines in the price of equities, a loss of consumer and business confidence, and a contraction in access to private credit markets. Banks and other financial institutions may face challenges in managing their portfolios. Industries such as travel, entertainment, luxury goods, and other non-essential consumer goods and services might experience negative impacts as well, as consumers cut back on spending.
Exchange Rates: The US debt ceiling issue can impact currency exchange rates, particularly depleting the Australian Dollar value against the US dollar and other strong currencies. Fluctuations in exchange rates can affect the cost of imports, which, in turn, can influence prices of goods and services in Australia. Higher import costs may lead to inflationary pressures, potentially impacting consumers’ purchasing power and spending habits and heightened operation costs for businesses, which makes it harder for businesses and entities to accrue revenue.
Industries that heavily depend on exports and international markets, such as automotive and spare parts, electronics, energy and petroleum, clothing and textiles, chemicals, and aerospace and aviation, may face increased adversity to exchange rate losses. Weakened Australian Dollar also means these businesses, that are likely to trade in different currencies, will have to absorb greater currency exchange fees when converting funds from Australian Dollar.
Clara is a Business Reporter for The Sentiment.
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