WASHINGTON – A U.S. debt default in the event that a politically divided Congress fails to raise the federal borrowing limit would imperil the entire global economic recovery, a senior International Monetary Fund official warned Wednesday.
But Jose Vinals, the IMF’s financial counsellor, said he sees the actual risk of such a default as very low.
“It would be a worldwide shock,” Vinals told a Washington news conference, at which the IMF released its Global Financial Stability Report.
“This is something that would have very significant repercussions on financial markets around the world, not just on the United States,” Vinals said. “So let’s hope that we never get there.”
The report was released ahead of the IMF and World Bank’s annual meeting later this week. It’s a gathering that brings together leading financial officials from around the globe. The IMF said that the partial U.S. government shutdown, now in its second week, is adding to uncertainty about the still-fragile global economic recovery.
“While the damage to the U.S. economy from a short shutdown is likely to be limited, a longer shutdown could be quite harmful,” the report said. “And even more importantly, a failure to promptly raise the debt ceiling, leading to a U.S. selective default, could seriously damage the global economy and financial system.”
The bulk of U.S. governmental operations were shuttered last week after lawmakers in the House and Senate failed to agree on a spending bill to fund government at the start of the new fiscal year. Republicans in Congress are refusing to approve a temporary spending bill, demanding changes or elimination of Obama’s 2010 health care law.
Republicans are linking the health care plan to the budget battle because they contend the costs of it could severely harm the U.S. economy. Democrats say it is legislation that has already been approved as “settled law” and that it has been upheld by the U.S. Supreme Court. They insist that spending and debt ceiling bills are vital in their own right and should not come with conditions attached.
Separately, Democrats and Republicans are also clashing as a deadline approaches for boosting the government’s $16.7 trillion borrowing limit. Republicans are demanding spending cuts to reduce the budget deficit as the price for supporting an increase in the debt ceiling. The president and fellow Democrats insist that Congress first end the shutdown and extend the debt limit before any negotiations.
The worries about the U.S. economy extend beyond the shutdown and prospects, albeit remote, of a debt default.
The IMF report also said the U.S. central bank’s expected tapering of its economic stimulus program would pose one of the biggest challenges to increasing global financial stability.
The Federal Reserve is expected to begin the transition early next year, scaling back its $85-billion-a-month in bond purchases that have injected cash into the sluggish economy to boost growth. The easing will be a vote of confidence that the economy is strong enough to stand without extraordinary stimulus.
The IMF report said this U.S. strength should help shore up global financial stability. Yet managing a smooth transition out of the extraordinary bond purchases “could prove challenging” as both interest rates and market volatility rise.
“This process will be unprecedented and complex,” said Vinals, who also noted that long-term market interest rates have already begun to rise in anticipation of the tapering. Higher interest rates could put a dent in the U.S. economic recovery.
The report said one potential danger to greater global financial stability is the possibility that long-term interest rates could rise more sharply than anticipated. In one of the report’s recommendations of policies to enhance global financial stability, it urged the Federal Reserve to clearly communicate its intentions on tapering the stimulus.
It also urged Europe to move forward on a banking union — a single body that would restructure or unwind failed banks across the region.
The “stressed economies” of Italy, Portugal and Spain continue to be plagued by heavy corporate debt loads, the report said. A significant share of the corporate debt in stressed economies is now owed by companies with weak debt servicing capacity and this could negatively affect bank balance sheets and cut into profits, it added.
It said Europe needs to improve credit to viable enterprises. The report noted that many policymakers see weak credit growth generally in the global economy as a primary reason behind the slow economic recovery.
Developing countries saw a larger than normal surge in bond investments over the past five years, said Vinals. And they are already seeing significant capital flows out as interest rates rise in the U.S. and attract investment. Highlighting one risk to global financial stability, these outflows could increase significantly along with volatility.
Financial authorities may need to intervene to ensure the process is smooth, the IMF report said.