By: Dr. Mike Campbell

On a tour to China, US Vice President, Joe Biden, promised his hosts that the world’s largest economy would never default on its debts. Why is it unthinkable that the Americans should become unable to pay their debts? The American political establishment indulged in an orgy of bipartisan brinkmanship recently when arguing over an increase in the US borrowing ceiling, only finally coming to an agreement at the last moment before the US would have defaulted on part of its enormous debts. Such behaviour does not inspire confidence and, no doubt, figured in Standard and Poor’s decision to downgrade America’s credit rating from its top AAA grade to AA+.

China is America’s single largest “creditor” (that is to say it holds the greatest worth of US bonds) with assets valued at over $1 trillion. Whilst the face value of those bonds will not change and, short of a default, the Chinese will get the face value of the debt back when it becomes due, the Chinese are clearly worried about the intrinsic value that it represents. As Euro watchers will readily confirm, doubts about a nation’s ability to repay its debts (whether founded or not) cause the currency to depreciate. This means that the buying power of the currency outside of its territory will fall. Should this happen to the US currency, the Chinese will “take a bath” over the value of their US denominated assets.

The US debt stands at something like $14 trillion. If other ratings agencies take a more pessimistic view of the US economic outlook and the political will to do something meaningful about debt reduction, the US credit rating is likely to slip. Should this happen, then the cost of servicing Americas debt will rise as investors demand a higher return to compensate them for the higher risk associated with their investment. At a time of economic slowdown where government revenue is low, a partial default (whilst hugely unlikely) becomes more plausible.

Mr. Biden pointed out to his hosts that 87% of US financial assets (debt) is held domestically. This is little comfort to the Chinese since $1 will still be worth $1 in the USA even if the value of the Greenback were to go into freefall.