A prelude to financial Armageddon?

Posted on July 27, 2011

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The United States braces for an historic default. What’s the impact on the Middle East?

Come August 2, 2011, and the world’s largest economy will run out of money and potentially default on its debt payments. If the US administration fails to raise the debt limit by that time, the impact will be felt across global markets, including the ones in the Middle East and North Africa. The already weakening dollar is likely to witness a sell-off as it loses its safe-haven positioning. Rating agencies have already indicated that the United States may lose its triple-A status, potentially sparking Armageddon in financial markets. The contagion effect will pretty much wipe out economic growth in the US and consequently demand for energy.

Over the last decade the US has had to consistently raise its debt ceiling as public sector borrowing has increased. The US national debt currently stands in excess of USD14.5 trillion. That means it has already breached the USD14.3 trillion limit set in February 2010. Over the same period, the dollar has been on a downward trajectory, with only a few brief respites, as the US deficit has slid into negative territory.

As of May 2011, Treasury Department and Federal Reserve data show that foreign holdings of US paper totaled USD4.5 trillion. The largest holding outside the US is by Mainland China, to the tune of USD1.1 trillion. Oil exporters as a group are in fourth place, with USD230 billion, after Japan and the United Kingdom. This group includes Saudi Arabia, UAE, Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Algeria and Libya. Egypt holds USD13 billion of US debt.

The question that has been dogging investors in US paper continues to haunt the markets. Will the loss of the triple-A rating make most of this paper worthless? Raising the debt ceiling is only the first step. Analysts have warned that if Republicans and Democrats do not agree on a viable plan to shave at least USD4 trillion off the total debt pile, chaos will rule.

Coming as this does on the heels of the massive bailout packages announced in Europe, it is little wonder that investors have turned defensively into assets like gold. This week will be a crucial one for global markets as the US battles to save its public finances. The US will also release GDP data for the second quarter this week, and this too could deliver some nasty surprises. Weak growth and a debt impasse is a toxic mix for the dollar – as well as for investors in dollar-denominated securities.

 

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Posted in: Economy