China warns US playing with fire on debt

Singapore - US Republican lawmakers are “playing with fire” by contemplating even a brief debt default as a means to force deeper government spending cuts, an adviser to China’s central bank said on Wednesday.

The idea of a technical default - essentially delaying interest payments for a few days - has gained backing from a growing number of mainstream Republicans, who see it as a price worth paying if it forces the White House to slash spending.

But any form of default could destabilise the global economy and sour already tense relations with big US creditors such as China, government officials and investors warn.

Li Daokui, an adviser to the People’s Bank of China, said a default could undermine the US dollar, and Beijing needed to dissuade Washington from pursuing this course of action.

“I think there is a risk that the US debt default may happen,” Li told reporters on the sidelines of a forum in Beijing. “The result will be very serious and I really hope that they would stop playing with fire.”

China is the largest foreign creditor to the United States, holding more than $1 trillion in Treasury debt as of March, US data shows, so its concerns carry considerable weight in Washington.

The US Congress has balked at increasing a statutory limit on government spending, as lawmakers argue over how to curb a deficit which is projected to reach $1.4 trillion this fiscal year. The US Treasury Department has said it will run out of borrowing room by August 2.

If the United States cannot make interest payments on its debt, the Obama administration has warned of “catastrophic” consequences that could push the still-fragile economy back into recession.

“It has dire implications for the economy at a time when the macro data is softening,” said Ben Westmore, a commodities economist at National Australia Bank.

“It’s just a horrible idea,” he said.

'Wouldn't happen'

The Republicans’ theory is that bondholders would accept a brief delay in interest payments if it meant Washington finally addressed its long-term fiscal problems, putting the country in a stronger position to meet its debt obligations later on.

But interviews with government officials and investors show they consider a default such a grim - and remote - possibility that it was nearly impossible to imagine.

“How can the US be allowed to default?” said an official at India’s central bank. “We don’t think this is a possibility because this could then create huge panic globally.”

Indian officials say they have little choice but to buy US Treasury debt because it is still among the world’s safest and most liquid investments. It held $39.8bn in US Treasuries as of March, US data shows.

The officials declined to be identified because they are not authorised to speak to the media.

“It just wouldn’t happen,” said Barry Evans, who oversees $83bn in fixed income assets at Manulife Asset Management. “They would pay their Treasury bills first instead of other bills. It’s as simple as that.”

Marc Ostwald, a strategist with Monument Securities in London, called the default scenario “frightening” and said bondholders’ patience would wear thin if lawmakers persisted in pitching this strategy in the coming weeks.

“This isn’t a debate, this is like a Mexican standoff and that is where the problem lies,” he said.

Yuan Gangming, a researcher with the Chinese Academy of Social Sciences, a government think tank, smelt some political wrangling behind the US debt debate as the 2012 presidential election draws nearer. He said Republicans “want to make things difficult for Obama”.

But with time running short before the US Treasury exhausts its borrowing room, Yuan said default was a real risk.

“The possibility is quite high to see a default of the US debt, which would harm many countries in the world, and China in particular,” he said.