ANALYSIS: Why Canadians should care about a U.S. debt default

A U.S. debt default, if it rattles global markets, could be dire for Canada. The problem is no one knows how the markets would react.
The failure of lawmakers in Washington to reach a deal on raising the U.S. borrowing limit would lead to an unprecendented government debt default. (Alex Brandon/Associated Press)
When even the  U.S. Treasury refers to the possibility of a debt default by the American government as "an unprecedented event in American history that would precipitate another financial crisis," that tends to get the world's attention.

The doomsday scenario is certainly scary: A default causes global interest rates to soar as debt priced in the world's most liquid currency comes to be regarded as more risky, banks become more reluctant to lend — even to each other — and debt, the lifeblood of business investment, becomes less available.

As well, stock markets sell off and plunge the world into another recession.

And Canada, as an exporting country doing three quarters of its trade with the U.S., would share in that pain.

"The nuclear option," Peter Buchanan, senior economist at CIBC World Markets, told CBC News, "is certainly something one doesn't really want to think about."

But whether the sky will fall on Canada if lawmakers in its biggest trading partner don't manage to do a deal on raising their debt ceiling, cutting spending and lowering taxes is far from certain.

It depends.

A default is a problem if lenders lose confidence in the borrower's ability to pay back what it owes, refuse to lend it any more and the country runs out of money.

Market reaction is unpredictable

A key element of this debt showdown is no one knows how seriously financial markets will interpret a statutory default.

"We're really in some sense dealing with unknown waters," said Buchanan. "The U.S. has never defaulted on its debt before."

"There's no doubt that it would have serious repercussions," he said, but whether it would lead to another financial crisis is uncertain.

"Whether it would lead to a Lehman moment (a reference to the collapse of Wall Street investment bank Lehman Brothers in 2008) or not, I think it could, but we'd have to see. It's not something markets have had a great deal of experience with."

"There have been many, many experiences of sovereign defaults through history," said Martin Schwerdtfeger, a senior economist with TD Bank Financial Group, "but none of these have been so significant as a U.S. government default could be."

But Schwerdtfeger expects the effects of a default would be limited. "It's not that the markets have completely lost faith in the U.S. and its ability to repay debt," Schwerdtfeger said.

"We would expect that that situation would be corrected within a matter of days," he said, "because there is room for credit rating agencies not to assign a rating to all U.S. debt but just to one debt issue (if it's in default). And then that could be corrected once the U.S. made the (interest) payments."

Still, both economists agree a default would lead to higher short term interest rates.  Because U.S. Treasuries are regarded worldwide as the safest debt anywhere, global bond markets would demand higher interest to reflect the increased risk of all debt, including Canadian bonds, but Schwerdtfeger believes the effects would be limited.

More than a default, which he believes is unlikely, Buchanan worries a deal to avert a default will include sharp spending cuts, a troubling possibility given that federal spending accounts for eight per cent of the American economy.

"That could weigh quite a bit on an already weak economy," he said, given the June employment numbers disappointed economists, showing job creation of just 18,000 compared with the 90,000 new jobs most had expected.

A debt limit agreement that included cutting $2 trillion in spending, Goldman Sachs economists have said, could shave 0.8 percentage points off economic growth next year.

"If the U.S. economy slows further or even lapses in recession that would have clear implications for Canada's economy given that about half our GDP is trade-related and three quarters of our trade is with the U.S.," Buchanan said.

With files from The Associated Press