As the euro zone and the U.S. alike wrestle with debt troubles, courting default in one form or another on both sides of the Atlantic, the tremors are being felt half a world away. China and Japan, the former in particular with its huge U.S. debt holdings, are watching the political circus and wondering whether the safety nets will hold. If not, repercussions could be severe, not just for Asia but for the U.S. and euro zone as well.
Reuters reported that Asia holds approximately $3 trillion in U.S. treasury debt, more than $2 trillion of that by just China and Japan. If the U.S. is hit with a downgrade, Asia will suffer, and it cannot simply divest its portfolio of U.S. holdings. Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York, said in the report, "Where could these investors go to put that amount of cash to work? Answer: Nowhere."
Officials cited in the report said they couldn’t do much but watch and wait. Some are more concerned over the European debt situation than that in the U.S., although the risks contained in each are substantial. A senior Japanese official who did not want to be identified said in the report, "Holding onto [U.S.] Treasuries could cause some capital losses in case of a downgrade, but we could live with it. We have no problems investing in sub-AAA rated bonds," he added. "Besides, what else should we buy by selling dollars? Euros? Would that be a safer investment than the dollar?"
The biggest danger in case of a U.S. default is a global panic such as the one that arose in the wake of the Lehman Brothers failure in 2008. While Asia suffered little damage thanks to limited exposure, this time it cannot avoid trouble; its holdings are far too vast.
Funds would suffer as well; those mandated to hold only AAA-rated bonds would be forced to sell if a default occurred, throwing yet more turbulence into an already shocked market. Banks might have to halt lending or sell some of their riskier assets to increase their reserves. And spooked investors might dump emerging market stocks out of fear of further losses.
Foreign exchange markets could be hit really hard, thanks to foreign margin rules that allow as much as $100 to be bet for every $1 the trader actually possesses. If the U.S. goes down, Treasuries used for collateral or to fund that margin would cause chaos.
Despite the potential for severe consequences, Asian nations appear not to have contingency plans. Faith in a positive outcome is one reason, despite the fact that others are not so sanguine. Chris Krueger, research analyst at MF Global in Washington, said in the report that as of Friday he gave the U.S. a 40% chance of failure to raise the debt limit by August 2.
If the unthinkable happens, Asian countries may have to lower their investing standards. A senior official at the Reserve Bank of India said that the country did not invest below AAA-rated Treasuries, but might have to change its strategy should the U.S. be downgraded—something threatened by Standard & Poor's if the U.S. fails to cut the long-term deficit. "We can only wait and watch," the official said. "Alternate options like the euro are equally bad, and [British] pound sterling hardly has the depth to absorb this kind of investment."