​Trade Consequences for Developing Countries of the U.S. Hitting the Debt Ceiling

Note from the Editor: The deadline for the United States Congress to expand its ability to take on new debt is Thursday. For weeks now, observers have speculated widely about what could happen within the U.S. if there were a failure to lift the “debt ceiling.” Retirees might not receive their Social Security checks. Companies with federal contracts might not be paid. U.S. bond holders might not receive interest payments. At The Trade Post, we thought it would be interesting to consider the implications outside the U.S., for developing countries. We asked a trade expert at the World Bank, economist Michael Ferrantino, to discuss the possibilities.

Michael Ferrantino is Lead Economist in the World Bank's Economic Policy, Debt and Trade Department. Prior to joining the Bank, he was Lead International Economist at the U.S. International Trade Commission. Michael's published research spans a wide array of topics relating to international trade, including non-tariff measures and trade facilitation, global value chains, the relationship of trade to the environment, innovation, and productivity, and U.S.-China trade.

The Trade Post: What would happen to developing countries if the U.S. debt ceiling were not to be renewed? 

Mr. Ferrantino: The first observation is that market participants do worry about these types of events. There is some evidence that trade will contract whenever financial markets are volatile.  One recent study by our colleagues Daria Taglioni and Veronika Zavacka has shown that countries with big surges in stock market volatility tend to import less. This was a factor in the Great Trade Collapse that accompanied the Great Recession of 2008-09, and it comes into play even when looking at less dramatic episodes.  

Thus, if a debt ceiling event led to greater financial volatility in the U.S., the country could potentially end up importing less from developing countries—even if U.S. demand growth did not decelerate.  If worries about the U.S. debt lead to greater volatility in other countries, this could lead to greater volatility in other countries, and they, too, could end up importing less. Foreign direct investment (FDI) may be even more sensitive to volatility than trade is. 

The other thing one could expect is that U.S. interest rates would rise to incorporate a risk premium for potential default. We already saw what happened earlier this year when rates rose in anticipation of a possible unwinding of quantitative easing by the Fed– capital flowed out of emerging markets seeking the higher U.S. rate, and exchange rates depreciated, most notably in India and other countries with large current account deficits. If such depreciation persisted, it would lead to price inflation in those countries, with negative consequences for those living in poverty. Emerging market “hot money” could chase this new higher U.S. rate, but that is far from certain.

The good news is that the players closest to this crisis – traders of U.S. debt – seem not to have placed very high probability on a default at this point.   Rates on U.S. one-month debt spiked in an unusual way last week, but only to 0.46 percent, on Wednesday, October 9.  This works out to an expected 0.04 percent probability of default, since the quote is on an annualized basis.  At the time of writing, this risk premium has eased markedly.