US debt default would be a ‘triple whammy’ for Chile

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Published On : Tue, Oct 15th, 2013

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Chile faces plunging copper prices and turmoil in international financial markets if US defaults on its debts, but would likely ‘weather the storm.’

As the U.S. Congress scrambles to avoid plunging off the fiscal cliff, the rest of the world watches anxiously — reverberations of U.S. debt defaults would be felt in every country, including in Chile.

While the Andean nation, like the rest of the world, would suffer dramatic repercussions if U.S. lawmakers can’t agree to lift the debt ceiling by Thursday, Chile would be likely able to “weather the storm” because of its sound macroeconomic situation.

Ernesto Talvi, the director of the Brookings-CERES Economic and Social Policy in Latin America Initiative, told The Santiago Times a U.S. debt default would most affect Chile in three ways.

“It’s going to affect Chile as a triple whammy: increased interest rates, decreased copper prices and a fall in world economic activity,” Talvi said.

A manufactured crisis

The potential debt crisis originates from the fact that the U.S. spends more money than it collects in taxes. To make-up for this is spending gap, its government accumulates debt by selling U.S. Treasury bonds. Other countries or private entities can buy this debt as a form of investment.

Chile holds a little more than US$29 billion in U.S. debt.

These bonds have always been viewed as a safe place to invest money. If the U.S. Congress does not permit the debt ceiling, or the total amount of debt the U.S. can accumulate, to be raised, the U.S. would not be able to pay back the interest on the debt it owes to private entities and to other countries.

The debt cap has been raised 78 times since 1960. The limit is currently US$16.7 trillion. Raising the debt ceiling allows the government to issue more debt to pay its existing bills.

If the U.S. does not raise the debt ceiling by Oct. 17, the U.S. government would no longer be able to borrow. Within weeks, the U.S. would not have sufficient funds to finance all it’s spending and could potentially default on its debts for the first time in recent history.

‘Opening Pandora’s box’

Talvi said the U.S. defaulting on the debt is a very unlikely event because the problem is caused more by a political gridlock than the U.S.’ economic inability to back its debt.

However, if the debt ceiling was not increased, the U.S. would still be receiving some revenue in the form of taxes, so it could cover part of its costs.

“It would become a choice of whether to continue paying interest on existing debt or delaying payments of other spending items in the budget, like social security or Medicare,” Tilva said. “My bet would be that the U.S. would continue honoring interest payments on existing debt and they would delay payments of other spending items in the budget.”

Some question whether the U.S. Treasury would be able to to prioritize payments given the size of the system. The Treasury’s current system automatically makes payments of US$80 million a month.

“It is designed only to make all payments on time and in full,” Mark Patterson, former chief of staff at the U.S. Treasury told NPR. “There’s no switch that says, ‘Pay payment A, C, D and G today and tomorrow pay some other set of priorities that’s not all payments.’”

However, if the U.S. did default on its debt payment or stopped paying the interest it owed on its debts, Talvi said it would open up a “Pandora’s box.”

What would be most dramatic for the South American country is not whether the direct interest owed to Chile is paid, but rather the other the effects a U.S. default would have on the world economy and, thus indirectly on Chile.

Increased interest rates

If the U.S. defaults, the value of U.S. Treasury bonds and of the dollar would plummet. The U.S. government would have to pay investors much higher interest rates in order for them to invest. Many interest rates around the world are tied to the U.S.’s, causing the cost of government borrowing around the world to skyrocket.

More concerning for Chile, though, as Finance Minister Felipe Larraín said, would be a drop in demand of commodities throughout the global market.

Drop in price of copper

China is the largest owner of U.S. debt, holding more than US$1 trillion in U.S. Treasury bonds. China’s economy would be hugely damaged by the U.S.’ failure to repay the interest on those bonds.

Such a blow would greatly harm Chile as China is Chile’s largest trading partner, representing 25 percent of the South American country’s exports. A weakening of China’s economy would decrease Chinese demand for Chilean exports, especially copper.

Copper accounts for more than half of Chile’s exports.

Andrés Solimano, former adviser to the United Nation’s Economic Commission for Latin America and the Caribbean (ECLAC), told The Santiago Times that the price of the red metal would “suffer dearly” in the case of a U.S. default.

“It would indirectly affect on the price of copper. The price of copper is affected by what is happening in China,” said Soliman, “A U.S. default would affect China and this would create a slowdown in China. It would then affect the price of copper.”

World market disruptions

In addition to increased interest rates and decreased copper prices, Chile would suffer from the countless other less-easily measured effects the U.S. default would have on the world market, such disrupted trade flows and a lack of confidence in the system.

“It would ripple through the world economy in a way that you couldn’t possibly understand,” Jamie Dimon, Chief executive of JP Morgan told BBC.

‘Weathering the storm’

Although a default would be dramatic for the entire world market, Talvi said Chile would be the most likely be able to “weather the storm.”

“Within Latin America, Chile is best positioned to weather any storm,” he said. “Now if the storm gets severe, they are going to suffer. But Chile is very well managed and well prepared to weather a very severe storm.”

Talvi cites Chile’s macroeconomic stability as the reason that Chile won’t fall into a crisis in the wake of a U.S. default.

“Chile is my opinion is the best managed country in Latin America in a macroeconomic perspective,” Talvi said. “It has very solid fundamentals and a fiscal position that will be extremely resilient in trying times.”

Chile is a net creditor on the global market, meaning it lends more than it borrows. Larraín told Reuters last Tuesday that Chile had no plans to sell its debt on the international market, citing that the country does not need the extra cash.

By Katie Steefel (steefel@santiagotimes.cl)
Copyright 2013 – The Santiago Times

About the Author

Katie Steefel
Katie Steefel is from Colorado, USA. She studied International Politics and Latin American Studies at Georgetown University. She will be in Santiago for a year before starting law school in the U.S.