Dollar's key role could limit default impact

The fall in the dollar, the three days straight of drops in US stocks, and the rise in the cost of insurance against default on US Treasury bonds, all point to nervousness in markets.

And warnings have come from near and far of an economic "apocalypse".

"We would risk sparking a deep economic crisis," said US President Barack Obama.

"To have a default or to have a significant downgrading of the United States signature would be a very, very, very serious event," warned International Monetary Fund head Christine Lagarde.

"If we default on August 2nd... it's going to be financial Armageddon," said former US treasury secretary Larry Summers.

But analysts say that the fallout might be contained -- if only because the greenback dominates global markets.

There aren't many alternatives. The dollar, and dollar-denominated Treasury bills, are the world's key reserve units. And Treasuries are deeply relied on as collateral and reserves in many financial institutions.

If Washington's coveted triple-A rating is cut moderately, ratings agency Fitch said Wednesday, there might be short-term volatility in markets, especially in short-term inter-bank exchanges.

But Treasuries "would likely retain their standing as the benchmark security that anchors global fixed-income markets."

"It does not change our view that there is no better benchmark asset than US Treasury debt," Standard Chartered Bank said of a downgrade.

If both are right, the result of a downgrade or temporary default might only be a slight increase in Washington's borrowing costs -- right now some of the world's lowest -- and a slight loss in value of investments in the dollar.

But the focus of Washington's political fight -- how to cut the country's budget deficit -- could have a huge impact on the world if it forces a spending crunch in the US economy.

There are two issues. Currently the United States needs some ê120 billion in additional loans each month to bridge its funding gap. But Republicans in Congress are refusing to raise the country's already maxed-out, $14.3 trillion borrowing ceiling.

If it isn't raised by August 2, the government says, it will have to slash spending and default on a range of commitments -- whether government salaries, retirement benefits, or debt.

Already in June the three leading credit raters -- Standard & Poor's, Moody's and Fitch -- warned they could downgrade the US AAA rating if they ceiling isn't hiked, because it could push the US toward default.

Republicans have tied raising the debt ceiling to the bigger issue, the need a plan to reduce the long-term US deficit.

But they cannot agree with the White House and Democrats on what that plan should contain -- so the debt ceiling remains held hostage.

S&P has now warned it could cut the US rating anyway unless the country has an adequate plan for deficit reduction.

The possibility of default then looms on August 15, when the country will be challenged to shell out some ê30 billion in coupon payments on long-term bonds, while its receipts are hobbled by the debt ceiling row.

Yet markets are still sanguine -- US debt prices remain low. Traders believe that eventually the ceiling will be raised, and bond holders will be "made good".

Indeed, some economists point to S&P's April 2002 downgrade of Japan. Yields on Japan's debt, what it pays to borrow, actually fell for the following year, because of confidence in Tokyo's commitment to pay its debts.

"The US can pay its bills: it's a self-inflicted problem," said Nariman Behravesh, chief economist at global consultants IHS.

But the bigger picture is that the world's largest economy has to cut spending. If it makes a political decision to slash spending precipitously -- which some Republicans advocate -- this could send the already feeble US economy into another recession.

As the IMF warned this week, that would spill over into other economies with devastating effect, reversing the recovery from the 2008-2009 crash.

"The impact for other parts of the world would be dramatic, especially the ones that are growing slowly like Europe. Because trade with the US would be affected," said Behravesh.

Whatever the case, the US eventually will feel the impact if it does not finesse this crisis.

Fitch says that over the longer term, investors are likely to be motivated to find alternatives to US Treasuries as the global benchmark. That means a weaker dollar and higher borrowing costs for Americans.

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