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Federal Finance Minister Jim FlahertyCHRISTINNE MUSCHI/Reuters

Finance Minister Jim Flaherty says he is "relatively confident" that the United States will reach a debt ceiling solution in the next few days.

Mr. Flaherty called the U.S. debt situation "very worrisome" but he remained tight-lipped about any contingency plans for Canada in the case of a U.S. default. He was in the picturesque city to host a roundtable with a number of small-business leaders to gauge their views on the economy.

"We are very concerned," Mr. Flaherty said, speaking to reporters at the Palletta Park Mansion in Burlington, Ont.

"This is an issue that has consequences for not only the United States but the global economy because of the reliance of the global economy on U.S. Treasuries."

Still, he acknowledged that global risks have intensified. In particular, he fingered the "uncertain pace" of the U.S. economic recovery as a matter of concern, especially against the backdrop of a "volatile" global situation which includes lingering worries over the European debt crisis.

While the Group of Seven nations has not held a recent consultation on the U.S. debt situation, it has held a number of calls on the issue in the past that also touched on the ongoing situation in Europe.

"I have quite frequent telephone conversations with the U.S. Secretary of Treasury Tim Geithner."

While he did not elaborate further, he stressed the Americans are "fully cognizant of the consequences of failing to arrive at some sort of an agreement."

There is just one week left before the Aug. 2 deadline to raise the $14.3-trillion ( U.S.) debt ceiling, leaving the world to watch with bated breath as the political gridlock continues in Washington.

Mr. Flaherty signalled, however, that he is also looking beyond next week's deadline, noting that much heavy lifting remains as the longer-term issues of debt and deficits must also be resolved.

It matters to Canada, he said, that its largest trading partner get its fiscal house in order.

In addition to the U.S. debt situation, there are also lingering concerns with respect to sovereign indebtedness of certain European countries that require long-term planning "in order to maintain market confidence," he said.



Still, Mr. Flaherty remained mum on Canada's contingency plan if the U.S. does end up in default. Nor did he say whether he has been in contact with the Bank of Canada on the issue.

"What we are doing in Canada is what we are able to do in Canada. As we did before the recession, we maintained balanced budgets and paid down large amounts of public debt," he said, adding Canada is on track to return to a balanced budget by 2014.

If U.S. lawmakers fail to reach a deal to raise the debt ceiling in time, the U.S. risks defaulting on its debts along with a humiliating downgrade of its stellar triple-A credit rating.

Standard & Poor's warned on July 14 that Washington's inability to reach and implement a "medium-term fiscal consolidation policy" in a timely manner would be "inconsistent" with its current credit rating.

A credit downgrade would likely cause a spike in interest rates and create fresh malaise for an already struggling U.S. economy -- the impact of which would be felt around the world.

Mr. Flaherty acknowledged that "disorder" in credit markets could result in less available credit and higher interest rates.

Canadians, he added, are also recognizing they must control their own personal debt loads, including residential mortgages.



"This is a good thing. This is something that I have been encouraging Canadians to do," he said.



He also reiterated his warning that mortgage rates will rise over time and that Canadians should be prepared to pay those higher rates.

On Monday, when asked whether he has a plan in place to cushion Canada from the impact of a U.S. default or credit downgrade, Mr. Flaherty sidestepped the question but strongly suggested that the Finance Department is worried.

``As the largest economy in the world and Canada's largest trading partner, we are closely following the current political impasse in the U.S. regarding debt and deficit concerns,'' Mr. Flaherty said at the time in an e-mailed statement. ``Clearly, we believe the situation needs to be addressed in the very near future to ensure continued confidence in the American and global economy.''

Last week, Bank of Canada Governor Mark Carney told reporters in Ottawa that he believes ``U.S. authorities will come to an arrangement that honours their obligations to debt holders.'' A default would have ``profound implications'' for the global financial system, he said, but ``it's not our expectation that it will happen.''

If it did happen, though, short of a coordinated response by G7 finance ministers and central bankers to put a floor under the U.S. dollar, Canadian policy makers' options in the immediate aftermath would be limited.

Should markets take a precipitous dive similar to what happened in the autumn of 2008 or right after the 9/11 terrorist attacks, the central bank might issue a statement -- as it did in those instances -- pledging to maintain the ``orderly functioning of core funding markets.'' In other words, standing at the ready to juice markets with liquidity through a range of emergency lending mechanisms, if that is what's needed to keep credit flowing.

In December, 2009, a central bank assessment of the financial system showed that Mr. Carney was devoting significant effort to making the arcane markets that cycle money through the financial system more resistant to the types of shocks that brought down the world economy the year before.

The article also for the first time identified "core funding markets" that the Bank of Canada considers necessary for the proper functioning of the financial system, implying policy makers would do whatever necessary to keep them from collapsing. They included repurchase agreements, or repos - essentially, cash loans backed by collateral, with a promise to repurchase the collateral at a future date - markets for government debt, securities lending, bankers' acceptances, and foreign exchange.

Doug Porter, deputy chief economist at BMO Nesbitt Burns in Toronto, said the central bank could certainly revisit the liquidity provisions it used during the 2008-09 financial crisis, though he's not yet convinced things would come to that. A more likely immediate ``headache,'' he said, would be a strengthening currency, as investors who used to flock to U.S. Treasuries as safe havens increasingly turn to the loonie and Canadian bonds. Already, the Canadian dollar is at its highest level since November of 2007, and could climb further as the greenback weakens.



Other than a tactic known as ``jawboning'' -- where central bankers try to cool speculators' enthusiasm by, for instance, hinting that their stance on interest rates isn't likely to support a higher currency -- it's unclear policy makers can do much in the short term to avoid the loonie gaining at the expense of a falling U.S. dollar.



At the same time, Mr. Porter noted, a U.S. default might hurt equity markets and commodities, since it would heighten fears that the global recovery might veer off course. That would put a brake on the oil-fuelled currency, although it's hardly a rosy scenario for Canada, either.

Even without a default, there are clear implications for the Canadian economy. If the Aug. 2 deadline passes without a deal, the likely course for Washington would be to avoid default by putting a freeze on other spending. As Mr. Carney explained last week, that would slow growth in Canada's main export market ``because there would be less government spending in the short term at a time when it's quite reliant on that government spending.''

Currently, the central bank's latest forecasts assume ``significant'' belt-tightening in the United States, a virtually certain by-product of any deal reached on the debt ceiling, would cut America's economic growth by 1 percentage point next year and 1.7 percentage points in 2013.



Ultimately, though, the impact of a default will depend on how long it takes for cooler heads to prevail and to raise the debt limit in a way that satisfies creditors, Mr. Porter said.



``If they actually do default and it goes beyond a day or two, then I think you get into a variety of different concerns, whether you're talking about consumer confidence in the U.S., or business confidence, or global investor confidence about the U.S.,'' he said. ``Those are such great unknowns I'm not sure what the Bank and the Department of Finance could do in that circumstance to really soften the blow.''



What makes this situation so unusual, and the reason it's so hard to assess the potential impact, is that U.S. Treasuries are usually where investors flock in times of stress or uncertainty. While it's not happening just yet, as Aug. 2 gets closer a run on Treasuries becomes a more realistic possibility.



``In any times of uncertainty or stress you automatically just assume Treasuries are going to benefit from it, but of course we're in a situation where Treasuries are the very thing whose value is being called into question,'' Mr. Porter said. ``That really upsets the apple cart for the markets. Obviously the ultimate safe havens like gold or the Swiss franc can benefit, but beyond that I don't think anything is very obvious about what the market response would be.''





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