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Jeff Rubin's Smaller World

Debt ceilings aren’t the only way America can default Add to ...

For the People’s Bank of China, which is long a trillion or so dollars of U.S. Treasury bonds, it is impossible not to notice the game of debt brinkmanship currently being played in Washington.

If Congress does the unthinkable by not raising the debt ceiling, the U.S. government will start defaulting on its debt, of which the People’s Bank of China is the single largest holder.

There, of course, have been other debt ceiling impasses on Capital Hill in the past, and there will undoubtedly be more in the future. The Chinese can rest assured that the current budget impasse, like the others before, will not be allowed to trigger a default.

At the same time, the Chinese know there is more than one way for America to default, especially for a borrower such as the U.S. whose debt is conveniently funded in its own currency.

The U.S. Treasury has never defaulted in the classic sense of not paying its bondholders on time but that doesn’t mean it hasn’t short changed its foreign creditors before. Just ask Japanese insurance companies that loaded up on Treasury bonds during the 1970s, seeking the higher yields they were offering over the JGB (Japanese Government Bond).

The U.S. Treasury never missed a coupon payment and all the bonds were paid out 100 cents on the dollar. Only the U.S. dollar didn’t buy the same number of yen when those insurance companies cashed in their maturing 10-year Treasury bonds than it did when they bought them.

Between 1971 and 1981 , the U.S. dollar lost 40 per cent of its value against the yen, leaving the Japanese insurance companies with a huge foreign exchange loss on their U.S. bond portfolios. In retrospect, those yield-hungry institutions would have been better off if they had invested in lower interest bearing JGBs.

Given the size of the trade imbalance between China and the U.S., it is not difficult to imagine an even larger depreciation of the greenback against the yuan over the next decade. Indeed, the greenback could easily lose half its value against the yuan over the course of a 10-year Treasury bond.

One way or another, Congress will call off its game of chicken with the Obama administration by raising the debt ceiling before the Aug. 2 deadline. But that doesn’t mean the U.S. won’t be defaulting on its Chinese creditors down the road, just as it did on its Japanese creditors in the 1970s.

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