Kevin McCarthy Chaos Puts Asia’s $3.5 Trillion In Jeopardy

As Republicans controlling the U.S. House of Representatives stumble out of the gate, Washington mustn’t forget its Asian bankers are watching with growing alarm.

The chaos surrounding Congressman Kevin McCarthy’s campaign for House speaker smacks of amateur hour. But it’s also a stark warning to Asian governments that America’s financial management is in fresh doubt.

In the weeks before and after Republicans won the House in November elections, some members hinted that votes to increase the U.S. debt ceiling—which is needed to make U.S. debt payments—might come only after President Joe Biden’s Democrats agreed to their priorities. Goldman Sachs predicts Washington’s accounts could run dry by July.

Asia, which holds about $3.5 trillion of U.S. Treasury securities as foreign-exchange reserves, has seen this horror movie before. In 2011, for example, a group of Republican activists held the debt limit hostage. That gambit sent bond and stock markets reeling. It also prompted Standard & Poor’s to strip the U.S. of a AAA credit rating.

The downgrade, and resulting turmoil, left Asia with the financial equivalent of post-traumatic stress disorder. The U.S. may have built the biggest economy in human history, but Asian governments hold the deed. None more so than Japan and China, which together are sitting on roughly $2.3 trillion of U.S. IOUs that are suddenly in harm’s way again.

There are other reasons for Asian central banks to reduce their exposure to the dollar. The U.S. national debt topping $31 trillion is one turn off. So is inflation surging the most in 40 years. Throw in a Federal Reserve that first fell behind the tightening curve and now seems determined to drive the economy into recession.

But politicians toying around with default is both the last thing Washington’s Asian bankers need and eerily reminiscent of the events of 12 years ago.

With America’s finances all too strained already, 2023 could see quicker moves by the S&P, Moody’s Investors Service or Fitch Ratings to let the pro-default caucus know it’s gone too far. Any move by Moody’s or Fitch to yank away America’s AAA rating would send far bigger shockwaves through global markets than S&P’s downgrade.

That’s because of the cumulative PTSD from the Covid-19 pandemic and all the financial baggage the global economy accumulated in the years before and since then.

Along with a disastrous Covid response, Donald Trump’s 2017-2021 presidency left the dollar with other credibility problems. One was a China trade war that hurt U.S. allies like Japan and South Korea more than Xi Jinping’s economy. Trump attacked Federal Reserve Chairman Jerome Powell and threatened to fire him to extract rate cuts. Trump’s own temptations to default on U.S. debt left a mark in Asia.

On the campaign trail in 2016, then-candidate Trump wondered aloud about using default as a negotiating tactic. As he told CNBC then: “I would borrow, knowing that if the economy crashed, you could make a deal. And if the economy was good, it was good. So therefore, you can’t lose.” In April 2020, the Washington Post reported that Trump officials mulled cancelling debt held by China as a form of punishment.

Officials at the Bank of Japan, People’s Bank of China and their peers in Taipei, Mumbai, Hong Kong, Singapore, Seoul and elsewhere in the region have enough to worry about in 2023. Fears of a U.S. recession, a deepening energy crisis in Europe, a chaotic Chinese exit from “zero Covid” lockdowns, a gyrating Japanese yen and uncertainty about Russia’s Ukraine invasion have policymakers plenty busy.

At the same time, central bankers from Washington to Seoul are hiking borrowing costs to tame overheating risks. Then there’s the borrowing glut from the pandemic era.

If you think the roughly $3.5 trillion of U.S. Treasuries sitting on Asian central bank balance sheets is a big number, try $235 trillion. That’s how much of total public and private debt the International Monetary Fund estimates is outstanding globally. That’s even after a sizable drop in 2021—of roughly 10 percentage points—as global growth returned.

Total debt stood at 247% of global gross domestic product, compared to about 95% of GDP in 2007 before the Lehman Brother crisis rocked markets. Obviously, this limits the fiscal space nations have if 2023 is a year of red economic ink.

It also puts the globe in greater jeopardy if House Republicans decide to hold Washington’s credit rating hostage. Even if McCarthy manages to secure the speakership, he’ll lead a caucus that seems willing to trash America’s credit to make a political point at Asia’s expense. If Washington’s top financiers were to call those loans, look out world.