Asia braces for direct hit from the West's debt woes

SINGAPORE Mon Jul 18, 2011 10:12am EDT

SINGAPORE (Reuters) - For Asia, the deepening debt troubles in the West are like a giant asteroid on a collision course -- too big to dodge or ignore, and difficult to pinpoint precisely where the worst damage will be done.

With roughly $3 trillion (1.86 trillion pounds) of reserves held in the form of U.S. Treasury debt -- more than $2 trillion in China and Japan alone -- Asia would be directly exposed to a U.S. debt downgrade or default. The sheer size leaves Asia with nowhere to hide.

"Where could these investors go to put that amount of cash to work? Answer: Nowhere," said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ in New York.

Government officials interviewed by Reuters said there was little they could do but watch, wait and hope for the best as Washington struggles to find a politically palatable agreement to avoid an August 2 default and satisfy ratings agencies looking for proof of longer-term debt sustainability.

Indeed, some officials sounded more worried about risks emanating from Europe, where debt fears have spread beyond Greece, Ireland and Portugal to a much larger economy: Italy.

"Holding onto (U.S.) Treasuries could cause some capital losses in case of a downgrade, but we could live with it," said one senior Japanese government official who requested anonymity because he was not authorised to speak to the press about contingency planning.

"We have no problems investing in sub-AAA rated bonds," the Japanese official added. "Besides, what else should we buy by selling dollars? Euros? Would that be a safer investment than the dollar?"

Japan's worry would be a strengthening in the yen currency versus the dollar or euro if debt troubles deteriorate, which would hurt its exporters and constrain economic growth.

The biggest concern for Asia as a whole would be a global panic, similar to what followed the bankruptcy of Lehman Brothers in 2008. Asia fared better than the United States or Europe in that episode because its banks had little direct exposure and its public finances were healthy.

A U.S. default would be a direct hit.

Not only would Asia's Treasury holdings be at risk, a severe bout of risk aversion would probably mean investors pull money out of emerging markets, even though their growth prospects look healthier than those in many of the advanced economies.

Banks that count on Treasuries for ultra-safe reserves might have to curb lending or sell riskier assets to bolster capital.

A U.S. debt downgrade could also have wide repercussions. Funds that invest only in AAA-rated debt would be forced to sell. Ratings agency Moody's has put 7,000 U.S. municipal bond issues on review because they have direct links to U.S. debt.

Asian financial markets could take a beating. U.S. Federal Reserve Chairman Ben Bernanke pointed out last week that Treasuries are often used as collateral or margin, so a default could throw the entire financial system into "chaos."

Foreign exchange markets in the region look particularly vulnerable because many investors bet with borrowed money. Individuals can easily obtain foreign exchange trading accounts allowing them to bet $100 for $1 they put up. That cushion could be quickly wiped out in the case of a U.S. default.

NO ALTERNATIVE

Chris Krueger, research analyst at MF Global in Washington, said as of Friday he saw a 40 percent chance that Congress would fail to raise the U.S. debt limit by August 2, the date the Treasury said it would run short of money to pay bills.

Despite the potential for massive upheaval, several Asian policymakers said they had no formal contingency plans for that possibility.

South Korea's finance minister, Bahk Jae-wan, told Reuters in an interview on Friday that his country was not drafting plans for how to cope with a U.S. default, believing that lawmakers would eventually work out a solution.

Financial markets appear to have drawn the same conclusion. The yield on 10-year U.S. government bonds was under 3 percent, indicating investors still see it as the preeminent safe haven.

But for both the United States and Europe, the biggest impediment to resolving the debt troubles is political, not economic. That makes it even trickier to predict the outcome.

A fallback plan gaining momentum in the United States would avert a default by allowing President Barack Obama to raise the nation's borrowing limit before the August 2 deadline.

However, that would simply put off the tougher task of cutting the long-term deficit. Ratings agency Standard & Poor's warned last week that raising the debt limit would not be enough. It would probably downgrade the U.S. sovereign rating if officials failed to address longer-term strains as well.

To be sure, a downgrade of a notch or two would not send every investor scurrying for the exits. But it would likely raise borrowing costs for other countries, corporations and even consumers worldwide because U.S. Treasuries are the benchmark by which many other loans are measured.

It may also force governments in Asia to lower their investment standards. A senior official at the Reserve Bank of India said the country does not currently hold bonds rated below the top-tier AAA, but would probably have to if the U.S. rating is downgraded.

"We can only wait and watch," the official said. "Alternate options like the euro are equally bad, and (British) pound sterling hardly has the depth to absorb this kind of investment." (Additional reporting by Tetsushi Kajioto in TOKYO, Suvashree Dey Choudhury in MUMBAI, Yoo Choonsik in SEOUL, and Ellen Freilich in NEW YORK; Editing by Mathew Veedon)

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