How U.S. Debt Crisis May Impact India

While the rupee has depreciated, dominant domestic factors continue to keep financial markets stable.

<div class="paragraphs"><p>An Indian 10 rupee banknote and a U.S. one-hundred dollar banknote. (Photographer: Dhiraj Singh/Bloomberg)</p></div>
An Indian 10 rupee banknote and a U.S. one-hundred dollar banknote. (Photographer: Dhiraj Singh/Bloomberg)

American markets are jittery ahead of the U.S. approaching its debt ceiling. So far in India, the rupee has depreciated against a strengthening dollar, though domestic factors continue to outweigh global ones in Indian financial markets.

The U.S. is rapidly approaching the date at which the government can no longer pay its bills, also known as the "X-date." Even getting close to a breach of the U.S. debt ceiling has, in the past, caused significant disruptions to financial markets in the US, with global spillovers.

This time around, Republican and White House negotiators are moving closer to an agreement to raise the debt limit and cap federal spending for two years, according to Bloomberg, though a deal has yet to be struck.

An actual breach of the U.S. debt ceiling would likely cause severe damage to the U.S. economy, with global spillovers. However, economists and analysts globally and in India are so far working with the base case scenario of a resolution close to the American economy approaching the limit.

Why The World Faces U.S. Debt Threat

Base-Case: When, Not If  

Even if the deal is reached at the last moment, the uncertainty is causing volatility in stock markets and currencies, said Radhika Pandey, senior fellow at the National Institute of Public Finance and Policy. The delay in reaching a deal has strengthened the dollar index, which puts downward pressure on the rupee. Investors retreat to safe haven investments amid volatility in markets, she explained.

While the chances of the U.S. defaulting on its debt obligations are far-fetched, the looming deadline is turning investors cautious, said Jahnvi Prabhakar, economist at the Bank of Baroda. If the deal is not reached, some spillovers might be visible on domestic shores, she said.

The dollar could be considerably impacted, and this will be reflected across the globe as it plays a dominant role in the international market for trade. The uncertainty might also cause volatility in the financial market, with the rupee coming under pressure. Stock markets, too, are expected to feel the heat. Any business with exposure to the U.S. market might also be wary in the given scenario.

The debt default risks and cautionary call from rating agencies might put pressure on U.S. sovereign yields, the ripple effect of which cannot be ruled out entirely on domestic yields.

If there is a resolution, there should be no impact on Indian financial markets, according to Gaura Sengupta, an economist at IDFC First Bank. Once the debt ceiling is raised, "we could see some increase in US Treasury yields as issuances rise once the debt ceiling is increased".

Alternate Scenario: Brief Default  

In the unlikely case of no resolution, there could be a short-term growth shock to the U.S. due to a sharp decline in government expenditure, Sengupta said. That said, a sovereign default by the U.S. is unlikely as debt servicing will be met while other expenditure items would be cut, she added.

In the second scenario, risk-off sentiment would be triggered and could result in depreciation pressures on emerging market currencies such as the rupee, said Sengupta.

No deal and a default will obviously be negative for India as flows will move out of risk assets, but it will also depend on how much the U.S. government will be forced to cut spending and where, said Suvodeep Rakshit, senior economist at Kotak Institutional Equities. If that has the effect of a deep recession, then there are multiple repercussions for India's capital and trade flows, Rakshit said.

To be sure, at this stage, the situation remains speculative, he said.

A default will have catastrophic consequences, said Pandey. Indian exports could plummet further, there could be changes in trade patterns, and non-U.S. trade could gain impetus, she said, adding that sectors having exposure to the U.S. could see a hit to their earnings.

The yield differential between Indian and U.S. bonds could narrow further, leading to implications for foreign portfolio investment flows, Pandey said.