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Tom Holland

Ask most financial analysts about the likely consequences of a US sovereign default - or even just a ratings downgrade - and the chances are that you will get the same answer.
'It's unthinkable,' they will reply, quickly following up with, 'but it's not going to happen anyway.'
Well, a sovereign default by the world's largest debtor and the issuer of its reserve currency may have been unthinkable in the past. But a lot of financial certainties have been shattered in recent years, and now some observers are considering the possibility of a US default.
Last week Moody's Investors Service placed America's top notch Aaa rating on review for a possible downgrade, citing the risk that US politicians may not agree to increase the federal government's debt ceiling in time to prevent 'a missed payment of interest or principal on outstanding bonds and notes'.
As a result, the ratings agency concluded, 'there is a small but rising risk of a short-lived default'.
For Hong Kong, with its currency link to the US dollar, the possibility of even a short-lived technical default by the US government is a nerve-wracking prospect.  
The first impact of a default would be an immediate re-rating of the risk involved in holding US assets. The effect on financial markets could be devastating. US Treasury bonds are posted as collateral for every sort of transaction imaginable. With financial institutions suddenly forced to reassess the value of their collateral, it is likely that US dollar money markets would temporarily seize up, with severe knock-on effects around the world.
In Hong Kong, activity in the interbank market would grind to a halt as short-term interest rates leapt, forcing the Hong Kong Monetary Authority to provide emergency liquidity to the city's smaller banks.
Meanwhile, asset market volatility would soar as investors attempted to bail out of risky plays in favour of safe-haven assets like the Swiss franc, gold and possibly even sterling.
In Hong Kong the rise in risk aversion would trigger a steep fall in local stock prices as investors fled in search of refuge elsewhere.
Hopefully, many of these violent effects would be short-lived. But the longer-term impact of even a temporary technical default by the US would still be far-reaching.
Understandably, investors would no longer be so keen to hold US dollars, and the currency would fall, dragging the Hong Kong dollar down with it.
If the fall were sustained - and the chances are that it would be, given the blow to US credibility - the result for Hong Kong would be a rise in inflation. The prices of imported foods and manufactured goods would rise as other currencies appreciated against the US dollar. Energy costs would increase as commodity prices adjusted upwards to reflect the US currency's weakness.
Investors would also demand a higher return for holding US Treasury debt to compensate for the higher risk. Treasury yields would rise, which would push up the cost of both US dollar and Hong Kong dollar debt for corporate borrowers in Hong Kong, slowing business activity.
Higher long-term interest rates, together with perceptions of increased risk, would also prompt local banks to increase their mortgage rates, further hammering transaction volumes in Hong Kong's property market and precipitating a nasty decline in prices.
To add insult to injury, the Hong Kong government's own financial position would suffer. The Exchange Fund, which manages Hong Kong's financial reserves, doesn't declare how much it has invested in US Treasury debt. But given that at the end of last year 79 per cent of its portfolio was held in US dollar-denominated assets, and 81 per cent consisted of debt securities, the proportion is surely greater than 50 per cent.
With the prices of US agency - Fannie Mae, Freddie Mac and the like - and corporate debt also sure to fall if the US Treasury defaults, Hong Kong's Exchange Fund would certainly sustain heavy losses.
And the effects wouldn't stop there. In the longer term a US sovereign default would accelerate the decline of the US as a financial superpower, and bring closer the eventual demise of Hong Kong's exchange rate peg to the US currency.
Happily, though, despite all the warnings, the chances of a US sovereign default look extremely slim, at least if you believe the signals emanating from the financial markets.
As the charts  illustrate, over the last couple of months the US dollar has actually strengthened by almost 4 per cent on a trade-weighted basis, while the yields on US Treasury debt have fallen.
For the time being, it's clear that investors are not taking seriously the possibility of a US default.
For Hong Kong's sake, let's hope they are right.



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What a US sovereign default would mean for Hong Kong