October 15, 2013
Two weeks after the Federal government shutdown and two days before the Federal government runs out of means to pay all its bills without additional Federal borrowing, the unthinkable development of a Federal debt default needs to be thought about. The responsibility for this situation lies squarely with the House Republicans, who have refused to bring to a vote a resolution to raise the debt ceiling without conditions. Moderate Senate Republicans and Senate Democrats have been working on a resolution that would raise the debt ceiling until January and re-open the Federal government at current, sequestration-reduced spending levels, in return for initiating negotiations between the White House, Democrats, and Republicans on longer-term deficit reduction plan and some minor adjustments to the Affordable Care Act. While this could well form the basis for a way out of this deadlock before midnight on Thursday, October 17, some House Republicans have already labeled it "a surrender" and vowed to oppose it. So, I think the risk of a Federal debt default is at 10% and rising.
The actual shape of a default is still unclear. Republicans have argued that the Treasury Department could avoid a default by paying interest on all Federal securities coming due out of existing incoming tax and other revenues, but in that case the Treasury would not be making payments to Social Security beneficiaries, recipients of Medicare-covered health treatment, and other US citizens. In addition to the political uproar about paying interest to the Chinese government, other foreign governments, and big banks that hold Federal securities, but not to US citizens who receive Social Security, Medicare, and other benefits, a failure to pay these benefit obligations would generally be seen by financial markets as a Federal government default, with all the resulting effects of such an action. The Treasury Department instead has said that it would pay obligations as they came in to the extend it had cash on hand to do so, and whenever the cash ran out it would not be able to pay any obligations in the queue at that point. So, it is highly probable that the Federal debt default would apply to both Federal debt securities and to Federal commitments to benefit program beneficiaries and to any entity that has sold goods and services to the Federal government.
For CIOs and other tech buyers, extreme caution and tech spending cutbacks are called for in the event of a default.
- There are no good outcomes from a Federal government default, only bad ones, with the only question being how bad the damage will be. Interest rates on virtually all forms of lending would spike up, since these are generally set in reference to the interest rates on what has up until now been the safest financial instrument, US treasury securities. While interest rates will probably subside from elevated levels at the time of a Federal debt default once the Federal debt ceiling is raised and the Federal government is again able to borrow to fill the gap between revenues and expenses, they will almost certainly remain higher than they were before the default. State and local governments will find their borrowing costs will be permanently higher after a default, forcing them to cut back other categories of spending in response. Private businesses will also face higher borrowing costs, though not to the same degree as state and local governments.
- Many businesses will be looking at reduced revenues, as both consumers and businesses cut back their spending given the financial crisis. Our guess is that US real GDP in Q4 2013 would drop by 5% to 7% compared with Q3 2013 levels. These are similar in magnitude to the 8.3% drop in US real GDP in Q4 2009 and 5.4% decline in Q4 2010 at the time of the Lehman Brothers default and the resulting financial crisis.
- Given this degree of economic and financial fall out, businesses will want to conserve cash against the prospect of reduced revenues and higher borrowing costs and reduced lending. Cutbacks in capital equipment like computer and communications equipment are a traditional way for companies to conserve cash, and CIOs will certainly follow this course. But big software implementations are also vulnerable during financial crises, so these projects will be delayed, deferred, or strung out. SaaS software will get a lift because these applications have lower upfront costs than licensed on-premises software, but even these will see little growth as firms slim down their project portfolios in light of the more hostile and threatending economic and financial environment.
- While IT outsourcing and telecommunications services spending is less sensitive to immediate cutbacks by CIOs due to contractual commitments, CIOs will be scrutinizing their contracts for every clause they can find that can justify lower spending, and put pressure on vendors to re-negotiate existing contracts in light of the new, more adverse business conditions.
For tech vendors, the impact of a default would be significant.
- Any invoice for goods or services sold to the Federal government due in the next week or so would most likely not be paid, though these vendors are still likely to ultimately get paid in full at some point in the future.
- Any ability to close a new contract with a Federal government agency — already reduced with many Federal agencies operating on skeleton staff and no budget for new purchases — will be severely limited until the debt ceiling and Federal government shutdown is resolved. Even after this happens, the volume of new contracts will probably be reduced as Federal agencies seek to determine how much budget authority they actually have and how much it has been or will be reduced.
- Even vendors who don't serve the Federal government but instead sell to defense contractors and other businesses who sell to the Federal government, to state and local governments who receive Federal grants and loans will see sales dry up as these entities cut back their own tech purchases due to the shocks to their revenues and their borrowings.
- Tech vendors with variable-rate debts would experience sharp rises in these liabilities. More importantly, their business clients in any interest-rate sensitive industry will immediately cut back their tech spending as part of a broad-based effort to reduce costs to match their now reduced revenues.
- Vendor sales to overseas markets would likely be suspended as buyers in those market waited to see what the impact of the Federal default would be on their own economies, on their cost of borrowing, and on the exchange rate between the US dollar and local currencies.
- Add these up, and we think even a short-term US Federal government default would lead to at least a 10% drop of tech vendors' US revenues in Q4 2013 compared with Q4 2012, with continuing weakness in the first half of 2014, with even steeper declines for vendors with heavy concentrations of sales to the Federal government or to sectors that depend on Federal government spending. Sales outside the US may not fall as much, but they would almost certainly be in negative territory.
Let us hope that an agreement is reached to raise the Federal debt ceiling before October 17 so we avoid these consequences. But even more, I hope that business and tech leaders will tell their Congressional representatives to stop using the debt ceiling as a negotiating tool. The damage to the US from even threatening a debt default, let alone allowing one to happen, is not worth any political gains that come this threat.