On Wednesday the 23rd, the US House of Representatives voted to suspend discussions on the US debt ceiling until May (2013). By doing this, they averted a potential US default but also bought some more time for extended budget negotiation between the parties.

The subsequent Bill now goes to the US Senate where it is expected to pass and then be approved by the newly re-elected President Barack Obama (Democrat), defusing tensions between the Democrats and Republicans as they continue to negotiate on how to rein in US deficits and debt.

While this is not the preferred outcome as global markets must now wait until May, it is a positive note coming off the back of successful negotiations around the US Fiscal Cliff which we reported upon in the December update.

So what is the “debt ceiling” and why does this impact global markets in such a manner?

Under Article 1, Section 8 of the US Constitution, Congress has the sole power to borrow money on the credit of the United States. Since the United States was founded in 1917, each individual debt issuance has always been directly authorised by Congress separately where the authorisation of borrowing is governed by the Second Liberty Bond Act (1917). Under this act Congress has established a limit, or ‘ceiling’ on the total amount of debt that may be issued (in the form of bonds).

The Federal Government can pay for expenditures only if their Congress has approved the expenditure in what is known as an appropriation bill (a piece of proposed legislation). If the proposed expenditure exceeds the revenues (that have been collected), then naturally there is a deficit or a shortfall. This deficit can only be financed by the Government, through the Department of the Treasury, by borrowing the shortfall through the issuance of debt instruments. Under US federal law, the amount that the Government can borrow is limited by the debt ceiling, which also can only be increased with a separate vote by Congress.

If the debt ceiling is not increased, then the US Government cannot pay its bills. Like anyone who cannot pay their bills, they can fall into default. As a major player in the global financial markets, such a disruption to the US economy would invariably affect the economies of the rest of the world.

You may recall the 2011 US debt ceiling crisis, which was a political debate in the United States Congress about increasing the US debt ceiling that resulted in a financial crisis. The crisis ended when a complex deal was reached that raised the debt ceiling and reduced proposed increases in government spending. In June 2011 the US was fast approaching their latest debt ceiling limit of $14.3 trillion. Both political parties then proceeded to disagree on largely all recommendations put forward by their opposition. This brinkmanship continued right up to the August 2011 deadline where common sense prevailed and the ceiling was limited to $16.4 trillion. While the eventual result was expected (there hasn’t been a situation where the debt ceiling has not been increased), the approval was only made possible after very long deliberations over a weekend between the Democrats and Republicans. The increase of the debt ceiling to $16.4 trillion was expected to provide the necessary funding to the Government until 2013 – which brings us to the present.

What was unfortunate for global markets back in 2011 was that on August 5 2011, Standard & Poors (credit rating agency) downgraded the credit rating of US Government bonds for the first time in US history. This sent shock waves through global investment markets as well as the three major indexes in the US which experienced their most volatile week since the 2008 Global Financial Crisis -the Dow Jones Industrial Average dropped 635 points (or 5.6%) in one day.

While this was not an isolated event, it does provide a sufficient level of uncertainty and fear to the market and requires investors to remain diligent and vigilant.

Another example of the US political system failing to reach a swift outcome was witnessed during the Clinton administration in 1995 and 1996, where the US Federal Government shut closed their operations for a total of 28 days. Again, this was due to a political and legislative non-alignment between the Democrats (Clinton) and the Republic controlled Congress over funding for Medicare, education, the environment, and public healthcare. Back then the US Federal Government shut down after Clinton vetoed a spending bill Congress sent to him. The US Federal Government then put non-essential Government workers on unpaid leave and suspended non-essential services from November 14 through November 19, 1995 and from December 16, 1995 to January 6, 1996 - 28 days.

As Clinton refused to cut the budget in the way Republicans wanted, they threatened to refuse to raise the debt limit, which would have caused the United States Treasury to suspend funding other portions of the Government to avoid placing the country in default.

The matter was finally resolved in August 2011 but not without ripples again running through global investment markets.

In 2013 it would appear that with a stronger majority, Obama will gather greater support from the Republic party and world markets will avoid a repeat of August 2011.