China and Japan are the US government’s largest single creditors. As the two largest owners of foreign reserves in the world, they have consciously invested the majority of their assets in US Treasuries. The reason they chose the US Treasury market is because it fits their strict investment guidelines as determined by their respective Ministries of Finance and ultimately set down in legislation. These guidelines stipulate “safe investments” that are default free.
While nobody really expects the US Treasury to default on its obligations, the prospect of a ‘technical default’ in the form of a delayed coupon unless the US Congress resolves their impasse has reserves managers shaking in their shoes around the world. While a small delay in the receipt of a coupon would be made good after the fact, it still represents a default. Under strict interpretation of investment guidelines this could, in the worst case, require China, Japan and many other Central Banks to jettison their existing holdings of US Treasuries, or more likely to exclude future purchases of US Treasuries from foreign reserves portfolios. Since foreign reserves managers must operate strictly according to the law, they do not have the discretion to ignore a technical breach of a guideline-only an Act of Parliament in each country can create an exception.
The implications of being excluded from foreign reserve portfolios are obvious. The US Treasury would have to seek other avenues to fund their obligations, driving up interest rates and their cost of funds. It would be many years before their folly was forgiven.
The gravity of the situation seems to be lost on the US Congress. Communication channels between foreign Central Banks and the US Treasury are scant at the best of times so it is unlikely that the Americans are paying attention to their creditors. The US Treasury claims to have special contingencies lined up to avert default, the list of which has not been made public, but which might include the sale of their own foreign assets to generate USD cash etc.
Notable by its silence, however, the Federal Reserve holds the key to avoiding default simply in its capacity to print the money to pay a coupon (a practice that they are very familiar with). Technically, this would not violate the debt ceiling since no new debt would be created. It would, however, violate its independence.