British and Japanese officials warned on Sunday of disastrous consequences for the global economy if last-minute talks among lawmakers in Washington failed to agree on raising the U.S. borrowing limit and averting a debt default.
Governments across the world fear that because of the key role of the U.S. dollar in global banking and trading systems, there could be severe instability when Asian financial markets reopen on Monday if a U.S. debt deal is not in sight by then.
In Washington, Senate Minority Leader Mitch McConnell, the top Senate Republican who is playing a key role in the debt talks, said "we're very close" to a $3 trillion deal that would raise the debt ceiling while cutting the U.S. budget deficit.
But a senior White House official warned that an agreement was "not there yet."
"If they get this one wrong and there's a default — we don't expect that, we think that they will sort this out — but if that were to happen, it has consequences for every family and every business in this country and all across the world," said Danny Alexander, Chief Secretary to the British Treasury.
"I think in the end the politicians on Capitol Hill can see that the precipice they are looking over is one that they are going to step back from," Alexander told BBC television.
"But it is something that would have a big effect on the global financial system and on the global economy, where the United States is one of our major trading partners, that could have really big implications for the United Kingdom."
In Tokyo, sources familiar with Japan's international and monetary affairs said they were increasingly concerned that markets might be too optimistic about prospects for a lasting solution to the crisis.
Japanese officials still hope Washington can strike a deal and if that proves impossible, will give priority to interest payments to international holders of U.S. Treasury debt to limit the immediate market impact, the sources said.
But Tokyo's concern is that if the crisis drags on without a clear and long-term solution, markets may be thrown into turmoil in the same way that they suffered when U.S. investment bank Lehman Brothers collapsed in September 2008.
"If there is a default, the impact on global markets will be huge," said one of the sources, who declined to be named because of the sensitivity of the matter.
Another Japanese source said, "Nobody thought Washington would let Lehman collapse. But look what happened."
U.S. lawmakers have set themselves a Tuesday deadline to reach agreement and the U.S. Treasury has said it will run out of borrowing room on that day, although analysts think the government may have enough cash to keep servicing its debt and paying its bills through the middle of this month.
Britain is the third largest foreign holder of U.S. Treasury debt and Japan is the second largest. China is the biggest with well over $1 trillion invested in U.S. Treasuries; about two-thirds of its $3.2 trillion of foreign exchange reserves are estimated to be held in dollar assets.
On Saturday the official People's Daily newspaper, the mouthpiece of the Chinese Communist Party, castigated the U.S. handling of the debt crisis in an editorial as "irresponsible" and "immoral".
It said the U.S. democratic system was to blame for the "farce", claiming that "not a single representative has considered the world, and even U.S. national interests are being banished from the mind".
On Friday a senior economic policymaker in the euro zone, who declined to be named, told Reuters he was optimistic Washington would solve the problem but expressed surprise and anger that U.S. politicians were "playing chicken" with an issue of such importance for the global economy.
Euro zone leaders are struggling to control sovereign debt crises in several countries in their region, and the U.S. debt problem is making this more difficult by adding to upward pressure on the yields of government bonds in those weak states.
If there is no U.S. debt deal by Monday morning, central banks around the world are expected to stand ready to provide emergency supplies of money to commercial banks in case the banks become too nervous to lend to each other.
Japan's first defense will be to ensure that Japanese financial institutions have a sufficient supply of dollars, the sources in Tokyo indicated.
The Bank of Japan believes Japanese commercial banks have sufficient dollar cushions but will use its dollar swap arrangement with other central banks to prevent a dollar squeeze in case of market turmoil.
In late June, the U.S. Federal Reserve agreed to extend liquidity swap arrangements with other major central banks until Aug. 1, 2012.
The Japanese central bank is also prepared to flood markets with yen through its open market operations in case interbank borrowing costs spike, BOJ officials say.
In Europe, there were minor signs of strain in the money markets last week with some banks becoming unable to take out longer-term dollar loans, but the effect was small since banks still expected Washington would reach a deal.
The European Central Bank already offers unlimited euro loans to banks in some of its money market operations as part of its response to past crises, and it could use that policy to cope with any market problems this week.
A spokesman for the Swiss central bank said, "The Swiss National Bank is ready to react appropriately at any time to market disruptions."
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