How will this resolve itself going forward? President Barack Obama has ruled out innovative solutions such as invoking the 14th amendment to the US constitution that says that the "validity of US debt shall not be questioned" or minting, as some fairly heavyweight economists had suggested, a one trillion dollar coin. The best case scenario seems to be a short-term deal with minimum conditions for either side of the aisle that buys the government a couple of months of time. Thus, the US government could just avoid a default on its debt and other big-ticket payments such as social security. Some fairly social security payments and coupon payments on US debt (about $55 billion in total) are, incidentally, due in the last week of October and the first fortnight of November. However, a lasting bipartisan consensus over the direction of fiscal policy, particularly health care, seems unlikely and markets need to be prepared for flashpoints in the near future.
The bottom line is that just as the markets were getting used to some stability and the prospect of a recovery in the developed markets, at least, the world has suddenly again become a riskier place. The question is : how will traders play this risk going forward? The safe haven over the past few years has been the dollar even at a time like 2008 when the US, with its sub-prime crisis and Lehman was the seismic epicentre. Thus, one cannot rule out a flight to the dollar even if the US government were to face the tail risk of a default. However, I would argue that a default would reduce the appeal of the US as a safe haven and the flight to safety might be away rather than towards American shores. Gold, now the clapped-out has-been of the asset repertory, could make a big comeback. Investors now believe that Europe is a far less dangerous place than it was a year back and a safe-haven trade could mean flows into things such as German Bunds and even British assets. This would lead to some appreciation in these currencies.
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For emerging markets, "risk-off" is a bad thing and any escalation of risk could see flows exiting the region. This would also come at a time when the sentiment towards emerging markets is weak and heightened risk could see a sell-off in the short term, in assets and currencies. The rupee is unlikely to be the exception and some depreciation in the short term could well follow even if some of the "subsidised" inflows such foreign currency non-resident (banks) remain robust.
But at a time when the major central banks are supporting financial markets across the board through massive infusions of liquidity, bad news can also be good news. While the shutdown in the US government isn't likely to dent growth severely (the think tank Capital Economics estimates a hit of less than 1 per cent on growth at an annualised pace for a fortnight of the shutdown that would be recouped later as government workers get back to work and paid their arrears), the risk of another fiscal fight sapping the US' growth momentum has certainly increased. Of course, the damage to the economy could be worse if a solution to the debt ceiling problem remains elusive. The Fed's response to these risks could be to delay the "taper" of its QE3 programme beyond December (the time when most investors expect it to happen). This would be positive for emerging markets particularly those such as India that depend on this liquidity flow to fund their current account deficits. In short, India gets a larger window of opportunity to get its macroeconomic house in order.
Tailpiece: Some commentators have raised what I think are legitimate concerns over whether the government's mood has swung from anxiety to complacency. This is particularly true of the fiscal deficit where reaching the 4.8 per cent target looks particularly daunting. The government should bother to acknowledge this. That said, I have always been critical of the permanently alarmist nail-biting mode that the previous regime at the Reserve Bank of India had been. It's good to see a central bank governor who bothers to acknowledge some of the positive developments (like an improving current account deficit) and seek to alleviate some of the market fears rather than add to them. In the presence of an active offshore market ever ready to price in these fears and beat the rupee, sentiment is as much of a factor in determining the rupee's exchange rate as are flows. The rupee's entirely unjustified move towards the 70 level to the dollar was due in large part to irrational pessimism. We should certainly avoid that.