The US fiscal cliff negotiations seem to be getting increasingly murky but financial markets still seem to be convinced (or perhaps just hoping) that the economy will not actually topple over. This is despite the fact that a bipartisan resolution seems light years away.
The general sense in the markets still seems to be that US law makers on either side of the aisle do not want to appear to be giving into a compromise. They are betting on the negotiation process continuing through the Christmas week, and possibly reaching a climax by the first week of January. By then, the economy would have technically tipped over the cliff but a week of fiscal squeeze is not going make much of a difference. If a bipartisan deal is reached by the middle of January, the US economy would have perhaps put the worst behind it. As I write, I am going with this assumption.
The deal would likely involve the democrats agreeing to extend the bulk of the tax cuts introduced in the Bush era and in the wake of the 2008 crisis. Republicans will reciprocate by holding on expenditure reductions. Such a compromise does not mean that there would be no fiscal consolidation whatsoever. Even in the most optimistic circumstance, the combination of the bare-minimum tax increases and expenditure cuts (there are some relatively non-controversial items like the payroll tax and emergency employment) would add up to between 1.2 and 1.5 per cent of the gross domestic product (GDP). This would be higher than the consolidation that took place this year and would be a drag on GDP growth. Given this, the best possible growth rate that the US economy can achieve would be in the ballpark of two per cent for 2013.
That, however, is not the end. The so-called “resolution” of the cliff would really constitute the postponement of some of the hard decisions that US authorities need to take to bring national debt under control. While it perhaps makes sense to avoid sudden and sharp fiscal contraction when the economy is barely out of the doldrums, the fact remains that US law makers need to arrive at more permanent (and possibly quite aggressive) mix of tax increases and spending cuts to bring the debt burden down to sustainable levels. The consensus seems to be that national debt needs to be down by about $4 trillion over the next decade. This is likely to cap the medium growth rate for the American economy.
That said, one can argue that the US economy is building a base for a long-term recovery — a base that would consolidate further in 2013. For one, the housing market is showing signs of a permanent revival. House prices were up five per cent in the January-September 2008 period. The home-builder association’s confidence index, which has historically correlated well with “housing starts” (a jargon for new residential projects), has moved up sharply over the last couple of months. Thus, a flurry of housing construction activities might be on its way.
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Bank lending has also started picking up with bankers shedding their aversion to lend to consumers and small businesses. Credit growth in October was up five per cent year-on-year — a healthy number by American, or for that matter, any developed market standards. There is some evidence to show that the process of balance-sheet repair by American households has slowed down. In short, some American households seem willing to borrow and banks seem willing to lend to them.
Capital economics, a think-tank whose research I follow closely, points to another possible driver of growth. It claims (“2013 – Make or break?”, December 6) that there is a significant pent-up demand for cars that has built up on the back of a persistent wedge between new car sales and scrappage rates of cars. The period between 2009 and 2011 saw scrappage outstrip new car sales, and it is only recently that sales have started to catch up with the number being scrapped. As the backlog clears, aided by extremely low financing rates for cars, the auto sector could see a dramatic pick-up in sales.
What do the signs of sustained recovery in the US bode for the dollar? In the near term, confirmation of a pick-up is likely to trigger “risk-on” trades and investors are likely to take advantage of the low-interest rates in the US to fund carry trades into higher yielding assets, including Indian equities and debt. Thus, while intermittent shocks (say, another episode of sovereign stress in Europe) could send portfolio managers scurrying back to the safety of the dollar, I expect 2013 to be, on average, negative for the dollar.
However, the long-term story for the dollar could be different. If the US does emerge as the engine of growth for the developed world, the markets are likely to reward its currency. Therefore, unless Europe pulls off something spectacular over the next year in terms of structural policy shifts that forces markets to re-rate its growth prospects, it might perhaps pay to be a long-term dollar bull.
The author is with HDFC Bank. These views are personal