The federal US government is moving closer and closer towards the “fiscal cliff”, revealing the degree to which political brinkmanship can hold the entire world economy to ransom. If US President Barack Obama and the Republican-controlled US Congress are unable to agree on a series of compromises to cut the budget deficit by the end of 2012, then a previously mandated halving of the deficit will go into effect. By all accounts, this sudden and massive contraction of spending will cause a recession in the United States and have correspondingly negative effects on the global economy. The mild recovery in the United States is the only unambiguously good news about the world economy for all of 2012, and the implementation of the fiscal cliff would reverse that. The fiscal cliff originated from several laws passed since 2010, which included provisions postponing their contractionary implications till the beginning of 2013. Avoiding putting these provisions into effect would require complex legislative compromises to reduce the deficit some other way – and that is precisely where the US’ political paralysis comes in.
The US Congress is now on its Christmas vacation, and President Obama has gone to Hawaii for the holidays, without any compromise being reached, although one was first expected and then hoped for by this time. The Republicans, led by Speaker John Boehner, want entitlement cuts to lead the deficit reduction efforts; the Democrats, led by Mr Obama, expect that role to be played primarily through taxes. Mr Obama apparently has accused Mr Boehner of trying to implement Mitt Romney’s preferred tax plan although Mr Romney lost in November. Mr Boehner has said that Mr Obama is refusing to compromise or look at alternative ways to cut the deficit. Economists, too, are divided; many progressive economists insist that a fragile recovery should be guarded, and this is the time to protect employment and growth, not deficits; others have warned against short-term fixes and grand bargains. Given how partisan gridlock has derailed reform in America in the past, a significant element of risk has returned to world markets, and investors are watching the news from Washington, DC nervously.
The implications for India, and especially the markets, are considerable. First of all, and most obviously, another downturn in the United States will be accompanied by a further reduction in export demand for Indian goods and services. However, there is a more worrying point about how allowing the fiscal cliff provisions to come into force will affect international investor sentiment. Risk aversion will take over, as investors begin to worry about the unknowable and incalculable consequences of such a sharp, contractionary fiscal event. India’s markets and external account have been buoyed by bullish foreign institutional investors, who have moved in over $23 billion to India so far this year. A switch to a global “risk-off” profile will reveal the extent of India’s dependence on such money. Given that FIIs are financing India’s alarmingly high current account deficit – foreign direct investment fell 42.8 per cent in the first half of the year -- the chances of a major external-account crisis cannot be easily dismissed.