A bit of good news that brought some cheer to the global markets last week was the US Republicans’ decision to back off from what could have been an acrimonious battle over the US debt ceiling. The current debt-ceiling law defines a debt limit of $16.4 trillion for the US government that has been breached already. If the Republicans had insisted that the ceiling remains in place, it would have – at least technically – shut the US government down from March this year. The Republican-dominated House of Representatives averted this by agreeing to a temporary breach of the limit until May 19.
This certainly gave global markets a moment to exhale but is by no means an end of the US fiscal impasse. The Republicans stood close to lose politically if they were seen as the party that forced a default by the US government. Thus, their cooperation on the debt ceiling was a tactical move, and it does not imply a softening stance on the tax-and-spend policy. In fact, a series of Budget “fights” are likely over the year that could lead to “risk-off” phases in the markets. This, following the typical safe-haven trade that we have seen over the past few years, is likely to favour the dollar and drive depreciation in the rupee, among other currencies.
The first such fiscal flashpoint could come as early as March 2 when the $120 billion of “sequestration” cuts in the government expenditure – postponed from January – has been scheduled to kick in. The grapevine has it that the Republicans would agree to push back, yet again, larger cuts in government expenditure, if the Democrats agree to relatively smaller reductions. A bigger fight could build up over the 2013-14 Budget and extensions to appropriation bills that are due to expire on March 27.
The US fiscal system is notoriously complex, and some explanation of its basic elements might be useful. The US fiscal year begins in October and ends in September. The initial Budget proposals are presented in February, followed by a debate in the Congress, and negotiations between the Republicans and the Democrats. The US federal government has, incidentally, not been able to pass a Budget in the last three years because of partisan brinkmanship. The federal government expenditure has been cleared through extensions of appropriation bills.
Unless there is another extension of appropriation bills, the federal government will not be able to spend further. The fact that Republicans have agreed to raise the debt ceiling until May, might mean that they are unlikely to block a temporary extension of appropriation bills. However, if the Budget negotiations head nowhere and a partisan divide remains, the real risk is that of a government shutdown in May — either because the debt ceiling is not raised further or because the appropriation bills expire.
Given that a “grand bargain” between the Republicans and the Democrats is unlikely, the best that one can hope for is that the flashpoints do not trigger a real crisis, and the difficult fiscal decisions are continuously deferred. The financial markets might learn to live with this procrastination, but it is certainly going to act as a drag on risk appetite. Credit agencies, on the other hand, might not be as patient and were this dilly-dallying to continue, a sovereign rating downgrade, or perhaps even a series of downgrades, for the US might follow. A downgrade is certainly going to roil the markets for a number of reasons. It could mean a rise in the government’s borrowing costs and have ripple effects across the bond and credit markets. Rising interest rates could then emerge as yet another constraint on the US recovery. As the government’s interest burden rises, it would increase the debt burden entailing more effort at fiscal consolidation.
Most importantly, businesses hate fiscal uncertainty. Unless there is both clarity and stability in the US fiscal regime, companies would shy away from putting up fresh capacity. The drag on business investments could set a ceiling for growth in the 1.5 to two per cent range.
The American fiscal situation is the biggest risk in a year that seems to have begun with the promise of a recovery led by the US. The strategy of kicking the can down the road that the US Congress seems to favour at this stage will weigh both on the US growth and the investor’s risk appetite. The irony is that while American politicians seem to understand that a comprehensive fiscal resolution is imperative, such a resolution is likely to remain elusive for now.
Tailpiece: The recent rise in the euro to over 1.35 to the dollar was partly the result of a technical adjustment that seems likely to morph into a sustained rally. Last week, European banks were paying back some of the loans that they rook under the emergency Long-Term Refinance Facility that the European Central Bank (ECB) offered in December 2011 and February 2012. This amounts to monetary contraction and pushed up short-term interest rates.
This supported the euro. However, while this was the initial trigger, the markets seem poised to take the currency up in response to the perception of improving fundamentals and the fact that ECB has the tightest monetary policy among all the developed market central banks. This appreciation is bad for the region that continues to be in a recession. Thus, a correction in the currency from these levels is desirable, not further gains.
The author is with HDFC Bank.
These views are personal
