Last week’s agreement between the Barack Obama administration and the Republican Party to postpone a proposed tax hike by two years, in return for Republican support for an extension of existing relief programmes such as employment benefits, cuts in payroll taxes and tax credits for parents and college students, will have implications not just for the US economy but also for other economies. It can have the effect of lowering US interest rates and usher in a cycle of investment-driven growth. JP Morgan has raised its forecast of fourth-quarter growth for next year from 3 to 3.5 per cent, while other forecasting groups are even more sanguine. This surge in growth is expected to dent the unemployment rate that is officially estimated to be close to 10 per cent. This is certainly a break in the clouds for a country desperately seeking some economic sunshine by way of a return to rapid growth and lower unemployment. The reluctance to address the issue of the fiscal deficit setting aside political differences is, however, surprising. The tax increases on the rich were expected to finance the continuation of existing mitigation programmes directed towards sections more vulnerable to the economic downturn. It is now estimated that continuing to extend economic benefits would cost the exchequer an additional $300 billion, at a time when the fiscal deficit is 8.9 per cent of GDP and is expected to cross a trillion dollars this year. In letting political expediency prevail over economic commonsense, the leadership on either side has ensured that any recovery as a consequence of the deal will be shortlived.
The Obama decision will have global reverberations. The fall in the dollar will, ceteris paribus, make American exports more competitive, while making imports more expensive. With economic recovery in Europe nowhere on the horizon, it could dampen the nascent recovery of several export-driven economies. An equally serious consequence would be the inevitable increase in capital flows, especially to star-performing emerging markets already grappling with an embarrassment of foreign capital. Commodity prices will expectedly head north on the back of a weaker dollar, stoking inflation, which already threatens to derail economic growth globally. India cannot expect to be impervious to the ramifications of the Obama tax deferment plan. Export-dependent sectors, especially those with exposure to the United States, are expected to be hit, though the incremental decline may not be significant. A sharp increase in capital flows could compel the Reserve Bank to review its policy of refraining from imposing controls on capital flows into the country. This would be unfortunate because it would merely redirect capital to countries with less stringent controls. Capital controls once in place would be hard to undo at a later date when India could effectively use these inflows. It is the impact of higher commodity prices that should worry India. A contractionary monetary policy is bound to impact domestic investment which is increasing steadily. A carefully calibrated policy response is needed to ensure that India’s growth story continues unabated and is not impacted by the consequences of Mr Obama’s compromise.
