The American ‘fiscal cliff’ and India

HURTLING DOWN? Should the economic situation in the U.S. worsen, its impact on emerging market economies will be much more severe than in the case of the situation in the euro area.   | Photo Credit: Richard Drew

The unfolding “fiscal cliff” in the United States is going to be as dramatic as the Barack Obama-Mitt Romney election was and it will hit the American – and global – economy with all the force of a financial Hurricane Sandy.

The term “fiscal cliff” has been coined to describe several big fiscal events set to occur in the U.S. at the end of this year and in early 2013. Among them:

The expiration of the Bush-era tax cuts at the end of 2012, including current lower tax rates on capital gains, dividends, income, and estates, as well as number of other measures.

The expiration of fiscal stimulus measures, such as the payroll tax cut and extended unemployment benefits.

Spending cuts scheduled to be triggered automatically in January 2013 as a result of the failure of the deficit reduction super committee last year.

Without a broad consensus among Republican and Democrat lawmakers to ensure the required Congressional action before the end of this December, up to $600 billion of expiring tax cuts, the levy of new taxes and automatic spending cuts are set to take effect at the beginning of 2013. If they hit all at once, the impact could be as much as a four to six per cent decline in the GDP of the U.S., according to some researchers — the equivalent of falling off a “fiscal cliff.”

In the less likely scenario that Congress and the White House fail to reach any compromise whatsoever and are unable even to agree on how to delay the looming measures, there would be major consequences for global financial markets.

At present, the U.S. economy is growing roughly at two per cent per annum. A four to six per cent contraction in GDP caused by the “fiscal cliff” would push the world’s largest economy into a recession. Coupled with the sagging European economies and a slowdown in China’s growth, a recession in U.S. could be really bad for the world.

S&P 500 and Dow Jones are now trading nearer to their all-time highs. Hence it would not be too surprising if U.S. stock markets fall in the possibility of a fiscal cliff. According to a recent Bank of America Merrill Lynch fund manager survey, nearly three-quarters (72 per cent) of global investors believe that the fiscal cliff is not substantially priced into global equities and macroeconomic data. The fiscal cliff is identified as the number one tail risk by 42 per cent of respondents – up from 35 per cent in September and 26 per cent in August.

However, some people regard Emerging Market (EM) equities as safe haven assets. There may be that perception. But if you look at the correlation of returns of EM equities, they are positively correlated to global equities. Hence any fall in global equity markets due to a fiscal cliff could cause a fall in all emerging stock markets including India. A fiscal cliff in the U.S. could also lead to a reversal of capital flows to emerging markets.

At the recent International Monetary Fund meet in Tokyo, Finance Minister P. Chidambaram said that “the issues of fiscal cliff and the lifting of the debt ceiling in the U.S. also need to be resolved. The need is to put in place a medium-term fiscal plan while avoiding excessive fiscal correction in the short run. Should the economic situation in the U.S. worsen, its impact on emerging market economies will be much more severe than in the case of the situation in the euro area.”

Markets have been working on the assumption that the U.S. is going to address the fiscal cliff challenge with a more gradual adjustment.

Should a falling off the cliff really happen, global stock markets would go in for a major correction.

(V. Venkateswara Rao is a finance and management professional.)

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Printable version | Dec 2, 2020 7:18:18 AM |

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