FISCAL CLIFF? WHAT ME WORRY..

A view on the FISCAL CLIFF The "fiscal cliff" is a term used in discussions of the U.S. fiscal situation to describe a bundle of momentous tax increases and spending cuts that are due to take effect at the end of 2012 and early 2013. In total, the measures are set to automatically slash the federal budget deficit by around $600 billion or approximately 4 percent of GDP between FY 2012 and FY 2013, according to the Congressional Budget Office (CBO). The abrupt onset of such significant budget austerity in the midst of a still fragile economic recovery has led most economists to warn of a double-dip recession in 2013 if Washington fails to intervene in a timely fashion. (The above is a succinct summary from the Council on Foreign Relations (CFR) USA) The US has a ceiling for debt that cannot be breached without legislative action. The grim financial position led to an unprecedented credit downgrade, with the US losing the prestigious triple A rating. To cut this $600 billion, it involves an expenditure cut of nearly $400 billion and hike in revenues by around $200 billion. At this juncture in time, when the US economy is poised between recovery and recession, the impact could be catastrophic. Raising taxes, removing tax breaks, reducing defense expenditure, reducing healthcare, reducing unemployment benefits and other unpopular decisions would have a deep economic impact too. Healthcare cuts would impact drug companies; defense cut would impact fortunes of defense equipment suppliers and so on. The other thing that will surely play a role in what action America takes, is the recent disaster caused by hurricane Sandy. The impact on US would surely be shrinkage in GDP (with worst case estimates being a four percent drop in GDP!), job losses and drop in corporate profits (a combination of higher taxes and falling demand). More moderate estimates peg a half percent decline in the GDP of the US during 2013. IMPACT When the US sneezes, the world catches cold. Within US, there would be higher unemployment, lesser corporate earnings and reduced economic activity. Coming on the back of a none-too exuberant 2012, the outlook for 2013 will be adversely impacted. Reduced imports by the US will have impact on all economies in the world. Global money flows would be uncertain as US corporations will be bent on preserving cash rather than investing in growth. It would have a cascading impact on global growth and across the world, economic growth would be dampened. The Euro zone and Japan would be particularly vulnerable given their fragile economic situation. What would it mean for India? Difficult to guess at this stage, except to guess that it would be another negative factor for capital flows. US centric Indian companies would face some squeeze on their businesses. One possible impact could be lower oil prices, if US demand contracts. That could be the silver lining on the cloud for India. As far as our markets are concerned it would mean increased volatility in our equity markets, making the case for higher asset allocation to fixed income. MIDDLE OF THE ROAD? Many global experts opine that it would be impractical or impossible to achieve the fiscal measures that are prescribed. In the US, it is likely that a half way approach would be taken to ensure growth in the economy. Instead of trying to slash the budget deficit by the prescribed four percent, the real cut may be between one and two percent. This would mean only a partial cut in expenditure and a calibrated hike in taxation rates. Perhaps a more gradual road map would be laid out for fiscal consolidation. This would mean that the US would have to resort to higher borrowings. After the experience of the Euro zone with higher borrowings, it would put pressure on US credit ratings again. The US would perhaps benefit from the confidence of the global investors (who keep seeing their options declining day by day) who would still perceive US as a relatively safe harbour in a storm. Many possibilities exist and from here, we cannot really take an informed view. All it means is that the world’s largest economy is going through turbulence and the impact will be felt across the globe. And given the fact that most economies are driven by big business interests, I would put my money on the US not wanting to sacrifice growth. Fiscal discipline and consolidation can wait.