Fiscal Cliff

The Indian markets promptly ascended on the news of Barack Obama’s re-election as the US president. Although India witnessed a lacklustre and directionless trading day with an upward bias, European, American and Asian markets lost more than 1 per cent in a single day as investors turned their heads to the highly concerning ‘fiscal cliff’. So what is the fiscal cliff and how can it affect the US economy?

In A Nutshell

In order to bring down the burgeoning fiscal deficit of the US there is a two-point agenda set to be implemented on 1^st January 2013. One, the administration is all set to reinstate the taxes to their original rates as were prevailing before George Bush cut them by two percentage points and two there is a proposal to cut down on government expenditure to the tune of almost USD 1.2 trillion over the next decade. All this would bring down the fiscal deficit in the US by almost USD 600 billion in 2013 itself.

So why is it being called a Cliff?

The U.S. has been running twin deficits (fiscal deficit and current account deficit) for years. For the fiscal year 2012, the federal government incurred a budget deficit of USD 1.1 trillion, or 7 per cent of the nation’s GDP. As of today, the total outstanding national debt according to the Treasury Department amounts to USD 16.214 trillion, a massive amount that needs to be worked on at the earliest.

The fiscal cliff was designed as a result of the lack of a long term deficit reduction plan by the Congress. The Obama government pushed forward any decision on this matter to avoid pre election disruptions. Moreover, QE3 was announced to steer through this period. However, with about 43 days left for a consensus to arrive at, markets are considering the probability that going down the cliff could be even more now. But taking into consideration, the promptness at which the debt ceiling was raised in August 2011 prior to a repayment deadline, 43 days being a short time can be arguable.

The Implications

Getting back to the basics of economics, the GDP is a sum of consumption, investment, government spending and net exports. Reducing government spending to a large extent would have a drastic impact, it being a major component of the US GDP. It is estimated that the short term impact of this move would be severe, even to the extent of putting the economy back into a recession, with the GDP shrinking by 0.5 per cent. Moreover, a drastic decline in demand would be seen resulting out of lesser disposable incomes further hampering growth. However, the effect is to be beneficial over the longer term on account of lower deficits, debt and better growth prospects. All this though would be avoided if a compromise is reached between the Congress and the White House.

Impact on India

A fiscal cliff in the US is likely to be responsible for a downward trend in global equity markets. This would in turn also drag emerging markets lower, including India. Although one may argue that emerging markets can act as a safe haven for investors, a crunch in liquidity may in fact, lead to a reversal of capital inflows into Indian markets. At the recent International Monetary Fund meet in Tokyo, Finance Minister P Chidambaram said that “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.”

It is also important to remember that Obama’s re-election would result in a higher capital gains tax (from 15 per cent to 20 per cent). The new tax policy and other areas of impact are more at a local level than a global level, also because of the nature of the American economy being domestic driven. Thus, while U.S. markets yesterday were low in the range of 2.34 per cent and 2.49 per cent, Indian markets are lower by a relatively mere 0.30 per cent. While all this seems scary, there could certainly be a flip side scenario. Watch this space for more on it.