Abheek Barua: Looking for the next crisis

With the US approaching the so-called 'fiscal cliff' by year-end, it may slip back into a full-blown recession

Where could the next “shock” to the global financial system come from? The answer, surprisingly, might not be Europe. European politicians have made some progress in setting their house in order (see “Not the same old, same old”, Business Standard, July 9) . The European Union (EU) meeting at the end of June produced a blueprint that, if implemented, could see the first signs of a banking union emerge in the region by the year-end.

It also floated the idea of a centralised rescue fund that would bail out overstretched banks directly — this would take the sovereign governments out of the equation and ensure that not every banking crisis morphed into a sovereign debt crisis. These measures would address some of the long-term risks for the region. In the near term, both the fiscal and monetary authorities seem better prepared to handle either a banking and sovereign crisis through a combination of handouts from the central stability fund and monetary easing.

The IMF in its updates to the World Economic Outlook and Global Financial Stability Report released last week, points out that the epicentre for the next crisis could well be the US, yet again. Why? The US approaches the so-called “fiscal cliff” at the end of the year — the convergence of tax cuts expiring and automatic spending cuts kicking in at the year-end that could result in fiscal tightening equivalent to four per cent of GDP. This would result in a full-blown recession.

Another complication is that the US debt hits a ceiling (of $16.4 billion) at the same time as the fiscal cliff and needs to be raised if the day-to-day government expenditures are to be met. Thus, the US Congress needs to come up with bi-partisan agreements, both to raise the ceiling and to adopt a more gentle approach to fiscal consolidation that what the fiscal cliff entails. One obvious step to address the fiscal cliff would be to extend the “Bush era tax cuts” of 2001 and 2003 that lowered the marginal tax rates for virtually all American taxpayers. These were incidentally due to expire in 2010 and were extended for two years.

Financial markets have over the past few months remained firmly focused on Europe and seem to be assuming at this stage that the bulk of the fiscal adjustment will be deferred until later and the US economy will not topple over the fiscal cliff. They are also assuming that US politicians will see the light of reason and vote for an increase in the debt ceiling well in advance of the deadline. This might well be the most likely scenario but the risk of political brinkmanship holding back resolutions of these two issues cannot be ruled out.

What could happen then? The US went through a temporary political impasse over the debt ceiling in August 2011. That episode saw a sharp rise in short-term money market rates and a squeeze in liquidity. The credit default swap (CDS) markets started pricing in the prospect of a near-term default and the sovereign CDS curve inverted. The impasse was resolved but rating agency Standard & Poor’s downgraded the US sovereign ratings from AAA to AA.

If the markets sense that a resolution to either the fiscal cliff or the debt ceiling issue is not forthcoming, they are likely to panic. The specific impact on the market could be similar to August 2011 — only the intensity of the upheaval is likely to be much stronger, given the fact that much more is at stake this time around.

However, even if they manage to resolve the problems of the fiscal cliff and the debt ceiling, US fiscal managers cannot rest easy. The IMF points out that the US has actually gained from the heightened uncertainty in the global markets. The search for “safe havens” amidst this turmoil has meant that investors have been willing to hold US government bonds, even if they offered very low rates of return. The US 10-year bond offers a miserable 1.5 per cent these days. This has enabled the government to finance the deficit somewhat comfortably.

The problem is that if risk appetite improves globally, the rush for safe havens will slow down and yields could move up sharply. This could trigger another round of turbulence in global markets and set off a spiral of rising yields and growing public debt ratios. The IMF’s opinion is that while a sharp fiscal contraction on the lines of a fiscal cliff is undesirable, the US needs to put a credible fiscal consolidation plan to avoid this sharp escalation of yields. Japan, which has the highest sovereign debt-to-GDP ratio in the world and has also benefited from safe haven flows, needs to get its act together, too. It seems to have made some progress in this direction — for instance, in June it passed a Bill in the lower House of Parliament to double its consumption tax rate to 10 per cent by 2015. It is now awaiting its passage through the upper House.

However, the IMF seems to believe this is far from adequate. As its report puts it — “To anchor market expectations, country authorities need to specify adequately detailed medium-term plans aimed at lowering debt ratios and backed by binding legislation or fiscal frameworks. Among large advanced economies, both the US and Japan still lack such plans”.

The era of financial crisis started in 2007 with the US sub-prime fiasco. It seems to be far from over.

 

The author is with HDFC Bank. These views are personal