P K Vasudeva: Debt & taxes in US - The fallout for india

A weaker dollar would hurt Indian exports by making them less competitive, while cheaper imports will put pressure on domestic manufacturers

A weaker dollar as a result of the US downgrade would hurt Indian exports by making them less competitive, while imports will become cheaper and put pressure on domestic manufacturers.

When President Barack Obama averted a debt default by signing a bill raising the debt ceiling of the US on 2 August, Standard & Poor’s, one of the world’s three major credit rating agencies, cited “difficulties in bridging the gulf between political parties” as a major reason for the downgrade from AAA to AA+. The rating agency has essentially lost faith in Washington’s ability to work together to address its debt. Currently, fewer than 19 countries have AAA ratings. Among them: the United Kingdom, Australia, Germany and Singapore.

The downgrade, hours after markets closed on 5 August, is a first for the US since it was granted an AAA rating in 1917. S&P’s decision came after a fractious debate over raising the nation’s debt ceiling ended in a compromise that would reduce the country’s debt by more than $2 trillion. Other prominent credit rating agencies — Moody’s Investors Service and Fitch Ratings — also said that downgrades were possible if lawmakers fail to enact debt reduction measures. The budget released earlier this year showed a staggering $1.65 trillion deficit for the current fiscal year. The US national debt has increased, and touched $14.3 trillion in May.

After its banking system collapsed in 2008, the US had to flush the economy with cash to keep the ship afloat. To keep the economy going the US borrowed several trillion dollars, but this did not prove enough. The Republicans, who are in the Opposition now and whose erratic economic policies caused the problem, decided to show the US President their power. They refused to raise the government’s borrowing limit.

A great deal of political haggling over more taxes and less spending ensued. The US is not Portugal, Italy, Greece and Spain (PIGS) and, in the end, American politicians, perhaps because the August vacation is sacrosanct, worked out an arrangement at the last minute. No one really understands how the government can reduce the deficit by $2.4 trillion over the next decade, in return for which its debt ceiling has been raised by around $3 trillion.

Surprisingly, President Obama got what he wanted in return for a promise that future Presidents will have to keep. The markets stopped biting their lips and got back to their usual betting. S&P 500 futures went up by 1.2 per cent, as did the dollar, by about one per cent against both the yen and the Swiss franc. To be sure, the new arrangement still has to be approved by the Senate; however, the House of Representatives has already cleared it. No one really had any doubts that the US would default because of the continuing fragility of the US economy. So severe was the banking crisis of 2008 that it could take another five years to work itself out.

The main gainer has been gold. As an outcome of all these developments, the demand for gold has increased, gold being the safest heaven. As the Indian economy is not insulated from the world economy, there will definitely be some tremours here. Both imports and exports will be impacted. India’s exports to the US, particularly IT services, will suffer an adverse impact.

“Any slowdown in the US will have an impact on India in terms of our ability to export,” said C Rangarajan, chairman of the Prime Minister’s Economic Advisory Council, about the implications of the US debt crisis on the Indian economy. He also pointed out that Indian exports had declined sharply in the second half of 2008-09 due to a slowdown in the US economy.

Mr Ramu S Deora, president of the Federation of Indian Export Organisations, said that India’s exports to the US would also be hit because Washington is likely to raise taxes for reducing its deficit as part of the deal to increase America’s overall debt ceiling. The weakening of the US dollar resulting from the downgrade would make India’s exports less competitive, even while imports to India would become cheaper and put further pressure on domestic manufacturers.

At the same time, there may be higher inflows of foreign institutional investor (FII) funds. This will lead to appreciation of the rupee, which in turn will help bring down the current account deficit. It is obvious that global investors would consider diversifying their assets out of US treasuries. This move can exert pressure on the dollar. There is also fear that some funds that are not allowed to hold any asset without an AAA rating might be forced to sell treasuries.

India may not be as vulnerable as China, Japan, Hong Kong or Brazil to losses on its forex portfolio from a spike in US interest rates, as only 13 per cent of its forex reserves are in US treasuries.

But India is not insulated from the increased uncertainty about prevailing conditions in the US economy and the continuing turmoil in global financial markets, the Reserve Bank of India cautioned. In the immediate future its priority will be to ensure that adequate rupee and forex liquidity are maintained to prevent excessive volatility in interest and exchange rates.

Overall, this means that global growth will be slower than what it would otherwise have been. This should come as a relief to India, whose growth depends on its domestic market but which needs its imports, especially of crude oil and gas, to be cheap.

Unfortunately, Prime Minister Manmohan Singh, thanks to his curious leadership style, is not in a position to take advantage of this serendipitous hiatus in global economic activity. India needs more reforms now, but for the next three years, it is stuck with this paralysed government, as it is confronted with monumental scams. The UPA government has no time to take advantage of this situation by concentrating on economic reforms and improving the country’s BBB- debt rating status in the world.

The future second generation reforms should be in the areas of controlling inflation and reducing fiscal deficit; improving economic efficiency; ensuring equitable growth; thrust on education, health and sanitation; an additional three to four per cent investment on infrastructure; addressing issues of land acquisition, rehabilitation and resettlement; deepening policy reforms in the financial sector; addressing gaps in the overall economic regulatory architecture; and environmental issues caused due to mining.

The author is Advisor, Institute of Development Studies and Training, Chandigarh. He can be reached at vasu022@gmail.com