Originally Published 2013-01-04 00:00:00 Published on Jan 04, 2013
Like the US, India, too, is grappling with its own version of the fiscal cliff, the biggest challenge before Finance Minister P. Chidambaram. The UPA has exhausted its fiscal space even as growth has fallen to a 10-year low. The challenge is to effect a sharp reduction in the fiscal while not adversely affecting quality public investment, which can in turn give a fillip to private investment.
On cliff's edge
Most world economies have hurtled towards the fiscal cliff after 2008.

The Americans coin visually evocative terms to describe the very essence of the economic crisis they face. Indeed, 2013 begins with the US President Obama desperately trying to avert what has been widely referred to as "America's fiscal cliff". It signifies that the US government finances, indeed the economy, could fall off the cliff if some of the tax cuts and social security benefits carried forward from the Bush era, through a timebound legislation, were to end in January 2013. Indeed, the legal mandate extending such benefits, amounting to about $600 billion a year, expires now. Obama is negotiating with the Republicans to ensure that the entire budgetary stimulus of $600 billion does not get slashed at once, causing a hard landing.

The US economy will not be able to take a hard landing of such magnitude. Six hundred billion dollars is nearly 4 per cent of the US GDP. Imagine slashing, at one go, over half the current US fiscal deficit of 7.5 per cent of the GDP. This is like asking India to cut its gross fiscal deficit (Centre and states) from 8.5 per cent of the GDP to 4 per cent in just one year. It is clearly an impossibility. But the fact is the US political class has landed itself on the edge of this cliff, knowing fully the consequences. According to experts, even a 2 per cent reduction in the fiscal deficit in 2013 could push the US GDP growth to near zero. This will have consequences for the rest of the world. In some sense, in a globalised world, everyone is standing on the edge of a cliff. The visual metaphor is compelling.

Economic analysts say Obama is still working on a grand bargain with the Republicans and has reached a broad agreement in the new year that the tax cut for most Americans shall be continued, except for those individuals earning above $4,50,000 a year. Further, Obama has asked for two months to resolve the more politically sensitive question of cutting $150 billion of spending annually, as part of the big bargain with the Republicans. Republicans are always itching to attack Obama's spending on welfare.

On Day One of the new year, the Indian stock market cheered Obama's effort to avert the fiscal cliff. The benchmark index showed a remarkable bounce on the optimism over the soft landing of the US fiscal cliff. But the key question is whether the global economy will indeed see a sustained recovery in 2013. India's performance will also partly depend on that because the Indian trade to GDP ratio has doubled from 21 per cent to 43 per cent over the past decade. What happens in the rest of the world affects us profoundly.

What does 2013 have in store for the global economy? Most analysts say the world growth rate this calendar year will probably be marginally more than the GDP growth of 2.5 per cent seen in 2012, unless there are some big surprises. The IMF forecast for global GDP growth is 2.9 per cent in 2013 and 3.5 per cent in 2014. Indeed, it appears that global growth is bottoming out and the second half of 2013 should see some pick up in GDP growth. India's GDP growth also appears to be bottoming out at 5.5 per cent, the lowest quarterly number in a decade.

A global recovery will certainly give further momentum to domestic policy efforts to kickstart investment and growth in the economy. I have always maintained that the policy paralysis of 2011 and the first half of 2012 was only partly responsible for GDP growth falling so sharply - by nearly 4 per cent off the peak. For, other economies, such as China and Brazil, also experienced growth rates decelerating by 4 per cent. India could not have averted a fall in its growth rate to the extent to which it is in sync with the rest of the world.

Of course, with some global recovery, India can quickly come back to 7.5 per cent-plus GDP growth because the domestic potential for growth is immense. Some of the global markers that appear to be very positive in 2013 are a possible recovery in the US economy, fuelled by lower energy costs and an improved housing market, and the peripheral economies in the eurozone improving their public finances substantially, thus creating a positive sentiment.

What is not fully recognised is the manner in which the eurozone economies have taken immense pain through 2011 and 2012. The head of the European Financial Stability Facility (EFSF), Klaus Regling, told this writer some time ago that the eurozone will surprise everyone by bringing down its combined fiscal deficit to 2.5 per cent of the GDP by 2013 end. After the austerity measures undertaken by Spain, Italy, Portugal and Ireland, many of them are on the path to recovery. Only Greece remains a bit of a problem, but the damage has largely been contained in Europe.

If the eurozone achieves a fiscal deficit of 2.5 per cent of GDP, which it is likely to, it will be a historic achievement. Though Obama is also attempting a medium-term fiscal correction, the US deficit will remain around 7 per cent for some years to come, if one goes by the grand bargain over the fiscal cliff being worked out between the Democrats and the Republicans.

Therefore, the eurozone economies have done far better in terms of controlling incremental public expenditure in the post-global economic crises period. The tendency all over the world, including in India, has been to just let the fisc go haywire in the name of rescuing the economy. The subtle skill of applying the brakes on an ever-expanding fisc has rarely been tested anywhere in the world since 2008. The possible exception is the eurozone, which has managed to scale down its deficit quite dramatically.

In some sense, the bulk of the world economies have preferred to lazily hurtle towards the fiscal cliff in the four years after 2008. For instance, China's GDP was around $4 trillion in 2008. After the global economic meltdown, Chinese banks decided to pump another $4 trillion (100 per cent of its GDP) of new investment in housing and manufacturing as a special stimulus. Obviously, no one can keep such a high level of incremental investment going forever. So Chinese policy-makers are now saying they have had enough investment-led growth and it is time to move to a relatively consumption-led model. This is a clear recognition of the fact that China cannot afford government bank-led stimulus on the same scale as before. Indeed, China may be facing its own version of a fiscal cliff. It is trying to soft land from its fiscal cliff by scaling down its GDP growth projection to 7.5 per cent over the next five years, down from an average of 9.5 per cent in the previous five years.

India, too, is grappling with its own version of the fiscal cliff, the biggest challenge before Finance Minister P. Chidambaram. The UPA has exhausted its fiscal space even as growth has fallen to a 10-year low. The challenge is to effect a sharp reduction in the fisc while not adversely affecting quality public investment, which can in turn give a fillip to private investment. In a way, Chidambaram's dilemma is the same as Obama's. Obama has a slight advantage, he doesn't have to face an election in 2014.

The views expressed above belong to the author(s). ORF research and analyses now available on Telegram! Click here to access our curated content — blogs, longforms and interviews.