The political gridlock in the US could push the world economy over the ledge in the coming months. The tax cuts introduced 10 years ago by the George Bush administration are due to expire soon. The provisions of the Budget Control Act of 2011 will lead to spending cuts. These two developments will shrink the US federal deficit by an estimated $503 billion, according to the Congressional Budget Office. Deficit reduction of this scale at a time when the US economy is still weak will almost definitely push the global economy closer towards a new recession.
To what extent should Indian policymakers be worried? In its economic review released on 29 October, the Reserve Bank of India cited World Bank research that predicted only a modest impact on India: Economic growth in South Asia would fall by 0.2 percentage points while the current account deficit would improve by 0.1 percentage points of gross domestic product. But the central bank seems worried enough to add: “…a sharp fiscal contraction may have a deleterious impact on global growth.”
There will be two factors at play. A weaker global economy will likely hurt domestic growth further while lower crude oil prices could ease some of the current pressure on the balance of payments (BoP). The more tricky challenge will be to manage the immediate impact of a global shock if the US economy tumbled over its fiscal cliff. The experience of September 2008, when Lehman Brothers imploded and global financial markets froze in shock, is fresh enough to dismiss any empty hopes that India will be immune from a new global shockwave.
The fundamentals of the Indian economy are far weaker than they were at the end of 2008, which means that the ability of policymakers to intervene effectively is less than before. One indication of this is the level of foreign exchange reserves with the central bank relative to monthly imports. Such import cover has nearly halved in the past four years, from 12 months to six months. The firepower available to join battle in case there is an attack on the rupee is less impressive than it was in the aftermath of the Lehman collapse.
The most likely outcome still seems that there will be some political deal in the US at the very last moment, as happened during the negotiations to increase the debt ceiling in August 2011. It could lead to modest fiscal consolidation rather than something that is brutal enough to destroy the fragile global recovery. The more important issue is likely to be how India—both the government and the private sector—manages to negotiate the volatility that will accompany every twist and turn in US fiscal politics.