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Lawmakers in the US narrowly avoided a federal government shutdown last week with a compromise legislation that will allow the government to function till November 17. While the US Congress now has more time to settle differences, the recurring risk of government shutdowns owing to one reason or the other doesn’t bode well, either for the US economy or global financial markets. Although interest payments and essential government functions are unlikely to be affected by a shutdown, investors may not want to ignore default risks for long, particularly because they could affect the basic functioning of markets globally. The frequent political brinkmanship on budgetary issues, in fact, reflects the underlying weakness in overall fiscal management.
Notably, while downgrading the US’ long-term foreign-currency issuer default rating to AA+ from AAA in August, Fitch Ratings had said that “there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters…”. There has indeed been a structural weakening in the US government’s finances. According to the recent projections of the Congressional Budget Office, the federal budget deficit is expected to average 6.1 per cent of gross domestic product (GDP) between 2024 and 2033, which is significantly higher than the 50-year average of 3.6 per cent. This structural increase in the US budget deficit will require more financial savings, leaving so much less for the rest of the system. Higher borrowing by the US government, along with potential investor demand for higher yields to account for the worsening fiscal position and frequent shutdown risks, could lead to a structural increase in interest rates. Relatively high US interest rates will have implications for capital flows. It would make accessing global financial markets more difficult for low- and middle-income countries — a number of them are already struggling to raise funds.
Although yields on US government bonds have been pushed up by the Federal Reserve’s monetary policy action to contain inflation, they are unlikely to revert to the pre-Covid levels anytime soon because of the elevated budget deficit. With 10-year government bonds yielding 4.7 per cent — yields are higher at the shorter end — raising risk capital will become more difficult, which could affect growth outcomes, both in the US and around the world. What is perhaps more worrying is that things are unlikely to change in the near to medium term because the debt stock is expected to increase. According to the International Monetary Fund’s projections, the US general government debt is likely to increase to 136.2 per cent of GDP by 2028, compared with 122.2 per cent in 2023, which would keep the level of interest payment elevated.
Where does all this leave India? The global economic environment, in general, is unlikely to be supportive in the medium term and Indian policymakers would do well to keep this in mind. In the context of the US fiscal condition and its implications for financial markets, it is worth noting that India runs a current account deficit (CAD) and imports capital from the rest of the world. Considering the anticipated structural shift in the US and global financial markets, it would be advisable to expand domestic savings and maintain a moderate CAD that can be financed by stable flows. Attaining and sustaining higher economic growth would require careful policy interventions.
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Structural shift
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Lawmakers in the US narrowly avoided a federal government shutdown last week with a compromise legislation that will allow the government to function till November 17. While the US Congress now has more time to settle differences, the recurring risk of government shutdowns owing to one reason or the other doesn’t bode well, either for the US economy or global financial markets. Although interest payments and essential government functions are unlikely to be affected by a shutdown, investors may not want to ignore default risks for long, particularly because they could affect the basic functioning of markets globally. The frequent political brinkmanship on budgetary issues, in fact, reflects the underlying weakness in overall fiscal management.
Notably, while downgrading the US’ long-term foreign-currency issuer default rating to AA+ from AAA in August, Fitch Ratings had said that “there has been a steady deterioration in standards of governance over the last 20 years, including on fiscal and debt matters…”. There has indeed been a structural weakening in the US government’s finances. According to the recent projections of the Congressional Budget Office, the federal budget deficit is expected to average 6.1 per cent of gross domestic product (GDP) between 2024 and 2033, which is significantly higher than the 50-year average of 3.6 per cent. This structural increase in the US budget deficit will require more financial savings, leaving so much less for the rest of the system. Higher borrowing by the US government, along with potential investor demand for higher yields to account for the worsening fiscal position and frequent shutdown risks, could lead to a structural increase in interest rates. Relatively high US interest rates will have implications for capital flows. It would make accessing global financial markets more difficult for low- and middle-income countries — a number of them are already struggling to raise funds.
Although yields on US government bonds have been pushed up by the Federal Reserve’s monetary policy action to contain inflation, they are unlikely to revert to the pre-Covid levels anytime soon because of the elevated budget deficit. With 10-year government bonds yielding 4.7 per cent — yields are higher at the shorter end — raising risk capital will become more difficult, which could affect growth outcomes, both in the US and around the world. What is perhaps more worrying is that things are unlikely to change in the near to medium term because the debt stock is expected to increase. According to the International Monetary Fund’s projections, the US general government debt is likely to increase to 136.2 per cent of GDP by 2028, compared with 122.2 per cent in 2023, which would keep the level of interest payment elevated.
Where does all this leave India? The global economic environment, in general, is unlikely to be supportive in the medium term and Indian policymakers would do well to keep this in mind. In the context of the US fiscal condition and its implications for financial markets, it is worth noting that India runs a current account deficit (CAD) and imports capital from the rest of the world. Considering the anticipated structural shift in the US and global financial markets, it would be advisable to expand domestic savings and maintain a moderate CAD that can be financed by stable flows. Attaining and sustaining higher economic growth would require careful policy interventions.
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