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After Spain and Japan, US cliff is a sideshow

21 Dec 2012 THE AGE - MALCOLM MAIDEN


AMERICA'S fiscal cliff shouldn't be ignored, but it should also be put in perspective. When the history of the global crisis is written, it will be lucky to rate as a footnote. There are at least two events looming that are much more important for the global markets, and one of them is right on our doorstep, in Japan.

The "cliff" matters because on an armageddon scenario it would push America back into recession next year. About $US600 billion or 4 per cent of gross domestic product would be ripped out of the US economy if temporary tax breaks and government spending cuts are triggered in the new year, and stay in force throughout 2013.

The United States is currently expanding by about 2 per cent a year, and the cliff could turn that into a 2.9 per cent contraction in the first half of 2013 followed by a 1.9 per cent rebound in the second half, according to the US Congressional Budget Office.

These are calculations based on a level of sustained stupidity and intransigence in Washington that not even Washington's politicians will endure, however.

The cliff is an unwanted by-product of Washington's failure to agree on a deficit reduction plan in 2011 when Republicans stood in the way of an expansion of the government's debt ceiling, but hard-line elements of the Republican Party were set back in the November US election, making a repeat of that debacle less likely.

House Speaker and lead Republican negotiator John Boehner has already conceded that taxes on the very wealthy will go up, and President Barack Obama has already agreed to lift the income level that will escape them.

They are still apart. Boehner is pushing for tax rises on incomes of $US1 million or more and the White House wants tax increases to begin at $US400,000. They are, however, closer to a deal than most believed they would be with the deadline still 12 days away.

It is possible that negotiations will stretch into January, and the markets will probably go weak in the knees if they do.

However, it will probably be a buying opportunity for investors. If the temporary tax cuts that were introduced during the global crisis and cuts in government spending are triggered, the way will be clear for both sides to negotiate a solution that leaves most on the table as a deficit-cutting program, but gives some back as a political sweetener, by limiting the extent of the tax rise, for example. There will be melodrama on the way, but the cliff will be negotiated.

Two other national balance sheet dramas will loom larger in 2013.

The best known one is Spain. Its economy has been shrinking for more than a year, unemployment is at 25 per cent, and the OECD forecasts that growth will not resume until 2014.

Spain's banking sector is on its knees and propped up buy cheap European Central Bank funding, and a money market attack that was pushing the government's borrowing costs to levels that would have seen its debt load expand automatically was only headed off mid-year by European Central Bank President Mario Draghi's promise to stand in the market for Spanish government bonds if necessary and push yields down.

Spanish bond prices rose, yields fell and the financial pressure on Spain eased after that. Spain has not yet needed to formally ask for help, and commit to tighter fiscal controls in order to get it.

There is no revenue relief for the government coming from the economy in 2013, however, and that means that at some point in the year Europe's big moment will arrive: Spain will either ask for help, or be forced to ask for it when the bond market attack resumes. The market nervousness around this event will make the fiscal cliff look like the sideshow it is.

The new market drama is Japan. The nation that is still Australia's second-largest export destination and its third largest source of imports has just held an election that changes everything. The landslide victory for Shinzo Abe's Liberal Democratic Party last weekend hands power to a party that is promising massive fiscal and monetary stimulus, and has the ability to deliver it.

Abe is expected to gear up the already heavily indebted Japanese economy to fund fiscal expansion aimed at eliminating deflation and fuelling economic growth, and he has also vowed to push Japan's central bank into much more aggressive monetary easing.

The bank of Japan is not exactly a slouch in that department. It has been holding its key interest rate at zero for more than two years, and has been pushing cash into the economy by buying financial assets, in a quantitative easing program that has expanded its balance sheet out to more than 30 per cent of GDP. The Reserve Bank of Australia's balance sheet by way of comparison is about 7 per cent of GDP.

The BOJ met on Thursday and boosted the size of its asset buying program by another ¥10 trillion or $112 billion, to ¥101 trillion ($1.1 trillion).

Abe will want the Bank of Japan to do even more, however, and he will probably get what he wants. He has the numbers in parliament, and while the Bank of Japan's enabling act states that its "autonomy regarding currency and monetary control shall be respected," it also states that its policies must be compatible with the government's.

We will have to wait to see how this plays out, but it could send shockwaves around the world that reach these shores.

QE in the northern hemisphere is a money-printing exercise that debases the home currency, and currency depreciation that boosts international competitiveness is one of QE's unstated aims. In Japan, the key currency target is the yen-US dollar cross rate.

QE is, however, one of the reasons Australia's currency has stayed high and depressed domestic activity even as commodity prices have fallen this year, and Abe's growth crusade raises the prospect of even more intense pressure on the $A on the yen-$A conduit.

A debt-funded push for growth in a Japanese economy might also move Japan into the sights of the debt market bears that have wrought havoc in Europe. Japan's debt load already exceeds 200 per cent of GDP, a ratio that puts every beleaguered European nation in the shade. It has been funding itself domestically, and is less exposed, but Abe's growth push is a new and unexpected wild card: it's going to be another exciting year.

mmaiden@fairfaxmedia.com.au