Japan looms as new fault line
The fiscal cliff matters because in an Armageddon situation it would push the US back into recession next year. About $US600 billion ($572 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 next year.
The US is 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 next year, followed by a 1.9 per cent rebound in the second half, according to the US Congressional Budget Office.
However, these are calculations based on a level of sustained stupidity and intransigence that not even Washington's politicians will endure. The cliff is an unwanted by-product of Washington's failure to agree on a deficit reduction plan last year 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 US election, making a repeat of that debacle less likely.
The House Speaker and lead Republican negotiator, John Boehner, has already conceded that taxes on the very wealthy will go up, and the 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. But they are closer to a deal than most believed they would be with the deadline still 12 days away.
It is possible the negotiations will stretch into next month, and the markets will probably go weak in the knees if they do. 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 increase, for example. There will be melodrama on the way, but the cliff will be climbed.
Two other national balance sheet dramas are likely to loom larger next year. 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 by cheap European Central Bank funding. A money market attack that was pushing the government's borrowing costs to levels that would have caused its debt load to expand automatically was only headed off mid-year by the promise of the European Central Bank president, Mario Draghi. He vowed 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, and the country has not yet needed to formally ask for help, and commit to tighter European Union fiscal controls in order to get it.
There is no revenue relief for the government coming from the economy next year 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 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 the 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 programme 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 this week, and announced it was boosting the size of its asset buying programme by another 10 trillion yen or $112 billion, to 101 trillion yen ($1.1 trillion).
Abe will want the BoJ to do even more, however, and he will probably get what he wants. He has the numbers in parliament, and while the central bank's enabling act states that its "autonomy regarding currency and monetary control shall be respected", it also states that its policies and the government's must be "mutually compatible". The government is able to put its case in person to the bank's board if necessary.
We will have to wait to see how this plays out, but it could send shock waves around the world, and they will definitely reach these shores.
Quantitative easing in the northern hemisphere is a money-printing exercise that debases the currencies where it occurs, and currency depreciation that boosts international competitiveness is one of the unstated aims of quantitative easing.
In Japan, the key currency target is the yen-US dollar cross rate. Abe wants to the yen to fall.
Quantitative easing is 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 Australian dollar on the yen-Aussie conduit.
A debt-funded push for growth in a Japanese economy might also move that country 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 another exciting year.
Frequently Asked Questions about this Article…
The fiscal cliff refers to a package of expiring temporary tax breaks and automatic government spending cuts that could be triggered at the turn of the year. According to the article, if fully enacted it would remove about US$600 billion (around 4% of US GDP) from the economy and could push the US into a sharp near-term contraction. For investors, the worry is that such a shock would weaken markets and create volatility — although the article also notes politicians are likely to negotiate a deal, and any market weakness could present buying opportunities.
The US Congressional Budget Office projections cited in the article suggest the United States, which is expanding at about 2% a year, could see growth turn into roughly a 2.9% contraction in the first half of the next year, followed by about a 1.9% rebound in the second half if the fiscal cliff is fully enforced. Those are sizable swings that could affect corporate earnings, risk sentiment and asset prices.
The article highlights disagreement over where tax increases should start. House Speaker John Boehner was pushing for tax rises to begin on incomes of US$1 million or more, while the White House wanted increases to start at US$400,000. The piece suggests both sides were closer to a compromise than many expected, making a total breakdown less likely.
The article flags Spain as a national balance-sheet drama with deeper problems: its economy had been contracting for over a year, unemployment was around 25%, and the OECD forecasted growth not resuming until 2014. Spain’s banking sector was under strain and reliant on cheap ECB funding. If bond-market pressure resumed, Spain might be forced to ask for external help, creating market turmoil that could dwarf the US fiscal cliff’s impact.
Abenomics refers to the policy mix promised by Shinzo Abe’s Liberal Democratic Party after its landslide election win: large fiscal stimulus combined with much more aggressive monetary easing by the Bank of Japan aimed at ending deflation and boosting growth. The article warns this combination could send shock waves globally because it is likely to involve heavy quantitative easing and a desire for a weaker yen to help competitiveness.
The article explains the BoJ had kept key interest rates at zero for more than two years and engaged in quantitative easing that expanded its balance sheet to more than 30% of GDP. It recently boosted its asset-buying programme by another ¥10 trillion (roughly US$112 billion) to ¥101 trillion (about US$1.1 trillion). The incoming government is likely to press the BoJ for still more easing.
The article notes that quantitative easing tends to debase the currency where it occurs, and one unstated aim is to boost international competitiveness via currency depreciation. Abe wants a weaker yen against the US dollar, and that pressure could transmit to the yen–Aussie relationship, putting further downward pressure on the Australian dollar and affecting exporters, importers and currency-sensitive investments.
The article points out Japan’s debt already exceeds 200% of GDP, a ratio higher than any troubled European nation. Japan has been funding itself domestically so far, which reduces immediate vulnerability, but a debt-funded push for growth is an unexpected wild card that could attract debt-market bears and create volatility. For investors, that means monitoring policy moves and market reaction, because the risks could affect global financial conditions.
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