Perpetual Fiscal imprudence of the US and its Impact on world Economy

Recently there has been a lot of concern globally about what’s happening in the US economy , especially to do with the debt ceiling also due to other factors.

So what is the debt ceiling and does India also have it ?

US has legislative limit on how much can the US government can borrow. This whole thing started in the first world war, through a law which was passed to limit the federal bowering . Whenever the economy approaches the debt limit , the us congress votes to increase the limit . It has been regular affair , to get an idea about the frequency by which it has been increased , since 1960 ,78 times the debt ceiling has been increased in the US. The government has been running deficit , when expenditure has been more than revenue the government needs to borrow. The congress votes to increase the ceiling . This time around , or in last 12-15 years we are seeing that there has been disagreements between the two parties.

In India , we have different system , We follow FRBM ( Fiscal responsibility and budget management ) Act , it was introduced in 2002 . That time we didn’t have the debt limit , we only had targets in the form of fiscal deficit and revenue deficit . The act mandated that fiscal deficit has to be achieved to 3% of GDP by 2008 and revenue deficit had to be made by the same time. However , after the global financial crisis this act was suspended because the government couldn’t achieve its targets.

It was re- introduced , but government hasn’t been able to meet their targets. In 2017, it was recommended that in addition to fiscal deficit we should have debt targets and from then onwards FRBM has two main targets – Fiscal deficits & Debt to GDP Ratio. So , Debt to GDP is for general government is 60% by 24-25 and for Central government is 40% . But even after multiple revised timelines , the Government hasn’t been able to achieve any of these targets.

So , the core difference between us and how the US does their job is that we set a percentage of GDP as limits Vs in the US they have the absolute numbers as the limit . They have to vote to pass the increase in the limit , in India it is a bill so someone can raise a question in the Rajya Sabha but Lok Sabha doesn’t need to listen to that .

So , what is exactly happening in the US now?

In 2021 they had increased the debt ceiling , which was 31.4 trillion dollars which they approached in mid-January this year . The treasury wrote a letter to congress saying that we have exhausted the limit , so they are introducing extra ordinary measures to limit spending and save on cash.

There have been disagreement between the republicans and democrats . The Rep say that we will agree to this only if the government reduces spending . Treasury secretary has said that by June , they will be completely bankrupt and they will be not able to service payments of treasury bills and other bonds if congress decides not to increase the debt ceiling

The cash available with US treasury( 68 B $) is less than what most companies have on their balance sheets.

This whole financial situation is also impacting the consumers sentiments around the world .University of Michigan of consumer sentiments , which is survey of sentiments of present consumer sentiments and also on the future . Both have plummeted to a great extent .

Impact of this issue on India ?

If you last see the data on the exports , they contracted by more than 12% . US is one of the major trading partners , and because of high inflation in EU they have also curtailed spending . In EU they have raised the policy rates . All these factors cumulatively India’s exports , earnings of companies which have exposure to the US , IT sector Etc.

What Happens if the US defaults.?

Well, we have to first understand the US dollars runs the world. Why ? well, it is world reserve currency . No matter how much you read about that US dollars will be dethroned and some other currency will take over , it is not going to happen in our life time at least.

So, coming back to the why US dollar runs the world. First understand , that globally investors invest in financial assets and even non financial assets taking the US T Bills as bench mark. What is the rate on the T Bill is considered globally as the risk free rate.

So , Imagine if the US Investor will spend some money on a Corporate bond , they will expect Atleast the following return.

Return =Risk Free rate ( US Treasury Bond rate – US T Bill Rate ) + Default /Credit risk Rate of the bond + Liquidity Risk rate + Inflation Rate .

If the rate of risk free return increase , the yield ( Return ) of the bonds will increase drastically ,the situation we had In the SVB bank will happen due to mark to market losses.

The impact will be seen in the global stock markets too , because as the risk free increase the expected returns or the discount rates on the equity will also increase.

Return on stocks( Discount rates) =Risk Free rate ( US Treasury Bond rate – US T Bill Rate ) + Default /Credit risk Rate of the bond + Liquidity Risk rate + Inflation Rate + EQUITY RISK PREMIUM

As per the US government , the Stock markets in the US will go down by Atleast 60% , and the impact will be there in India too .

The interest rate sudden increased Spread will be catastrophic to say the least for economy .

In- fact globally institutions have been shorting US stocks and also some have been doing this globally in last one year or so .

What has led to this situation in the first place?

The reason is simple , the US doesn’t make as much in tax revenue as much they spend on the their annual operations . Fun fact – US spends because of this imprudence, more on servicing debt than national defence( around 1 trillion Dollars ) .

Is the Debt Ceiling Concept Flawed?

The annualized cost of servicing this debt has jumped an estimated 90% compared to 2011, driven by increasing debt and higher interest rates.

Some economists argue that the debt ceiling helps keep the government more fiscally responsible. Others suggest that it’s structured poorly, and that if the government approves a level of spending in its budget, that debt ceiling increases should come more automatically.