US debt ceiling conundrum – What matters to India
The recent agreement between US policymakers to suspend the nation’s debt ceiling until 2025 has been met with a collective sigh of relief from the global financial community. The potential economic catastrophe that could have been triggered by a default on the U.S. debt had been a huge overhang, casting a pall of uncertainty over the markets worldwide.
What is debt ceiling all about in the first place?
The debt ceiling is the maximum amount of money that the United States can borrow cumulatively by issuing bonds. The debt ceiling was created under the Second Liberty Bond Act of 1917 and is also known as the debt limit or statutory debt limit. It’s a limit on borrowing more money just to meet some of its existing obligations — such as government salaries, pensions, and even the interest on current debt. The ceiling exists to prevent the country from going into that vicious cycle. The problem for the US is — they’re at the ceiling already. Which means they can’t borrow more money. They’ll have to hope that their tax revenues are good enough for now.
The Treasury Department must find other ways to pay expenses when the debt ceiling is reached; otherwise, there is a risk that the U.S. will default on its debt. The debt ceiling has been raised or suspended several times to avoid the risk of default. There have been a number of showdowns over the debt ceiling, some of which have led to government shutdowns and so this is not new. In fact, since 1978, they’ve actually tweaked this ceiling at least every 9 months! How else do you think the limit soared from $1 billion when it was first introduced in 1917 to a whopping $31.4 trillion now.
Impact
The debt ceiling resolution brought a positive response to the Indian market, which speaks volumes about the interconnectedness of the global economy and the significant influence of U.S. fiscal policy on emerging markets. With the announcement of the deal, the BSE Sensex rose, nearing its all-time high, and the Nifty50 likewise gained significantly.
However, this near-term relief is only part of the story. The debt ceiling deal has broader, more profound implications for the Indian economy and other emerging markets. The global economic interdependence and the significant effect of the U.S. economic policies on global markets across the world is profound. This is not about understanding and managing immediate impacts but preparing for the long-term ramifications of such fiscal policy decisions.
Understanding the ramifications
If this agreement would have failed, the consequences could have been severe. A default on U.S. Treasury obligations would have reverberated across the global financial system, creating an economic upheaval that could dwarf the 2008 financial crisis. Emerging economies like India, whose financial markets are heavily influenced by the U.S., would have experienced increased volatility and possible capital outflows.
During the brinkmanship on the debt ceiling, yields on T-bills in the US soared to 7% on bonds maturing around June 2. Further, derivatives that are used to hedge US treasuries also shot up. This also stresses the global foreign exchange market, particularly emerging market currencies. Another key concern raised by experts is the potential of reduced confidence in US assets over the debt limit and the position of the dollar as a global reserve currency. As the U.S issues debt in its own currency, it does not hit its fiscal situation like countries with high current account deficits.
Now that the immediate crisis has been averted, asset price volatility has been lower. From a historical perspective, the 2011 downgrade of the US credit rating during the debt ceiling crisis had the created a panic in the global markets. While a part of the reason for the downgrade was attributed to the high indebtedness in the US, its ultimate impact on financial markets cannot be undermined.
For India, an economy heavily reliant on foreign portfolio investments, a sudden outflow of capital could have created substantial volatility and downward pressure on the Indian Rupee. This, in turn, could have stoked inflation, hurt corporate profitability, and undermined economic growth.
Furthermore, a U.S. default could have increased global risk aversion, leading to higher borrowing costs for countries like India. Higher interest rates would have put additional pressure on India’s fiscal situation, particularly its debt sustainability. The resultant increase in India’s cost of borrowing could have constrained its ability to finance infrastructure and other growth-enhancing investments.
Policy priorities post resolution
Even so, the current debt ceiling agreement has been a compromise. A significant component of the settlement is the tightening restrictions on food assistance program and the temporary assistance for needy families’ programs. Any decrease in American spending power, particularly among the lower class, could indirectly affect global markets. The deal agreed on billions dollar funding for clean energy. This should have positive implications for international climate change initiatives.
Now, even with the deal in place, the U.S. will still have to contend with the future implications of its soaring national debt. This temporary solution will mean that such matters will be revisited including another round of negotiations in two years. On the flip side, global economic growth would remain positive due to high US spending.
Still, the episode underscores the importance for countries like India to build resilience against such external shocks. It reiterates the need for a robust fiscal strategy that can effectively navigate the uncertainties of the global economic landscape.
India has to continue to drive growth in the domestic markets and increase spending on growth policies. The external sector management should increase its toolkit to deal with foreign exchange and rupee volatility, strengthen reserves, and widen its external liabilities investor base. On the fiscal front, it is crucial for India to maintain a disciplined fiscal path with an emphasis on revenue augmentation, and efficient debt management.
Further, structural reforms should be aimed at increasing competitiveness of the Indian economy, promote further investments in critical sectors and core infrastructure that support growth. Over the longer run, this multi-pronged approach can better equip India to navigate the challenges posed by global fiscal events like the U.S. debt ceiling crisis.
Domestic economic strategies should be calibrated in response to global fiscal events, keeping in view the overarching objective of sustainable and inclusive growth. And the current compromise has given India a window of opportunity to strengthen its base and economic fundamentals.