COMMENT: Why the fiscal fudge is important in emerging markets too

By bne IntelliNews January 14, 2013

Marcus Svedberg of East Capital -

The fiscal situation in the US matters a great deal for emerging markets. The fact that financial markets welcomed a deal like this is only a result of the alternative - no deal at all.

The already overly analysed fiscal deal in the US was not only an enormous anti-climax, it was also one of those events that everyone believes was good, but not good enough. It was good because the worst case scenario of sharp tax rises and dramatic budget cuts, which would have propelled the US economy into recession, with substantially negative implications for global growth and risk appetite, was avoided. But it was not good enough because the most difficult issues were not resolved but rather postponed for a few months.

The Economist argues pointedly that US policy-making is starting to resemble that of the Eurozone. Political prestige and vested interests lead to endless negotiations that result in partial and suboptimal solutions. A fiscal fudge is better than a fiscal cliff, even if it means that the discussion will return and dominate the agenda in the coming weeks and months.

It matters a great deal for emerging markets

The US fiscal problems are not new, and one may be excused for wondering what the fuss is all about. The problem is that the fiscal situation in the US matters a great deal for the rest of the world in general and for emerging markets in particular. There are two transmission mechanisms.

The first and most obvious one is the real economy. The US is the largest economy in the world and thus very important for global trade and investment, as well as for commodity prices. A failure to reach any deal would have reduced US growth by 5 percentage points, resulting in a sharp recession, whereas the fiscal fudge solution is likely to limit the negative impact to 1-1.5 points.

A second consequence is related to risk appetite. The US is not only the largest economy in the world; it is also the largest financial market. An inability by politicians to solve fundamental economic problems will make investors more risk averse and vice versa. The irony is that it tends to not be the American dollar or bonds but rather EM assets that suffer the most when risk appetite dries up. The reason behind this counterintuitive market reaction is that most of the capital originates from developed economies and money tends to return home when there is volatility.

A good example is the Russian equity market, which depends a lot on foreign capital. The RTS index seems to be inversely correlated with the S&P 500 VIX index, which measures volatility.

Politics vs. economics

Just like during the euro crisis, which by the way has been successfully contained for the time being but is not yet solved, politicians fail to do what economists argue is necessary. There was plenty of time for US politicians to solve the fiscal cliff before the end of the year and there were plenty of decent compromises. An early and comprehensive resolution would most likely also have been less costly, as economic uncertainties would have decreased. But the political realities proved once again to be very different from the economic ones.

Muddling through is, therefore, as real in the US as it is in Europe. But this is no catastrophe for financial markets. Last year was a good one for almost all asset classes, even though the euro crisis dominated the agenda.

2013 - financial markets returning to normal

As long as central banks continue to provide support through their extraordinary policies, which they are expected to do throughout this year if necessary, markets should be able to hold up or even move higher.

Illustratively, financial markets welcomed the fudge but are likely to get concerned again about fiscal cuts and the debt ceiling. But the fact that the worst-case scenario has been avoided in the US, just like it was in Europe (Eurozone breakup) and China (economic hard landing) in the second half of 2012, supports our view that the global economy should start to normalise over the course of the year, with financial markets gradually returning to basics where fundamentals matter more than sentiment. But it will not happen overnight.

Marcus Svedberg is Chief Economist at East Capital

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