Global economy watch - February 2013
Navigating through US fiscal uncertainty

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2013 began with last minute positive news to avert the US fiscal cliff. But this is only a stop gap. In the next few months, three key pieces of fiscal legislation will have to be agreed and voted on. The most important piece of legislation is to extend the US debt ceiling.

In the aftermath of the fiscal cliff negotiations businesses in the US are worried. A recent survey of small and independent enterprises suggests that tax policy is of a bigger concern to entrepreneurs than revenue growth.

However UK business is relatively insulated to the debt ceiling discussions in the US. What is more relevant to companies here are the developments in the Eurozone. The German economy, the powerhouse of the Eurozone, shrunk in the last quarter of 2012 which was a big swing from the positive growth recorded in the previous quarter.  The contraction in the German economy could signal more disappointing Eurozone growth data to come. 

One thing we’re also following is the bailout negotiations to resolve the debt crisis in Cyprus. This is proving to be the latest real-life test of the commitment of Eurozone policymakers to break the vicious cycle between bank and the sovereign. For Cyprus, the policy dilemma Europe faces is to either lend directly to the sovereign which could put it under considerable stress or lend directly to the banking system, which will open up Pandora’s Box for the existing procedures already in place for the Spanish and Irish banking systems.

At a glance

Key messages:

  1. Fiscal policy uncertainties will continue to overhang the US recovery despite a delay to mid-May in the debt ceiling deadline.
  2. European problems continue, following contractions of the UK and German economies in the last quarter of 2012.
  3. Cyprus is providing the latest test to Eurozone policymakers on how to break the potentially vicious circle between banking sector and sovereign debt problems
  • 2013 began with positive news of a last minute agreement to avert the US fiscal cliff. But this is only a stop gap. In the next few months, several key pieces of fiscal legislation will have to be agreed and voted on.
  • The most important of these is to extend the US debt ceiling. Figure 1 below shows that the debt ceiling has in fact already been reached, although the deadline  is being pushed back to mid-May. But there are likely to be continued fiscal skirmishes on this for months to come, which will represent a continued drag on the US recovery. Growth is likely to remain stuck at around only 2-2.5% this year, similar to 2012.
  • Businesses in the UK, however, should be more worried about recent developments at home and in the rest of Europe. Fourth quarter GDP fell by an unexpectedly large 0.3%. Underlying growth may still have been modestly positive excluding special factors relating to North Sea oil outages and the reversal of the Olympics boost in Q3, but the economy clearly remains fragile and we have revised down our 2013 growth projection to 1.1%, similar to the latest International Monetary Fund (IMF) forecast of 1.0%.
  • The announcement of a possible referendum on UK membership of the EU in 2017 could also create unwelcome uncertainty, particularly for overseas investors in the UK.
  • Across the channel, the surprising contraction in the German economy for the last quarter of 2012 (see Figure 2) presages more disappointing Eurozone growth data when Q4 figures are released in mid-February.
  • Germany relies heavily on its export-oriented manufacturing sector for growth. But the outlook for its key overseas markets is mixed with China still growing strongly, but the French market stagnating and the Italian and Spanish economies contracting.
  • Cyprus is the latest potential flashpoint in the evolving Eurozone crisis.  Finding a resolution to the debt crisis there will test the commitment of Eurozone policy makers to break the “vicious cycle between banks and sovereigns”.
  • European policymakers face a dilemma. Lending directly to the state would ensure that the Cypriot government remains responsible for rescuing its banking system, but it would also put Cypriot government finances under considerable stress. 
  • Alternatively, lending directly to the banking system would risk raising questions on the appropriateness of the existing mechanisms in place for the economies of Spain and Ireland. The Cyprus situation should therefore be monitored carefully due to both contagion risk and the precedents its resolution may set.

Charts of the month

Figure 1 – The US government hit its previous debt ceiling at the end of last year before the Federal Government adopted extra ordinary measures
Image in a modalNote that the anticipated temporary suspension of the debt ceiling is not shown
Source: Thomson Datastream, US Treasury
Figure 2 – A surprising contraction in the German economy in the last quarter of 2012, suggests more bad news for the Eurozone

Image in a modalEurozone Q4 data will be released on 14/02
Source: Eurostat, German Statistical Office