The U.S Fiscal Cliff analysed by Kampamba Shula

The U.S.A Fiscal Cliff

Much has been debated recently in International media as well as in the U.S.A over the fiscal cliff. Democrats and Republicans are at longer heads to get to some amicable deal while the market limbos in uncertainty and businesses hold back on recruitment and capital expenditure.

“Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect. Planned tax rises and government spending cuts will create a ‘fiscal cliff’ in the US in 2013 equivalent to 4.7% of national income.

Several fiscal stimulus measures are due to expire at the start of 2013 at the same time as additional tax rises and spending cuts come into force. Should this happen the expected tightening during 2013 would be $655bn, or 4.7% of national income. This is the ‘fiscal cliff’. It dwarfs the planned consolidation in the UK over the same period of 1.3% of GDP. Indeed it is much larger, and more sudden, than planned in bailed out Eurozone countries such as Greece (2.8%) and Ireland (2.6%). Such a sharp and aggressive adjustment in fiscal policy will significantly damage US growth and employment.

• This would lead to a pronounced recession next year. National income would fall by 1.0% and unemployment would rise to over 10%.

• Even partial implementation of these tax and spending changes would severely hamper growth and employment.

• It is imperative that policymakers prevent this outcome. Yet the poisoned political environment makes it difficult to generate the consensus needed to revoke these plans. Looser monetary policy wouldn’t fully offset this fiscal headwind.

• Even if crisis is averted, the long term outlook for the US public finances is a growing concern. Policymakers will have to make tough decisions in order to prevent debt reaching unsustainable levels. This will again require the sort of political consensus that has been sorely lacking over recent years.

Why is the Fiscal Cliff a Big Problem?

The important question to ask is why the fiscal cliff is such a big problem and should the rest of world really be concerned about its implications. Then answer lies twofold, firstly the fiscal cliff is a big problem because it means that the U.S, the world’s largest economy is unable to pay back its debt and secondly when it hits the debt ceiling in February 2013 it will have to default and will not be able to borrow any more, a devastating turn of events.

Why should the world be concerned?

The question that remains unanswered now is what does this have to do with the rest of the world and should they even be bothered. The answer for this question is also twofold; countries like Switzerland, Japan and China would be worried since they own U.S debt while the rest of the world could suffer from a crisis of confidence, and yes we mean crisis. If Stock market indexes in Asia and Europe rally on better housing market data from the U.S what could possibly be the effect of a default on U.S sovereign debt, definitive, the correlation between international markets has deepened due to globalization.

The Real Focus

During an interview with Bloomberg’s Charlie Rose on the Fiscal cliff Warren Buffet said “The world may think we are idiotic, but we are not suicidal.”According to Warren, there is not much to read into the fiscal cliff because he believes a solution will be found that will avert market fears. I tend to agree with Warren but only to certain extent as I do believe there is also a substantial confidence risk that the fiscal cliff poses in the short term.

The real focus of the fiscal cliff discussion is around the tax increases and budget cuts. This seems to be the pin point where Democrats and Republicans seem to be differing in congress. President Obama has proposed a tax increase on high net worth individuals (top 2 %) while rates remain unchanged for the rest of the population. Many say this is a step in the right direction but some CEOs believe it will not be enough; I tend to agree with this view in part.

There is a sacrifice that has to be made. With U.S growing at about 1.5%, for every $1 trillion of budget cuts about half a percentage point will be shaved off GDP, a $4 trillion budget cut is needed.

 Key issues

The incentives to prevent the fiscal cliff from putting the US back into recession are very strong. Even during periods of robust growth such a large and sudden change in fiscal policy would be unwise, but with the US still struggling to recover from the financial crisis it would be a baffling decision. The poisoned political environment, however, makes progress on new legislation difficult. Both the main parties agree that current policies are unsustainable and that deficits need to be reduced. They disagree on how to achieve these objectives. Neither of the competing presidential candidates has offered much by way of specifics, but at a broad level the Republican party continues to advocate spending cuts and reject tax rises while the Democats prefer tax increases and fewer spending cuts. 

To get to the core of this issue it would be appropriate to establish the actual cause of the fiscal cliff, and by this I don’t mean who is to blame between Republicans and Democrats but what policies have led to the U.S incurring such a large sovereign debt. Part of the reason lies in welfare, Medicare and military spending. The problem is neither the republicans nor the democrats are willing to tackle issues of welfare, though the republicans are eager to attack Obama’s healthcare package.

Unfortunately, the fiscal cliff isn't the only problem facing the United States right now. At some point in the first quarter, the country will again hit the "debt ceiling" - the same issue that roiled the markets in the summer of 2011 and prompted the automatic spending cuts that make up a portion of the fiscal cliff.

What do the markets want?

The markets are looking for about a $4 trillion budget cut to ease their fears. The problem is that they probably won’t get that much.

What will the markets get?

In my personal view the markets will probably get some deal from congress which will be something small, maybe in the range of $1.3 trillion (not including the expired Bush tax cuts) and a promise of something bigger later on.

Solutions

 

 

Republicans want to cut spending and avoid raising taxes, while Democrats are looking for a combination of spending cuts and tax increases. Although both parties want to avoid the fiscal cliff, compromise is seen as being difficult to achieve. There's a strong possibility that Congress won't act until the eleventh hour. 

Avoiding the fiscal cliff would be positive in the short term, but the US still needs to take decisive action to put its public finances back on a sustainable track. The CBO estimates that the fiscal restraint embodied in current law will reduce the budget deficit markedly to an average of 1.4% of GDP over the 2013-2022 period. Debt as a share of GDP would peak at 76% in 2014 before falling to 61% by 2022. Alternatively, if some but not all of the current tax and spending policies are extended the budget deficit would average 5.3% and public debt as a share of GDP would keep on rising, reaching 93% by 2022 – the US public finances would remain unsustainable. Given this, US authorities need to at some point agree on how to make this medium term fiscal adjustment. The ideal outcome of this issue would be for policymakers to avoid the shock of a fiscal cliff, but commit to long term deficit

Technically, there is a December 31 deadline for Obama and Congress to find a way to avoid hundreds of billions of dollars in tax increases and spending cuts that experts say would give Americans a hangover far worse than what any drunken New Year's Eve celebration could deliver.

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Rebasing the Zambian Kwacha analysed by Kampamba Shula

Rebasing the Zambian Kwacha

On 23 January 2012, GRZ gave approval to BOZ’s recommendation to rebase the Zambian Kwacha. The change over date has been set for 1 January 2013.

 •The rebasing will involve dividing the existing currency by one thousand (1,000). To illustrate, the current K50,000 note will become K50 following the rebasing exercise.
••The BOZ have indicated that the key drivers for implementing the rebasement are as follows:
1. To facilitate easier business transactions: use of smaller units simplifies accounting and reduces the risk of errors arising from data input and time spent reviewing such financial data.
2. To increase confidence levels in the Zambian currency: People tend to have less confidence in currencies with numerous zeros.
3. To reduce the costs associated with adapting standard accounting packages: Most accounting packages are developed in countries where currencies have significantly few zero’s compared to Zambia. Accordingly, Zambian entities purchasing these accounting packages, are required to customize them by increasing the field size to accommodate multiple zeros, at a cost.
4. To encourage an efficient payment system: the adoption of a rebased currency will enable easier use of vending machines, car park meters and other related technologies. In addition it will avoid the need to carry large sums of money for transactions.
5. To facilitate the introduction of coins: the rebasing of the currency will enable the BOZ re-introduce the use of coins, which are significantly more durable compared to notes.

In 2012 the Zambian Government began discussing plans to re-base the Kwacha. The reason for this was to reduce accounting errors by eliminating three zeros from the currency.

There has been wide media coverage to sensitize the Zambian public on the implications of the new re-based Kwacha. This has created a need for an economic analysis of the new re-based Kwacha.

Key Points

Amounts converted from old to new currency will be rounded off to two decimal places. When the third decimal of an amount converted is equal to or higher than 5, the second decimal is raised by 1. If the third amount is less than 5, the second decimal remains the same. E.g. K38,255 becomes KR38.26 and K38,351 becomes KR38.35. The exception is Wages and salaries, pensions, retirement funds and other social benefits of workers, which should be rounded upwards.
The exchange of old notes over the counter will be limited to K25 million (K25,000 rebased currency) per individual transaction.

Anti- Dollarization

 The anti-dollarization policy eliminated artificial demand of the US dollar, which was created by certain individuals and firms who quoted their services in US dollars. This was a timely move to bring stability to the exchange rate which suffered severe volatility in the earlier part of this year. Let me elaborate, given the rebasing of the Kwacha there is an incentive for individuals and businesses to hold their money in US dollars to keep value. This is understandable, but given that US dollar is not legal tender it will still be changed back to Kwacha. The benefit here is at least artificial demand has been eliminated and market forces of supply and demand can dictate the exchange rate.

Money Supply to Interest rate Policy

Money supply is the amount of total money circulating in the economy. This refers to the summation of notes, bank deposits and coins. The economic abbreviation of this is called M3.The Bank of Zambia was initially using a money supply mechanism to control monetary policy. This proved rather counterproductive as the interest rates remained high at micro-financing institutions though it slightly lowered in Banks. Bank of Zambia now uses an interest rate policy with a rate that stands at 9%.

Now Given the Rebasing it is estimated that the Interest will have rise somewhat to about 10% to cushion upward inflationary pressures.Let me explain further, certain individuals (you may know some or be the one) prefer to keep their money under a mattress or in a ditch on some farm (no pun intended).This money will have to come into circulation in the next 6 months for which the old kwacha will still be legal tender.
BOZ has placed a K25mil (old kwacha) transaction limit to changing the old currency to the new one.This makes an incentive for people with too much money to change at once to use it to purchase goods and services.This will effectively increase money supply and in turn raise the Inflation rate.

Inflation

Zambia has recorded a significantly lower inflation rate in the recent past years which created a solid fundamental ground on which the rebasing of the Kwacha would be sustainably effective. There is however, a high probability that there will be short term upward inflationary pressures as both the new and old Kwacha circulate in the economy simultaneously. This will increase the money supply temporarily as the old Kwacha will still be legal tender for at least 6 months.

The re-basing of the Kwacha has one notable change to the currency which is a hedge against inflation, Coins. The introduction of Coins as legal tender back into the Zambian economy will help keep inflation low in the long run, effectively. It may take some time for society to come to terms with the new coins which many may perceive as an inconvenience, which indeed they are, but a necessary one as I will explain.

By virtue of their nature coins are rather cumbersome to move around with. This inconvenience is surprisingly a component of a hedge against inflation. The velocity of money is higher at the lower ends of currency strength, meaning money changes hands faster at lower notes e.g. K10, K2, K1. Given the introduction of Coins this velocity is reduced which in turn reduces the growth in money supply and effectively inflation in the long run. Once most people have collected enough coins they will usually go to the Bank and change them, the Bank will in turn give its customers coins back from deposits thereby maintaining a stable money supply.

The most effective hedge against inflation that coins provide is in the overall circulation of bank notes. Unlike Zambia’s previous currency regime, coins allow for limitation of the notes in circulation by accounting for a decent portion of the total money supply in the economy.

Last but not least is what many would call a disadvantage of coins, they easily get lost. Surprisingly though this is also a hedge against in inflation as it marginally diminishes the money supply, thereby keeping inflation low.

Round off Inflation

Amounts converted from old to new currency will be rounded off to two decimal places. When the third decimal of an amount converted is equal to or higher than 5, the second decimal is raised by 1. If the third amount is less than 5, the second decimal remains the same. E.g. K38,255 becomes KR38.26 and K38,351 becomes KR38.35. The exception is Wages and salaries, pensions, retirement funds and other social benefits of workers, which should be rounded upwards.
"Round off Inflation" is a term that I have coined myself to describe the slight inflation or general increase in prices due to rounding off from the old to the new currency.This could affect essential commodities and luxury goods.For example for Shop owners who have been given a Government mandate to quote both the old and new price this will not be a problem.However for deals done on the "street" this will be a big opportunity for sellers to slightly increase their prices without consumers noticing the difference.This will cause round off inflation.

Advantages of Rebasing	Disadvantages of Rebasing
Reducing Accounting Errors	Adjustment phase may be frustrating
More accurate estimation of Money supply	Short term inflationary pressures
Creates Global confidence in Kwacha
More Effective Monetary policy

It must be emphasized that the downside to re-basing the Kwacha is the inevitable upward inflationary pressure. Part of this will stem from the dual circulation of both the new and old Kwacha but this will be rectified once the old Kwacha is no longer legal tender. The other part of this inflationary pressure will arise from the food and commodity prices. This will be because some wholesalers and retailers will have an incentive to slightly over quote their prices during this transition phase. This could have us see a visibly higher food and commodity inflation rate unless the Zambian Government steps into to regulate this transition. It can be foreseen that the Consumer could suffer unless corrective action is taken to ensure this does not happen.

Exchange rate
The Kwacha has been trading at about K5200 to the US dollar with a lower level of K5000 and an upper level of K5400.Check the graph below

  

 The graph above was prepared by myself with data that was made available to me for the period.
With Rebasing coming to effect I estimate that the Dollar will gain against the Kwacha.This is because a short term incentive for investors and BIG players will exist to short the Kwacha.In other words they will sell their Old Kwacha and trade it into Dollars until they feel the exchange rate has stabilised.This will drive up the Kwacha to about K5.5 with an upper limit of K6 to the Dollar.
These are only estimations and I will not be held responsible for trades and transactions made on this information.
 

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