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FISCAL CLIFF AND ITS IMPACT

What is the fiscal cliff?
The fiscal cliff is the phrase thats become associated with the combination of $500 billion in spending cuts
and tax increases that are scheduled to automatically start at the start of 2013 in the United States.
Tax Increases:

The Bush-era income-tax rates, which have been extended once already under President Barack Obama,
will expire at the end of the year for all taxpayers.
Also ending is a payroll-tax holiday, which means a tax increase for workers of as much as two
percentage points.
In addition, some 26 million additional people face the alternative minimum tax, or AMT, which would
raise their taxes liability sharply unless Congress acts.

Spending Cuts:

Across-the-board cuts in domestic and, particularly, defense spending would be triggered, including a $55
billion, 9% cut in the defense budget next year and another $55 billion in cuts to domestic programs,
including a 2% cut to Medicare providers.

Whats the economic impact of going over the cliff?

If the said measures are taken, the Congressional Budget Office has projected the economy would
contract 1.3% in the first six months of 2013, with the economy stabilizing in the second half and
eventually achieving an annual growth rate of 0.5%. Joblessness would rise to 9.2% at the end of 2013 if
Congress didnt act.
But alternately, it has been argues that the budget cutting that would automatically take place will
eventually boost growth by putting the government on a firmer and more sustainable financial footing.
The counter argument is that going over the cliff would cause a) investor panic and b) consumer panic
and fundamentally derail whats already a weak economic recovery.
"The US fiscal cliff represents the single biggest near-term threat to a global economic recovery," the
Fitch ratings agency said recently.
The dramatic fiscal tightening implied by the fiscal cliff could tip the US and possibly the global economy
into recession. At the very least it would be likely to halve the rate of global growth in 2013.
The IMF has warned that even the uncertainty raised by the fiscal cliff has hit global investment and job
creation.
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What is the likely impact on India?

Reserve Bank of India cited World Bank research that predicted only a modest impact on India:
Economic growth in South Asia would fall by 0.2 percentage points while the current account deficit
would improve by 0.1 percentage points of gross domestic product. But the central bank seems worried
enough to add: a sharp fiscal contraction may have a deleterious impact on global growth.
Commodity prices will ease off and oil prices will stay significantly lower than in the recent past. In fact,
fear of the fiscal cliff has already drove down commodity prices, starting in October. This will mean that
Indias inflation rate may come down fast enough for the central bank to cut interest rates more quickly
than anticipated to stimulate growth. Lower crude oil prices could also ease some of the current
pressure on the balance of payments (BoP).
Trade: However, there could be potentially adverse impact on the Indian economy from reduced trade
and investment. Indias merchandise exports now account for nearly 16% of Gross Domestic Product,
while total exports account for approximately 24% of GDP. With Indias major trading partners in
trouble, exports are expected to take a hit.
Capital flows will also be affected as the global recession that may result, even if the fiscal cliff is
avoided, will lead investors to safe havens. That means rising demand for gold and dollar-denominated
assets and capital will move away from risky assets (both equity and currency) of emerging markets,
including India.
Equities: If we look at the correlation of returns of EM equities, they are positively correlated to global
equities. Hence any fall in global equity markets due to a fiscal cliff could cause a fall in all emerging stock
markets including India..
The fundamentals of the Indian economy are far weaker than they were at the end of 2008, which means
that the ability of policymakers to intervene effectively is less than before. One indication of this is the
level of foreign exchange reserves with the central bank relative to monthly imports. Such import cover
has nearly halved in the past four years, from 12 months to six months.
At an International Monetary Fund meeting in Nov 2012, FM P. Chidambaram said that the issues of
fiscal cliff and the lifting of the debt ceiling in the U.S. also need to be resolved. The need is to put in
place a medium-term fiscal plan while avoiding excessive fiscal correction in the short run. Should the
economic situation in the U.S. worsen, its impact on emerging market economies will be much
more severe than in the case of the situation in the euro area.

BITCOIN AND THE VIRTUAL CURRENCY

What is Bitcoin?
Bitcoin is a digital currency designed by Satoshi Nakamoto, a pseudonym, in January 2009. Bitcoin allows
users to send payments within a decentralized, peer-to-peer network, and is unique in that it does not
require a central clearing house or financial institution clearing transactions. Users must have an
internet connection and Bitcoin software to make payments to another public account/address.
Satoshi is the smallest unit of Bitcoin; 1 Bitcoin contains 100 million Satoshi. By design, the supply of
Bitcoins cannot exceed 21 million Bitcoins (2,100 trillion Satoshi). The total amount of Bitcoin in
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circulation will increase predictably, based on its underlying code, until reaching the cap in 2140. The
current supply is 12 million Bitcoins or 57% of the eventual total.
Exchanges allow the conversion between real-world fiat currencies and Bitcoin. The participation in
exchanges requires consumers to take on credit risk by transferring Bitcoins from a personal account to
a third-partys account, which is similar to entrusting real-life cash to depository institutions.
Money/currencies are generally thought to have three distinct roles: as a unit of account, medium of
exchange, and store of value. To the extent that Bitcoin offers users many benefits and efficiencies as a
medium of exchange, this means it possesses some fundamental value that may increase over time as it
gains wider use. However, as a unit of account and store of a value, it has considerable shortcomings
which we believe will ultimately hinder it from ascending to international currency status.
Advantages

As a medium of exchange, Bitcoin is attractive as it offers low transaction costs. It does so by

eliminating the need for a central clearing house or financial institution to act as a third party to
financial transactions. Using a decentralized, peer-to-peer network, transactions are verified
independently by network users (i.e., miners) who are rewarded for their work with newly
minted Bitcoins. In addition, it provides an alternative payment method to users who may not
have access to credit or debit cards, or, other forms of electronic payments.
Bitcoin offers an attractive alternative to cash in terms of security, transparency of
transactions, and counterfeiting. Bitcoins reside in an encrypted format on their owners
computer, making it difficult, though not impossible, for hackers to access and steal
electronically. Physical Bitcoin theft is also possible, but it seems no easier to carry out on a
large scale than for cash. In addition, given their digital format, Bitcoins are much easier to carry
than cash, which could be a particular benefit in economies where large scale transactions are
conducted in cash. Bitcoin also offers the benefit of being easier to track than cash given that
each coin contains an electronic record of each transaction that coin has gone through since it
was created. Not only is each transaction recorded on each Bitcoin, but all transactions are
recorded in an online public ledger, offering a level of transparency that is not available with
cash. Such transparency offers regulators means to track potentially illicit activity. Lastly, the
digital format with automatic verification also makes it impossible to counterfeit.
There is a finite supply of Bitcoins. The design of Bitcoin seeks to mimic the supply of gold in
that the system will create a finite supply of the currency, which its proponents see as a way to
protect its value from profligate governments or central banks.
Bitcoins relative anonymity is advantageous to citizens of crisis countries. It has been reported
that some believe Bitcoin can be used by those seeking to avoid evade high taxes, capital
controls, and confiscation.
Winner Takes All market ensures that increasing acceptance and popularity of Bitcoin
increases likelihood of success. As Bitcoin becomes more popular, competitors will face higher
barriers to entry, making it less likely they will be successful in supplanting Bitcoins market
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share. Several other digital currencies with similar features to Bitcoin have been introduced with
limited success. However, we believe the structure of the digital currency market is one of
winner takes all whereby as Bitcoin becomes more popular and is easy to use, consumers will
have much less incentive to experiment with an alternative currency with similar features.
Disadvantages

Bitcoins role as a store of value is seriously compromised by its elevated price volatility. The
dollar price of Bitcoin has moved 10% on a daily basis since its inception including days when the
price moved 190% from that days highs to lows. It can be argued that these swings reflect shifts
in estimates about the fundamental value of Bitcoin as more people become aware of it, or, use
it. For example, the Bitcoins dollar price increased 50% to $785 following a Senate Hearing on
November 18th after which a couple regulators took a more positive stance towards the use of
Bitcoin as another form of payment..
High volatility also undermines Bitcoins role as a medium of exchange as large retailers are
much less likely to accept it as a form of payment with prices so volatile. Stores accepting it now
are effectively internalizing the costs of this volatility and not passing it onto consumers, but we
would not expect such likely unprofitable practices to last.
Regulators could try to impose controls that would increase the transaction costs for using
Bitcoin despite its efficiency and the transparency relative to cash. Firstly, the government is
unlikely to want to promote a new currency that could be viewed as one that could help
facilitate black market activities, or, tax evasion. As a result, regulators are currently thinking
about how Bitcoin will fit into the broader payment and tax system, and what makes sense in
terms of regulation. The bottom line is any new regulation will raise Bitcoins transaction costs,
offsetting and/or eliminating one its main benefits. In addition, the ease with which Bitcoin can
be used internationally increases the need for international regulatory coordination. While
coordination raises the risk of an uneven regulatory landscape for Bitcoin, stringent regulation
by a few large countries/regions would significantly increase the costs of using Bitcoin, thus
limiting its usefulness as a medium of exchange.
The quality of Bitcoin exchange security, where consumers exchange dollars for Bitcoins (and
vice versa) is suspect. For Bitcoin users not able to mine their own Bitcoins, their only
alternative is to exchange their local currency for Bitcoins at an exchange. Aside from the FX
risks these customers take, a large number of Bitcoin exchanges have been hacked with large
amounts of customer Bitcoins stolen. In one reported case Bitcoinica, an exchange, lost 18,547
Bitcoins from its deposits after its systems were hacked. More recently, a European exchange
called BIPS lost 1,295 Bitcoins (or $990,000) following a security breach.4 As the vast majority of
potential Bitcoin users cannot mine their own Bitcoins, exchanges will be critical for linking local
currencies with Bitcoin. Without deposit (FDIC) or investment (SIPC) protection, Bitcoin
users/investors have little recourse to retrieve stolen funds so in addition to investment risk
they are also carrying credit risk.

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A 50 minute wait before payment receipt confirmation is received will prohibit wider use. Fifty
minutes is the time needed for enough additional blocks to be added to the chain to protect
against double spending. This is less of an issue for two parties that know each other because
they trust the other will not double spend, but when dealing with an anonymous counterparty
this creates a high level of unhedgeable risk. As a result, in the absence of a central counterparty
verifying transaction/clearing Bitcoin is likely to remain illiquid, and will prevent it from
becoming a significant international currency.
Bitcoins use as an international currency will likely be hindered by the fact that it is not a legal
tender. Unlike fiat money, nobody is under any obligation to accept Bitcoins as a mean of
payment. Therefore, its value is only as good as the perception of its worth by its users. Without
a backstop buyer, Bitcoin could disappear very quickly should perceptions of its usefulness
decline. Repeated bouts of volatility and further cyber-attacks which put consumer and investor
money in jeopardy will certainly inform this perception even as Bitcoin does offer many
benefits.

RBIs view on Bitcoin Notice on 24 December 2013

The creation, trading or usage of VCs including Bitcoins, as a medium for payment are not authorised by
any central bank or monetary authority. No regulatory approvals, registration or authorisation is stated
to have been obtained by the entities concerned for carrying on such activities. As such, they may pose
several risks to their users, including the following:

VCs being in digital form are stored in digital/electronic media that are called electronic wallets.
Therefore, they are prone to losses arising out of hacking, loss of password, compromise of
access credentials, malware attack etc. Since they are not created by or traded through any
authorised central registry or agency, the loss of the e-wallet could result in the permanent loss
of the VCs held in them.

Payments by VCs, such as Bitcoins, take place on a peer-to-peer basis without an authorised
central agency which regulates such payments. As such, there is no established framework for
recourse to customer problems / disputes / charge backs etc.

There is no underlying or backing of any asset for VCs. As such, their value seems to be a matter
of speculation. Huge volatility in the value of VCs has been noticed in the recent past. Thus, the
users are exposed to potential losses on account of such volatility in value.

It is reported that VCs, such as Bitcoins, are being traded on exchange platforms set up in
various jurisdictions whose legal status is also unclear. Hence, the traders of VCs on such
platforms are exposed to legal as well as financial risks.

There have been several media reports of the usage of VCs, including Bitcoins, for illicit and
illegal activities in several jurisdictions. The absence of information of counterparties in such

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peer-to-peer anonymous/ pseudonymous systems could subject the users to unintentional

breaches of anti-money laundering and combating the financing of terrorism (AML/CFT) laws.
The Reserve Bank has also stated that it is presently examining the issues associated with the usage,
holding and trading of VCs under the extant legal and regulatory framework of the country, including
Foreign Exchange and Payment Systems laws and regulations.

JUDICIAL ACTIVISM

Judicial activism is a philosophy of judicial decision-making whereby judges allow their personal views
about public policy, among other factors, to guide their decisions. It can be narrowly defined as one or
more of three possible actions: overturning laws as unconstitutional, overturning judicial precedent,
and ruling against a preferred interpretation of the constitution. (For instance widening the right to life
to include right to free legal aid, right to privacy, right to healthy environment etc)
The chief instrument through which judicial activism has flourished in India is Public Interest
Litigation (PIL). In normal course of law, an individual can approach the courts only if he/she has been
personally aggrieved. But in the case of PIL, the case is filed not by the aggrieved persons but by others
on their behalf. Many public spirited citizens and voluntary organisations (eg. Center for PIL - CPIL
represented by Prashant Bhushan and Shanti Bhushan) sought judicial intervention for protection of
existing rights, betterment of life conditions of the poor, environment etc.
Detractors of judicial activism charge that it usurps the power of the elected branches of government or
appointed agencies, damaging the rule of law and democracy. They argue that an unelected or elected
judicial branch has no legitimate grounds to overrule policy choices of duly elected or appointed
representatives, in the absence of a real conflict with the constitution. In some instances, government
regulation by appointed officers in government agencies are overturned by elected judges.
Defenders of judicial prerogatives say that many cases of so called "judicial activism" merely exemplify
judicial review, and that courts must uphold existing laws and strike down any statute that violates a
superseding law.
Some recent instances of Judicial Activism can be
o Distribution of food under Public Distribution System to poor free-of-charge instead of letting it
rot in godowns
o The SC ordered the Delhi Government not to demolish night shelters in Delhi for the homeless
in the midst of winters as it is against the right to life. The court had taken suo moto cognizance
from news paper reports
o The brawl on the appointment of CVC PC Thomas
In India, even as Prime Minister Manmohan Singh frowned upon judicial overreach, Supreme Court
former chief justice K G Balakrishnan had welcomed its outcome as a desirable tension between the
judicial and the legislative and executive branches. The source of the tension, however, lies in the vacuum
created by the lapses of both the legislative and executive branches.
The judiciary is giving the impression of stepping in to fill the vacuum by often forcing the executive to
take action (against the privileged sons of politicians, as in the Jessica Lal case) or compelling
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Parliament to enact laws (for example, to curb sexual harassment at workplaces). This has encouraged
the Indian urban middle class to repose its faith in the new-found concept of judicial activism, and to
wish that the judiciary replaces the corrupt legislature and bureaucracy as the benevolent authority. But
there is a catch in this wishful belief. Barring a few recent cases of judicial intervention, which have had
some positive effect on governance, the Indian judiciary on the whole has not displayed any spontaneous
will to act on behalf of the common people.
Even though this phenomenon has been welcomed by many, it has many negatives
o It has overburdened the courts leading to delayed justice for normal cases
o It has blurred the line of distinction between the legislature on the one hand and the judiciary
on the other.
o It has made the balance among the three organs of government very delicate. Democratic
government is based on each organ of government respecting the powers and jurisdiction of the
others. Judicial activism may be creating strains on this democratic principle.
Even though Judicial review is essential to maintain the fundamental rights of citizens, the
constitution clearly defines the legislature as the law making body. Any aberration in either of these will
be against the spirit of the constitution. The two parts should try to work together without stepping into
the jurisdiction of each other for the benefit of the nations common man.

IMPACT OF RUPEE DEPRECIATION

There are three important effects:
1. Some people had borrowed in dollars, and left it unhedged since they were speculating that the INR
would appreciate. They get hurt in the process. But this is fine as in a market economy, many people
place bets about future fluctuations of financial prices, and half the time the speculator loses money. (If
the rupee had not depreciated sharply, these speculators would have been gained).
2. When the rupee depreciates, imports become costlier and India's exports become more competitive. So
exports (X) gradually start going up and imports (M) gradually start going down. The net gain in X-M is
increased demand in the local economy. Hence, INR depreciation is good for aggregate demand
(and conversely INR appreciation pulls back demand). However, we have to bear in mind that these
effects are small and take place with long lags.
3. Many things in India are tradeable. It is important to focus on the things that are tradeable and not just
on the things that are imported. As an example, there are many transactions between a domestic
producer of steel and a domestic buyer of steel. The buyer and seller are both in India. But the price at
which they transact is the world price of steel (which is quoted in dollars) multiplied by the INR/USD
exchange rate. This is called `import parity pricing'. Through this, the domestic prices of tradeables goes
up when the rupee depreciates.

OPTIONS BEFORE RBI AGAINST A FALLING RUPEE

Problem: The falling rupee is worrying policymakers, not least because a steady drop in the countrys foreign
exchange reserves and a worsening current account deficit make it vulnerable in a tough global environment.
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Why the problem arose:

1. The Euro zone crisis has triggered risk-aversion among investors and slowed capital inflows
2. pressure on the economy and the currency from a slowing economy, a widening trade deficit amid high
contractual repayment obligations.
3. Dollar liquidity crunch globally in the wake of downgrades by ratings agencies of European countries and
banks.
Measures Taken: The government has already taken measures to boost capital inflows. These include
raising the foreign institutional investment limit in government securities and corporate debt, raising
borrowing limits for banks and companies and asking companies to quickly bring back home funds raised
overseas.
Measures which are being considered:
1.
2.
3.
4.
5.
6.

Imposing restrictions on overseas investments by local companies

Curbing pre-payments of foreign loans
Enforcement or revision of prudential limits on currency positions
Strong communication to cool markets
Steps to curb speculation
Ease overseas borrowings for corporates and banks

Long term measures

1. Assess preparedness to deal with any financial crisis
2. Freeze the contours of the proposed Crisis Management Group with more clarity on its role and powers

INFLATIONS IMPACT ON ECONOMY

Inflation has an adverse impact on the real economy. The following points are worth noting
1. High and persistent inflation imposes significant socio-economic costs. Given that the burden of
inflation is disproportionately large on the poor, high inflation by itself can lead to distributional
inequality. Therefore, for a welfare-oriented public policy, low inflation becomes a critical element for
ensuring balanced progress.
2. High inflation distorts economic incentives by diverting resources away from productive investment to
speculative activities.
3. Inflation reduces households saving as they try to maintain the real value of their consumption.
Consequent fall in overall investment in the economy reduces its potential growth.
4. As inflation rises and turns volatile, it raises the inflation risk premia in financial transactions. Hence,
nominal interest rates tend to be higher than they would have been under low and stable inflation.
5. If domestic inflation remains persistently higher than those of the trading partners, it affects external
competitiveness through appreciation of the real exchange rate.
6. As inflation rises beyond a threshold, it has an adverse impact on overall growth.

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7. RBI's current assessment suggests that the threshold level of inflation for India is in the range of 4-6%. If
inflation persists beyond this level, it could lower economic growth over the medium-term.
Hence there is a need for a monetary policy response by the Central Bank to control inflation

'Essays for IIM' brings to you a holistic e-book on Current Essays/Notes with
topics ranging from Political, Economic to Business Affairs. For ordering the
complete package (Rs. 750/-) call us on 099532 45572. Visit
www.essaysforIIM.com for more information

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