U.S. lawmakers are edging toward a stopgap pact that will keep the American economy from toppling over the so-called fiscal cliff, but a sweeping deal that would deliver long-term certainty to investors – and to the Canadian economy – remains far out of reach.
The prospective deal that emerged Monday evening would extend tax cuts for most Americans instead of allowing the reductions to expire Jan. 1. It also renews benefits, such as child and tuition tax credits, that President Barack Obama said were critical to the middle class while raising the tax rate on the wealthy. Republicans and Democrats remained at odds over how to handle $110-billion (U.S.) in spending cuts.
But the deal leaves the U.S. economy, and Canada’s, in a state of uncertainty. A more comprehensive pact – what the President called a “grand bargain,” addressing the long-term deficit crunch with a mix of tax hikes and spending cuts totalling more than $500-billion – proved too ambitious by Monday’s deadline, Mr. Obama said. “We’re going to solve this problem instead in several steps,” he said.
Such a comprehensive pact is, however, what markets need to avoid prolonged uncertainty amid an “underperforming” U.S. economy, said Paul Ferley, assistant chief economist of economic research at Royal Bank of Canada. Political gridlock in the U.S. Congress is helping drive the uncertainty.
“There doesn’t seem to be the willingness to compromise, to come to some sort of comprehensive agreement that more fundamentally addresses the problem. In this case, the fiscal imbalance. In that regard, the uncertainty that we’re starting to see evidence of, in terms of business investment, consumer spending, consumer confidence, may continue to linger as we move into 2013,” he said, adding that he suspects a “demonstration of bipartisanship” would buoy markets.
The standoff had long been brewing. It was Federal Reserve Board chairman Ben Bernanke who coined the “fiscal cliff” term 10 months ago, referring to a series of tax cuts set to expire Jan. 1, but a deal only began to emerge the night before, the latest example of dysfunction in Washington.
Much of Canada’s economic fate hangs in the balance, heavily dependent on American fortunes while lawmakers there try to balance short-term prudence with a long-term overhaul of a fragile economy.
“We’re kind of mixed in this temporary versus medium-term implications,” said Camilla Sutton, chief foreign exchange strategist at Bank of Nova Scotia, adding: “The reality is, without a final plan in place, it does create uncertainty on the business investment front, and that’s likely negative for the economy over all and somewhat negative for Canada on the back of that.”
Any downturn to the U.S. economy would affect Canada by cutting into demand for exports and by depressing commodity prices, which tends to also drag down the value of the Canadian dollar. “It’s just a weaker economic environment that the Canadian economy will be exporting to, and, as a result, it will have a weakening impact on the Canadian economy,” RBC’s Mr. Ferley said.
Canadian businesses and investors face a host of other changes from the U.S. budget showdown, including discussions of a higher tax rate on capital gains and dividends. The former would affect, for instance, any Canadian who sells or rents out property in the U.S., while the latter could scare off American investors from dividend-paying stocks or trusts, including those of Canadian companies, and devalue them. “The dividend plays will not be as exciting,’ said Gary Gartner, a New York-based partner at Kaye Scholer LLP who specializes in advising Canadian clients on American tax law.
The so-called cliff wasn’t a drop-dead deadline – economists say the term is a misnomer – in that any deal could be struck in the coming days and applied retroactively. Congress isn’t expected to vote until at least Tuesday. Investors weren’t in a panic, as markets were up slightly in trading Monday.
But Mr. Obama acknowledged negotiations are far from over, saying Americans are “going to have to think about how we put our economy on a long-term trajectory of growth.” That will include cuts and tax hikes, he said. “If we’re going to be serious about debt reduction and deficit reduction, it’s going to have to be a matter of shared sacrifice.”
While any deal Monday avoids the one-off shock that could trigger another recession, some fear it kicks the can down the road. “I think [Monday’s deferral] is not good news for Canada, because it just shows the Americans apparently think they have time,” said Walid Hejazi, an associate professor of international business at the University of Toronto’s Rotman School of Management. He believes tax hikes are inevitable, even if politically controversial.
“Until they come up with sort of a grand bargain, or sort of a fundamental change in raising taxes and cutting government spending, they are heading towards a real cliff. And I think this was just a warning sign.”