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Many investors were shocked when the US government announced a partial government shutdown at midnight on 30 September, sending home non-essential government employees. While essential services necessary to protect life and property are continuing, all other government services have come to a halt until further notice. How can this happen in the world’s biggest economy, and what are the economic and market implications both globally and locally?

It is important to understand how it happened. The US fiscal year ends on 30 September. Before 1 October, Congress and the President needed to pass a full-year budget or an interim funding measure to provide funding for government programmes. As Democrats and Republicans could not come to an agreement, there is no official budget in place and hence the partial shutdown. Republicans could not agree to the budget given their reservations on so-called Obamacare and medical device tax.

How long it would take to unlock an agreement in Congress this time around is hard to predict. In prior shutdowns, the disruption to government activities quickly affected political sentiment and caused lawmakers to reach an agreement within a few days. An adverse market reaction could add to that pressure.

A shutdown has modest macro-economic effects. The reason the effects is not greater, despite the size of the federal government, is that only discretionary spending is affected, which represents about one-third of total federal spending. In the areas that are not exempt, employee salaries are cancelled during the shutdown, but most other services and procurement of goods are made up shortly after the shutdown ends. Estimates suggest that 0.02% of GDP is threatened every day the government is shut down. This is likely to be less the shorter the closure, and more the longer it continues.

Financial markets took a dim view of the events as global equity markets came under immediate pressure. However, the initial response was certainly not severe and US equities recovered most of the losses on the following trading day on the back of stronger-than-expected economic data releases. As was the case during previous shutdowns, the investment uncertainty and newspaper headlines resulting from the event are likely to increase volatility in risky assets.

The partial government shutdown has, however, placed US fiscal matters under the microscope. US authorities need to raise the debt limit to enable the US treasury to meet all its obligations after 17 October. It is likely that the government shutdown will facilitate negotiations on the extension of the debt ceiling, which are due to take place in about two weeks' time. According to the US treasury, the ceiling is likely to be reached on 17 October. Although the shutdown will reduce government expenses, the treasury is likely to have run out of cash by the end of the month at the latest. Estimates suggest that the debt limit needs to be raised by $1.1 trillion to fund the government through September 2014.

The treasury has yet to face a situation in which it is unable to pay its obligations as a result of reaching its debt limit. Since 1992, federal debt outstanding has reached the statutory limit seven times (in 1995, 2002, 2003, 2004, 2006, 2011 and early 2013), causing the treasury to adopt extraordinary measures for a few months until the debt limit was raised.

These “extraordinary measures” need to be debated. The government shutdown can also lead market participants to assign a higher probability to a scenario in which lawmakers remain entrenched in their positions and do not reach an agreement on the debt limit. This is likely to lead to robust debate.

Financial markets are likely to mirror the sentiment as the debate proceeds and the US approaches the deadline. Again, volatility is to be expected and will be unnerving. Despite the view that the US fiscal situation is dysfunctional, the budget and debt negotiation are likely to keep spending in check and curb debt growth, and should reduce the risk of a jump in borrowing costs. Investors should also take comfort from the fact that the US economy is stronger than it was in mid-2011 and investors are less prone to panic, having become accustomed to last-minute deals since then to avoid fiscal shocks.

Sanlam Life Insurance is a licensed financial service provider.
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