Emerging Markets Decoupling Theory - A Myth


Dr. Saima Rizvi
Lecturer (Finance)
Amity Business School, Amity University
Lucknow Campus

Like 'globalization' which has hogged the limelight in the recent past, decoupling theory has nowadays caught the fancies of the policymakers and investors across the globe. The supporters of the decoupling theory have been advocating the idea that the Asian economies can chug along even in case of a recession in the US economy which is indeed a local problem because it is an outcome of the widespread default in the sub prime mortgage market. The crux of their argument has been that the US and the rest of the world have now decoupled and so the economic growth path of the US and the rest of the world can diverge sharply. The theory is indeed modern, catchy and invigorating and has thus unsurprisingly created much hype. But now with the US slowdown spreading across the globe coupled with a declining dollar, advocates of the decoupling theory are debunking their claims. Even a couple of months ago, the Indian equity analysts were also claiming that India has decoupled from world markets. Now with the specter of US recession gradually gaining strength, the decoupling theory appears to be fast losing ground. The new theory is that in this utterly globalized world no market can remain completely insulated from global shocks.

The US economy is on the verge of a recession as a result of the subprime crisis which engulfed the country in 2007. Believers in the "decoupling" theory -- that other regions can prosper during a U.S. downturn -- are facing off against those who say the ups and downs of the world's largest economy must still be followed by similar movements around the globe. Decoupling theorists had drawn strength from the fact that until last summer the gradual slowdown in the United States had had little effect on growth in most other countries and that trade linkages with the United States had become less important. An enormous shift has occurred in the global Economy away from the developed world to emerging markets , said Antoine van Agtmael, who is chairman of Emerging Markets Management LLC in Arlington, Virginia, and who is credited with coining the term "Emerging Markets." Emerging Markets now account for about one-quarter of global gross domestic product, about the same as the U.S. contribution, he noted. The idea of decoupling has come to limelight over the past year. Accordingly, even if the US asset markets collapse, markets in the rest of the world could remain bullish. In other words, equity markets in the rest of the world could remain insulated from external shocks and can stay aloft even without correlating itself with other markets.

With each passing day this decoupling theory is proving to be a myth. The notion that the U.S. is no longer the driver of world economic growth is in vogue on Wall Street, yet the idea that Europe and Asia have "decoupled" from the American economic engine may be more an investor's hope than a sound investment theory. Investors would like to believe that a portfolio which is diversified across both developed and emerging markets would continue to perform well, even during a U.S. recession, because Chinese economic growth is creating insatiable demand for raw materials in particular.

In the globalized world no country can remain isolated and hence developments taking place in one part of the world have their repercussions on the other part of the world and capital markets are no exception. The Indian capital market is also showing bearish trends with banking stocks moving down in recent times.

The Asian economies though enjoying good fundamentals are also witnessing slowdown in the economy as an aftermath of the slowdown in the US economy. In the Budget 2008-09 steps have been taken by the Indian government such as excise duty cuts to boost up the domestic demand and bring the economy back on the growth path.

US contributes fifth of the global demand and any slowdown here is bound to have repercussions globally. A depreciating dollar puts the export led growth of Asian economies, including India and China at risk. Margins have already been affected in these two economies and there has been clamor for support for the dollar, especially in India. But supporting the dollar entails sterilization of reserves impacting the domestic money supply and therefore asset and consumer prices. Also the countries that have been following export led growth strategies have had to support the dollar. This tied their monetary policies to the easy monetary policy of US.

The strong lobby for decoupling theory started taking a soft stand when New York based Morgan Stanley's Chief , Stephen Roach commented that "Decoupling is a good story but is not going to work". Goldman Sach's Economist Peter Berezin coined a new term and opined that the year '2008 will be the year of recoupling".  Analysts across the globe are not anticipating decoupling now. It is accepted that if growth in the US declines, Japan, Europe and China would be hit hard. If China is impacted badly, it will tumble emerging Asian markets in Korea, Taiwan, the Philippines and Indonesia. India would also be marginally affected.

Initially the impact of the subprime crises was on the US directly but what we are observing now is a more insidious paralysis of credit conditions moving across different  markets and thereby proving the decoupling theory wrong.

It is consequently surprising that recent months have seen the emergence of this new hypothesis. Asia is seen as the engine of growth that could drive the global economy out of the recession induced by the sub prime crisis in the US. The argument runs roughly as follows. As Arthur Lewis pointed out in his Nobel Prize lecture three decades ago, economic growth in developing countries has historically been dependent on economic prospects in OECD countries that account for the major share of global GDP. In 2006, the US, UK, Japan, France, Germany, Italy and Spain still accounted for 58% of global GDP at market prices, with US alone accounting for 27%. Their share at purchasing power was 41%.

Over the last few decades, however developing countries, in particular those in Asia, have been growing much faster than OECD countries. Thus the combined share of China and India in global GDP increased from 5.7% in 1975-75 to 14% in 2005 at PPP. The share of the four largest developing (BRIC) economies was 20%. The BRIC nations are the least dependent on the US, with the exports to America accounting for just 8% of China's GDP, 4% of India's, 3% of Brazil's and 1% of Russia's. Over 95% of China's growth of 11.2% in the current year came from domestic demand. The argument is sometimes more nuanced. A recent IMF paper argues, for instance, that while there is now a closer coupling between so called 'developing economies' and OECD countries. There are other versions of the same basic argument. John Authers described, in the Financial Times of Feb 29, 2008, decoupling as "the notion that demand for raw materials in the developing world will allow emerging markets to grow even if there is a US recession." The 'decoupling' sentiment is certainly implicit in the current boom in world commodity prices that are scaling historic highs despite the fears of recession in OECD countries, particularly America.

The decoupling hypothesis notwithstanding, the US share in Chinese exports has remained constant at just over 20% over this period, even though half its exports are now developing countries. Indeed, Asia runs a huge cumulative current account surplus of over $300bn with the rest of the world, which is at the core of a fundamental global imbalance that keeps the global financial and real economies closely coupled. Because of this continuing external dependence it is difficult to see how Asia would not be significantly affected by a US recession unless China and other developing countries are able to expand domestic demand substantially. This would mean abandoning their current mercantilist mindset, letting their currencies appreciate, thereby increasing the purchasing power of their people. India appears to be less vulnerable to the global downturn because it is much more dependent on domestic demand for growth, being unique amongst Asian countries in continuing to run a current account deficit. Even so, India's engine of growth is its booming service sector that is highly coupled with global, and especially US markets.

The domestic demand by far the biggest source of GDP growth in China and India. However, the trend over the last 20 years actually indicates greater coupling. China's consumption has declined from two thirds of the GDP in 1986 to just over half in 2006, and India's from 85% to three fourths. The combined share of Chinese and Indian GDP in 2005 was only about 8% at market exchange rates, and the entire BRIC share was just over 10%.

Decoupling skeptics are on even stronger ground when they draw attention to growing global coupling in capital flows and inflation. Between two thirds to three fourths of export revenues, remittances and foreign investment, and almost all cross border syndicated loans in developing countries continue to be along the North South axis. US monetary policy is exercising stronger, indeed determining, pull on volatile cross border capital flows. The huge hard currency reserves of developing countries, the flip side of the global imbalance, are also deepening financial integration which may well be the ultimate root of current storm in credit markets. Stock markets, certainly, are far from convinced that some countries can continue to swim robustly even as others find it difficult to swim. On balance, the decoupling hypothesis that growth in developing countries is increasingly decoupling from OECD countries does not appear to be very compelling and hence stands nullified in the present scenario.


* Sanjay, D. and Barathi Y.B. (March 2008) "Debunked for now" Chartered Financial Analyst, Vol. 14, No. 3, pp. 17-21.
* Sheel, A. (April 2008) "Decoupled Globalisation?" The Economic Times, p.10.
* Venu, M.K. (March 2008) "The Decoupling formula" The Economic Times, p.10.


* www.iupindia.org
* www.theeconomictimes.com

Dr. Saima Rizvi
Lecturer (Finance)
Amity Business School, Amity University
Lucknow Campus

Source: E-mail April 22, 2008


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