Micro-decoupling factors in a macro-coupling world

During early part of the recent financial crisis, decoupling concept started popping out in financial markets, that certain part of the world is not dependent on the rest of the world. But as crisis deepened, people started realising that in the present globalised world, it’s very difficult say that we are no longer dependent on others!

But there are certain factors, which are very micro, country specifics and are decoupled in macro-coupling economic world. To begin with end, I am still saying global world is a coupled one and no country or state can say that they are fully immune from the rest of the world. Nobody can say that, they are growing only because of domestic reasons.

But below mentioned micro economic factors, which are country specific, are giving signals that they are decoupled in nature in short to medium term.

Inflation

As all of us know inflation, change in the price levels of essential goods and services in a country, plays important role in the country’s economic policy making. I am not such a big fan of Milton Friedman’s proposal of inflation: Inflation is always and everywhere a monetary phenomenon.

I think inflation can also be because of fiscal expansion, like government spending more but without actually increasing output of the country, leading to bigger amount of money chasing same goods and services, which in turn creating demand-supply mismatch in an economy. Also there can be various other causes like, monetary policy cycle, demographics of the country, savings and expenditure pattern and currency fluctuation.

Keeping aside these causes, Inflation in countries like India, Indonesia and Venezuela is beyond central bankers’ comfort zones whereas in certain parts like Japan, Euro-zone and U.S. it is much below their central bankers’ targeted levels. These developed countries' central bankers are trying pump up the inflation or trying to avoid the deflation whereas developing countries central bankers are trying to minimise the inflation and inflation expectations. Reasons for both the cases vary from country to country, but in above mentioned each part, central bankers are struggling to anchor the inflation in different directions! 

Interest rates

Central bankers of each country (or zone) will be having different mandate/s like growth and/or inflation or only price (inflation) stability or currency stability. Depending on these mandates central bankers decide their course of action in deciding the interest rates and also cycle (upward or downward trend).

Now without getting into each central banker’s mandate, it is easy to say from currently available picture that each country’s interest rate is decoupled from rest of the world. For example India, Brazil, Indonesia are following contractionary monetary policy whereas U.S., Euro-zone, Japan are following ultra-expansionary monetary policy because of the issues these countries (zones) facing are different for different parts of the world.

Current account

In layman terminology, current account is nothing but difference between imports and exports. Depending on the difference between exports and imports, countries will be bifurcated as current account surplus and deficit countries. I believe global trade is a zero-sum as ones loss is others gain, so always there will be current account surplus and deficit countries as long as trade is global and liberal.

Countries like Germany, China and Saudi Arabia are current account surplus ones whereas U.S.,  India and peripheral countries of Euro-zone likes of Greece, Portugal and Spain are current account deficit ones.

Reasons may vary from efficient productivity, economies of scale, natural resources and others but countries are clearly decoupled in this context way above margin!

Equity markets

I would like to cast equity markets in a coupled-macroeconomic section as free capital (hot money) flow in a globalised world is not a country specific phenomenon. Easy money strategy followed by developed world like QE (1, 2, 3 and operation twist) of U.S., low interest rates and LTROs from Euro-zone, Abenomics in Japan is not only pumping their domestic equity markets to new (or regaining historical) levels, but also other countries’ equity markets are also trading at record levels.

Dow Jones and S&P 500 (@highest levels), NASDAQ (@13 year high) of U.S. and Dax of Germany are trading at historical levels. Japan’s Nikkei 225 is at almost 6 years high, India’s Nifty and Sensex are trading either highest level or around historical high levels.

Emerging economies can decouple from the US

The much-debated decoupling theory had propagated that emerging economies, in particular the BRIC nations, had grown to the point that they were no longer reliant on the US for their future growth. Furthermore, in the event of a slowdown or even a recession in the US, their growth would largely remain insulated or, in other words, they would have decoupled from the US.

The theory was, however, dealt a severe blow by the credit market crisis in the US. The housing slump and the ensuing credit crisis, believed to be a domestic phenomenon, sent shock waves, tumbling capital markets across the world. The bottom-line: Problems in US markets are felt instantly elsewhere. It is true, when the Dow rises, so do all Asian markets and, conversely, every time the Dow falls, so does all of Asia’s markets.

Let’s elucidate. The housing crisis, which was previously perceived to be a domestic predicament, was actually not so because of its manifestation in the financial markets. The sub-prime securities issued by Wall Street were traded by financial institutions across the world. So when defaults started escalating in the US, these financial institutions were forced to write-off losses. Tribulations in the US real economy had flown into its financial markets and then quickly engulfed markets the world over.

Risk-averse US investors, attempting to shore up their balance-sheets, withdrew their investments from the emerging economies causing their rapid meltdown. The ability of capital to move seamlessly across borders had ensured that financial linkages, that is, the capital and money markets, were much stronger than previously anticipated. Critics of the decoupling theory quickly pounced on this opportunity, hailing its demise.

This scenario poses certain interesting questions: First, do the US financial markets dictate real growth of emerging economies the world over? Second, if real growth in the US slumps after peace is restored in the financial markets, will emerging economies sustain their growth rates? Clearly, a distinction has to be made between the real economy and financial markets.

With the ability of capital to move seamlessly across borders, the decoupling theory falls flat on its face when applied to the financial markets. However, in the context of the real economy, a strong argument can be made for it. The three scenarios examined below, operating in tandem, are pre-requisites to the success of the theory.

Policy decoupling

While the US Fed has been actively slashing its benchmark rate to stem the credit crisis and, thereby, deviating from its primary objective of inflation control, central banks, the world over, have for the first time chosen not to follow suit. Central banks from Beijing to Budapest have been raising key rates to combat the inflation demon. Clearly, domestic considerations are over-shadowing the erstwhile dominance of the US monetary policy on the world. In addition, most emerging economies, with the exception of India, now boast of a current account surplus which, coupled with sizeable foreign exchange reserves, leaves plenty of room for a fiscal stimulus if the need arises.

Thus, for the first time, emerging economies can fully utilise their monetary and fiscal policy to cushion their economies which, in turn, diminishes the probability of their growth being determined by US policy. It is, thus, safe to assume that emerging markets will continue to grow respectably, particularly those with high forex reserves

Export profile

With the US experiencing a slowdown, exports to that country have naturally stumbled. But, surprisingly, those to other emerging economies have only surged. China’s exports to Brazil, India and Russia are up by more than 60 per cent and those to oil exporters by nearly 45 per cent. Roughly half of Chinese exports are directed to other emerging economies.

Four of the biggest emerging economies, which accounted for two-fifths of global GDP growth last year, are least dependent on the US. Exports to the US account for just 8 per cent of China’s GDP, 4 per cent of India’s, 3 per cent of Brazil’s and 1 per cent of Russia’s.

Furthermore, emerging markets as a group now export more to China than to the US, implying that while a US slowdown may affect the world, it may not have the catastrophic repercussions as previously conceived.

Over the past few years, trade surplus has allowed emerging economies to build up a $3.2 trillion foreign exchange war chest. This acts as a strong buffer against any credit market disruptions in the US. Asia, in particular, should profit from rising domestic demand, especially in China, which should continue sustaining growth in the region.

Interestingly, a substantial portion of exports to China is now being retained. As China continues to rely on imports to feed its growth, it has uniquely positioned itself at the epicentre of the decoupling process. If exports to the US weaken further, many Asian governments can stimulate demand by boosting public spending, thanks to more prudent budgeting than in the past.

In the event of a decline in export demand owing to a US slowdown, Europe and Japan will not be able to bridge the gap. The much-talked about domestic demand in the emerging economies, though at present cannot fill the void, has the potential to be a powerful substitute.

Domestic demand

The low level of wages in most of these countries ensures that in the long-term wage levels will rise, thereby raising their per capita disposable income creating the largest known source of global demand. Recent data has suggested that consumer spending in emerging economies rose almost three times more rapidly than in the developed world. In the absence of any major externality coupled with the strengthening of domestic structures in the emerging economies, it is safe to assume that their growth trajectory cannot be cut short and eventually their real economies will decouple from the US.

However, one particular problem threatening to derail the emerging market’s growth story is inflation. The phenomenal rise in commodity prices across-the-board has resulted in global inflation touching all-time highs. Most central banks have reacted by raising key rates in an effort to curb aggregate demand, thus negatively impacting growth.

By

Ishan Bakshi

Senior Manager, Kotak Mahindra Bank

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