Saturday, October 13, 2007

Decoupling from the US economy

One of the most debated issues these days is about how the world economy will fare in case of a recession in the US economy. In other words, will the global economy successfully decouple from the US economy? The IMF in its World Economic Outlook 2008 expects demand in the rest of the world to be largely decoupled from the weakness in the US. In contrast, Morgan Stanley claims that 2008 will be the year of re-coupling.

For years, the massive US economy and its voracious consumers have provided the powerful engine for global economic growth. This consumption binge saw the American trade deficit reach $800 bn in 2006-07, as the Chinese and East Asian exporters competed with each other in exporting to the Americans. As James Suroweicki explains in Greenback Blues, despite the falling dollar and the resultant rising dollar costs, these exporters have refrained from increasing prices and have accepted reduced profit margins, so as to retain their market shares. The huge prospect and potential offered by the US economy encouraged them to adopt this policy. But now, with prospects of a weakening US economy and established market shares, they may feel constrained to keep the prices low, thereby further weakening the US consumers.

The low interest rates were the critical internal determinant in generating and then sustaining the consumer boom. It fuelled the stock market and then real estate booms, which in turn generated a "wealth effect", that saw "irrationally exuberant" consumers throw caution to the winds and indulge in a spending binge.

The decoupling may not be so evident in the financial markets as in the real economy. It will be more complex for the financial markets, given the ever growing integration of the $170 trillion global financial markets. Further, unlike the US economy, Wall Street is still firmly entrenched as the standard bearer of the health of the global financial markets. The massive losses suffered by the Wall Street Banks and the solvency problems facing many institutions over-exposed to the sub-prime mortgage and related asset backed securities, will tighten the credit available for new investments.

But there are other dimensions to the story, which claims that any recession in the US, in the short and even medium run, is likely to benefit the emerging markets. The weak dollar and falling interest rates, coupled with inflationary expectations and recessionary fears, makes the US equity and bond markets unattractive for Financial Institutions. In this context, the emerging economies are an excellent alternative, especially with very high profit opportunities. Another unpredictable element in the picture is the ever growing corpus of the Sovereign Wealth Funds (SWFs), who would look for diversifying their investments. All this will also provide an opportunity for the financial markets in the emerging economies to develop the requisite depth and breadth, besides the regulatory and other capacities, necessary to emerge as developed financial markets.

In contrast, any recession in the US will immediately hurt imports and thereby directly affect jobs and economic growth in the emerging economies.

Nouriel Roubini warns that decoupling may not be easy, "The rest of the world – including Europe – has so far deluded itself that it can decouple from a US slowdown. But decoupling would occur only if the US experienced a soft landing; if the US experiences a recessionary hard landing there will be no decoupling and global growth will sharply slowdown. And Europe could be one of the first victims of the US hard landing. Already the European financial system not only has not decoupled from the US one; it has been rather subject to a massive contagion since August. And since European firms depend on bank lending more than US ones the coming credit crunch will hit the European corporate sector and its ability to produce, hire and invest. Also boom and bubbles in housing were not limited to the US; similar bubbles were experienced by Spain, the UK, Ireland and, in smaller scale, by France, Portugal, Italy and Greece. Now such housing bubbles are starting to deflate in Europe adding to the downside growth risks.

Add to the problems of Europe the strength of the Euro that is sharply reducing the external competitiveness of the Eurozone; as well the forthcoming weakening demand for European goods from the US hard landing. Add to the mix high and rising oil prices. Then this combination of shocks implies serious risks of a sharp growth deceleration in Europe and even the possibility of a Eurozone hard landing. In the meanwhile while the Fed has already started to aggressively cut interest rates the ECB is deluding itself that it could raise its policy rate further once the perceived temporary financial crunch is past. What the ECB should instead to is to start cutting its policy rate now. Temporizing, like the ECB did in the 2001-2002 episode, will ensure that the negative growth contagion from the US to Europe will be more severe and protracted."

The story is no different with the Asian economies. The weakening US and European demand will adversely affect the export engine. The increasing share of internal trade among the Asian economies, will only slightly mitigate the impact of an American slowdown. The danger for Asian economies, except China, from a US recession is indirect. China is significantly dependent on exports to the US market, and any fall in that will be dterimental to Chinese growth prospects. This will in turn affect the East Asian exporters and commodity suppliers, who have been piggy riding on the Chinese growth.

The Chinese growth engines' dependence on trade is still substantial. Exports form 40% of GDP; investment is 50% of GDP and, leaving aside housing investment, most of such investment is directed towards the productions of more exportable goods; current account surplus has gone from $20b in 2002 (2% of GDP) to an expected $300 billion plus this year (12% of GDP).

A recent ADB report captures the essence of the new trade dynamics in East Asia, "But the rise of China has radically changed the Asian global production and supply chain: now East Asian countries tend more to produce inputs and intermediate goods and raw materials that are exported to China; in turn China, given its lower labor cost, processes these inputs and assembles them into final goods that are exported to the US. Thus, in spite of growing intra-Asian trade the dependence of Asia on US growth is now larger than any time before, both structurally and cyclically. So the argument that Asia can decouple from the US because of this greater intra-Asian trade is altogether flawed. Rather, once China slows down the Chinese demand for these Asian intermediate inputs and its demand for raw materials from Asia, Latin America and Africa will fall. Thus, you will observe both a slowdown in Asian growth and a sharp fall in commodity prices that will hurt all commodity exporters."

Ultimately the impact of the US recession will also depend, to a large extent on how the domestic economies are able to keep up consumption spending. In 2007, despite slowdown in exports, all the emerging Asian economies grew faster as domestic demand more than made up for the fall in exports. The health of the corporate sector in most of Asia is robust, with high capacity utilization, good profit growth, stronger balance sheets. The macroeconomic fundamentals are strong - balanced budgets, growing forex surpluses, managable inflation - giving these countries enough room to manouevre if the US problems start impacting economic growth. Though exports, especially to the US and Europe, still form a significant part of the economy, there are enough cushions in place to tide over a US recession, without as much adverse impact as in previous US downturns. Standard Chartered forecasts, emerging Asia to grow by 6.4% in 2008, as against 7.8% in 2007, a much smaller fall than the 3% slump to 4.2% following the 2001 US recession.

Among the Asian and other emerging economies, India seems best placed to tide over any US recession. Unlike the East Asian economies, it is not as closely integrated with the global economy by trade, nor is it dependent on any country for its exports. Its exports form just 23.5% of GDP, as against 36.6% for China, 36.7% for S Korea, 59% for Taiwan, and 72.7% for the ASEAN countries. It share of exports to the US is only 18.59%, to 21% for China, 22.5% for Japan, and 13.3% for S Korea. The exports to US is only 2% of GDP, compared to 8% of GDP for China and over 20% for Singapore, Hong Kong and Malaysia. Unlike the other East Asian economies whose major exports to the US are manufactured goods, employing large number of poeple, the major exports from India are software services, whose direct influence on jobs and the larger economy, is not very high.

Another consequence of a US recession and slowdown in Europe will be a downward pressure on commodity prices. This in turn will have different impacts on the commodity exporters and the commodity consumers like many Asian and East European economies. While the former wills ee a fall in export revenues, the later will benefit from cheaper import prices and thereby more competitive prices for their import heavy exports, besides encouraging domestic demand and keeping inflationary pressures under control.

The Central Banks of the world appears to have already de-coupled. Recession fighting has become the pre-dominant concern for the US Federal Reserve, while inflation remains the determining factor for most other Central Banks. This decoupling was highlighted by the fact that except for the Canadian Central Bank, no other major Bank cut rates in response to the two unprecedented 125 basis points cuts by the Fed in late January. The European Central Bank (ECB) Governor Jean-Claude Trichet even warned that he would not hesitate to raise rates. Our own RBI Governor YV Reddy declared that inflation concerns were pre-dominant in influencing rate decisions.

To conclude, the global financial markets will certainly remain coupled. If the conclusion is that the emerging economies will catch cold, now that US has sneezed, then it may not happen so. But their growth projections will have to be scaled down.

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