Thursday, February 21, 2008

Decoupling-recoupling debate

Will the rest of the world stay coupled to or decouple from the US economy? This is the crux of an interesting debate going on about the likely impact of a US recession on the global economy.

If the actions of the Central Banks in the past few weeks are anything to go by, the world economy appears to have de-coupled from the US, atleast for the present. This decoupling was highlighted by the fact that interestingly, except for the Canadian Central Bank, no other major Bank cut rates in response to the two recent, unprecedented 125 basis points cuts by the Federal Reserve. While recession fighting is the pre-dominant concern for the US Fed, inflation remains the major worry for most other Central Banks.

For many years now, the US consumers and the financial innovations of Wall Street firms have been the engines of global economic growth. The historic low interest rates first fuelled a stock market and then a real estate boom, which in turn generated a "wealth effect” that saw "irrationally exuberant" consumers spend like there was no tomorrow. The trade deficit touched $827 bn in 2006-07, as the Asia-Pacific economies competed with each other in exporting to the US. This deficit was in turn financed by their huge foreign exchange surpluses, through what Kenneth Rogoff described as “the biggest foreign aid programme in world history”.

The impact of a US downturn will be most immediately and strongly felt in the closely integrated $170 trillion global financial markets. The recent boom in the emerging equity markets have been driven in large measure by huge Foreign Portfolio Investments from US and Europe. The massive sub-prime mortgage related losses suffered by the Wall Street banks and the solvency problems facing them will now constrain the credit available for new investments. There is also a strong possibility of capital flight from investments in emerging economies, so as to cover the losses in their home markets.

Conversely, the weak dollar and falling interest rates, coupled with inflationary expectations and recessionary fears, makes the US equity and bond markets unattractive, thereby presenting the emerging economies as excellent alternatives. This will also provide an opportunity for their equity and debt markets to develop the requisite depth and breadth, besides strengthening of the regulatory framework.

The closely integrated financial markets on both sides of the Atlantic, and fall in demand for US imports, will render Europe especially vulnerable in the event of a recessionary hard landing. Similar housing bubbles and sub-prime mortgage problems in many European countries, coupled with a strong Euro and high oil and commodity prices, will keep Europe coupled. Any credit crunch will adversely affect the bank lending dependent European corporate sector’s ability to produce, hire and invest. The ailing, export-driven Japanese economy is also more vulnerable to a US recession and supply shocks. A slowing economy, as in Europe, and weak domestic demand means that there are limited internal sources of economic growth.

It is a little different with the emerging economies. A US recession will immediately hurt imports and thereby directly affect jobs and economic growth in the trade dependent Asia-Pacific. Exports form 40% of GDP for China and S Korea, and 50-75% for the rest of East Asia, and the US accounts for a 20-30% share. Also, the rise of China has radically changed the Asian global production and supply chain, making everyone more dependent on the US. Increasingly, East Asian countries export inputs and intermediate goods to China, which in turn leverages its low labor costs to process and assemble these inputs into finished products that are then exported to the US. Further, with over $2 trillion invested in US T Bonds, a US recession and weak dollar will lower returns.

However, the impact of a US recession can be considerably mitigated if these economies manage to generate adequate domestic consumption. In 2007, despite the slowdown in exports, all the emerging Asian economies grew faster as domestic demand more than made up for the fall in exports. The corporate sector in most of Asia is healthy, with high capacity utilization, strong balance sheets and robust profits. Unlike previous US downturns, the macroeconomic fundamentals are stronger now - balanced budgets, growing forex surpluses, lower inflation - giving them enough room to maneuver even with a hard landing in the US.

The danger for the rest from a US recession is indirect. A slowdown in China will reduce the demand for raw materials and commodities from Asia, Latin America and Africa. This will exert a strong downward influence on commodity prices, thereby hurting all commodity exporters, who had been hitherto piggy riding on the gluttonous Chinese appetite. However, this will benefit the commodity consumers among the emerging economies, as the cheaper imports will make their import-intensive exports more competitive, besides encouraging domestic demand and restraining inflationary pressures.

Among the emerging economies, India seems best placed to tide over a US recession. Its exports form just 23.5% of GDP, and the share of exports to US is only 2% of GDP, compared to 8% for China and over 20% for ASEAN. Unlike East Asian economies whose major exports to the US are manufactured goods, employing large number of people, the major exports from India are software services, whose direct influence on jobs and the larger economy, is much less.

To conclude, while the global financial markets are likely to remain closely coupled to Wall Street, the real economies elsewhere, without being fully coupled or decoupled, may still emerge unscathed from the Main Street recession. The emerging economies are unlikely to catch a serious cold as the US economy sneezes into a recession, but they will surely feel the chill!

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