Monday, August 24, 2009

Why the world economy should remain coupled?

The OECD's latest forecast for the world economy in 2009 and 2010 predicts a return to robust growth in emerging economies, even as the developed economies labour back to some form of recovery. This has naturally re-ignited the debate about decoupling of the emerging economies from the rest of the world economy.

The OECD estimates China to grow at 7.7% this year and 9.3% in 2010, India at 5.9% and 7.2% respectively, and Brazil’s economy, after slowing down, to reverse this year and expand 4% next year. In contrast, it predicts the US economy to shrink by 2.8% this year and grow by 0.9% next year, Japan to shrink 6.8% and Europe 4.8% this year.

I have atleast three important reasons why the re-decoupling phenomenon could be bad for the world economy as a whole and would only end up reinforcing some of the macro-economic imbalances that played a major role in blowing the sub-prime bubble.

1. It could unleash another round of capital flight into the emerging economies and creating an equity market bubble there. There are already indications, based on the performance of emerging economy stock markets this year (already up more than 50%), that this may be on the way. The faster than expected return to economic normalcy in these countries, the persisting low interest rates in the developed economies, the declining strength of the US economy and the weakening dollar, and the demand for foreign capital by private businesses in the emerging economies (for investments in infrastructure etc) have all contributed to this trend. The effect of this could be disastrous.

2. This capital flight could lead to substantial appreciation of emerging economy currencies, which in turn would reduce the competitiveness of their exports. This would force the Central Banks into intervening and and purchasing dollars to prop up their domestic currency. The result would be an increase in the pace of accumulation of foreign exchange reserves, which would invariably find its way into the US Treasuries, thereby making available an increased pool of cheap debt which would, in all likelihood, fuel financial market bubbles.

3. The adverse impact of the slowdown in exports to US and Europe on the emerging economies, especially those of East Asia, is by now well acknowledged. It is imperative for the green shoots of recovery taking hold in these emerging economies that their export markets in the developed world gets back to normalcy at the earliest or atleast shadow their own recovery.

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