Decoupling : A fresh perspective.

Decoupling debate is an interesting subject for Economists, who have been

discussing it for well over a decade. Before sub-prime crisis, popular notion was:
“Emerging markets are no longer hinged to the ups and downs faced by the
developed markets”. However, global financial meltdown which started in 2007,
made almost all theories of decoupling, invalid, and forced Economists to have a re
look.

To understand the theories of decoupling, we need to first understand the

economic, financial and trade balances of the economies today.

Much has changed during the last two decades as developing economies today are
playing an anchor role in world growth rate, while developed economies of the
world struggle to find their feet. International trade has tripled over last 2 decades
and BRIC economies share in international trade has more than doubled from 6% in
1997 to 13% in 2008.

In 2008, emerging Asian Economies accounted for 18% of total world GDP on PPP
basis compared to 9% in 1990. During the same period share of G-7 economies on
PPP basis has gone down from 51% to 42%.

According to Overseas Development Institute (leading independent think tank in

UK), African growth rate exceeded OECD growth by margins not seen in 25 years.
Similarly since 2001, emerging market GDP has exceeded the developed nations
GDP by 4 percentage points.

History of Decoupling:

Study of decoupling has been analyzed through pervious stock market crisis, like,
the stock market crash of 1987, Asian financial crisis and the IT bubble burst
which began in 2000.

During the market crash of 1987, while the Dow Jones Industrial Index (US) fell by
around 35% during 5 trading sessions while stock exchanges of the 19 of top 23
industrial nations fell by more than 20%, maximum impact been taken by the
Emerging market exchanges. Similar impact was seen after dot cum burst of 2000,
and the consequent recession when almost all global markets fell from 2000 to
2003.

Latest financial markets crash, which started in 2007, was led by the sub-prime
crisis and was followed by liquidity crisis. The crisis was caused by the local
problems of developed economies, yet the ripples were so strong that the Global
economy had to bear the brunt of the same.

Proponents of the coupling theory suggest that though the emerging markets are
becoming more interdependent among themselves for growth, their dependence on
developed world is still huge. Moreover, it is not just the trade balance which
couples economies today, it is the global financial system which causes immediate
flight of capital (to low risk assets) across geographical boundaries.

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 According to them decoupling cannot be fully achieved in today’s time where
global financial markets are so closely linked and bulk of the global demand and
flow of seed capital largely comes from developed economies.

Proponents of decoupling theory suggest that although strong correlations in the

Benchmark indexes have been witnessed during the period of panic and crisis,
Emerging markets have continued to grow at growth rates much higher than
developed nations through this entire crisis.

A very clear case of decoupling comes from the correlation data between African
GDP Growth and world GDP Growth rate. While in 1980 the correlation stood at
0.5.whereas in 2000 and 2007 the correlation went down to 0.2.

Decoupling is commonly understood by people as dependence of an economy on

domestic consumption versus its overseas trade. While this explanation though to
some extent is true but is incomplete, Economists believe that though coupling and
decoupling of economies can be related to overseas trade, it can also be related to
the flow of capital, as in case of India.

Countries like India which has both Fiscal and ever expanding Current account
deficit are dependent on the FDI dollars, to build the foreign exchange reserves,
which acts as a backup for justifying huge investments that the govt. is making for
its infrastructure development.

Dependence of Indian markets on foreign capital can be witnessed by tracking net

FII flow and corresponding movement in the benchmark BSE Sensex Index. If we
analyze the FII data between January 2008 and December 2009, the relation
between them is much more pronounced with Benchmark Index almost tracking the
FII movement. It has also been suggested that reason for high financial markets
correlations and high beta during crisis has been under-developed financial markets
in these nations and major market participation of foreign investors.

While Indian Economy is coupled to the developed world due to financial

dependence, linkages are more related to trade with Asian Giant China; with more
than 40% of its GDP contribution from exports, and more than fourth of its exports
come from US alone it is highly unlikely that these two geographic regions will
attain economic decoupling with high trade dependence.

Debates of coupling and decoupling of economies are going to continue for some
more time to continue and more so during a financial crisis.

Proponents of decoupling theory are correct in their analysis that dependence of

emerging economies to trade with developed economies might go down in mid-
term as they shall find ways to mitigate these risks by stronger intra-regional trade,
increasing trade volume with African nations, investment in domestic economy,
etc...

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However, as global financial markets become more & more accessible, there will be
a constant flight of capital towards riskier assets in stable time and conversely
during the time of financial instability, wealth will flow rapidly towards less risky
assets, which will continue to impact more geographies than those directly hit.

Meanwhile, it is necessary for emerging economies to realize that most of the G-7
economies, with their highly leveraged balance sheets are losing their appetite for
consumption, and that the developing economies need to find new ways of growth
through investment in local economies & build a demand-based economy, with
strong Financial and Capital Markets with large scale financial inclusion.

Resources:

Public data from WTO, IMF,

http://www.uschina.org/statistics/tradetable.html
FII data from SEBI website.
Various blogs and editorials including:
http://seekingalpha.com/article/148336-why-decoupling-failed