Revisiting Global De-coupling

Finance is the art of passing money from hand to hand until it finally disappears.

- Robert W. Sarnoff

In the early days of this housing and financial crisis, many thought that parts of the global economy might escape unscathed. This was said most often with respect to the BRIC countries and some of the smaller Asian economies as well. The argument seemed compelling in certain respects - after all, in most of these countries, banks for the most part had no subprime exposure, consumers weren't as leveraged as in the U.S. and, unlike in 1997, most countries had built up large reserves and had their fiscal and monetary houses in order.

With the benefit of 20-20 hindsight, that logic was flawed for a few reasons. The first had to do with underestimating the damage caused by declining demand from the U.S. market and ultimately from Western Europe as well. Several Asian countries had, and still have, exports as their main engine of growth. When exports collapsed, their domestic markets were woefully inadequate in picking up the slack and sheltering their economies from falling exports. The next reason was the impact of slowing demand on commodity prices and consequently commodity-exporting nations like Brazil and Russia - a dramatic impact that continues to be felt. Finally, the carnage on Wall Street hit every investor's wallet and with it came extreme risk aversion. The impact of that risk aversion was felt acutely by the countries mentioned above, as capital fled their equity and debt markets and for the most part went into the "safe haven" of U.S. government securities.

We are now at a point when perhaps the worst pace of global growth decline is behind us, but nowhere close to a broad-based recovery either. The U.S., Europe, the UK and Japan - to name just a few - continue to struggle. It is very likely that GDP will continue to fall in Q1 and Q2 virtually everywhere and the return to positive growth in the second half of 2009 is far from certain. Even if there is the occasional positive quarterly GDP print in developed economies, the U.S will likely end 2009 with GDP contracting by 2.5 or 3 percent for the year. Europe and the UK could be somewhat worse, Japan a lot worse and the prospects for growth in 2010 look anemic at best for most of the developed world.

However, it is also clear that there is relatively greater optimism in parts of the emerging markets world (once again, largely Asia) and forecasts reflect that. There are mixed signals from China in recent months. While it remains to be seen whether this is the beginning of a sustainable recovery or just a temporary blip, it is a positive sign. China's growth will probably slip to 5 percent for all of 2009, India about the same or slightly weaker, but India should grow at 6 percent in 2010 and China possibly closer to 8 percent. Countries such as Singapore, Taiwan and Korea look set for negative year-on-year growth in 2009, but they are projected to bounce back in 2010 as well, though not quite as fast as China.

Is it realistic to expect some emerging market countries to rebound strongly when the developed world remains mired in sub-par growth, or is this another de-coupling myth? It is hard to be sure, but on balance I think there are reasons to be cautiously optimistic about growth in Asia relative to the OECD world.

Early in the recession, manufacturers around the world were caught unaware and inventory levels surged. Since then, adjustments have taken place and inventories are lean, which is a positive for Asian exporters if demand picks up - and that is the rub. So far, demand continues to slide, but when it does stabilize, it ought to be good news for countries like Taiwan and South Korea that have been especially hard hit. With the exception of the CNY, most Asian currencies are significantly weaker as well and this will tend to boost GDP and improve competitiveness. Reserves remain ample, which is an encouraging sign and will help with the rebuilding effort. Weak commodity prices may have hurt Russia and Brazil, but have largely helped Asian countries - despite some recent firming in the commodity space (including oil) prices are likely to remain relatively benign for the rest of this year. It also appears as if capital has started moving back into some of these markets - Asian equity ETFs have recently seen a lot of new buying.

Finally, what I consider the most compelling reason. I believe this crisis will force a global rebalancing. Countries that run large, persistent deficits, like the U.S. and the UK, will be forced to get their fiscal house in order. Consumers in these countries will have to do likewise by rebuilding savings. That combination implies general belt-tightening and de-leveraging, which argues for weak domestic growth and somewhat weak trade patterns. On the other hand, many of the surplus nations of Asia have realized that they need to boost domestic demand and consumption to reduce their dependence on exports and buffer their economies from the next exogenous shock. As a result, we are already seeing signs of increased spending from consumers in some countries and consequently a growing share of GDP from domestic consumption. In addition, regional trade is growing, while trade with the OECD world is declining, which will reduce some of the drag from weak OECD demand. If this plays out, we could see several years of sub par growth in the developed world, while Asia and other regions enjoy a more robust rebound.

A lot could go wrong with this scenario, including more turmoil in the markets and fresh bouts of risk aversion. However, if it does play out the way I think it will, the countries that rebound strongly will be the first to face inflationary pressure, rising rates and stronger currencies. The ones that lag will see little or no inflationary pressure, rates on hold for some time and downward pressure on their currencies.