Decoupling: the myth exploded

IFR, World Bank edition, October 2008

A year ago, decoupling was a buzzword. As economists and the markets reached an increasing consensus that the US was heading for a slowdown, attention turned to the likely effect it was likely to have on emerging markets, and Asia in particular. Opinion was divided: would Asia be dragged down with the US? Or was it strong enough by now – and with sufficient intra-regional trade, as opposed to just exports to the west – to be able to carry on relatively unscathed?

One year on, in market terms at least, the very idea of decoupling looks absurd. Far from showing resilience against a US downturn, Asian markets have actually done dramatically worse. Whereas the US S&P 500 is down 22% year to date, Asian markets have fared worse still: Hong Kong is down 34%, India 33% and China an eye-watering 61%. Emerging markets, which stood at a premium to many developed markets a year ago relative to earnings, have swiftly turned to a discount, as capital has taken flight to the US at precisely the same time the US itself has led world markets into a downturn.

So what was wrong with the theory? Or is it a valid theory, but just too early?

Many believe it was always flawed. It’s true to say that the debt loads of Asian companies, and in particular the currency of those debts, is much healthier today than before the Asian financial crisis a decade ago. But that’s not quite the same as creating near immunity from slowdown or recession in western trading partners.

At the heart of this debate is the idea of intra-Asian trade. Those who argued for decoupling tended to do so on the basis that trade between Asian nations had grown sufficiently to insulate Asia from slowdowns elsewhere in the world, including slowing US demand or even recession there.

But well before sub-prime kicked in and the US housing market ran into trouble, an increasing body of study was being developed to look at the nature of Asian exports. Ifzal Ali, the economist at the Asian Development Bank, argued more than a year ago that correlations between Asia and the G3 were getting stronger, not weaker. Studies around that time frequently suggested that intra-Asian trade accounted for up to half of exports from Asian nations. Ali concluded, though, that most of these exports were simply being assembled into something else and then exported again, to the west. With that considered, by the ADB’s reckoning, 79% of exports from Asia were still ending up in G3 countries.

As Michael Spencer at Deutsche Bank puts it: “Think about it at a micro level. Suppose you are a company in Korea making cell phones. You decide you’re not making money making cell phones in Korea so you move to a cheaper location in China. You’re still making the same phone, and you’re still selling it to the US, but in the interim you are sending it to China – you have created intra-regional trade. You haven’t changed the volume of exports to the US.”

Global markets and economics involve a complicated world of interlinkages, which is why some think there’s little point talking about decoupling. “I think the whole idea of a disconnect is a bizarre proposition insofar as the economies globally are more interconnected than they ever were before,” says Jonathan Slone, CEO of CLSA. “The idea that you can decouple any part of the economy from any other part is not well thought out. It’s a vast oversimplification of the very complex system that is the global economy.”

Others believe the whole decoupling term mixes a variety of different dynamics. “Decoupling is a very confused and over-trotted phrase,” says Jonathan Anderson, economist at UBS. “It covers a lot of different issues, and using one term – ‘decoupling’ – is fairly useless.” On the side of the equity markets, he says, there has clearly been no decoupling: “the world invests and disinvests as one.” In terms of the bond markets, though, there is a very clear difference. “To give the most blatant example, the US and Europe were embroiled in massive credit retrenchment, with very big shortfalls of liquidity. In most Asian markets that didn’t play out at all, and there was very little contagion.”

Between the two is the macro situation, where the impact of global events has varied from place to place. Broadly, the smaller emerging markets have suffered more than the larger ones, with India, China and Brazil still growing at very high single digit rates regardless of events in the developed world. That’s partly a function of reliance on exports: while China’s exports are significant, they are smaller relative to such a large economy, and represent around 45% of Chinese GDP. In other countries, notably Singapore, that figure periodically rises above 200% of GDP.

China is a clear illustration of how one can argue for decoupling in an economic sense, but not in the markets. China is slowing down, for sure – but still grew 10.4% in the first six months of this year. At the same time, its domestic stock markets are down 60% in 12 months. Only in a handful of markets, notably Brazil, has economic and stock market growth continued despite what has been happening elsewhere in the world. (The Middle East is an exception: chiefly because of the oil price, this bloc is arguably the least closely correlated to developed world markets of any on the globe.)

At Deutsche Spencer wonders why anyone ever hoped for decoupling in the first place. “The whole development strategy for Asian governments over the last 30 years has been to firmly couple their economies to the US and Europe, and they’ve been very successful in that,” he says. “It bothers me to hear people talking about the fact that Asia hasn’t decoupled as somehow a criticism. It has been phenomenally successful. But that has meant growth in the region relies on growth outside the region. You have to accept that when export markets are in recession – and they probably are now – it is very difficult to maintain growth rates.”

That said, there will at some stage be an economic decoupling – but it’s going to take a generation to come through.  “Decoupling will happen gradually over time as a result of rising incomes in Asia,” Spencer says. In the meantime, though, it is far more lucrative for Asian companies to focus on exports to wealthier nations. “For investors, the most profitable, fastest-growing, most interesting opportunities are still in sectors primarily oriented towards consumers in the rest of the world.”

He adds: “Think in terms of life cycles of electronic innovations like the iphone. It wasn’t sold at first in Asia, there weren’t enough consumers who could afford to spend $500 on a phone. Now it sells for $200, it’s being rolled out in Asia. The profit margin has fallen dramatically in that product. If that’s what you’re asking the export sector in Asia to do today – telling them to stop making  things where they are making a profit and focus on things where the margin is whittled to zero – then that’s where the whole idea about decoupling falls apart.”

The only point where that stops being the case, and where Asia is truly insulated from a reliance on developed world exports, is when consumers become sufficiently wealthy to support prices on a similar level to those in the west. And despite the high macro growth rates in Asia, that’s clearly a long way off. “It is not something that is going to happen with the snap of the fingers this year,” Spencer says,

Slone adds: “We are seeing clear evidence that Asia is increasing its importance in the global economy as a consumer of goods and services outside of export sectors and external economies. It is very true aggregate demand is rising throughout Asia. But whether those increases are enough to counteract falling economies elsewhere is a moving feast.

But it is coming. “There is no doubt the emergence of the Asian consumer is a significant paradigm shift in the global economy.”

So where to from here? Merrill Lynch expects worse to come in emerging markets  – or, as it put it in an August report, “submerging markets”. “The twin drivers of commodity prices and domestic rates are moving in the wrong direction for the first time since 2002,” notes Michael Hartnett, global emerging market equity strategist. “The potential downside from here is 10%.”