Why Decoupling Failed

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Includes: ADRE, DIA, FXY, IFN, QQQ, SPY, TBT, TIP, TLT, VWO
by: Shiv Kapoor

The decoupling myth has made the rounds. Emerging markets stayed resilient despite a global crisis unfolding for several months. They then collapsed as it became apparent that no one is safe. Why did the decoupling rationale fail?

When people looked at decoupling, they looked at relative dependence of an economy on its domestic consumption versus its export/import dependence. This is a mistake, and an easy one to make.

Globalization is a much bandied about word. It is embedded in the worlds psyche and it is a model which such vast benefits that it cannot fail. Globalization in the long term will provide a resource and capital allocation model, which optimally allocates across all geographies. This will be far more effective that a domestic resource and capital allocation model.

GDP growth being more domestically dependent does not decouple an economy; it might insulate, but will not decouple. There are several areas of dependence which make decoupling impossible. These include; where there is a dependence on capital to finance the growth. Or, where there is dependence on international trade. Or, natural resource dependence will also work against decoupling.

In the Indian market, capital flows is the re-coupling factor; it was a major positive during the boom and a massive overhang during the bust. Absent an efficient domestic market for debt, it is difficult to allocate domestic capital efficiently. Even if India had an effective domestic market for debt, to benefit from globalization, we would have to let the domestic resources compete with foreign resources; so we can never be truly decoupled.

Make no mistake about it, without effective capital flows the economy cannot grow; for this reason the question of a decoupled economy cannot arise. The high contribution of domestic consumption as a proportion of GDP is no doubt an insulator.

However, in addition to reliance on capital flows, the dependence on natural resources and international trade are both re-coupling factors. Within the domestic economy, each area of dependence can spill over and impact other areas of dependence.

For example, even a small degree of dependence on export can damage domestic GDP as unemployment spreads through that sector. Natural resource price elevation can act as an impediment to growth as it did when oil prices shot through the roof; falling natural resource prices can also be a boon in nurturing an ailing economy back to health.

Only an economy which shuns globalization can be decoupled and in my view an economy which shuns globalization is a failed economy. Policy actions by nations can insulate an economy, not decouple it.

In the past, boom and bust cycles were caused principally by domestic circumstances. Over time, reducing the severity of busts and the buoyancy of booms was attained through policy; more monetary than fiscal and regulatory, but all three remained an important part of managed growth. This was only possible because over the years cycles were understood; coming from that understanding, came an ability to manage the cycle.

Today we live in a new era; the age of globalization. To manage an economy during this era is a different ball game. Firstly, globalization has to be accepted by governments. Secondly, it has to be incorporated into policy – regulatory, monetary and fiscal. Thirdly, there will be a learning curve; understanding causation will be an important factor; the lessons learnt will need to be incorporated into new policy and this process will ultimately cause better economic management for the new environment in which we live.

This is possibly our third flirtation with crisis arising out of an increasingly globalized world – during 1997 we had the Asian contagion, coming into the new century we had the IT explosion and now we have the mother of all crises. Notice the short duration between each event; we need to learn from these experiences to manage the severity and extend the duration of the economic cycle. To do this we must first understand cause and then experiment with policy.

Crisis Cause – Source Nation US

In my view, the crisis was caused by the simultaneous explosion of the property bubble and the debt bubble in the United States. Globalization was in no small measure a great contributor to the creation of this bubble.

The starting point is of course the voracious appetite of an irresponsible US consumer; but senseless lending to US is partly to blame for inflating the bubble. It is the demand for US treasuries despite low interest rates which propped the US dollar; it was low inflation rates caused by a strong dollar (mainly vis-à-vis Chinese currency) which kept interest rates low, which in turn spurred US consumption onwards.

It is the absurdly low US and Japanese interest rates which encouraged uncontrolled risk taking, specially as an illusion of low risk was created through mispriced derivative instruments. Globalization can also claim credit for the survival of the US. The risky debt had been repackaged sold throughout the world; had it all been absorbed in US financial institutions, I have no doubt the financial crisis would have crippled the US; and with the US, the rest of the world.

Because of globalization, the global allocation of capital spread the risk globally. And because of this, good policy has a chance of restoring the global economies to health.

The lesson to learn is that better regulation is necessary; more importantly, regulation must be globally coordinated. There are many ways in which the nature of cross border capital flows can be re-characterized. Some of these methods can lead to excessive risk taking with sound domestic regulation at both ends; for policy to achieve its objective regulation will need to be globally coordinated.

Some blame the Fed in general and Mr. Greenspan in particular for keeping the interest rates low post 2001. Long interest rates (GS10) averaged 4.44% between 2001 and 2006; inflation averaged 2.66% during this period for a net rate of 1.78%. During the period since 1929, long interest rates (GS10) averaged 5.22% while inflation averaged 3.33% for a net rate of 1.89%.

During this five year period, GDP grew at just under 3% annualized; a rate not inconsistent with the 3.22% annualized GDP growth rate since 1929. Fed funds rate averaged 2.7% during the five year period; which means net of inflation rate remained at near zero % which is far below the long term average short term fed funds rate. Perhaps interest rates should have been raised because it was abundantly clear that asset prices were rising because of excessive risk taking.

But in theory, there was no real reason to raise rates as consumer price inflation remained under control, while GDP growth maintained growth consistent with long term growth rates. The policy failing was in my view caused by ignoring globalization; while everything in the US was chugging along quite nicely, the dollar as the global reserve currency should have taken note of overheating global GDP growth and inflation rates.

Lesson to learn includes consideration of global growth and inflation levels as an integral part of domestic monetary policy.

Fiscal policy measures also need to be coordinated at a global level. The level of co-dependence amongst economies now means that policy action needs to be more cooperative since a failing in one economy can lead to unintended adverse consequences in another.

Lesson to learn is to empower and expand the G8. I suspect there is a lot of learning to be done at this level – particularly when it comes to taxation. I do not think taxing foreign profits of companies is good fiscal policy and over several years, I expect a transition to a territorial system of taxing together with globally coordinated transfer pricing regulations.

Contribution to the Crisis

The US dollar stayed relatively strong versus the Chinese currency despite mounting deficits, simply because of the insatiable Chinese demand for US treasuries. The Chinese currency should have appreciated as a result of a large recurring surplus in trade with US; large capital inflows into China would have added further to the appreciation. No appreciation was seen simply because of China’s voracious appetite for US treasuries. Part of this crisis has arisen, because a key player in globalization was not a part of free markets because of its controlled and manipulated currency.

China also utterly failed to diversify its asset base in order to keep its currency cheap. While this fed the flames of excessive consumption and risk taking, did it help? Today China is sitting on vast holdings of US treasuries and risks a significant impairment in value of its assets. Versus other major trading partners, the US dollar weakened because of low interest rates together with the balance of payments position. Other emerging markets saw their currencies appreciate because of a huge demand for the non US currency on capital inflows.

Outlook

China as the factory of the world served as a catalyst to usher in an era of low multi decade inflation levels. While the story of China remains untold, the inflation impact has been played out. We will see the US dollar weaken and resource prices rise. The appreciation in the Chinese currency will raise inflation levels globally; at the same time contraction in global demand will make sure that we do not get into a hyper inflationary environment.

To offset the adverse affect of reduced global demand, China will have to invest aggressively in building its own domestic demand. We can expect to see very significant fiscal stimulus for a long time as this is what will be used to maintain and grow domestic demand; we can also see significant continued spending on infrastructure.

As China seeks to diversify its asset base out of US dollar, we can expect significant investments in resources and business, particularly those in emerging markets. We can see several resource rich African nations as being beneficiaries of inbound investment from China; this is one part of the world where Chinese capital and expertise will always be welcome. We can also see several currencies appreciating along-with the Chinese currency as China diversifies its US dollar holdings. We can also see China target new export markets.

We see China as being the single most important economy to lead the world out of the crisis. Regulation will be an area of policy focus, and one important factor will have to be quality of inbound capital; at the same time because of a low dependence on inbound global capital flows, China will need to be very careful with regulating outbound capital flows. It is managing outflows which will be critical; the impact on capital outflows would normally depreciate the currency, but since outbound capital flows will flow from existing foreign currency reserves, it is unlikely to weaken the currency.

On monetary policy, so far China has been very insular and inward looking. It is likely that its monetary policy will need to become more open and transparent. The currency will need to appreciate; the Chinese currency shall gain in stature as a foreign currency holding for other economies but for this to happen there will need to be more transparency and less currency control.

On fiscal policy, continued fiscal stimulus will be a must to develop domestic demand and reduce dependence on exports; not only does it make sense, failure to do so would result in civil unrest in China. This will be inflationary to an extent and so it is likely that a high interest rate environment will persist.

Massive evolution in regulatory, monetary and fiscal policy is likely to be seen throughout the world. It is essential; but everything points towards China as a dominant party to lead the way out of the crisis.

Conclusion

In my view misguided regulatory, monetary and fiscal policy from governments throughout the world, which failed to address and understand globalization had a large role to play in the debacle which followed. No longer can a country stand by and ignore what occurs outside its borders, for those events will have a profound impact on the home economy. Globalization is here to stay, ignore it at your own peril.