Reverse decoupling: For whom the bell tolls?
Each piece of the world’s economy, a part of the main and combination of cheap money, a false assumption and poor information will create disaster for all. If an economy is washed away, the world is poorer. Therefore, send not to know whose currency is collapsing, it is yours
Once upon a time many years ago, well actually three years ago, a terrible economic plague descended upon the old financial empires of the north. With their banks under siege by falling markets and defaulting collateralised debt obligation (CDOs), the wise asset managers, analysts, economists and pundits began to tell a story of sunny lands most in the south and east. These lands were known by many names, sometimes emerging markets, sometimes BRICS (Brazil, Russia, India, China and South Africa). According to the story, in these lands the cold winds of recession never blew. The banks and currencies were always strong. The investment returns always increased at a phenomenal rate. These lands were also young and vibrant. They were free from the problems of the old, cold north. They were so strong that they could not be touched by the epidemic credit crises or the foul breath of sovereign debt ratings at junk levels. These emerging markets had decoupled from the crippled developed world. Their economies were on a sustainable, self-reinforcing growth path that would insulate them from any economic problems.
Nice story, but sadly wrong. As the cheap money from central banks begins to wane, currencies in India, Indonesia, Turkey, Thailand and Brazil have crashed. Despite the assurances of finance ministers and local central bankers, there are questions now about the strength of these economies. However, this has given rise to a new story. The developed world now seems to be strengthening. In the US, the economy has healed to the point where it no longer needs the monetary stimulus known as quantitative easing (QE) which will now be tapered off. Europe has just begun to grow after 18 months of recession. The problems in emerging markets will have absolutely no impact on the continued growth in developed countries. The developed countries have (wait for it) decoupled from the problems in emerging markets.
The reality is that both the decoupling and now the reverse decoupling theories are simply absurd. The problems in developed markets and emerging markets are just the same. They are all part of a global economic system where issues in one country are not hermetically sealed anymore. Contagion in one form or another will occur despite the assurances. However, to better understand the issues we have to look at both the decoupling story and the reverse decoupling.
The first decoupling story was intensely attractive. All countries did suffer some economic damage in 2008 and 2009. But in the developed world growth remained anaemic. The US technically recovered from the recession in 2009, its growth rate has rarely exceeded 2%, not the 3% or more required to reduce its unemployment rate to more ‘normal’ levels of about 5%. Europe is worse. It also recovered in 2009, but was back in recession by 2012.
Meanwhile, by 2010 emerging markets were enjoying spectacular growth rates. India was growing at 9.4%; China at an amazing 11.9%; Thailand at 12%; Brazil at 9.3% and South Korea at 8.7%. It was not only the growth that was impressive. It was where the growth was coming from. In times past emerging markets were dependent on trade with the developed countries. In the past few years, there has been an explosion of trade between emerging markets. Countries like Brazil and South Korea’s main trading partner for many years had been the US. Now it was China. In addition to inter regional trade, the growth was no longer just dependent on export of commodities or manufactured goods. A new emerging market middle class had been created and they were hungry for all sorts of goods like refrigerators, cars, television sets and smart phones that people in developed countries took for granted. For example, about two-thirds of Indonesia’s $600 billion economy is dependent on domestic demand.
The western economies did try to get their economies to grow through various experiments in stimulus, but nothing on the scale of emerging markets. As a percentage of the gross domestic product (GDP) the biggest stimulus packages were in Asia by far. Many of these packages were funnelled through state-owned banks, so they could be more quickly deployed.
The result of all this success was predictable, but so was the eventual outcome. Investors wanted higher yields and so they transferred money into emerging markets to take advantage of the attractive growth. This would have caused a problem, but it was exacerbated by the experimental programs especially of the US Federal Reserve, which suppressed interest rates for much of the world. Investors poured massive amounts of money into anything and everything in emerging markets that promised a decent yield, regardless of the risk. What would have been a flood of cheap money became a tsunami.
The same thing happened before the recession. Cheap money from Germany poured into the Eurozone’s peripheral countries. Cheap money from the US Federal Reserve poured into subprime housing. Eventually both collapsed. The tipping point comes when the source of cheap money dries up and investors suddenly realize that the tide is going out and some debtors are financially naked. Current account deficits (CADs) become unsustainable. Investment returns are far below the level of risk. Both corporations and consumers are up to their eyes in debt and bank balance sheets are awash in red ink. The difference between the present issue and what happened before 2008 is a matter of size.
The regulatory framework in the US was not up to the job prior to the recession. The regulatory framework in emerging markets is far below that standard. So exactly, where all the cheap money went is going to take a long time to figure out. Getting it back is not in the cards. Even in Europe, multiple stress tests have not precisely determined the nature and extent of the problem. The size of the asymmetries of information in emerging markets is exponentially larger as will the eventual market instability.
The story is as old as capitalism and is bound to be repeated. But markets in developed countries have an interesting response. So what? Markets in the US and Europe are a few percentage points off their all-time highs. The troubles of emerging markets seem far away. For example, only 0.09% of sales in the US and 0.07% of sales in the UK are generated by sales to China. China does not buy anything but commodities, so if it crashes, it will not affect anyone but the Chinese, right?
Wrong. Twenty years ago, developed countries’ share of the world’s GDP was 70%. Now it is only 50% or less. While the US’s exports as a percentage of GDP are only 12%, in Germany it is 47%. US might not have problems if China has a recession, but Europe is one of its largest trading partners. Europe’s economy is heavily based on exports. It emerged from recession not so much because of the growth in domestic demand, but because of the growth of exports, much of that to emerging markets. Emerging markets are a huge part of every aspect of the world economy. Even a slowdown not an outright crash will have a significant impact everywhere.
The US and European pension funds have made substantial investments in emerging market bonds and equities. A substantial percentage of every portfolio is recommended to contain emerging market investments. I cannot think of a presentation by a chief executive of an American or European company over the past few years that did not contain a statement about how they were going to exploit the spectacular growth opportunities in emerging markets. The stratospheric valuations of every social media company are in part based on advertising to the growing emerging market middle class. Now their record profits are dependent upon it.
Before the 2008 crash, it was assumed in the US market that a crash could never occur because real estate prices would always grow. Even today, I have read recent articles assuring investors that the same is true of emerging markets. The combination of cheap money, a false assumption and poor information will create a disaster for all. To paraphrase John Donne, each piece of the world’s economy, a part of the main. If an economy is washed away, the world is poorer. Therefore send not to know whose currency is collapsing, it is yours.
(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first-hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)
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