Decoupling and recoupling

Britain was the colonial superpower of the world till the start of the 20th century. Following World War II, the US took over the global economic leadership. Japan and Germany became economically powerful as they became export powerhouses. Till about 30 years back, the G-7 countries (USA, Canada, Britain, France, Germany, Italy, Japan) dominated the global economic agenda. The developed countries did not really take the developing ones like India and China very seriously. These Asian giants were considered too poor and too insignificant and struggling to get their economies going. But since the late 1990s, China and India, thanks to economic liberalisation, have emerged as two of the most dynamic economies of the world. Many economists have argued that these emerging markets have grown to a point where they would more than compensate for any slowdown in western economies. This phenomenon has come to be called decoupling.

In the early months of the sub prime crisis, the champions of decoupling seemed to be winning the argument. China and India continued to grow smartly even as the economies of the Western nations went from bad to worse. In the initial stages, the capital flows to the emerging economies actually increased. In the case of India, for example, the net FII flows during the five-month period from September 2007 to January 2008 was US$ 22.5 billion as against an inflow of US$ 11.8 billion during April-July 2007, the four months prior to the onset of the crisis.

But as the crisis deepened in 2008, it became clear that emerging economies could not be completely insulated from the current financial crisis. There was a reversal of portfolio flows due to unwinding of stock positions by FIIs to replenish cash balances abroad. Withdrawal of FII investment led to a stock market crash in many emerging economies and many currencies plunged against the US dollar. In the case of India, the extent of reversal of capital flows was $ 15.8 billion during the five month period February-June, 2008.

The situation worsened, following the collapse of Lehman Brothers in mid-September 2008. The Lehman bankruptcy combined with the fall of Fannie Mae, Freddie Mac and AIG created a crisis of confidence that led to the seizure of the interbank market. This had a trickle-down effect on trade financing in the emerging economies. Together with slackening global demand and declining commodity prices, it led to a fall in exports. Many South-East Asian countries that depended upon exports were severely affected. China’s GDP growth slowed down appreciably.

As the events unfolded, it became clear that India was far too integrated into the global economy. Export growth which had been robust till August 2008, became low in September and negative from October 2008 to March 2009. The sharp decline in growth to 5.8 per cent in the second half of 2008-09 from 7.8 per cent in the first half of 2008-09, seemed to support the recoupling perspective.

Meanwhile, the Indian financial markets were affected indirectly through the linkages with the global economy. The drying up of liquidity, caused by repatriation of portfolio investments by FIIs, affected credit markets in the second half of 2008-09. This was compounded by the “risk aversion” of banks to extend credit in the face of a general downturn. There was a contraction in reserve money by more than 15 per cent between August 2008 and November 2008. A series of unconventional measures by the Reserve Bank helped to push up the rate of growth of bank credit from 25.4 per cent in August 2008 to 26.9 per cent in November 2008. However, this only partly offset the impact on Indian companies due to the freezing of financial markets in the US and EU. The Indian IT industry went into a tailspin and employees became resigned to salary cuts and job losses, a dramatic change from the “red hot” labour markets of 2006 and 2007.

Other emerging markets also started facing a slow down. Dubai, the hub of the middle east, saw a major crash in the real estate markets and severe job cuts. This jewel of the middle east had to be “bailed out,” by the government of Abu Dhabi. Singapore, one of the major hubs of East Asia went through a severe recession.

As mentioned earlier, emerging economies also suffered in terms of foreign investment inflows due to a retreat to safety away from the emerging economies. In 2008, investors pulled out $67.2 billion for emerging market equity and bond funds, the worst since 1995. This represented more than 50% of the inflows of $130.5 billion into emerging markets between March 2003 and end of 2007.

Now as we approach the fall of 2009, many Asian economies seem to be rebounding smartly, through their growth alone may not be able to pull the global economy back on track. The rebound of the Asian economies has been aided by a turnaround in manufacturing, return of normalcy to trade finance and a huge fiscal stimulus. Many Asian economies entered the downturn with healthy government finances. Hence they have been able to inject a fiscal stimulus easily. Despite this impressive growth, The Economist[August 15, 2009.]sounded a word of caution: “But it would be a big mistake if Asia’s recovery led its politicians to conclude that there was no need to change their exchange rate policies or adopt structured reforms to boost consumption.” China for example, despite its impressive growth does not yet have a deep, well functioning financial system. The difficulties faced by Chinese leaders in stimulating domestic demand, have been partly due to the inadequacies of the country’s financial sector.