The European edition of the Financial Times carried an article (19 March) with a dramatic headline that the inflation genie in Asia had leapt out of the bottle (www.ft.com/cms/s/0/39b1d5b2-325b-11df-bf20-00144feabdc0.html). The article cites DBS Bank research stating that private consumption growth has averaged 7% in the 10 largest Asian economies, excluding Japan, in the last five quarters. Contrast this with the US, where sales eked out some gains in February due to statistical adjustment. Non-seasonally adjusted retail sales declined.
As if on cue, the Reserve Bank of India (RBI) unexpectedly raised the repo rate and the reverse repo rate on Friday by 25 basis points. It admitted to being surprised by the persistence of inflation indicators. There is more to come from the Indian central bank in the months ahead. This stands in marked contrast to the decision of the Federal Reserve in the US to leave interest rates at exceptionally low levels for an extended period. The Federal Reserve conceded that housing starts remained flat at depressed levels since the last meeting.
As soon as RBI raised the interest rate in India, the following sequence of headlines appeared in Bloomberg on its “India” pages:
BN 1:34 U.S. Stocks Decline on India’s First Rate Boost since July 2008
BN 0:57 + European Stocks Fall as India Raises Rates; Mining Stocks Drop
BN 3/19 U.S. Stocks Erase Advance as India Unexpectedly Raises Rates
BN 22:23 U.S. Stocks Drop as India Raises Rates for First Time Since ’08
Such headlines would have been inconceivable even a year or two ago. Hence, anecdotally, decoupling is not only evident, but is also strong.
It would be more reassuring if it is backed by formal statistical evidence. Conventional wisdom says that increasing linkages through stronger trade and financial ties should lead to business cycles synchronization across countries. This is achieved through the facilitation of international transmission of country-specific shocks.
One of the most prominent contributions to this debate is the empirical analysis done by Eswar Prasad and his co-authors in 2008 (http://prasad.aem.cornell.edu/doc/new_papers/DECOUPLING_AUGUST.pdf). They decompose the real gross domestic product (GDP) growth rates, real private consumption and real fixed asset investments of 106 countries into different factors. They are:
• A global factor common to all variables and all countries in the system
• A regional factor common to each group of countries
• A country-specific factor; and
• An idiosyncratic component
They estimate the factors over two time periods: pre-globalization (1960-1984) and globalization (1985-2005). Their results show that during the globalization period, it appears that there has been some convergence of business cycle fluctuations among the group of industrial countries and among the group of emerging market (EM) countries.
In other words, there is increased coupling within emerging economies. Quite clearly, the rapid rise of China has contributed to the strong integration within EM economies. China has become the largest trading partner for several developing nations such as South Africa and Brazil in the last few years. This brings us to the question of the outlook for China.
Outlook for China
The World Bank has released its latest quarterly assessment of the Chinese economy. It revised up its estimate for China’s GDP growth by 0.5% to 9.5% in 2010. It anticipates 8.7% GDP growth in 2011.
China weathered the challenge of maintaining growth in 2009 with a massive fiscal stimulus when net export growth collapsed. Now, it faces the challenge of accounting for the costs of that stimulus such as high inflation, problems with local government debt and a property bubble. It has acknowledged all the three risks and has begun to tackle them.
It has tightened bank reserve requirements this year. It has moved to cancel guarantees extended by local governments to special purpose vehicles. That would move banks to adopt a more prudent approach to lending to local governments. The government has introduced a slew of administrative measures to cool down the property market.
Both India and China should be raising rates aggressively this year to glide their respective economies into a sustainable growth path. That would be the ultimate test of their decoupling and being global growth engines in their own right.
In the light of the anecdotal and formal evidence presented in this note, investors should assume that decoupling is real in the real world. Short-term correlations mask the decoupling already under way in financial markets. Emerging market stocks have outperformed developed markets substantially in the last 20 years. Morgan Stanley Capital International index for 22 developed countries has delivered an annual average return of 3.1% in the last 22-plus years, whereas, their Emerging Market Index has delivered 10.6% annually during the same period. Returns are measured in US dollars.
Investors should proceed to invest assuming that decoupling is proceeding in a subterranean fashion. They should use market corrections to increase allocation to emerging market assets.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org