The Decoupling Myth Demystified!

Emerging Markets – Have they really decoupled from the Rest of the World?

Significant increase in cross-border trade, foreign direct investments, spread of technology and migration led to the coining of the term “globalization”. Globalization opened up the world’s economies - both domestically AND internationally – and resulted in the setup of an international industrial and financial business structure. The pace of globalization was such that ripples felt in one part of the world easily found their way to other parts of the world, regardless of geography.

The most recent example of such a rippling effect is the ongoing U.S. crisis, brought about by a severe housing slump and simultaneous credit crunch, that has resulted in a waterfall effect on the economies of the rest of the world. And to think that some very influential people were discussing the decoupling of the emerging markets from the rest of the world, or to be more specific, from the United States of America.

Now before I go into a discussion of the last statement, let me first briefly describe the decoupling theory and emerging economies. According to the decoupling theory, economies of emerging markets and the U.S. can grow at the two different ends of the growth rate paths. Simply put, the decoupling theory argues that even if the U.S. economy falls into a recession, the economies of the emerging markets will remain untouched and continue their sharp upward growth curve. Emerging markets are defined as world economies which are in a transitional phase between developing and developed status. The four biggest emerging markets are Brazil, Russia, India and China, collectively known as the BRIC economies.

Now coming back to the topic, I would like to state that in this globalized world, no market may remain insulated from global shocks. With the USA accounting for 20% of the global demand, any shocks felt in this economy will have severe repercussions on most of the markets around the world. Despite emerging markets enjoying good fundamentals and strong domestic demand, the shortfall in exports (courtesy the worsening credit crunch in the USA) will need to be replaced by an exceptional (and sustained) increase in domestic demand for these markets to continue growing the way they have done in the past.

Additionally, consider the fact that owing to the opening of world economies, increasing amount of FDI investment has occurred in emerging markets. Most of these FDI inflows are coming in from the U.S. – now with most banks and financial institutions facing severe credit crisis in the USA, investments made in the emerging markets are being liquidated and used to fund the financial needs of the firms back in the USA. This resulting decrease in investments in emerging markets, if not made up by a subsequent increase in domestic investments, will result in loss of liquidity, accompanied by a sharp correction in the valuations of these emerging markets. And this is precisely what has been witnessed. Stock markets in these emerging markets have corrected by a greater margin than the ones in the USA.

Now if we were to even accept the assumptions of the decoupling theory for an instant, how do we then explain the resulting flight of liquidity from these emerging markets without first dismissing the basic assumptions of decoupling? Decoupling suggests the shift of economic power from the USA to the economies of the emerging markets, most notably the ones in Asia. While I do not expect the economies of the emerging markets to follow that of USA’s into recession, I do expect a moderation in the growth rate at which these economies will grow in the coming years. While I do expect the good fundamentals and strong domestic demand in China and India to shift the balance of power from the USA into the hands of these emerging economies in the long-term, I do not anticipate this shift to occur suddenly or in a short span of time.

I believe in the adage that change is constant but I also believe that only a gradual change in the underlying dynamics of the world economy is sustainable. While the emerging markets growing at an exceptional rate, they need to increase the domestic demand and consumption in their markets. This in turn will reduce their dependence on revenue from the USA. To boost domestic consumption in these markets, I believe that their currencies need to appreciate significantly to enhance the purchasing power of the people of these markets. For long we have seen the USA driving the growth for the world markets and hence, it is only justified that the shift of growth drivers occurs gradually. Decoupling is not expected to happen overnight and hence, my belief that emerging markets have not really decoupled from the rest of the world – Yet.