The decoupling debate

As America's economy struggles to stay aloft, the developing world is learning to spread its wings

From The Economist print edition, Mar 6th 2008 | HONG KONG

MANY nasty words begin with the letter D: death, disease, depression, debt (when you drown in it) and deflation. “Decoupling”, on the other hand, has a nicer ring to it, even if it is the source of a great deal of controversy. Economists continue to argue about whether or not emerging economies will follow America into recession. The most pessimistic claim that “it makes no sense to talk about decoupling in an era of globalisation”: economies have become more intertwined through trade and finance, which should make business cycles more synchronised, not less. The slide in emerging stockmarkets on Wall Street's coat-tails appears to endorse their view. Yet recent data suggest decoupling is no myth. Indeed, it may yet save the world economy.

Decoupling does not mean that an American recession will have no impact on developing countries. That would be daft. Such countries have become more integrated into the world economy (their exports have increased from just over 25% of their GDP in 1990 to almost 50% today). Sales to America will obviously weaken. The point is that their GDP-growth rates will slow by much less than in previous American downturns. Most enjoyed strong growth during the fourth quarter of last year, and some speeded up, even as America's economy ground to a virtual halt and its non-oil imports fell.

One reason is that while exports to America have stumbled, those to other emerging economies have surged (see chart 1). China's growth in exports to America slowed to only 5% (in dollar terms) in the year to January, but exports to Brazil, India and Russia were up by more than 60%, and those to oil exporters by 45%. Half of China's exports now go to other emerging economies. Likewise, South Korea's exports to the United States tumbled by 20% in the year to February, but its total exports rose by 20%, thanks to trade with other developing nations.

A second supporting factor is that in many emerging markets domestic consumption and investment quickened during 2007. Their consumer spending rose almost three times as fast as in the developed world. Investment seems to be holding up even better: according to HSBC, real capital spending rose by a staggering 17% in emerging economies last year, compared with only 1.2% in rich economies.

Sceptics argue that much of this investment, especially in China, is in the export sector and so will collapse as sales to America weaken. But less than 15% of China's investment is linked to exports. Over half is in infrastructure and property.

It is not just China that is building power plants, roads and railways; a large chunk of the Gulf's petrodollars are also being spent on gleaming skyscrapers and new airports—not to mention ski-domes in the desert. Mexico, Brazil and Russia have also launched big infrastructure projects that will take years to complete.

The four biggest emerging economies, which accounted for two-fifths of global GDP growth last year, are the least dependent on the United States: exports to America account for just 8% of China's GDP, 4% of India's, 3% of Brazil's and 1% of Russia's. Over 95% of China's growth of 11.2% in the year to the fourth quarter came from domestic demand. China's growth is widely expected to slow this year—it needs to, since even Wen Jiabao, the prime minister, warned this week of overheating—but to a still boisterous 9-10%.

Smaller economies in Asia look more vulnerable. For example, Malaysia's exports to America amount to 22% of its GDP, and they fell by 18% in the year to December. Yet its annual GDP growth jumped to 7.3% in the fourth quarter, thanks to consumer spending and a jump in government infrastructure investment.

Mexico's exports to America are an even larger 27% of its GDP. Real GDP growth held steady at 3.8% in the year to the fourth quarter, but manufacturing jobs are falling and workers' remittances from abroad are falling. Retail sales grew by only 1% in the year to December. Yet the economy is holding up better than during previous American downturns, partly because high oil revenues have enabled the government to increase investment by around 50% over the past year.

American downturns have often caused the prices of oil and other raw materials to slump, but this time China's surging demand is propping up prices and fuelling booms in Brazil, Russia and the Middle East. Brazil's exports jumped by 26% in the year to February. In turn, if prices stay strong, so will China's exports to commodity-producing countries. A sharp slowdown in China would hurt them more than an American recession will.

Act global, think local

A recent IMF study* by Cigdem Akin and Ayhan Kose offers some support for the idea that you can have both decoupling and globalisation at the same time. They divide 106 countries into three groups—developed, emerging, and low-income developing countries (which are less integrated into the world economy)—and then measure how the correlation between economies has changed over time as cross-border flows have expanded. They find that growth has indeed become more synchronised among developed economies and also among emerging economies. But, surprisingly, economic activity in emerging economies has diverged (or decoupled) from that of developed economies over the past two decades. The impact of rich economies on emerging economies' growth has fallen sharply.

The popular argument is that business cycles should become more synchronised because in a globalised world everyone is in the same boat. But this rests on an out-dated impression that poor countries mainly export to rich ones. Instead, emerging economies' trade with each other has risen faster and now accounts for over half of their total exports. Emerging markets as a group now export more to China than to the United States (see chart 2).

Some contend that this mainly reflects imports of intermediate goods into China for assembly; the finished goods are then exported to America and so will be hurt by slower growth. There is some truth to this. However, an analysis by BCA Research, a financial research firm, finds that Asian exports to China are increasingly driven by China's own domestic demand. A growing share of emerging economies' exports are also commodities sold to China.

Another reason why globalisation and decoupling can co-exist is that opening up economies has not only boosted poor countries' trade, it has also spurred their productivity growth and hence domestic incomes and spending. In 2007 emerging economies' real domestic demand grew by an average of 8%, almost four times as fast as in the developed world.

A severe recession in America could still have a nasty impact on the developing world if commodity prices collapsed and if it caused stockmarkets to fall more steeply, depressing global consumer and business confidence. A sharper fall in the dollar could also further squeeze emerging economies' exports.

But for perhaps the first time ever, developing countries would be able to make full use of monetary and fiscal policy to cushion their economies. In the past, when they were net foreign borrowers, capital inflows tended to dry up during global downturns as foreign investors shunned risky assets. This forced governments to raise interest rates and tighten fiscal policy. Economies with large external deficits, such as South Africa, Turkey and Hungary, are still vulnerable. But most emerging economies now have a current-account surplus and large foreign reserves; many have a budget surplus or are close to balance, leaving ample room for a fiscal stimulus if necessary.

Perhaps the best support for decoupling comes from America itself. Fourth-quarter profits of big companies, such as Coca-Cola, IBM and DuPont, were better than expected as strong sales growth in emerging markets offset a sharp slowdown at home. In other words, bits of American business are rising above their own economy. With luck, the world economy can rise above America's.

*"Changing Nature of North-South Linkages: Stylized Facts and Explanations", IMF Working Paper WP/07/280.

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