Does the crash of stock markets in India and other emerging markets mean that the “decoupling” thesis — the notion that emerging-market economies can continue soaring even if the US economy dips — has been proved wrong? Not exactly. What it shows is that stock markets across the globe are more closely linked than economies. Over the last two decades, stock-market dependency has increased even as real-economy dependency has decreased.
However, do not assume that stock-market dependency means that Indian markets will always plunge along with US bourses in a US recession. The growing muscle of China and India, and their ability to grow reasonably fast even in a global recession, means that they will one day be viewed as the safe havens of the future. That is, we could see a switch of funds from the US to India in a recession. It may be premature to expect this to happen in 2008. But do not rule it out.
For a long time, the US has dominated the world economy, accounting for a quarter of world GDP and almost 40% of annual GDP growth some years ago. So a standard analogy to describe the world economy was that of a railway train, with the US locomotive pulling other wagons along. When the locomotive slowed, so did the wagons.
They were coupled. This was never a good analogy. That is demonstrated by the simple fact that a US recession is generally defined as a decline in GDP growth for two successive quarters, whereas a global recession is generally defined as global GDP growth of less than 2.5%. Clearly, a stalled US economy does not bring the world to a complete halt.
In recent times, many theorists and stock market practitioners have talked of the decoupling of the wagons from the locomotive. That’s a terrible analogy — decoupled wagons do not move forward at all! What the theorists actually want to say is that developing countries are capable of fast growth even if the US slows down.
A better analogy would be that of a series of speedboats (countries) tied to each other (globalisation). Each speedboat has its own engine and velocity, but can be slowed down or pulled along faster by the action of others. So, the net outcome depends both on internal and external factors.
What matters is not just the velocity of each speedboat (that is, its rate of growth) but its size (its share of world GDP). Thus the US may be moving more slowly than small Asian countries but has a greater influence on the overall line of ships than some small, fast-growing countries.
In the past four years, the contribution of countries other than the US to the world economy has risen significantly. Developing countries have accelerated phenomenally. China and India have done exceptionally well, but so have Russia and many others in Asia, Latin America, Africa, Eastern Europe. In 2007, the contribution of China to annual world growth overtook that of the US in dollar terms, and was several times as high in PPP terms.
Once, developing countries were highly dependent on exports to the US. But they have now diversified their trade. India’s merchandise exports are 14% of GDP, but the US accounts for only 2% of this. Similarly China’s exports are almost 40% of GDP, but the US accounts for only 8% of this, So, a US slowdown will have adverse effects on China and India, but will not make a huge dent in their exports or GDP.
The share of the US in world GDP has come down to perhaps 21%. The IMF projects that US growth will decelerate to 1.9% in 2008, yet projects world growth at a buoyant 4.8%. This suggests that the world has multiple centres of growth — several speedboats now have strong engines, and depend less on the US engine.
Why then have all emerging stock markets crashed in January, along with US markets? The simple answer is that the US may not dominate the world economy, but global investors dominate emerging-market bourses. A billion dollars is peanuts for global investors, but is a huge sum for emerging stock markets. The inflow of billions from foreign institutional investors (FIIs) has ramped up prices across emerging markets in the last decade. And the withdrawal of a tiny fraction of this sum in January was enough to ramp down prices.
Emerging-market economies may be less dependent on the US economy for real growth. But emerging bourses are more exposed to and dependent on global funds than ever. Domestic investors cannot move the markets as FIIs can.
Now, the strength of domestic mutual funds has improved in India. Indeed, on a few exceptional days the Indian market has advanced even when foreign institutional investors have been selling. Yet whenever FIIs are seen selling on a serious scale, no domestic investor dares buck the trend.
Twenty years ago, FII investments in emerging markets were negligible. These markets were considered too risky by global investors. Besides, many countries — including India and China — had severe restrictions or outright bans on foreign entry into local stock markets. In that era, links between the Dow and emerging markets were very limited. Not any more.
However, dependence on FIIs is not the same thing as dependence on US bourses. Till now, FIIs in emerging markets have bought and sold in line with US markets. But, given the new strength of emerging markets, the day will come when it no longer makes sense to treat the US as a safe haven—or emerging markets as unsafe—in the event of a global recession.
Indeed, it may be both profitable and safe to take money out of the United States and put it in emerging markets. This would constitute a revolution in the thinking of global investors about safe havens. It will happen one day, just may be by the end of this year. If that happens, global markets will indeed be coupled, but emerging markets will be the new locomotive.