Decoupling Theory – Truth or Myth? A Rogue Engineer turns Economist!

A few days back I was reading the book The World is Flat by Thomas L. Friedman, a bestseller by any regard. The book basically describes how Globalization 3.0 has emerged. This has not only brought countries and individuals close to each other; it proves how this has resulted in increased competition, the end result being a spur in innovation and increased cost advantage for companies and individuals. It also states the new fundamental tenet that globalization is the need of the hour and it’s good for everyone and not against particular individuals. It also states that in the present day global nations are very much interdependent on each other for economic growth and sustenance.

Decoupling Theory: The theory of decoupling suggests that emerging markets have broadened and deepened to the point that they no longer depend on the United States for growth, leaving them insulated from a U.S. recession.

The decoupling theory in no way shuns the globalization theory; all it says is that the major emerging markets primarily the BRIC (Brazil, Russia, India and China) countries have been showing increased economic activities and attracting foreign investments irrespective of the economic trends seen in the US. The theory took much flak off-late after the expose of the housing bubble in the US and subsequent Credit Crunch and Recession. The world markets saw a major downtrend, export driven sectors worldwide were hit by and large (E.g.: IT sector in India)

Demand for Commodities: Generally a recession results in a decreased economic activity, the demand for commodities is expected to fall and in some cases even spur cost-push inflation. The biggest critics of decoupling theory state that recession in the US will result in reduced demand for commodities and thereby hit the emerging economies because majority of their exports are commodity driven. But the supporters of this theory state that the recession is only going to affect the investments in the US and the general public would still be demanding the same level of commodities as before and that there will be no slowdown as such.

On the investment front, due to the declining dollar and interest rates cut by the Federal Bank resulted in diminished returns and hence investments started flowing to emerging economies where the returns were more lucrative (in India in terms of FII). So this resulted in increased economic activities in these economies for a while. However as the recession started finding its root in the export driven sectors in these economies, the companies started feeling the heat and subsequently they showed lower growth margins. Moreover as a result of rapid surge (due to increased foreign investments) these markets reached saturation and were sure to see the downfall. This was seen in the recent market downtrend in India where the stock markets have been falling ever since the start of the year. Now the decoupling theory supports it by stating that these stocks had already reached their peak (Technically say by the P/E) and the people thought that they were overvalued and their selling was imminent and bound to fall, the net sellers being FII. However the critics ridicule it stating that the market went into the bear mode due to increased risks pertaining to US recession and the liquidity crunch resulted in further keeping the investors from making huge commitments monetarily in these emerging economies.

Inflation, the critics of the theory state is an example of the developing nations to hold back the green buck (USD) and purposely devaluing their own currencies to make their exports competitive. This resulted in increased costs of imports for these countries. Now commodities like Crude oil went up. Now since it’s valued in dollars and these countries have devalued their currencies thereby passing on increased cost in their country triggering cost-pull inflation where the general input costs for production have gone up resulting in higher priced commodities, making it difficult for the common man. (For e.g. the RBI was accused of selling rupees and buying dollars to boost the export sector and curb inflation but did it work out? It only resulted in import getting costlier prices being passed on to the common man and thus increased inflation.) The supporters of Decoupling theory state that unlike general observation that due to the recession demand for commodities is going to go down, the opposite has happened and the increased economic activity and demand in emerging economies have pushed the prices up while the demand has reduced in the US supporting the theory further.

The increased per capita income in these emerging economies has resulted in improved standard of living and greater domestic demand for goods. Thus the local demand and supply has attained a greater share of GDP and greatly increasing the economic activity in the country. (for e.g. in India itself the rising standard of living has fuelled a great demand for electronic goods and connectivity leading to a boom in the telecom sector and subsequently in the semiconductor sector) The Economist a leading publication states the figure that the income level has seen a rise of 17% in emerging economies as compared to 1.5% in the developed ones.

Finally coming to Exports, figures state that emerging markets send half of their exports to the emerging markets itself. China’s total exports to US fell by 5% in the aftermath of housing bubble burst but exports to other Brazil, Russia and India was up by more than 60% and those to the oil producers by 45%. Moreover the export to US now contributes only 8% to Chinese, 4% to India, 3% to Brazil and 1% to Russia’s GDP. Thus the emerging economies surely have become more decoupled to the US than before. Moreover the domestic production and consumption has taken forefront.

Conclusion: The present US recession was initiated by the Sub-Prime mortgage crisis and the subsequent Credit crunch. This was followed by worldwide market downfall and at the same time the world witnessed the Food crisis (courtesy droughts, Floods, hoarding, Export bans, Bio-Diesel etc) and the Crude shock (courtesy OPEC’s bullying controlling the oil prices due to depreciating dollar and they trying to maintain their purchasing power, or because of the increased demands from China and India). The various reasons are yet to properly justified. Probably another recession in the US accompanied by a rapid economic activity in the emerging countries and devoid of basic commodity shocks is required to properly justify that the Decoupling theory stands or falls!

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