Chetan Ahya | Mumbai Decoupling debate back to forefront. The increasing level of globalization has meant that cycles in both real economies and financial markets in Asia and the US have tended to move in a synchronous manner. However, major strengthening of Asia Ex-Japan’s balance sheet over the last few years is fuelling expectations of a decoupling from the US economic growth. In 2006, AXJ’s nominal GDP is estimated to increase to 45% of US’s GDP from 33% in 2000. The debate is intensifying as recent data from the US indicate a potentially significant deceleration in America’s growth trend. Indeed, our US economics team now expects GDP growth there to slow to a 15-quarter low of 2.2% YoY in 1Q07. The key question for the markets in 2007 is whether AXJ will follow the US in the ensuing downcycle or will it emerge as a “decoupler”?
The case “for” decoupling. There are two key arguments supporting the case for decoupling. First, AXJ’s trade dependence on the United States has been declining gradually over the past few years. This is evidenced by the fact that the US share of AXJ’s exports decreased to 17% in 1H06 from 22% in 1998. Second, the rise in nominal interest rates in AXJ has been slower than the rise in interest rates in the US in the current cycle. Since the US Federal Reserve began its tightening campaign in June 2004, average nominal short-term rates in AXJ have risen by only 85 basis points (150 bps, excluding China), while US short-term interest rates have risen by almost 380 bps.
Evidence suggests linkages remain strong. The actual trend for AXJ export and GDP growth indicates that these economies remain highly correlated with US GDP growth. Since a period of divergence during 1997–98 (when AXJ’s growth decelerated sharply due to the Asian crisis), AXJ has been closely coupled with the US. Moreover, AXJ equity markets have also exhibited a tight correlation with those in the States. Indeed, over the trailing 24 months, monthly returns in Asia ex-Japan have shown a correlation of 0.8 with returns in the US.
We view 2007 as a testing year. For AXJ to decouple, the single-most important factor will be its ability to stimulate domestic demand (the major components being fixed investment and private consumption). In AXJ (excluding India), fixed investments are made with an eye on potential future global demand rather than domestic consumption. Hence, the fixed investment trend has tended to follow the region’s export and global growth cycle. The structural dynamics of private consumption are also uninspiring. Already decelerating, the private consumption trend in the region is unlikely to accelerate much in 2007, barring a sharp cut in interest rates. Indeed, a slowdown in US consumption would only reduce the region’s trade surplus and therefore lessen support provided by excess liquidity. Even though nominal interest rates in the region have lagged the Fed, short-term real interest rates have been rising and are now almost converging with those in the US.
Accounting for 17% of the region’s GDP growth, India is so far the only large economy in the region to have successfully stimulated private consumption growth. However, a large part of the country’s consumption growth is debt funded and dependent on global liquidity trends. Consumption growth in India is now beginning to reflect the rise in interest rates, which in turn have been influenced by the US monetary policy. We believe that the lagged effect of higher interest rates will further slow India’s consumption growth in 2007.
Bottom line — case for decoupling is weak. Although the jury is still out, we believe the case for AXJ decoupling remains weak. Exports and export demand-dependent fixed investment continue to be the key anchors of AXJ’s growth story. In the absence of structural reforms, private consumption is unlikely to take charge any time soon. We believe the case for decoupling is not convincing as we see little indication that AXJ economies can stimulate internal demand enough to offset a potential slowdown in the US.