China Tells

Far Eastern Economic Review – Ulrich Volz

Until September 2008 there was a lot of discussion about “decoupling”—the belief that emerging markets in Asia and elsewhere would be relatively unscathed from the bleeding of Western finance and that their economic growth would no longer rely on the well-being of the industrialized world. Emerging economies, it was argued, were resistant to American and European contagion due to their strong domestic markets, high currency reserves and prudent macroeconomic policies.

The decoupling debate came to an abrupt end, however, when the meltdown on Wall Street sent shockwaves through the entire global financial system, not least in the emerging markets of Asia.

Now talk of decoupling is back.

In May, the Economist magazine already detected a “Decoupling 2.0,” where some of the larger emerging markets, with China at the spearhead, would see a decent rebound whereas the U.S., Europe and Japan would remain in a prolonged slump.

Over the past months more good economic news, especially from emerging Asia, has sustained the impression that a rebound is underway and that their economies have indeed become less dependent on the fortunes or misfortunes of the West.

But is it appropriate to call this decoupling?

If decoupling is to mean more than just higher growth rates in emerging markets than in the G-7 economies (something we have long observed), it suggests that their business cycles are no longer determined by those of the major advanced economies but mostly by other factors. Is this the case now for Asian countries?

While structural changes, which most likely will be further accelerated through the current crisis, have been underway in the world economy long before the outbreak of the global economic crisis, it might be too early to declare a decoupling of Asian emerging markets (or those in any other region) from the West, for several reasons.

First of all, one should note that while virtually all Asian economies have been hit by the financial crisis, the damages, at least in their financial sectors, have been much less severe than in Europe or the U.S., which makes recovery of their real economies easier and more rapid. An earlier resumption of growth does not necessarily imply that emerging Asian economies have decoupled, especially as green shoots can also be seen elsewhere. Even Germany, which as the world’s biggest export nation has been hit particularly hard by the collapse of global commerce, has now technically overcome recession and reported positive (if tiny) output growth rates for the second quarter of 2009.

Second, while the world economy has stabilized over recent months and we are no longer operating in an environment of complete uncertainty, it is far too early to declare an end to the crisis—in Asia or elsewhere. Hopes are that even the U.S. and Europe are now on the way toward recovery, but there are still unknown risks und unresolved problems in the financial sector that could cause further setbacks. New shocks to Western economies would likely delay a full-blown Asian recovery. The reaction of Asian stock markets to the release of U.S. unemployment figures, for example, illustrates quite clearly that Asian traders are not indifferent to U.S. economic growth.

Third, most Asian governments were able to quickly implement fiscal-stimulus packages to stabilize their economies. In this regard, China’s state-ownership of the banking system proved to be an asset as it allowed the government to promptly spur investment and economic activity with a massive stimulus package. What is less clear is whether the recovery will be sustained once the effects of the stimulus fade. Moreover, the Chinese banking sector—which had a nonperforming loan problem already before the crisis—will most likely suffer the unpleasant consequences of unprecedented credit expansion.

Fourth, China, like the other emerging East Asian economies, remains tied to the U.S. economy through the dollar. As long as East Asian currencies are linked to the dollar through soft or hard pegs, the monetary policy autonomy of these countries will inevitably be constrained, as monetary policy will be influenced by the policies of the Federal Reserve. Without a delinking from the dollar, a decoupling of East Asian economies from the U.S. economy remains unlikely.

Nonetheless, business cycles within Asia—especially East Asia—have become more closely correlated as real and financial linkages have strengthened. Indeed, the development of extensive trade-production networks across East Asia has created a regional economy that is nearly as integrated as Europe. Further regional economic integration and development of consumer markets within Asia will conceivably reduce dependency on the U.S. and European economies, especially if this integration occurs along with a gradual delinking from the dollar and efforts to strengthen regional macroeconomic and financial cooperation.

In short, “Decoupling 2.0″ could be on its way, but it remains far off in the distance.

Ulrich Volz is senior economist at the German Development Institute / Deutsches Institut für Entwicklungspolitik (DIE). His book “Prospects for Monetary Cooperation and Integration in East Asia” is forthcoming at MIT Press.