Background There are many factors that could lead to a recession in an economy (poor macroeconomic fundamentals, financial market meltdown etc). Recessions are a part of the economic cycle and have been there since time immemorial. However, with passing time, the economists and policymakers have managed to lessen the impact of recessions on the economy. Earlier, the impact of recession was mostly limited to the domestic economy but with increasing globalization, the possibility of recessions spreading to other regions has increased. This is because of 2 main channels: 1)

Trade Channel: If an economy falls into a recession it would affect its trading partners. A recession would imply less demand for overall products and services including import items. A recession also leads to lower investments and corporates would not be able to export their products and services. The first would affect the incomes of its export partners and second would effect the consumption levels of its importing partners. Trade constitutes a significant part of world economy and the level has been rising over the years (Figure 1). This channel was quite powerful when the domestic recessions started impacting other economies. Figure 1: World Trade as a % of GDP 70 60 50 40 30 20 10 2006

2004

2002

2000

1998

1996

1994

1992

1990

1988

1986

0 1984

Amol Agrawal +91 22 66177921 [email protected]

The US economy is expected to go into a recession. As the crisis folded it was expected that the crisis would be limited to the US economy. Over a period of time the developed economies were also affected by the crisis requiring Central banks to cut rates and offer liquidity in their markets. The next part of the debate is whether the recession is going to impact emerging economies as well. This report attempts to answer the related questions.

1982

January 07, 2008

Decoupling or recoupling?

1980

ECONOMIC RESEARCH

Source: : IMF, IDBI Gilts Ltd.

2)

Financial Channel: This channel has received more attention in the recent years. This channel effects mainly through financial linkages across countries. The cross border financial linkages have increased substantially over the years. IMF reports that gross external assets of industrialized economies have increased from 28% of GDP in 1970 to 155% in 2005. The emerging markets the same percentage has increased from 16% to 57%. If the cross linkage is high the impact is likely to be higher. A drop in asset prices in one country because of recession also leads to lower asset prices in economies where the cross-linkages are high. This channel poses numerous challenges to policymakers as unlike the trade channel, financial channel works mostly without any lags. Another problem is that the correlation between assets has been rising across the world. An IMF study showed that correlation between the G-7 economies, the stock market correlation increased from 0.54 to 0.69 between 1995-96 and bond yields correlation coefficient increased from 0.54 to 0.80 in the same period. This implies that domestic macroeconomic fundamentals seem to matter lesser while pricing assets. Hence, any impact on US financial markets is not just transmitted to the other markets immediately, the movement is also more or less similar.

Economic Research: Decoupling or recoupling?

Decoupling from US economy Wikipedia defines Decoupling as "lessening of correlation or dependency between variables". In this report's context if we say that the economies have decoupled from US economy, it means the slowdown in the US economy would not effect other economies. The reason is there is less correlation between growth in US economy and the other economies. The other economies can sustain their growth levels in backdrop of strong domestic macroeconomic conditions. The opposite is recoupling which means the imapct on other economies is expected to be large if there is a recession in the US economy. The question that comes to mind is why is decoupling only considered with respect to US economy? Why not with any other economy? The reason is the size of the US economy. Despite the formation of Euroarea and performance of emerging economies, the US economy is still the largest economy in the world on most parameters (Figure 2). Euroarea, the second largest economy contributes more to the world exports than the US but on other parameters it is still smaller than the US economy (Figure 3). The impact of US recession can be felt via both the channels - trade and financial. US is the largest importer and most South Asian countries whose growth is export driven like China etc derive a large part of their export incomes from US. US also accounts for majority of the external assets held by other economies and US investors also holds more liabilities than other countries; meaning that financial linkage is pretty high. Another very important historic reason is that after World War II, the rebuilding of world economy was built around the US economy. The US has always been a net importer for many years thereby helping other economies prosper. Over a period of time it ushered innovations across its economy leading to higher growth and as a result, the US economy has always been at the center of the world economy. Figure 2: US economy as a % of World Economy 50

(in %)

40 30 20 10 0 GDP (at PPP)

GDP (at mkt ex ch.

Ex ports

Imports

rates)

Stock Market Capitalization

1971–75

1986–90

2001–05

Source: : IMF, IDBI Gilts Ltd

Figure 3: Contribution of US and Euroarea to World economy (2001-05) 50

(in %)

40 30 20 10 0 GDP (at PPP)

GDP (at mkt ex ch.

Ex ports

Imports

Stock Market

rates)

Capitalization US

Source: : IMF, IDBI Gilts Ltd

2

Euro Area

Economic Research: Decoupling or recoupling?

Decoupling evidence There has been plenty of research on the decoupling subject but the one done by IMF is the most comprehensive so far. They have studied the impact of various US recessions in select regions (table 1). O

O

O

O

O

On a quick glance one can see that US recession does impact the other economies. The regions usually experience a negative growth in the years US undergoes a recession. However, the impact on other economies has been lesser than the US economy. There is not a definite trend as in case of some recessions certain region has slowed more than others. In some cases the regions have actually grown. There are different reasons for the above trend. In some recession period, the growth has declined elsewhere because of common factors affecting all the economies like the 1974-75 oil crisis, 2001 dot-com crisis. Likewise, the collapse of the Savings & Loans institutions led to the 1991 recession and was limited to the US economy. On looking at the impact on India, there seems to be little impact of the US recession on Indian economy. The summary is that most regions do see slowing growth conditions post a US recession, but the reason is not due to US recession alone. It could also be because the conditions are such that they could affect the most regions in the world economy. Table 1: Change in GDP growth in select regions during US recessions (in %) 1974-75

1980

1982

1991

2001

Summary

United States

-6.1

-3.4

-4.5

-2.1

-2.9

-3.8

Other industrial countries

-5.4

-1.5

0.4

-1.3

-2.0

-2.0

Latin America

-3.2

-0.8

-3.9

1.1

-1.8

-1.7

Middle East and North Africa

1.2

-1.0

-3.3

0.8

-0.7

-0.6

Emerging Asia

-3.5

-0.3

-1.5

-0.1

-1.1

-1.3

India*

1.2

6.7

3.5

1.1

5.2

3.5

-0.5

-

1

Sub-Saharan Africa Emerging Europe and CIS

-

0.6

0.2

-6.9

-0.3

-3.6

Note: * For India we have added the % figures from RBI. As RBI gives data for the financial year, 1980-81 data is assumed as 1980 and so on just to give an indicative picture. Source: IMF,RBI, IDBI Gilts Ltd.

The sub-prime crisis decouple Let us understand the impact of the current crisis in terms of above channels: 1)

Trade Channel: The sub-prime crisis started surfacing in early 2007. In a recession both exports and imports are expected to decline (explained above) and this could have a negative impact on its trading partners. The figures show that in most of 2007, the growth rate in exports has picked up in recent months and in imports the growth appears to have slowed down (Figure 4). The growth in exports has also picked up because of the depreciation of the US Dollar against most currencies. The depreciation of US has been expected since many years mainly because of its huge current account deficit and the subprime crisis has acted as a trigger for the same. As imports have not really declined in absolute numbers the impact on other economies has not been felt so far. However, because of dollar depreciation the demand for US exports has increased. Income from exports will help the US economy fight recession better and it also means more competition in the export market. Overall, the damages from trade channels have started to show but it is still limited.

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Economic Research: Decoupling or recoupling?

Figure 4: Growth in US Exports and Imports (Y-o-Y) 20.0 15.0 10.0 5.0

Sep-07

Jul-07

May-07

Mar-07

Jan-07

Nov-06

Sep-06

Jul-06

May-06

Mar-06

Jan-06

0.0

Ex ports

Imports

Source: US Census, IDBI Gilts Ltd.

2)

Financial Channel: The focus of this crisis has been on the financial channel. There is a possibility that because of the attention on this channel the impact via trade channel has been ignored. Further research is needed to identify whether the channel has created any impact or not. Infact, the financial markets had pointed out long ago that a crisis is on the anvil as the spread between corporate bonds and treasury has been low as per historic standards and research shows whenever it is so low, a crisis is around the corner. Alan Greenspan recently wrote in Wall Street Journal: Over the past five years, risk had become increasingly underpriced as market euphoria, fostered by an unprecedented global growth rate, gained cumulative traction. The crisis was thus an accident waiting to happen. If it had not been triggered by the mispricing of securitized subprime mortgages, it would have been produced by eruptions in some other market. As I have noted elsewhere, history has not dealt kindly with protracted periods of low risk premiums. The sub-prime crisis started in US and the impact was initially felt on the US financial markets. Since, then enough coverage has been given to the way the crisis has impacted other financial markets and now their economies as well. Most developed economies have lowered their growth forecasts for the year 2008 and have reduced their benchmark rates at a time when inflation is inching upwards (refer IDBI Gilts report dated 31 Dec 2007 for details). The reasons for the linkages have been espoused above and are now well known. The main reason is that increasing financial globalization led to the crisis spreading elsewhere.

The summary is that the sub-prime crisis has impacted the other economies via the financial channel but so far the impact has been limited via the trade channel. Any further impact would depend on how the crisis unfolds in coming days.

Sub-prime sub prime on the Wall (Street), How far will you go, after all? This rhyme has been rephrased from the famous fairytale, Snow White and Seven Dwarfs. In the tale, the queen every morning looks at a magic mirror and asks "Mirror mirror on the wall, who is the fairest of them all?" In similar tone, only the subprime crisis knows how far will it go and how much damage it would cause, as most predictions have not really been correct. At hindsight the nature of the crisis has always been perplexing even for the best minds. Initially, most didn't expected that the crisis would hurt the entire economy as subprime was a very small market. But the widespread impact and huge magnitude of the crisis surprised all. Since then analysts have raised their concerns and expect the crisis to turn into a recession, but again the economic data released so far continues to be mixed. The housing prices have continued to fall sharply as expected but the impact on other variables has not shown in recent data releases. The regional Feds have indicated that overall activity has slowed in their regions in December but then for the crisis to be called a recession there is a need for a more unidirectional data, which is missing. Hence, only the crisis itself knows how much more damage would be caused.

4

Economic Research: Decoupling or recoupling?

The above analysis shows that damage has been caused and we cannot say that economies have actually managed to decouple from the US economy. But then again, as there is not enough evidence of how much other economies would slow, it is difficult to say that a recession in US would impact others as well. Above all, there is still no surety that there is going to be a recession in the US at all. Just as shown in Table 1, if a recession indeed takes place it will impact the other economies but the scale of magnitude will differ from US. The emerging markets have not really been impacted by the crisis as the crisis has mainly impacted via the financial channel. The emerging markets did not have as much exposure to the US mortgage markets. Table 2 shows that advanced economies had the maximum exposure to the US mortgage markets, seconded by the various tax haven islands like Cayman Islands etc. These islands are home to many hedge funds who have been major investors in the mortgage backed bonds and that is the reason for seeing such huge percentages against these islands. However, the trade channel may impact the emerging markets if the economic activity worsens in the US. As explained above, the US is the largest importer in the world and many developing/emerging markets depend much on the US import growth. Table 2: Exposure of regions to the US debt markets (in %) Total debt

Total Asset Backed

Mortgage Backed

Asset Backed

Advanced Economies

58.8

62.2

56.7

69.6

Developing Economies

2.6

0.4

0.3

0.6

Cayman Islands

5.8

17.4

21.2

12.4

Jersey

0.7

4.6

5.1

3.8

Bermuda

2.7

4.5

4.2

4.9

British Virgin Islands Above Total

0.5

0.1

0.1

0.1

71.0

89.3

87.6

91.5

Source: IDBI Gilts Ltd.

Impact on Indian economy Trade Channel: For this an analysis of direction of India's foreign trade in required. Figure 5 shows that India's direction of trade has moved increasingly from developed countries to developing countries. Whether we look at exports or imports, the trend is same. The developing countries contribution to India's exports has increased from 43 % in 2000-01 to nearly 60% in 2006-07. Likewise the imports' share has improved from 29.1% to 63.1%. On looking at the US case specifically, the share of imports to US has stayed constant around 6%-6.5% over the period and the share of exports has declined from 21% to 15%. Figure 5: Contribution to India's foreign trade 100% 80% 60% 40% 20%

2000-01

2001-02

2002-03

2003-04

2004-05 Dev eloped Economies

2005-06

Imports

Exports

Imports

Exports

Imports

Exports

Imports

Exports

Imports

Exports

Imports

Exports

Imports

0% Exports

1)

2006-07 P

Dev eloping Economies

Source: RBI, IDBI Gilts Ltd

5

Economic Research: Decoupling or recoupling?

Figure 6: Share of US in India's Trade 25.0

(in %)

20.0 15.0 10.0 5.0

2000-01

2001-02

2002-03

2003-04

2004-05

2005-06

Imports

Exports

Imports

Exports

Imports

Exports

Imports

Exports

Imports

Exports

Imports

Exports

Imports

Exports

0.0

2006-07 P

Source: RBI, IDBI Gilts Ltd

This means overall the reliance on developed countries has reduced for Indian and much of the exports and imports are going to developing countries. This implies, if a recession strikes in US economy and other developed economies as well, the it is likely have a limited impact on the Indian economy via the trade channel. But risks remain as the Asian economies are in turn dependent on US trade and the chain of events might hurt the Indian economy Another important point is to distinguish the impact of rupee appreciation from the mentioned trade channel. The rupee has been appreciating across the major currencies and if the trend continues it might worsen the trade balance in few years. But then rupee appreciation has not really impacted the exports as it was widely expected. (Figure 7) Figure 7: Growth rate in Indian exports (Apr -Nov 2007) 40

(in %)

30 20 10

November

October

September

August

July

June

May

April

0

Source: Commerce Ministry, IDBI Gilts

2)

Finance Channel: As explained above, the financial markets transmit the information almost immediately and price the risks as per the situation. In India, the corporate debt market is not very active and as a result the price movements cannot be seen in this market. The best way to analyze the impact via the finance channel is to see the movement in the equity markets of the 2 countries. India has been growing at a rate of average 8.5% and it is expected that the growth momentum would continue. Hence, capital inflows continue to surge looking forward to high growth rates in the country. The huge interest in Indian economy has led to a surge in equity markets in the country. So, the hypothesis is that if India growth story is to be believed then the impact of sub-prime crisis should not impact the Indian economy. Moreover, India is a consumption driven economy and the impact of the recession in US should be less on India compared to China which is an export driven story. In an effort to point out the linkage the return from Dow Jones have been taken and for BSE Sensex, the return from subsequent day has been taken. This means if the US markets close down today, what would be the changes in BSE Sensex next day? The analysis shows some interesting findings (Table 3). The correlation increased when the crisis looked severe i.e. in August 2007 and December 2007. This implies in times of crisis the markets track the movements in

6

Economic Research: Decoupling or recoupling?

US markets. The analysis also suggests that linkage between BSE-Sensex and Dow Jones has been increasing over the years. The conclusion is that the financial linkages between the US equity markets and Indian equity markets seem to be increasing over the years and more so in times of crisis. If the subprime crisis continues to effect the developed economies and their equity markets then the spillover is likely to fall on the Indian equity markets as well. This implies the Indian growth story might take a backstage for a while leading to concerns in the markets. Another point to note is that Indian equity markets have been rallying in backdrop of sustained pace of portfolio flows. Indian markets continue to be attractive as economy is expected to grow around 8%-8.5% over the next few years. The analysts believe that if the developed world slows this would mean more capital flows in emerging markets and India as the foreign investors would looks for returns elsewhere. This preposition is not entirely correct. These financial entities are highly leveraged and if there is a problem in their home countries the entities would reduce their leverage and use capital to cover their losses. This might lead to reduced capital inflows in India and apply downward pressure in Indian equity markets. Table 3: Correlation between BSE and Dow Jones Aug 2007

0.46

Sep 2007

0.40

Oct 2007

0.19

Nov 2007

0.32

Dec 2007

0.47

Jan- Jun 2007

0.41

Jul-Dec 2007

0.37

2007

0.38

2006

0.38

2005

0.31

Source: Yahoo Finance, IDBI Gilts Ltd.

Final thoughts The above analysis points out that couple of things. One is that the complete decoupling or recoupling theory is not correct. There is bound to be an impact on other economies but it will not be as much as is usually expected. Above all, there is still no clarity on whether the subprime crisis would lead to a recession in the US economy. Out of the two channels, the financial channel has been dominant so far. The trade channel has not really impacted and the concern has not been felt on other economies. It will all depend on how far the subprime crisis would go.

IDBI Gilts Limited (A wholly owned subsidiary of IDBI Ltd.) 1st Floor, Janmabhoomi Bhavan, Janmabhoomi Marg, Fort, Mumbai – 400 001. Phone: (91-22) 6617 7900. Fax: (91-22) 66177999 Disclaimer This report has been prepared by IDBI Gilts Limited (IDBI Gilts) and is meant for the recipient for use as intended and not for circulation. This report should not be forwarded or copied or made available to others. The information contained herein is from the public domain or sources believed to be reliable. While reasonable care has been taken to ensure that information given is at the time believed to be fair and correct and opinions based thereupon are reasonable, due to the very nature of research it cannot be warranted or represented that it is accurate or complete and it should not be relied upon as such. IDBI Gilts, its directors and employees will not in any way be responsible for the contents of this report. This is not an offer to sell or a solicitation to buy any securities. The securities discussed in this report may not be suitable for all investors. Investors must make their own investment decision based on their own investment objectives, goals and financial position and based on their own analysis. IDBI Gilts, its directors or employees may from time to time, have positions in, or options on, and buy and sell securities referred to herein. IDBI Gilts, during the normal course of business, from time to time may solicit from, or perform investment banking or other services, for any company mentioned in this report.

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