On Thursday, December 6, the Bank of England (BoE), the RBI's UK counterpart, cut its signal interest rate by a quarter of a percentage point. In doing this, the central bank put aside its concerns on inflation pressures and trained its focus on the problem of slowing growth in the UK economy.
The currency market had a niggling suspicion that this would happen and for about a week before this policy announcement, the pound sterling had shed quite a bit of its gains against the dollar (remember that in the short term, exchange rates are driven by capital flows seeking interest rate arbitrage; a lower interest rate thus discourages flows and pushes down the exchange rate).
At first glance, it seems like a somewhat irrelevant detail as far as Indian financial markets are concerned. I would argue that there is more to it than meets the eye. Most importantly it is the first major blow against the much-touted 'decoupling' theory that has held sway in global asset markets.
'Decouplers' argue two things. First, the current crisis in the US economy (and the possibility of a recession) is really a local problem since it stems largely from default in the American mortgage market. Second, and this comes as a corollary, the economic trajectories of the US and the rest of the world can diverge sharply. The rest of the world can chug along at a healthy pace irrespective of what happens in the US.
In short, the US and the rest of the world have 'decoupled.' It follows that even if the US asset markets were to crumble, markets in the rest of the world could hold up. This includes the foreign exchange markets and if one were to extend the logic, the US dollar is likely to take some more beating going forward.
The BoE's decision and its concerns about growth highlight two things. For one, some of the UK's domestic problems, particularly the presence of a large pool of dodgy mortgage borrowers, are similar to those of the US. Thus, if defaults in the so-called sub-prime market in the US can trigger a sharp slowdown, a similar fate awaits the UK. Two (and this is more relevant to the decoupling hypothesis), strong trade and investment linkages between the UK and US suggest that if the latter slows down, the British economy would also falter.
The rate cut thus hopes to achieve two things spur domestic investment and also help in correcting the overvaluation of the British pound to give exports a helping hand in the face of slowing demand from the US.
The European Central Bank, which manages monetary policy for the euroland economies, announced its policy on the same day but decided to keep its signal interest rate on hold. The euro-region has trade links with the US and hence its problems are similar to those of the UK.
However, its economy has, until now, shown remarkable resilience. Thus, while some of the big companies from the region like Airbus Industrie have been vocal about the threat from slowing US growth and a highly overvalued euro, headline macroeconomic data have remained strong. My sense is that by the second quarter of 2008, the European Central Bank will have to fall in line as the deceleration in the US begins to take a heavier and more visible toll.
'Decouplers' have been particularly strident about the ability of Asia to withstand shocks emanating from the US. One of the enduring arguments to support this hypothesis is that trade within the region now constitutes the largest share of Asian trade; the share of the developed markets (the G-3) has dwindled.
While this is true, the data have to be interpreted very carefully. As the Asian Development Bank's recently published Asian Development Report and the Monetary Authority of Singapore's October 2007 macroeconomic report show, much of the trade is in industrial intermediates used to produce goods for the rest of the world, particularly the US.
To quote the ADB report, "closer trade integration (within the region) emerges largely from back and forth trade in intermediate goods and parts, much of which is assembled in final goods for export to the US and other industrialised countries. Just under 79 per cent of the merchandise exports that leaves Asian ports eventually end up in external markets. A chill in the US is thus likely to send downdraft down the region's supply chains."
Turning from economic dependence to the possibility of contagion from US financial markets, this is what the ADB has to say: "[A]s the US is the global financial center, disturbances there almost inevitable reverberate in other regions including Asia."
I would argue that two things follow from the vulnerability of Asia. First, Asian economies are likely to be hit hard in the event of a slowdown. That I am afraid includes India. Second, if a large economic bloc like the eurozone is indeed relying on Asian markets to hedge against a US downturn, they might just be betting on the wrong horse.
But let's forget all the data and analyses for a moment and look at the problem more "philosophically" if you like. I think there is a broad consensus around the fact that there is increasing globalisation and international integration. My problem with the notion of decoupling is that it is fundamentally at odds with the idea of increasing globalisation. It is irrational to think that while the natural tendency is for world economies to become more closely linked, the largest economy conveniently delinks from the others when it faces a crisis.
The author is chief economist, HDFC Bank. The views here are personal.
