Decoupling - More a Myth than Reality

Fri. October 10, 2008; Posted: 05:14 PM

(RTTNews) - The financial world is crumbling, with the rug under it being pulled out mercilessly for its own fault. Companies defied the law of gravity and were soaring high, abetted by the excessive bets they took on risky investments. The outcome? Wall Street firms have now become an extinct species and many of the other financial firms have been absorbed into their bigger and more tenacious peers. The development triggered a chain reaction in the financial and credit markets, triggering a contagion effect among the rest of the world markets. The proponents of the decoupling theory who were valiantly proclaiming the liberation of the global economies from the clutches of their bigger brethren-the U.S. may now have to eat their words.

The theory of decoupling suggests that the European and the Asian economies, especially the emerging economies, have evolved so much so that they no longer look up to the U.S. for their survival. In other words, they are immune to the developments in the U.S. The theory is based on the assumption that most global economies have become robust to generate enough domestic demand to support growth internally and trading relations of the nations are now more diversified in terms of partners. However, globalization, another lingo that we have got accustomed to, negates the very foundation of the decoupling theory. With the world becoming a global village, it is quite possible that the development in one corner of the world can have an impact on the other nations.

There are others who argue that decoupling does not mean a complete severance from the U.S. economy, but a reduction in the degree of dependence. In other words, whatever happens in the U.S. is likely to have a lesser degree of impact than it would have had earlier.

The 'decoupling theory' stood exposed with weak defense following the onset of the current crisis in the U.S. in the middle of 2007. The problem, which came to the fore in the form of the subprime mortgage crisis and later boomeranged into a credit crisis, has resulted in a number of casualties in the financial sector. Bear Stearns become the first victim to the crisis and was merged with JP Morgan Chase (JPM | Quote | Chart | News | PowerRating) in a Fed-assisted takeover. Later government-sponsored mortgage giants Fannie Mae and Freddie Mac were nationalized by the Fed. Then came the absolute shocker-Lehman Brothers' 185-year old legacy coming to naught, as it meekly went under, with no rescuers coming to bailout the once storied investment bank.

Some of the banks across the Atlantic were also mired in controversy, necessitating a bailout. UK mortgage lender Bradford Bingley, Benelux bank Fortis and Belgian bank Dexia are among the banks that were bailed out. The government-led bailout of Fortis did not yield the desired result as a result of which French banking giant BNP Paribas came forward to buy up to 75% of Fortis. German commercial real estate lender Hypo Real Estate announced recently that the German government, the German central bank and the financial regulator BaFin have agreed to extend an additional secured credit line of 15 billion euros in addition to the 35 billion euros promised earlier.

Impact on Markets

The crisis has had its impact on the stocks markets, with the U.S. markets going through a very lean patch for about a year now. From its October 2007 peak of 14,165, the Dow Industrials has pulled back about 39.43% and is currently near a 5-year low. On the day, the House of Representatives voted against the financial rescue package propounded by the Treasury Secretary Henry Paulson, the Dow declined close to 7%, it biggest ever single day point-drop, although it was not as worse as the 20% plunge on the Black Monday in October 1987.

The bygone week witnessed mayhem in the markets. Notwithstanding coordinated efforts from central banks across the globe, the major averages tumbled, with the Dow notching up three-digit losses in each of the five sessions of the week.

Where does that lead the global markets, especially the emerging markets? Defying the decoupling theory, the tremor in the U.S. financial markets reverberated in the rest of the world markets also. They are facing an even worse predicament at a time when many had hoped that they would remain insulated against the global shocks, thereby offsetting some of the weakness in the developed markets. Although the emerging economies account for about half of the world's GDP growth, they constitute only 8% of stock market capitalization.

Russia has been hurt the most because of the political developments in the nation involving Georgia. According to Morgan Stanley, the primary risk is from possible sanctions by the U.S. and a collapse in the price of oil. Nervous over the likelihood of the rescue package cleared by the U.S. House, the RTS Index fell about 7% on October 3rd, primarily due to the dismal performance of oil & gas and metals & mining stocks, and was down 17% for the week. On Monday, a global market meltdown led to a whopping 19.10% loss by the index to 866.39. Trading has been suspended in the Russian market since Wednesday, though it was briefly opened today.

Incidentally, Russia has injected about $180 billion into the economy, including the $50 billion earmarked for distribution by the state-owned development bank Vneshekonombank. In the year-to-date period, the RTS Index is down about 53%. The Russian State Duma has recently approved a crisis package worth 63 billion euros to help banks boost their liquidity position.

Meanwhile, the Indonesian market suspended trading for the third straight day today, as its key index declined more than 20% early in the week. The Japanese stock market gauge, the Nikkei 225 average fell more than 9% on Friday and lost about 1781 points or 16% cumulatively for the week. From an early July 2007 peak of 18,262, the Nikkei is now down about 50% and is currently at a 5-year low.

What has led to this disproportionate reaction? Have the valuations gone up to astronomical proportions so that the earnings prowess no longer supports them? If that is true, then the problem is compounded by the fact that investors believe that these markets should be commanding only a discounted valuation, given the increased risks in investing in these markets, the likelihood of greater political and economic crises in these regions and the excessive dependence on overseas economies for growth.

Earnings of the companies in the region, which were up sharply since the beginning of the year, are expected to see a sharp slowdown over the coming quarters. Societe General's Investment Committee maintains its 'Neutral' rating on the emerging market equities, while it reduced its grading for the Asia-Pacific region to -1 due to the unfavorable economic backdrop in South Korea and lingering political uncertainty in Thailand.

Some of the emerging markets with big exposure to exports to developed markets are China, Taiwan, South Korea and Mexico, while countries like Russia, South Africa and Brazil have significant exposure to commodities. Global economic growth is expected to slow down to 3.9% in 2008 and 3.3% in 2009 from around 4.9% in 2007. According to State Street, the risk to growth are skewed to the downside, reflecting uncertainty about the depth and duration of a U.S. recession, the effect of higher oil prices on aggregate demand, potential policy responses to contain inflation and a further fallout from the sub-prime crisis.

That said, some analysts still vouch for the emerging markets. The rational behind their preference is that valuations are still cheap despite the recent pounding. The emerging economies have gone through the purgatory, especially after the Asian financial crisis in 1997 and are in ship-shape. They fund the deficits of developed economies and have huge current account surpluses to their credit. However, there is no denying of the fact that there is likely to be a slowdown over the next five years from the scorching pace of growth witnessed in the previous five years, as global growth and rate of natural resource utilization slow down.

Analysts believe that despite prognostications of a slowdown, China, India, South America and Eastern Europe and commodity and oil-producing nations are likely to remain the pillar of strength for the global economy. A pick up in domestic consumption and the emergence of China as a super power could reduce the risks arising from a slowdown in developed economies.

Credit has now become a scarce commodity, hard to come by, with credit spreads widening like a chasm between cliffs. For starters, credit spread is the difference in yield between different securities, with the difference stemming from the difference in credit quality. Yield is nothing but a return on an investment. The London Interbank Offered Rate-LIBOR, the rate at which banks lend to each other, and the treasury rates-called as TED is currently now at its highest level in about 5 years, which implies that banks are paying hefty premiums over the risk-free government securities to secure financing.

Essentially, money market funds are drying up. Investors, both institutional and retail, are moving cash to funds that invest only in government securities. Most investors are redeeming their investment out of prime funds that invest in short terms notes issued by corporations that help finance their daily cash needs. After the market for commercial paper, a security issued by corporations, ran into rough weather, it is rumored that the Treasury along with the Fed may purchase commercial paper or set up a special purpose vehicle to buy these instruments.

Socio-economic Implications of the crisis

Brazil, which is one of the quadruplets that constitute the BRIC nations, may also see a set back, with the fears evident by the steep decline in IBOVESPA, the key stock market gauge and the nation's currency, the Peso. However, Brazil is now more disciplined than ever, with $200 billion forex reserves and a trade surplus of $1.257 billion as of the second week of September. Additionally, Brazil exports less than 1% of its GDP to the U.S. and the country has other investment themes such as commodities.

Much has been said and written about India and China, the economies of which are growing at a scorching pace, outperforming growth elsewhere. Although China has been shunned for its excessive reliance on exports to the U.S., China and India have alternative buoys in the form of emerging middle class consumers, who are driving up domestic consumption, and rapid industrialization. India's Sensex, which peaked at 20,376 in mid-December 2007, is now down about 48% from the peak at 10,528.

South Korea's economic growth is closely linked to its exports and therefore, it goes without saying that the financial crisis and the accompanying global economic slowdown will impact growth domestically. Currently, about 11% of the South Korean exports go to the U.S., a significant reduction from 40% in 1986. That said, the bulk of products the nation produces go into products that would ultimately be shipped to the U.S. Foreign institutional investors, who own almost one-third of the domestic market is pulling out, primarily due to their fund needs than due to a loss of confidence in the domestic economy.

Healing Touch

Realizing the grave threat a U.S. recession could pose to the world economies, the central banks acted in unison and expressed solidarity in their fight against the current credit turmoil. The central banks have been regularly pumping money into the system. However, as the idiom goes- 'once bitten twice shy', the banks are shying away from lending and in turn increasing their holdings at the central bank.

The U.S. Federal Reserve announced late last month that it will increase the swap authorization limits with some of the other central banks, including the European Central Bank and the Bank of Japan, to $620 billion from $290 billion previously. Additionally, the Fed increased the 84-day maturity Term Auction Facility to $75 billion per auction beginning with the October 6th auction, while also deciding to conduct two forward auctions totaling $150 billion in November.

The Fed said on Monday that it would offer $150billion in 85-day credit through its Term Auction Facility. In a separate announcement, the central bank said it would begin to pay interest on the required and excess reserve balances of depository institutions. The Fed also hinted that it is in consultations with market participants on ways to provide additional support for term unsecured funding markets.

This apart, a proposal propounded by Treasury Secretary Henry Paulson to give $700 billion in funding to set up 'Troubled Asset Relief Fund' to absorb the losses of financial firms was approved by the U.S. Congress and ratified by President George Bush last week.

Where did all the problems originate? Ever since the financial system was deregulated in 1999, intense competition forced the blurring of lines between commercial and investment banking and insurance and real estate and also engendered many innovative financial instruments that allowed high leveraging. To be more precise, the current crisis is traced back to housing finance, which thrived on the back of a flourishing housing market. Taking advantage of the near zero percentage interest rates that prevailed in the aftermath of the bursting of the dot.com bubble and the September 11 attacks, the housing market was on a roll. A low interest rate environment in the U.S. was supported by the inflow of foreign capital into the U.S. The buoyancy prompted banks and financial institutions to excessively bet on exotic instruments that were created from the underlying mortgage debt. With the housing market losing steam, giving rise to defaults in mortgage payments, the derivative securities created from the mortgages became worthless.

Most of the financial firms, including hedge funds, insurance companies and special investment vehicles, were excessively leveraged. Some of the financial firms were leveraging 30 times the amount of the equity they hold. Such a predicament can be avoided only if stricter capital adequacy norms are enforced.

A maelstrom of this magnitude could have wreaked a havoc on the global economies and taken the wind out of their sails in the past due to the close intertwining they had with the U.S. earlier. However, the damage is unlikely to be so severe, given the reduction in the degree of dependence and the structural and fundamentals reforms the nations have implemented following the past crises. Although the degree of impact that a U.S. crisis has on the rest of the economies may be less, there is no denying of the fact that when U.S. catches a cold, the rest of the world does sneeze.

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