Abheek Barua & Bidisha Ganguly: 'Decoupling' from China

It's difficult for emerging economies to do so, integrated as they are to supply chains originating in China. But recent rallies in the markets offer hope

Soon after the global financial crisis (GFC) had its devastating impact in developed markets, a question was raised about whether emerging economies have "decoupled" from their advanced counterparts. Would it be possible for them to keep growing once they recover from the initial shock of the GFC? A similar question is now being raised about whether emerging economies can "decouple" from China. This seems difficult particularly for the Asian economies, which are deeply integrated with supply chains originating in China. Yet, optimism about a domestic-led growth revival in the ASEAN-5 - Indonesia, Thailand, Malaysia, the Philippines and Vietnam - is taking root.

Take the recent rally in commodity markets that has happened despite lower growth in China being accepted as the "new normal". China is no longer the driving force behind key commodities such as steel, copper and aluminium. Instead, demand emanating from the emerging market universe outside China is throwing its weight behind higher commodity prices. Infrastructure development and rising real incomes are expected to foster rapid economic growth in these countries over the next five years.

This is not to say that these countries or even India can replace Chinese demand for commodities. However, incremental demand outside China is enough to more than offset the fall in demand within China. This realisation has been enough to rejuvenate commodity markets and revive investment interest in emerging markets among portfolio managers.

Take the case of steel demand: According to the projections made by the World Steel Association, Chinese demand is expected to decline by four per cent in 2016 and again by three per cent in 2017. In contrast, demand in emerging and developing countries ex-China is expected to grow by 1.8 per cent and 4.8 per cent in 2016 and 2017 respectively, based on demand revival in countries such as India, Turkey and the ASEAN-5.

Of course, another reason for the rally in commodity markets is the US Federal Reserve's rethink on their interest rate action. In a recent blog, Ben Bernanke, former governor of the US Federal Reserve throws some light on the central bank's changing perspective on the economy. To the lay observer what looks like the Fed chickening out of a rate hike due to global developments such as Brexit, is really underlined by a fundamental shift in the evolution of key economic parameters.

Members of the FOMC (the Federal Open Market Committee that determines the direction of monetary policy) make long-run projections for three key variables: output growth, rate of unemployment and the federal funds rate that is consistent with stable, non-inflationary growth. Over the last few years, projections for all three variables have been adjusted downwards, indicating a change in how policymakers expect the US economy to evolve.

This reassessment of economic fundamentals is based on productivity growth being much slower than earlier anticipated, pulling down the rate at which potential output can grow. In fact, data watchers have been repeatedly surprised by output growth being lower than expected while job growth has exceeded expectation. This combination of data prints indicates that with productivity and potential output falling, more people are employed to produce lower output. This would also make the FOMC keep interest rates low for a longer period.

Of course, that does not mean that there will be no rate hike in the near future but the number of hikes will be less than earlier anticipated. The tremors set off in global markets since the Fed started talking about raising interest rates in 2013 may have been exaggerated. Even if the Fed does raise interest rates in its next meeting, the sell-off in commodities and emerging markets may be more muted.

Tailpiece: The dollar rallied and the US stock market fell in a knee-jerk reaction to Fed Chair Janet Yellen's speech that US economic conditions had made the case for a rate hike. Soon, however, there was a reversal in sentiment apparently because Yellen used the word "inevitable" instead of "imminent" but her deputy Stanley Fischer commented that his boss' speech did not rule out even two rate hikes this year (September and December). The Fed needs to hike once this year just to retain its credibility if not anything else. However, whether this is the beginning of yet another dollar rally remains an open question, as traders mull over whether to "price" this in immediately or await more data.

Abheek Barua is chief economist, HDFC Bank. Bidisha Ganguly is chief economist, CII