The Financial Crisis and Emerging Markets

Eswar Prasad and M. Ayhan Kose
M. Ayhan Kose Deputy Chief Economist - World Bank Group, Nonresident Senior Fellow - Global Economy and Development

September 24, 2008

Dissecting the Decoupling Debate

Emerging markets have turned in a remarkable growth performance in this decade, even as the advanced industrial economies were at best plodding along. This sparked a new conventional wisdom that emerging markets had become masters of their own destiny and “decoupled” from business cycles in industrial countries. Consistent with this view, the emerging markets seemed to have dodged the bullet of the sub-prime crisis. But there are now rising concerns that these economies, already beset by oil and food price shocks, may falter if the worsening financial crisis pushes the U.S. into a deep and prolonged recession. In other words, emerging markets may still be riding on the coattails of industrial countries.

Which of these views about decoupling is true? The answer has implications not just for the emerging markets but also for world growth since these economies have now become major players on the global economic stage. New research that we have just completed (along with Christopher Otrok, University of Virginia) reveals some surprising answers to this question. And it turns out that the issue has more subtleties than indicated by the popular discussion.

To begin with, why is there such a heated debate about decoupling? After all, economies around the world are becoming more interlinked through increasing flows of goods and money across national borders. Shouldn’t this make all economies closely tied together and more dependent on each other’s economic fortunes? Yes, but at the same time emerging market economies have become much larger and self-reliant than before. As a group, they have accounted for more than half of global growth during this decade. So far, these economies have shrugged off the effects of the financial crisis and, although their growth momentum has eased off as industrial countries are taking in less of their exports, they are still growing rapidly.

This raises two interesting issues. First, what is the evidence on whether business cycles around the world are becoming more closely correlated or not? Our research shows that in fact business cycles are becoming more closely linked amongst industrial countries and amongst emerging markets. Remarkably, however, there is a decoupling of common business cycles between these two groups. This suggests that emerging markets are standing on their own feet to a greater extent than before, even though many of them have not entirely shaken free of dependence on exports to industrial countries. And the huge increase in flows of goods and money among emerging markets themselves (rather than just between them and industrial countries) has made their economies more dependent on each other. For instance, about two-fifths of emerging markets’ total trade flows are now accounted for by trade with other emerging markets, double the level from two decades ago.

Indeed, in a striking reversal of fortunes, continued strong growth in emerging markets might help stir the industrial economies out of their own malaise. There is a growing appetite for imported goods in emerging markets including China and India, and their share of world GDP is only going to increase over time.

A second issue concerns the distinction between real and financial decoupling. Many observers argue that the decoupling hypothesis must obviously be wrong; after all, large swings in major countries’ financial markets almost immediately infect those markets in other countries as well. This is most evident in the increasing correlation of stock market fluctuations around the world. Steep drops in the Shanghai stock market now affect U.S. stock markets. And the cataclysmic events on Wall Street are clearly roiling financial markets worldwide.

The big question is whether these financial spillovers affect the “real” economy—variables such as GDP, investment and household consumption. Here the answers are less clear. So far at least, there seems to be a dichotomy between real and financial variables in emerging markets. Their stock markets have been infected by the turmoil in the U.S., inflation is rising on account of worldwide food and oil price shocks, but GDP growth continues at a reasonable clip in the major emerging markets.

How can this be? One possibility is that emerging markets have built up enough headwind that sheer momentum will carry them forward, so long as there isn’t a worldwide collapse of demand. But the spread of the housing price bust in the U.S. to countries such as China does not bode well.

Another possibility is that financial markets in these countries are still relatively small and disconnected from the real economy. The flip side of this argument, however, is that their financial systems may not be strong enough to cushion these economies if more negative shocks hit them. So there could be trouble brewing.

One thing that is clear is that the structure of the world economy is changing in important ways, with effects that are difficult to predict. The past may no longer be a good guide to the future and relying too much on conventional wisdom—either old or new—may be dangerous.

Editor’s Note: This commentary is based on the IMF paper “Global Business Cycles: Convergence or Decoupling?“. A revised version of this article will appear in VoxEU.