Now that the risk of a US hard landing – recession – has become very high the debate on whether the rest of the world can decouple from this US hard landing is returning.
In my view this debate on decoupling (this writer argued against the decoupling hypothesis already in mid 2006) is partly semantic: those who argued for a decoupling always did so conditional on the view that the US would experience a soft landing; and I would myself agree that, conditional on the US having a soft landing (i.e. growth below potential and ranging 1.5%-2.5% for a few quarters), there was enough growth momentum in Europe, Asia, BRICs and other emerging markets that such US slowdown would not lead to much of a slowdown in the rest of the world. But, conditional on a US hard landing, almost no one believes that the rest of the world would decouple from such a hard landing: this does not mean that the rest of the world would experience, like the US, a recession; it rather means that a US recession will lead to a significant and serious slowdown of growth in the rest of the world.
A typical example of how there is recoupling rather than decoupling is Europe. The old argument that, since only 3% of European output is exported to the US, European growth is unrelated to a US slowdown proved wrong in 2001-2002 and will be proven wrong in 2008. Europe is already slowing down given that booming – or bubbly – housing markets in some European economies – US, Spain, Ireland especially – are now starting to turn down. Also, measures of forward looking manufacturing activity and business confidence are slowing down.
But recoupling is also related to a variety of other factors: the euro strengthening relative to the US dollar is leading to a sharp fall in external competitiveness of European exports, not just in the Club Med countries (Spain, Portugal, Italy, and Greece) but now even in Germany. And since the RMB and other BW2 currencies have shadowed the US dollar downward the euro has sharply appreciated relative to the RMB and such other currencies. Thus, the Eurozone has experienced a double whammy: loss of competitiveness relative to the US dollar and other dollar-zone currencies. Indeed, Chinese exports to Europe are rising at a faster rate than Chinese exports to the US even if the bilateral trade balance of China relative to Europe is not yet as imbalanced as that relative to the US.
Recoupling or contagion is also evident in financial markets. Certainly European financial markets did not decouple from the summer and fall financial turmoil in US financial markets; rather there was massive contagion: the ECB was forced to inject liquidity faster and more than the Fed. And the lingering liquidity and credit crunch has been as severe – if not more severe – in Europe than in the US. Thus, based on recent European loan officer surveys, the credit crunch – especially towards corporate lending – is now more severe in Europe than in the US. This is no surprise as the relatively more bank-based financial system of continental Europe – relative to the capital markets-based financial system of the US and UK – is more vulnerable to credit crunches when there is a seizure of liquidity and credit that flows to the corporate sector.
Recoupling occurs not only in credit and debt markets but also in equity markets; there is a high correlation between equities and US equities. So downward pressures on US stock prices are rapidly reflected in similar pressures on European equities.
Europe is also hit by common global shocks that hit the US: higher risk aversion, cycles in housing that – with a lag- are now hitting Europe; shocks to oil prices and energy prices that are now hurting all oil importers, Europe as much a the US, Japan and other oil importers. Global shocks to other commodity prices – food, metals, minerals, etc. – also affect Europe as much as the US.
Recoupling is also occurring as the ECB – in a repeat of the 2001-2003 – is deluding itself that the Eurozone can decouple from the US slowdown and – unlike the Fed – is holding rates and arguing that – once the credit turmoil is passed (as if it would pass any time soon) – it would raise further policy rates. This delusion means that the Eurozone slowdown will become – like 2001-2003 – deeper and more protracted than the US one. At least the Fed is aggressively cutting rates now; the ECB is still in the dream mode that this is a temporary shock and that policy rates should be going up; in reality – as in 2001-2003 – the ECB will end up cutting rates but doing that too little too late.
Other macro policy tools are now not available to prevent recoupling: not only monetary policy is not helping but, with large structural fiscal deficits, the Eurozone can ill afford the fiscal easings that occurred after 2001; if anything tighter fiscal policy is needed in most of the Eurozone. Tight monetary policy, no leeway for fiscal policy, stronger and stronger euro: this is the macro mix that exacerbates the Eurozone slowdown.
Recoupling also occurs through confidence channels: Eurozone corporations and households have never been particularly confident during many years of slow EU growth; but the US slowdown and financial turmoil has dented again such confidence. And the prospect of a US hard landing, strong euro, higher risk aversion, credit crunch, and investors’ uncertainty means that capex spending by the European corporate sector will also slow down sharply in the quarters ahead. Large global corporations that are cutting on investment spending in the US and never spent much in capex in Europe will not start now to spend more in Europe given the global slowdown.
And the wealth effects of international portfolio diversification become another channel of recoupling. Home bias in much less now than it was a decade ago and European have large exposure – of the order of trillions of dollars – to US dollar assets. The negative wealth effects comes from two sources: a falling dollar reduced the euro value of European assets in the US; the fall in the market value of dollar assets – housing, RMBS, CDOs, US equities, etc. – is another negative wealth effect. Add to these losses the reduction in the profits/earnings of European firms – that have done FDI in the US – via the fall in such dollar earnings once the US hard landing occur and via the fall in the euro value of such earnings given the slide of the US dollar.
Similar recoupling channels from the US hard landing to global economic slowdown are relevant – even more than for Europe – for China, Asia, other emerging market economies, Latin America. And we will flesh out in more detail such channels in future writings. And just to be clear: I am not arguing that a US recession will cause a global recession; I rather argue that a US recession will lead to a serious and significant slowdown of growth in the rest of the world, i.e. absence of decoupling.
For now it is clear that it is still the case that when the US sneezes the rest of the world gets the cold. And since the US will not just sneeze but is risking a serious case of protracted and severe pneumonia the rest of the world should start to worry about a serious viral contagion from this US sickness. Certainly credit and financial markets have already suffered from such contagion; the dollar weakness is sending shivers to non-US investors, policy makers and exporters; and daily shocks to US equities are transmitted to Asia and Europe. It will take only a little longer – once the US consumer falters – for the US real hard landing to affect the growth rate of Europe, Asia and emerging market economies. There was never real decoupling; the perceived “decoupling” was only a side effect of the modest slowdown of US growth; now that the slowdown is turning into a hard landing contagion and recoupling is reestablishing itself with a vengeance.