The Weekend’s Contemplation – Emerging Markets Can’t Pick Up the Slack

Over the last several months there have been a number of posts on whether or not the rest of the world would slide into a recession if the US slid into a recession. Some believe that if the US slides into a recession other economies will not because their economy is sufficiently strong to get along without us (the whole idea behind de-coupling). Others believe that the opposite, that economies outside the US, primarily emerging markets, lack the size to make up for the US. This article from Bloomberg supports the latter position. Text in bold is my emphasis.

China is among the world's fastest- growing economies. Shanghai and Shenzhen are home to its hottest stock market. Now many investors regard the evolving Asian behemoth as the antidote to a slowing U.S. economy, picking up the slack in global growth as the American consumer retreats.

They probably shouldn't. China's growth has been fueled by exports and investment, not consumers, whose share of the country's gross domestic product is declining. From almost 80 percent in the first half of the 1980s, Chinese household consumption fell to 46 percent of GDP by 2000 and shrank further to 36 percent in 2006.

``The average consumer in China isn't a credit-card-toting shopper roaming malls in search of fashionable jeans or a large- screen television,'' says Joseph Quinlan, New York-based chief market strategist at Bank of America Capital Management.

Instead, the Chinese are savers. The average household banks a quarter of its after-tax income. That's to compensate for reduced government outlays for health care, unemployment benefits and pensions; more costly housing; the loss of guaranteed lifetime employment; and rising school-related expenses in a country obsessed with education.

``While China's global presence in certain industries has grown in significance over the past decade, Chinese consumers are not ready to drive global demand,'' Quinlan says. ``The Chinese are in no position to fill a consumption vacuum left by the U.S.''

China is part, a big part, of a growing consensus that emerging-market countries, can not only break free of their traditional dependence on the American consumer but that their own expanding domestic demand can cushion the global impact of a slowing U.S. economy.

Proponents of this thesis that the meek shall inherit the Earth -- or, at the very least, help stabilize it -- include Goldman Sachs Group Inc., Merrill Lynch & Co. and Lehman Brothers Holdings Inc.

Strong growth in emerging markets ``could balance the drag effect from the world financial turmoil,'' Lehman told clients at the end of August. On Sept. 12, Goldman economists boldly proclaimed: ``Our view of global decoupling has become the consensus view.'' Emerging markets generally and the so-called BRICs -- Brazil, Russia, India and China -- specifically, are key to global decoupling, they said.

The four BRICs, which sport growth rates of 5.4 percent to 11.5 percent, may be the toast of the evolving economic order. But declaring them the new citadels of the world economy is a stretch and premature.

Although developing countries are projected to account for about three-quarters of global growth in 2007, their size is still too small to power the world economy. Take the four BRIC nations: Collectively their GDP amounted to $5.6 trillion at the end of 2006. That's 43 percent of U.S. GDP, 56 percent of the 13- nation euro area's and 130 percent of Japan's.

When it comes to stock markets, the gap is even wider. The aggregate free-float value of the Brazilian, Russian, Indian and Chinese stock markets is a mere 4.9 percent of world market value, according to Morgan Stanley Capital International. The four BRICs are 12 percent of the U.S. market value, 16 percent of Europe's and 56 percent of Japan's.

China's CSI 300 Index has more than tripled in the past 12 months. Still, the country's stock market represents just 1.9 percent of total world-market value compared with U.S. equities' global share of 42 percent.

Even though developing countries are trying to boost domestic demand, they remain dependent on exports, accounting for about 45 percent of the world's cross-border sale of goods, according to Merrill Lynch.

Furthermore, the Japanese and German economies -- respectively, the world's second- and third-biggest -- are slowing, adding to the woes of emerging-market exporters already thumped by weaker U.S. growth. Japanese GDP fell an annualized 1.2 percent in the second quarter, and there's a good chance the ruling Liberal Democratic Party, eager to remain in power, will backslide on promised fiscal changes.

Meanwhile, Germany suffers from sluggish consumption, a strong euro that threatens exports, and a credit crisis that will increase the cost of financing investment.

No doubt, developing countries have come a long way since the 1997-1998 Asian financial crisis and the Russian default in 1998. Back then, Asian countries were starved for cash; now emerging-market economies, led by Asia, account for 66 percent of global foreign-exchange reserves. Inflation is down. And many countries have adopted flexible currency regimes.

As a group, the countries' total external debt-to-GDP ratio has been falling since 2000. And the aggregate current-account surplus of 54 countries studied by Goldman Sachs rose to 4.7 percent of GDP in 2006. That compares with a deficit of 1.4 percent of GDP in 1995.

Nonetheless, ``there are still plenty of vulnerable economies in the emerging-market space,'' says Gray Newman, New York-based senior Latin America economist at Morgan Stanley. South Africa, Turkey, Hungary and the Czech Republic have run current-account deficits averaging more than 4 percent of GDP for three years, while Turkey, Poland, Hungary and India have posted fiscal deficits of 3 percent to 8 percent of GDP in the last three years.

What's more, ``before we ring in the decoupling era, it is worth recalling that it has not been tested with a U.S. economy in recession,'' Newman says.

Bottom line: ``The old saying, `If the U.S. sneezes, the rest of the world catches a cold,' remains relevant,'' said the International Monetary Fund in its April 2007 edition of the World Economic Outlook.

How much of a cold depends on how big the sneeze.