The great de-coupling myth

Current economic circumstances allow us to test an interesting proposition, that an increased degree of economic integration can actually allow two economies to grow in different directions. This view, put forward by Eichengreen and Krugman (and Discussed by Frankel, 1999) would suggest that increased integration would lead to increased specialisation---a situation under which exogenous shocks affect the two economies differently. Antithesis to this view, is the conventional wisdom, held by Frankel: an increase in economic integration will lead to increased income correlation.

It has been interesting to watch, then, the popular media speculating China's present rate of growth can be maintained, or at least remain relatively high, in the face of a US recession. Not one to believe what Fairfax tells me, I decided to check this out, and you can too. Pull off the quarterly growth data for China and the US from 1979 (a handy reference year, as China began to open up) off the OECD website. Now, test the income correlations between the US and China for every business cycle (1979-1982, 1982-1991, 1991-2001, and 2001-2007). What is quite surprising, that is, if you are a true believer in the de-coupling myth, is the increase in income correlation (with fewer, smaller, errors) for every subsequent business cycle in that period. This would tend to suggest, at least in this example, that the conventional wisdom would seem to hold: increased integration between China and the US has further 'coupled' their economies; there is no 'loose caboose'.


What does this mean? Basically, we could say that should this model not break down instantly, that should the US be in recession (which it almost certainly has started), China will indeed slow. This is partly due to lower US demand for Chinese goods, partly due to the currency effect (to be discussed in a future blog) and partly that lower US demand for foreign goods will, ceterus paribus, lower foreign demand for Chinese goods. Exports make up some quarter of the Chinese economy, and from my figures, I'd predict about a 10-12% fall in this. This would equate to a cut of some 2.5-3% off current Chinese economic growth. Should current orders not be scrapped, this will probably set in in the third and fourth quarters this year.

What will this mean for Australia? Thankfully, Australia's exports to China contribute less to the manufacture of durable manufactureds, and more to fixed capital investment---think iron ore and coking coal (which is used to make steel). Fixed capital investment in undertaken on a long-view basis, and is less elastic to short-term income fluctuations than other areas of investment. Indeed, demand for Australian commodities would be likely to rise should the US slow. This would occur if China decides to enact countercyclical fiscal policy in fixed capital expenditure---build freeways and powerplants to employ workers affected by a slow in export growth.

Please feel free to comment.
Jim