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Table of Contents From the Editorial Desk……………………….........................................................................................………....1 OVERHEATING: The threat faced by Emerging Economies By Nandini Duggal...............……………….....................................………………..................................................2 Overheating of the Emerging Economies: Much Ado about Nothing By Umesh Saha, Niranjana Mishra....……………….....................................………………....................................6 World Economy: Not Out of Danger Zone Yet By Saurav Lugria, Vibha Bharati................……………….....................................………………...........................11 Overheating of Emerging Market Economies and the role of Central Banks By Laveen Ramrakhiyani, Saurabh Surana, Ankur Choraria..............………………....................................... 15 The Decoupling Debate: Do Emerging Markets hold the key to recovery after crisis By Ankit Sinha............................................……………….....................................………………..........................22 Future of Asian Giants By Senthil Kumar V............................……………….....................................………………...................................25 Currency Dynamics in the Emerging Market Economies By Annapoorni C S, Tisa Annie Paul, Richa Gupta.......................………………...............................................28

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From the Editorial Desk

The world economy has been recovering at a rate faster than what most economists forecasted just a year

ago. And it is the emerging economies like China, India and Brazil which have taken the bull by its horns,

leading to the revival of world trade and GDP. However, we must remember that India’s strength lies in

strong domestic consumption and China, which depends largely on exports, will have to re-focus on

domestic consumption sooner rather than later. Therefore, such emerging economies face a huge risk,

which is, the Overheating of their economies.

The level of inflation in these economies, especially the BRIC countries, is already at an uncomfortable level.

Most of these economies are highly dependent on commodities for their consumption and production.

Recent trends show that price rise has been maximum in oil and agricultural products (India). The non-oil

commodity price index has also risen very sharply in the last 6 months. This has given the economists and

financial experts around the globe another round of worry after the financial crisis, and has been the topic

of discussion at every major forum.

This is what the theme of the Journal is: “The Overheating of Emerging Economies and its effect on their

recovery”. It remains to be seen whether the hue and cry is justified, or if it is another irrational fear that has

gripped the world. Through the following articles, we have tried to cover both ends of the spectrum:

That the growth in Aggregate Supply can sustain the increasing demand because of strong growth

fundamentals

Or

The current inflation level will persist and only a reduction in demand can prevent another

recession.

Team FINAX

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VERHEATING: The

threat faced by

Emerging Economies

Abstract The world is on the path of global recovery

which is mainly being driven by growth in

emerging economies. Owing to strong growth

prospects and interest rate differentials,

emerging nations are attracting large amount

of capital inflows. However, the sudden surge in

capital inflows could lead to overheating of

these nations. This article discusses the concept

of overheating, its signs, its transmission

mechanism and possible policy measures to

avoid it. Taking the case of India from emerging

economies, this article discusses how Indian

economy is unique from other emerging

economies and its way forward in avoiding this

risk.

Emerging from the claws of recession, the world

is on the path of economic recovery. The

economic recovery continued to strengthen in

2010 with global activity increasing by 5.25

percent during the initial half of 2010. This

economic recovery is largely being led by

emerging economies with Asia leading the

group with its projected growth rate for 2011

being at 6.7%.i

Emerging economies, especially Asia, have

faced the economic crisis with firm resilience.

Owing to strong fundamentals like economic

growth, stable policy regime etc, there has been

a shift in asset allocation with this part of the

globe attracting large amount of capital inflows.

While capital inflows come with a basket of

benefits like meeting domestic demand, fuelling

economic growth, development of financial

markets and diversification of risk, its sudden

surge poses significant challenges for

policymakers in three ways.

Leads to overheating of economies

showing signs of inflation and formation of

asset bubbles.

Increases vulnerability due to sudden

reversal of capital flows.

With increase in financial integration,

autonomy for implementing policies,

monetary autonomy etc. gets

compromised.

At this critical time, the threat of overheating in

emerging economies presents itself as a

significant macroeconomic challenge and could

derail the process of economic recovery

worldwide.

O

Figure 1ii: Average Projected Real GDP Growth (2010-11)

Figure 2 iv

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Overheating of Economy

When there has been a prolonged period of

high economic growth, it leads to high

aggregate demand. In order to meet this high

aggregate demand, aggregate supply needs to

be increased. This is generally increased by

over-employment of resources like human

labor, machine hours etc. However, production

by over-employment of resources is not

sustainable for a long period of time. Thus,

there is an inefficient supply allocation and high

level of inflation leading to overheating of an

economy.

The signs of overheating are particularly evident

in the form of high inflation and formation of

asset bubbles. Recently, when Inflation in India

touched double digit figures at 10%iii, Gita

Gopinath, the professor of economics at

Harvard University, pointed out that it was a

clear sign of an overheating economy. The

increase in inflation is also reflected in sectors

like real estate etc. with formation of asset

bubbles. An asset bubble is formed when the

prices of an asset rise sharply owing to excess

demand. Currency appreciation, widening

current deficit and huge credit expansion in the

economy are other factors which can be looked

at to determine whether an economy is

showing any signs of overheating.

Leading countries of emerging Asia like India,

China, Indonesia etc, have grown at the rate of

more than 8 percent in the initial half of

previous year. As per IMF estimates, this region

is expected to grow at the rate of 8.4% in 2011.

Owing to strong growth aspects, large amount

of capital inflows are flowing into this region.

Moreover, increasing interest differential with

advanced economies is further aggravating the

situation by attracting more inflows. Large

capital inflows mainly come through the route

of FIIs which leads to rise in stock prices and

appreciation of rupee. If these inflows cannot

be absorbed in the domestic economy, they can

lead to overheating of the economy.

The effect of overheating due to huge surge in

capital inflows can be produced through

following transmission mechanism.v

If a country maintains an officially

determined exchange rate, in order to

main its peg in the market, it will have to

buy excess foreign currency which has

entered the system in the form of inflows.

It can do this by creating high powered

domestic money.

The expansion in monetary base can lead

to drop in interest rates and rise in prices,

thus, giving rise to aggregate demand.

If there is a scope to increase capacity to

meet increased demand, it is done by

increasing economic activity which puts

pressure on current account. However, this

scope would be limited and once it is

absorbed, the expansion in demand leads

to rise in inflation.

The rise in prices will lead to appreciation

of real exchange rate worsening the

current account status.

Figure 3vi,

Source:The Institute of International Finance

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To meet this threat, policymakers have several

macroeconomic measures at their disposal

which can be applied depending upon its overall

suitability. The four major ways to handle it

include use of tightening of fiscal and monetary

policy, use of exchange rate policy and capital

controls to restrict free movement of capital.

viiThere exist two policy measures to counter

the expansion in monetary base. These are

sterilized intervention and increase in reserve

requirements. Sterilized intervention has been

used widely till date. It involves attempts to

reduce the credit supply in domestic economy

by indulging in open market operations etc.

Fiscal contraction can also be used to reduce

the expansion of aggregate demand. Tight fiscal

stance can help to reduce inflationary

pressures.

To reduce net inflows into the economy, various

controls can be applied on inflows as well as

outflows. Liberalization of capital outflows or

repayment of public debt can be employed in

order to reduce net inflows. For countries with

fixed exchange rate, the most extreme option

that exists is conversion to free floating

economy. The appreciation of currency due to

inflows will lead to current account deficit and

reduce the net inflows.

What is interesting to note is that the current

economic situation demands a total contrasting

response from policy makers when it comes to

emerging economies as compared to advanced

economies. The loose monetary policy in West

is having spillover effects in emerging

economies in the form of flows. While interest

rates have been near zero percent level to

stimulate demand in economies of advanced

nations, the central monetary authorities in

emerging economies like India have been

increasing interest rates to arrest the rise in

inflation and reduce liquidity in market.

In India, the policy has been particularly price

centric as inflation reached double digits,

signaling overheating ,with RBI having increased

repo and reverse repo rates six times by

November. To avoid the risk of crash due to

overheating, China has also been gradually

withdrawing stimulus measures. In early part of

2010, Chinese govt. increased bank reserve

requirements and also asked banks to curb the

lending rate.

India: The way forward

Among emerging market concerns, the Indian

economy has some unique features which

distinguishes it from other emerging

economies.

viiiFirst of all, the growth in Indian economy is

driven by domestic demand in the form of

consumption and investment. Indian economy

has high savings rate and investment rate.

Secondly, coming to deficits, India faces double

trouble in the form of fiscal deficit and current

account deficit. On the back of stimulus

measures, fiscal deficit has reached dangerous

proportions with Indian govt. trying to peg it at

the level of 5.5 percent of GDP for the year

Figure 5x: Capital flows in India in 2010-11 so far

Source: RBI

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2010-11. Unlike other emerging economies

which have current account surplus, India has

deficit in current account as well. Lastly, India

suffers from severe infrastructural issues and is

a supply constrained economy.

Figure 4ix

Keeping all these in mind, determining the way

forward by striking right balance between

growth path and warding off the

macroeconomic risks in the form of inflation

etc. becomes a very challenging issue for the

Indian policymakers.

The various policy options in the form of fiscal

and monetary measures available to avert the

risk of overheating don’t appear to be wise

moves in case of India.

xiIf India doesn’t intervene in the forex

market and allows rupee to appreciate, it

puts significant downward pressure on

current account deficit which is already

high. Also, the rupee appreciation adversely

affects the exports.

Buying excess dollars and reduction in

interest rates might lead to rise in inflation

further. So, these responses appear to be

flawed as well.

Fiscal contraction can be applied but the

extent to which it can control inflows

remains doubtful.

xiiCapital control measures – Till date, the use of

capital control measures has not been very

extensive. However, IMF has recommended

use of capital controls as the part of policy mix

for nations facing surge in capital inflows.

Capital controls are measures taken to regulate

the inflows and outflows into/out of the

economy. They apply restrictions on free

movement of the capital.

Capital controls are of two types: -

Administrative controls and Market based

controls. Administrative controls tend to

prohibit or apply quantitative restrictions on

capital transactions. On the other hand, market

based controls increase the cost of transactions

by way of explicit taxes, indirect taxes etc. in

order to make foreign investment options less

attractive. Generally, administrative controls

are less transparent when compared to market

based controls.

Analyzing the options available, implementation

of capital controls could be the way forward for

India to effectively thwart the risk of

overheating and asset bubbles.

Thus, the policymakers of emerging economies

have a critical responsibility of maintain the

pace of global recovery and need to tread the

path proactively and cautiously to avoid

triggering of another crisis.

About the Author

Nandini Duggal is a student of MBA

(International Business) 2010-12 at Indian

Institute of Foreign Trade, New Delhi. She holds

a degree in Bachelors of Engineering (Computer

Science) from Panjab University, Chandigarh

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and has worked in Infosys Technologies for

aperiod of 31 months as a software engineer.

Email - nandiniduggal@gmail.com

References

i World Economic Outlook Oct 2010 Pg 81

ii World Economic Outlook Oct 2010 Pg 81

iiihttp://businessstandard.co.in/wef10/news/qa-

gita-gopinath-professoreconomics-harvard-

university/414837/

iv Macroeconomic and Monetary Policy

Developments Scecond Quarter Review 2010

v IIF Research Note Capital Flows to Emerging

Market Economies Philip SuttleAPil 15, 2010

vi Private capital flows to developing countries : The

road to financial integration by World bank Pg No.

171-184

vii Private capital flows to developing countries : The

road to financial integration by World bank Pg No.

171-184

viii Emerging Market Concerns : An Indian

Perspective Duvvuri Subbarao speech RBI monthly

bulletin Nov 2009

ix Macroeconomic and Monetary Developments

Second Quarter Review 2011

x Macroeconomic and Monetary Developments

Second Quarter Review 2011

xi http/www.icrier.org

xii Finance and Development September 2010

Overheating of the

Emerging Economies:

Much Ado about Nothing

Abstract The article refutes the proposition that the

emerging economies are overheating. A

comprehensive analysis across various

macroeconomic metrics ranging from potential

growth rate, actual GDP rates, inflation and

deficits has been performed to infer that the

growth in these economies hinges on strong

economic fundamentals and not on availability

of temporary liquidity. The changes in these

economies would obviously lead to a global

rebalancing. There would be a reallocation of

resources with currency appreciation, growth in

domestic demand and expansion in productive

capacity sin these economies. Patterns of global

investment and savings would change requiring

deepening of financial intermediation and

regulation.

The IMF says advanced economies will grow

2.7% in 2010 but emerging economies will jump

Figure 1: Price Rise

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7.1%.Emerging economies seem to be

overheating as these have become the favored

nations for investment inflows from the

advanced economies. The developed nations

are plagued by low growth rates coupled with

concerns of sovereign debt default and

prevalence of low interest rates leading to fund

flow to emerging nations. The flows of funds

are now directed to the emerging nations as

these are currently the growing entities. The

question staring in our face is “would these

funds lead to creation of bubbles and are these

real concerns”?

Understanding the “Overheating”

Phenomenon In the global economic scenario, we broadly

define overheating as a phenomenon when the

actual growth in the economy takes place at a

rate significantly higher than the potential

growth rates. Sometimes we refer to this as the

‘boom’ phase of the economic cycle where the

demand outstrips the supply of goods and

services. As economy grows, there is an

increase in the consumption which creates

excess demand. The actual increase in

aggregate demand depends on size of the

multipliers associated with each of the variables

in the equation below:

The expansion in the demand

gives rise to inflationary

pressures and increased

inflow of foreign capital in the

form of FIIs and FDIs to reap excess returns

prevailing in these economies. These flows

cause appreciation of currency and intensify the

overheating effect building speculation. Asset

prices, inflation and difference between

potential and actual growth rate are good

indicators of overheating.

Emerging Economies: Too Hot to

Handle? A number of subject experts have asserted that

“the emerging economic nations are slowly

slipping into the grip of another imminent

economic overheating”.…“the major threats to

emerging markets will arise from, and be

related to, their economic

success”….“overheating rather than deflation

will be the main threat”.

Investigation of various dimensions across the

economies of the emerging nations gives a

sense that there is no real overheating in these

economies. There have been FII inflows into

these nations but most of them have strong

fundamental growth drivers and potential

future plans for capacity expansion especially in

infrastructure and real estate construction. The

emerging economies fiscal balance trends also

do not reflect overheating. The domestic

consumption in some emerging countries is

trending downward and the supply factors on

the other hand are expanding. The difference

between the actual and the potential output

has also been analyzed. Potential growth has

been accounted through the growth the labor

productivity, total factor productivity and real

Figure 2: Actual and Potential Growth (Singapore)

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capital stock. Overheating would reflect as a

difference between the two rates.

The Singapore Story Singapore is witnessing a slowdown in personal

consumption to 5.2%. It is the other productive

factors of demand that are exhibiting growth

mainly government consumption and fixed

investment. On the supply side, all the sectors

are expanding albeit the rates of expansion are

small. A quick examination of the potential and

the actual real growth rates show minimal

difference between the two rates. The drivers

of growth span across the sectors and are not

dependent on external balance or liquidity. The

domestic demand also has been depressed.

There has been a decrease in the budget deficit

although marginal. The budget deficit is now at

1% of the GDP. Singapore has healthy fiscal

reserves. The government has even withdrawn

the stimulus packages in 2009. Singapore also

does not depend on foreign flows to finance its

public debt. Most of the public debt is

denominated in Singapore dollars.

The Consumer prices in the Singaporean

economy increased almost by 10 % (cumulative)

from 2006 to 2008, while it was just 3.2%

(cumulative) from 2008 to 2010. Although it is

on a rising mode but the magnitude is within a

manageable limits and there is little indication

of overheating.

Brazil’s Trends In Brazil, there is a slight reversal in the story.

Domestic demand is outstripping supply. But

the government is putting contractionary fiscal

and monetary measures in place. The country is

in slightly unique position as it is undergoing a

phase of political transition. The new

government would need time to settle and

initiate strict fiscal measures. The political

uncertainty is critical in leading to inflationary

tendencies. However, from 2009 the inflation

has remained stable at 5%.

An investigation of the differences in the actual

and potential growth rates still reflects very

little variance thus negating any evidence of

overheating. The increase in domestic demand

also has not increased dramatically over the last

5 years. In 2009, as expected, there demand

almost showed zero growth. The current

account deficit also is at 1.5% of the GDP

currently; though it is projected to reach 3%

which can be some matter of concern.

However, the FII inflows flowing into the

economy will be absorbed and neutralize the

current account deficit. Brazil also has a

diversified export base and a strong reserves

position. The fiscal deficit has increased to 3.3%

of the GDP. However, industrial production has

expanded and employment rates have also

exhibited signs of recovery. Analysts’ reports

Figure 4: Actual & Potential Growth (Brazil)

Figure 3: Inflation Trends (Singapore)

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seem to indicate the Brazil is growing currently

at 7% which beyond its potential of

5%.However, the country seems to have

tremendous potential to expand its production

capacity through increase in infrastructure

facility as would be hosting the FIFA WORLD

Cup (2014) and the Olympic Games. Massive

investments in the events would lead to

creation of production capacity and absorb the

excess demand.

The India Way An analysis of the Indian Economy shows that

labour productivity and growth of real capital

stock contribute significantly to the real growth

in output. Thus the high rates of growth are

buttressed by strong macroeconomic

fundamentals and real productivity gains. The

fiscal deficit has declined from 6.2% of the GDP

in 2006 to about 5.6 % of the GDP at present.

The deficit fell to Rs 1,86,522 crore thus

showing a 39% reduction in April-November

period as compared to the same period last

year .This was mainly due to increase in the

government revenue receipts.

One of other primary indications of overheating

is rising of inflation rate. However the trend

depicted in the figure aside Consumer Price

Index (CPI) for India is showing a declining trend

in 2009 to 2010 as compared the increasing

trend in the period 2006 and 2008. This

suggests that there is no strong indication of

the possibility of the Indian economy on the

verge of getting overheated. Moreover the

inflation is mostly concentrated in food articles.

The only concern seems to be rising asset prices

in the country. But in most of the cities,

demand of housing does not exceed the supply.

In order to curb demand, the RBI has also has

increased the rates of interest leading to a rise

in housing loans.

Strong Fundamentals of Emerging

Economies The growth fundamentals of the emerging

markets are robust. Their debt-to-GDP ratios

are comfortably below any danger mark and

these countries also possess foreign reserves to

tide over any crisis situation. Equity valuations

do not seem to be unreasonable. According to

HSBC, the MSCI emerging-market index is below

the 20 year average at a forward price/earnings

multiple of 11.

Figure 6: Actual and Potential Growth (India)

Data Source: EIU

Figure 5: Inflation in Brazil

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Demystifying the FII inflows

trends

Though the emerging economies contribute

47% to the world GDP, they are still

underrepresented in the investment holdings of

the OECD countries. These FII inflows mostly

are mostly reallocating investments to a higher

equity returns in these countries. The inflows

might lead to currency appreciation which

however would provide an incentive to

stimulate domestic consumption especially in

economies like China. The emerging nations

would hinge on their domestic demand rather

than on the fragile and declining export demand

from the advanced economies.

Implications There are some signs of irrational exuberance:

issuance of the 100 year bond by Mexico and

booming corporate bond debt. However,

overall the growth has strong foundations. The

changes in the emerging market economies will

change the structure of the global finance

architecture. Emerging markets would account

for most of the world’s investment as well as

savings.

From the present trend of economic growth in

emerging economies, one can observe that

there will be a persistent increase in global

investments. The increasing trend of

urbanization in the emerging economies would

lead to creation of homes, roads, power plants,

airports in these countries. Investment would

continue to rise so for almost a decade

especially in Infrastructure. According to the

McKinsey Report, global investment projected

to touch $24 trillion around 2030.Consequently,

there would be a lowering of savings. Although

the saving in the developed nation would rise,

as is evident now, on an average, the global

saving rate will decline.

The gap in investment and savings will further

increase the future cost of capital leading to

permanent changes in revenue models. Investor

strategies can get affected as long term interest

rates would surge. Finally, the role of the

government would become crucial in all

economies in creating more depth and breadth

in the emerging market financial economies.

About the co-authors:

Umesh Shankar Saha: Umesh is currently

pursuing MBA from ISB, Hyderabad. He has a

BTech from the IIT, Kharagpur and has worked

with reputed firms in the Maritime industry in

India before joining ISB.

Nirajana Mishra: Nirajana is currently pursuing

MBA from ISB, Hyderabad. She has a Masters

degree in Economics from Delhi School of

Figure 8: Cost of Capital

Figure 7: Inflation Rate (India)

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Economics. She has worked with American

Express and GE Capital in their Retail Banking

Division prior to joining ISB. At ISB, she is the

Knowledge Initiative Coordinator of the Finance

Club.

References:

Emerging Markets Information Service

Bloomberg Business Week

The Journal of Commerce, Jan 2004

Economist Intelligence Unit

http://online.wsj.com/article/SB40001424052748704361504575552011451494830.html

http://www.forbes.com/2010/12/20/forbes-india-economy-overheating-reality-check.html

McKinsey Quarterly Journal , Dec 2010

World Economy: Not

Out of Danger Zone Yet

Abstract

The International Monetary Fund and the

Organization for Economic Cooperation and

Development have highlighted the challenges of

a two-speed recovery: emerging markets racing

ahead and advanced economies slogging along.

One of the challenges was coming from the

financial imbalances globally, especially in

current accounts but there were also positive

signs of growth and rebalancing in China and

the US.

Growth and Balance How well would the positive signs of growth

and rebalancing in US and China prove to be

actual boost to the global economy is to be

waited and watched. Many forecasters have

given their revised estimates of growth in the

US and Europe which are pretty disappointing.

The resurging US trade deficit together with

China’s refusal to allow any further currency

appreciation make growth and rebalancing

more difficult. The world economic revival

needs the current account surplus countries to

have greater fiscal stimulus and the East Asian

countries should appreciate their currencies. In

the US, there was an economic slack and hardly

any inflation and yet US failed to expand its

short term fiscal and monetary stimulus. Here,

other economies of the world need to step in to

ensure a global recovery.

The policymakers face the tough task of

balancing and attaining both internal and

external equilibriums. The output levels in the

developing countries should match the

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potential GDP and remain consistent with the

non-accelerating inflation. Also, the current

accounts in countries like the US should match

the country’s development and fiscal policies.

This is a challenge that the policymakers have to

take up to ensure growth.

Developed Economies The developed nations, particularly the US, are

the key to economic revival but the

policymaking has not been effective for the

growth and rebalancing of the world economy.

There has been much ado about overheating in

the US with the IMF projecting 2010 output gap

of only about minus 4 percent of GDP, OECD

minus 5percent and the Congressional Budget

Office projecting minus 6 percent of GDP. After

the US GDP was revised by almost one

percentage downward, the output gap in

absolute terms seems to be even larger than

those estimated by various organizations.

Now, this makes it seem less important and

urgent for the policymakers to tighten the fiscal

policy. This is how the policies could not be

effective in bringing about good signs for global

growth and rebalancing.

The natural rate of unemployment is thought to

have increased suddenly due to the mismatch

between labor and output resulting from the

change in the composition of output. But large

proportions of the rise in unemployment cannot

be assigned to the natural rate.

Talking about the US economy, the inflation is

flat and would probably remain flat for next ten

years. The spread between inflation-indexed

bonds and the government bonds also show

that inflation would remain flat. What have led

to policies being ineffective are the fears which

misguide the policymakers. The feeling that US

would soon be touching the tipping point of

debt has tied the fiscal policy. True that US has

fiscal problems which are mostly long term in

nature, but these are due to increased spending

and not raising revenues from taxes and on top

of these all, there was the recession and the tax

cuts in 2001 and 2003 which blew up the fears.

As documented by Ostry et al, US can still go for

fiscal stimulus in the short term. In case of a

medium-term issue, a countercyclical fiscal

policy would form a solution with a plan for

medium-term fiscal consolidation.

How well could the US support rebalancing, is

difficult to judge as when we talk about the

global economy, there are a lot of other factors

relating to other countries. The current

exchange rates, particularly with China, and

that Europe is not expanding much, supports

that the US current account deficit is increasing.

The whole view could be changed if the US

dollar depreciates. With the fact that oil

accounts for a large portion of the trade deficit,

and that there is hardly anything being done

about the reduction in oil imports means that

the trade deficit in the US is highly susceptible

to a bounce in oil prices.

If US households seem to be controlling

spending more than had been earlier

anticipated, household saving rates have not

declined. Therefore, aggregate demand will not

have any upward push from domestic sources

Figure a World Current Account Balances (% of GDP)

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making a slack even more likely than

overheating, meaning imports will not increase.

Thus what helps one achieving one target

hinders in achieving another.

The Emerging-Markets If we talk about the emerging economies, the

problems facing them are quite different. The

current account balances of Brazil, Russia, India

and China are depicted in Figure b.

What stands out is China, which is projected to

resume expansion, and also Russia whose

current account balance is projected to

plummet close to zero.

What the danger is that the emerging

economies may overheat. At around 3

percentage points in 2007, Brazil, India and

China all had substantial output gaps before the

global recession (see figure 6). But except for

Russia, which has been negatively affected by

the slump in energy prices, forecast output gaps

for 2010 are all in the positive range. The

trajectory of the output gap for India, which is

slated to rise to above 5 percentage points by

2012, is one worrisome feature.

China plays a key role in global current account

imbalances. We can look at this issue through

the conventional “elasticities” view, where the

impact of Chinese currency misalignment is

assessed in a partial equilibrium approach. Has

China’s misalignment of the Yuan driven the

surge in its trade surplus? The fact that the

Yuan appreciates even as the trade balance

surges does not invalidate the proposition that

exchange rates can have an impact. As

countries experience rapid economic growth

exchange rates typically appreciate. Still, the

empirical evidence regarding the strength of

exchange-rate effects on Chinese trade is not

definitive. Studies using Chinese data predating

the recent recession find some effects of the

exchange rate on Chinese exports, but do not

typically find correspondingly large and

statistically significant effects on imports.

The lens of saving and investment balances,

which highlights the fact that the current

account is related to the budget balance and

the gap between private saving and investment,

is another way to look at the issue of Chinese

rebalancing. This perspective shifts the focus to

Chinese private saving as well as to government

saving. Recent analyses have focused on the

elevated levels of all three components of

household saving, corporate saving, and

government savings as against the mid-2000s,

when the surge in corporate savings was

identified as a key factor.

The trend decrease in the share of labor income

in Chinese GDP is part of the reason for this.

And along with the relatively high household

saving rate, it means that merely trying to raise

the household saving rate (by improving the

social safety net and increasing access to

consumer credit) cannot in itself solve the

problem. So, rebalancing involves a rebalancing

Figure b Current Account (% of GDP)

14

of the domestic shares of income away from

capital.

The bottom-line is that the Chinese government

has a lot of scope to accelerate rebalancing

through its policies. And this involves faster

currency appreciation in the short term while

over the longer term, it will require allowing

state-owned enterprises to pay dividends,

reducing the monopoly power of state-owned

corporations and accelerating the development

of a social safety net that will reduce incentives

for household saving, while decreasing

government saving.

Policy Implications With the likelihood of a two-speed global

recovery becoming quite apparent, the

possibility of overheating is more pronounced

in emerging markets. On the other hand, there

is little chance of overheating in the short term

in the advanced countries. Rather, the greater

risk is of deflation, combined with stagnant

growth.

With the current policies all over the world,

global adjustment of current account balances

is not proceeding with the speed it should. The

failure of countries with current account

surplus, like China, to resume currency

appreciation has basically resulted in quickest

means of effecting some adjustment being put

on hold. But it cannot be held back forever.

High unemployment combined with burgeoning

trade deficits, at some point, will increase the

likelihood of a destabilizing trade conflict.

About the Authors:

1) Vibha Bharati-Indian Institute of

Management Bangalore

2) Saurav Kumar Lugria-Indian Institute of

Management Bangalore

References:

World Bank, 2010b, Global Economic Prospects

(Washington, DC: World Bank).

IMF, 2010, “Chapter 4: Getting the Balance Right:

Transitioning Out of Sustained Current Account

Surpluses,” World Economic Outlook, April 2010.

World Economic Outlook, October 2010

Chinn, Menzie, Barry Eichengreen and Hiro Ito, 2010,

“Rebalancing Global Growth,” paper prepared for the

World Bank’s Re-Growing Growth Project (August)

Chinn, Menzie, and Hiro Ito, 2008, “Global Current

Account Imbalances: American Fiscal Policy versus East

Asian Savings,” Review of International Economics

16(3): 479-498

15

verheating of

Emerging Market

Economies and the role

of Central Banks

Abstract

In the aftermath of the Great Recession, the

developed world is striving to reduce its current

account deficit. Private consumption and capital

expenditure in the emerging economies is very

high. As recovery picks up in the west,

commodities are becoming dearer leading to

inflation in the developing world. Emerging

markets fear overheating. Their central banks

want to slow down growth. Liquidity is being

dried and rates are being increased to avoid

formation of asset bubbles and runaway prices.

But US unemployment and the EU debt concerns

still haunt them. They need to closely monitor

economic data and keep their tools handy for

any situation.

Global Financial Crisis

After the dot.com bubble burst in 2000, the

developed countries went into a mild recession.

To shorten the time taken for reversal and to

alleviate the pain caused by it, US Fed reduced

interest rates to unprecedented levels to boost

consumption. This led to a global shift in

Aggregate demand which boosts GDP growth

albeit in the short term. These rates were not

increased although the economy was on track.

Indeed, the real (inflation-corrected) funds rate

was negative for 31 months (from October 2002

to April 2005). The argument against raising

rates was that inflation was low and so there

was no need to raise rates. But the prices were

lower because of massive cheap imports of

goods and services from China, India and other

emerging economies. Thus the US consumption

was being fuelled by emerging economies and

the US trade deficit was at record high levels.

This would normally lead to devaluation of the

currency and make the imports costlier. But

there was huge appetite for dollar reserves

from China and Middle-East. Thus the slide of

USD was not much pronounced and imports

continued to grow.

An important distinction between open and

closed economies is the fact that the effect of

fiscal stimuli significantly different for both

models. In a closed economy, fiscal stimulus can

increase aggregate demand which can give a

boost to real GDP in the short term when prices

are sticky or constant. But for an open

economy, growth in aggregate demand can be

satiated by increase in imports which has no

effect on GDP. US being the most open

economy fuelled growth in many emerging

markets since 2001 but hasn’t been able to

raise its own GDP vis-a-vis its private

Consumption. This was a period of jobless

growth and sluggish real wage growth. Thus

private savings were getting depleted and loan

repaying capacity had slowly decreased to

alarming levels. But financial models which

were based on statistical models and historical

behaviours could not capture this. Also with the

complex derivative products like CDOs, risk was

passed on to the higher level. Asset bubbles

formed in real estate and equity markets.

Commodities too were at all time highs in 2007

before recession hit. All this eventually led to

large scale defaults and collapse of the Lehman

Brothers, AIG and all.

O

16

Steps taken by economies of the world to

contain the effects of the Great Recession:

To avoid the catastrophic collapse of the

financial markets and real economy, the

governments intervened in the following three

ways:

Bailouts and injections of money into the

financial system to keep credit flowing

Cutting interest rates to stimulate

borrowing and investment

Extra fiscal spending to shore up

aggregate demand

These measures have sought to prevent further

economic deterioration and ultimately keep

workers in jobs where possible and help create

new jobs to provide opportunities for the

unemployed. 48 countries provided fiscal

stimulus packages. Collectively, the fiscal

stimulus packages account for 3.9 per cent of

world GDP (as measured in 2008) and 4.8 per

cent of their national GDPs. 20 out of the 48 can

be classified as developing countries.

Stimulus packages helped in averting a disaster.

But the effects of the stimulus were different

for the developing and the developed world.

Developed world continued to struggle with low

growth and high unemployment whereas

growth in the developing countries was back to

pre-crisis levels.

G20 the consortium of twenty largest

economies of the world in their meeting

decided as one of the most important action to

be taken to bolster economic recovery:

‘In advanced G-20 economies, internal

rebalancing is advancing, albeit slowly.’

The focus of the meet was to reduce

dependency of the world on demand from the

developed world. As the private savings are at

an abyss, there is little demand left. Also, huge

trade deficits of the developed world will have

to be reduced. This will need to be done

through export promotion and import

substitution by the developed world. The US

wanted demand to come from India, China and

other emerging economies to substitute for the

lack of demand in its own territory. With newer

rounds of Quantitative easing, the US was

putting a lot of greenback into the market

which would put downward pressure on the

USD.

But export oriented economies need a strong

political will power to move from exporting to

consuming economy. China which had pegged

its currency Yuan since the advent of the Great

Recession is still reluctant to let its currency

appreciate. This will help shield itself from the

decline in exports considering the untested

domestic demand. Private savings in China are

not high in the first place as most Chinese

workers work at the lowest possible wages.

There have been attempts by the Unions (urged

by the government) to increase the daily wages

of the workers which will increase disposable

income. All these measures have raised

demand. But the extent of easing by the

government is questionable.

Figure 3: Growing consumption in the US during the

boom years despite stagnant real wages, 2006-20071

17

Figure 4: Real Contribution to World Consumption1

Other countries with floating currencies have

also taken a cue from China and have

undertaken measures to depreciate their

currency to safeguard their exporters. As a

result, we see the following two major themes

playing out:

Rise in commodity prices

As the USD weakens (oversupply of

dollars), commodities rise collectively as an

asset class. As the emerging market currencies

are undervalued, the commodities are costlier

for them as well. In an economy which is

completely free of any manipulation, this rise

would have been negligible as the currency

appreciation would have countered the rise of

commodity prices in dollar terms. These prices

are causing the core inflation to be high. The

central banks have not been able to control

prices as the rally is happening globally.

Social Policies impact demand

Through policies such as NREGS in India,

raising Minimum Wages in China, etc there was

tremendous increase in the demand at the

1GS Global ECS Research

bottom of the pyramid thus boosting demand in

these economies.

Figure 5: BRICS Income per Capita2

Infusion of liquidity in emerging

economies

As the currency is undervalued and

emerging economies are poised to grow, the

global capital is finding its way into these

economies. This hot money sought to take

advantage of this arbitrage opportunity. As a

result there is ample liquidity in these markets

and the central banks have had a tough time

sucking this amount of liquidity out of the

system. For example, Reserve bank of India

raised interest rates and cash reserve ratios

many times before the commercial banks

actually raised rates. This liquidity was also

giving rise to many asset bubbles like in the real

estate sector in china. Equities were performing

ever so well. But these economies are capital

deficient and need capital to support their

capital expenditures. It is extremely difficult for

governments to distinguish between hot and

real investments. With ample liquidity, there is

2GS Global ECS Research

18

always a shift in Aggregate demand and as such

the prices started rising.

Reluctance of Emerging market Central

banks to increase rates fast

Rates in the US were at all-time lows.

Raising rates in emerging economies at such a

juncture could have caused arbitrageurs to put

more money into emerging markets and add to

the liquidity. Hence the rates were raised slowly

which meant asset bubbles were given a free

ride till then.

Thus we see that overall demand is greater than

the supply could match. We also see asset

prices slowly inching towards pre-crisis levels.

These are signs of overheating in the economy.

Demand is growing faster than supply putting

pressure on prices. As the interest rates were

low to avoid massive capital inflow, the

consumers had a negative real rate of interest

scenario and as such their propensity to save

became lesser and to spend higher. The

demand for automobiles in the emerging

markets is at an all-time high to take an

example. This coupled with ample flows into

the economy and the buoyant equity markets

encourage the businesses to expand production

to meet demand. Supply will finally want to

catch up with this demand. But is the demand

here to stay?

With green shoots of recovery in the US and

relatively stable Europe (barring a few

sovereign default scares), the hot money will

eventually shift out of the emerging economies

back to the west. The demand in these

emerging economies which was largely liquidity

backed will dry up. Additional capacities created

during this boom may hurt the economy as

there is a possibility that the additional capacity

will remain idle.

The USD and Euro are depreciating against the

Asian currencies since the last two decades and

the momentum will continue. As a result,

exports by emerging economies will also not

pick up to pre-crisis levels. Moreover, with the

focus of the US to reduce trade deficit will also

result in more imports into the emerging

economies.

In such a scenario, there can be a deceleration

of growth in export oriented emerging

economies. It may cause unemployment and

reduce domestic demand further. As a result,

demand from both domestic and international

markets may dry up further putting pressure on

the growth prospects. We may not see these

economies replicating the runaway growth that

we witnessed during the last decade.

Course of Action to be taken by the

Central Banks

As the private investment is growing to

accommodate the overheating demand, base

metals prices are growing at an alarming rate.

The central banks which co-ordinated by

providing simultaneous stimulus packages must

now prevent asset prices to balloon especially

crude and base metals. The recent growth in

the last few decades has created a strong

middle class with considerable amount of

disposable income. Hence there is an upward

pressure on food prices as well. Labour wage

rates have increased substantially too. Inflation

is a very important political concern for the

governments too. Food prices constitute a

major portion of their income and as such food

inflation can cause political tensions in the

developing economies. Central banks and

governments must now look to reduce the

money supply and roll back fiscal stimulus

packages. This may increase unemployment but

will also cool off labour wage rates. Food prices

19

have been increasing steadily since 2005 levels

barring a blip in 2008. Thus, food price inflation

may be a result of supply concerns as well as

increases demand. Steps should be taken to

increase the supply of food grains to bring food

prices under control.

Another major aspect that the central banks

need to control is the credit growth. As the

liquidity was ample many companies went on

capital expenditure spree to meet the rise in

demand. It can cause upward pressure on

commodity prices. Emerging markets must try

to cool down. It will help in checking asset

bubbles and create an environment more

sustainable long term growth.

Signals from the developed world have been

mixed. The G20 meet too recognized threat to

global recovery. The major reasons could be:

Renewed pressures in the U.S. housing

market

Spill-overs from renewed turbulence in

sovereign debt markets, notably in

Europe

The lack of credible medium-term

consolidation plans

Financial and trade protectionism and

currency instability

This has kept the possibility of double dip still

on. Thus fiscal and monetary expansion cannot

be rolled back in a jiffy. But the impact of

overheating can be equally disastrous for the

developing world. Hence, central banks need to

take a balanced approach under current

scenario. They should also learn from the

previous scenario where excess liquidity caused

monetary transmission to be perilously slow.

Central banks need to keep the liquidity under

tight control so that any change in the policy

will affect the economy swiftly.

About the authors

Ankur Choraria graduated from National

Institute of Technology, Jaipur in 2007 and

joined Cognizant Technology Solutions. He

worked as an analyst in Banking & Financial

Services domain. He is currently pursuing

Master of Management program at the

SJMSOM, IIT-Bombay. His email id is:

ankurchoraria@gmail.com

Laveen Ramrakhiyani graduated from Dhirubhai

Ambani Institute of ICT (DAIICT) in 2009 and has

1 year experience with Infosys and Mu sigma

(Analytics). He is currently pursuing Master of

Management program at the SJMSOM, IIT-

Bombay. His email id is: laveen10@gmail.com

Saurabh Surana graduated from Mumbai

University (KJ Somaiya College of Engineering)

and has 2 year experience with Tata

Consultancy Services Ltd. He is currently

pursuing Master of Management program at

the SJMSOM, IIT-Bombay. He is interested in

finance and macro economics. His email id is:

saurabh2986@gmail.com.

References

1. Brazil, India, China may be overheating, says Roubini. (2010,

June ) Retrieved from

http://economictimes.indiatimes.com/news/economy/Brazil-

India-China-may-be-overheating-says

Roubini/articleshow/5996621.cms2)

2. India needs tighter policy to prevent asset bubbles: OECD.

(2010, Nov 18). Retrieved from The Economic Times:

3. Meeting of G-20 Finance Ministers and Central Bank Governors.

(2010, October 21 - 23). Retrieved from

http://www.imf.org/external/np/g20/pdf/102110.pdf4)

4. Moodys cautions against overheating of economy. (2010, Dec

18). Retrieved from ReportLinker:

http://news.reportlinker.com/n04101071/Moodys-cautions-

against-overheating-of-economy.html5) Rowley, A. (2010, Oct 10).

5. Asia overheating risk looms – IMF. Retrieved from Emerging

Markets:

http://www.emergingmarkets.org/Article/2690778/Asia-

overheating-risk-loomsIMF.html

20

he Decoupling

Debate: Do Emerging

Markets hold the key to

recovery after crisis?

Abstract

The Decoupling thesis has been a contentious

issue since its origin. It advocates that Asia’s

emerging markets can be insulated from the

global economy, especially during the period of

recession. After the global financial crisis,

emerging markets of Asia showed signs of

strong recovery while US economy was limping.

This provided further impetus to the decoupling

theory and proponents of the theory believed

that Asia will pull the world out of crisis.

However, critics argue that real decoupling is

not possible and current recovery is only due to

monetary and fiscal stimulus.

Introduction

The issue of ‘decoupling’ of emerging Asia has

always been at the center of much debate in

the economic circles. It refers to the thesis that

emerging Asian economies have become self-

contained entities and can maintain their own

growth independent of the trends in the

markets of the developed countries. The

theories of decoupling gained much emphasis

during the first decade of 21st century.

However, these theories received a strong

setback with the onset of the global financial

crisis, when the tremors were felt throughout

Asia.

The theories of decoupling again gained

impetus as the world recovers from the crisis.

Keith Fitz-Gerald advocates the term “The Great

Decoupling” in this new book, Fiscal Hangover:

How to Profit from the new global economy. As

the world witnesses some signs of recovery

from the crisis, the supporters of decoupling

thesis believe that emerging markets hold the

key to this recovery.

Defining Decoupling

There has been no standard definition of

decoupling. It is more appropriate to conceive

of decoupling as an idea rather than a strictly

defined term. The idea that Asian markets could

perform differently than developed

counterparts suffers from two major

weaknesses:(Foster, Decoupling, Further

Defined, 2010)

Are the financial markets decoupled or the

‘real’ economies? The movements of these

two need not be the same.

The time period of observation for

decoupling to be evident. Should it be

measured over days, months or years?

A better definition of decoupling, which takes

into account its long term nature, is based on

three pillars: Resilience, Uniqueness and

Independence.(Foster, Decoupling, Further

Defined, 2010)These pillars should be

interpreted as the necessary conditions for

decoupling to materialize. There is growing

evidence to support the existence of these

pillars. Bond markets have gradually developed

in Asia with domestic investors playing a

significant role. The growth of intrinsically

domestic service industries presents a unique

opportunity and shields the region from global

imbalances.

History of Decoupling Debates

Developing countries did not figure significantly

in the macroeconomic policy considerations in

T

21

the developed economies before the 1980s.

The concept of decoupling evolved with the

independence of Asian economies from

developed economies and “strong domestic

demand and confident consumer from Asia

were hallmarks of 1980s.”(Liang & Qiao, 2007)

However, 1980s were turbulent times for the

US economy with housing woes, large current

account deficits and weakening currency.

Decoupling thesis received a setback with the

Asian financial crisis of 1997-98. The domestic

weaknesses of the Asian economies made them

increasingly dependent on US demand, boosted

in 1990s by IT revolution.

Decoupling thesis gained prominence once

again after the bursting of dot com bubble and

September 11, 2001 attack in US. Emerging

economies like China and India maintained high

GDP growth while US and Europe tethered on

brink of recession. In 2002, while GDP of US and

Europe grew by 1.8% and 0.9% respectively,

that of developing Asia grew by 6.9%.(IMF,

2010). “The ‘decoupling’ thesis… [became] a

popular theme in Asian policy circles in the first

decade of the new millennium…”(Athukorala &

Kohpaiboon, 2009)

US growth slowed down again in 2005 providing

further impetus to decoupling theories. This

was brought out by IMF World Economic

Outlook 2007. Anderson claimed that “The

bottom line, as we’ve argued many times

before, is that there’s no reason to argue over

whether the mainland is “decoupling” from the

global cycle – as far as macro growth is

concerned the economy is and always has been

effectively “decoupled”, and China has little to

fear from a global demand

slowdown.”(Anderson, 2007)Dees and

Vansteenkiste reported that business cycles of

Emerging Asia moved independent of US

business cycle. This is mainly due to China,

which experienced strong growth independent

of its trading partners. They also estimate that 1

percentage point decrease in US GDP would

decrease GDP of emerging Asia by 0.23% from

baseline. (Dées & Vansteenkiste, 2007)Some

authors even supported decoupling thesis at

the beginning of the crisis. (Rossi, 2008)

The notion of decoupling gained acceptance by

large investment banks such as Goldman Sachs

and Morgan Stanley. Liang and Qiaowrote in

Asian Economics Flash “China, together with

emerging Asia, stands a very good chance of

outperforming and decoupling from the US

economy in the coming few years.” (Liang &

Qiao, 2007)However, decoupling was not

always observed as a result of inherent strength

of Asian economies. For example, a strong

performance of equity markets outside US

could have been attributed to a $54 billion

inflow to emerging market funds.(Prakash,

2008)

Evidence from Crisis

The global crisis in 2008 delivered a strong blow

to the decoupling thesis. Dooley and Hutchison

argue that “emerging markets responded very

strongly to the deteriorating situation in the

U.S. financial system and real

economy”.(Dooley & Hutchison, 2009)They

analyze the crisis in 3 phases: Phase I runs from

February 27, 2007 to May 18, 2008; Phase II

runs from May 19, 2008 to September 14, 2008;

Phase III runs from September 15, 2008 to

February 2009.

22

The 16 month period February 2007 to May

2009 presented strong evidence in favor of

decoupling of emerging economies from

developed countries. The MSCI emerging

markets outperformed the S&P 500 by nearly

40%. (Figure 1)The EM currencies also gained

value against the dollar by approximately 10%.

This appreciation against dollar can also be

attributed to carry trade inspired by high yields

in emerging economies. The investors clearly

did not anticipate that the events in US will

negatively impact the earnings in emerging

economies. Thus, in the early part of the crisis,

emerging markets were more or less decoupled

from the developed economies. This is also

underscored by the comparison of credit

markets in US and emerging economies. Figure

2 compares CDX EM, an index of credit-default

spreads for emerging market sovereign bonds

and an index of US investment grade corporate

bonds over US treasuries. In the early phase of

crisis, spreads in emerging markets declined

while the US index did not change by any

significant amount.

During Phase 2, from May 19, 2008 to

September 15, 2008, the MSCI EM index fell

and gave up its outperformance related to S&P

500. The currencies of the earlier assumed

decoupled markets also fell relative to the

dollar. Thus, during phase 2, there is little

evidence to support the fact that emerging

markets had not been affected by the collapse

of financial system in US.

The third phase also emphasis a recoupling of

the emerging markets with the US. The world

trade froze across all economies in the world,

and imports and exports fell about 30% after

September 2008 in most countries. Dooley and

Hutchison studied correlations between S&P

500 and indices of emerging markets and found

that they increased significantly during the

second and third phases of the crisis. An event

analysis also indicated that “U.S. news

significantly moved CDS spreads in selected

emerging markets.”(Dooley & Hutchison, 2009)

Evidence after Crisis

The support for decoupling thesis again gained

ground as the world saw greens shoots of

recovery after the crisis. In 2009, the economies

of US and Europe remained weak while India

and China showed signs of rebounding. IMF

predicted growth rates of 5.4% and 8.5% for

Figure 2: U.S. corporate and emerging market bond

spreads. Note: the two vertical lines mark the dates (May

19, 2008 and September 15, 2008) that separate the

three phases of the subprime crisis

Figure 1: U.S. and emerging market equity prices

23

India and China respectively. Mohamed El-

Erianpointed out, “With the ongoing

normalization of the financial system, the

decoupling camp is again in strong ascension

today. It is buoyed by the developing pick-up in

economic activities and the fact that equity

valuations are now back above the pre-Lehman

levels.”(El-Erian, 2009)

Decoupling a Myth?

With increasing globalization, it is often hard to

believe in full decoupling of Emerging markets

from the developed ones. Substantial evidence

is present to prove that decoupling theory is

premature. Decoupling is particularly applicable

for emerging economies, with headline exports

comprising of 70% of individual GDPs. The share

of exports in GDP has risen over the past

decades. The most popular evidence of

decoupling was the increasing intra-regional

trade in Asia, especially the rise in exports to

China. “China is the biggest export destination

of Japan, Australia, South Korea, the Association

of South-East Asian Nations, Brazil and South

Africa; and the third biggest export market of

the United States, the European Union and

India.”(Xinzhen, 2010)

Since Q2 2009, Asian economies have been on a

rebound. However, this can be attributed to the

fiscal and monetary stimulus by the

governments. China unveiled a CNY 4 trillion

($586 bn) package in November 2008 to

counter financial crisis (Menza, 2008) and India

also introduced a similar package. Critics of

decoupling argue that any economy will grow if

backed by such substantial amount of money

supply. At best, this signifies the

macroeconomic strength of the governments.

The increase in exports to China is also not any

measure of decoupling.

During each financial crisis of the last decade,

Asian equity markets have shown signs of

recoupling. This can be seen from Table

1.(Foster, Decoupling, Further Defined, 2010)

MSCI US

Index

MSCI

World

Index

MSCI AC

Asia ex

Japan

Index

Tech Bubble Dec.

99- Dec. 2001 -23% -28% -38%

SARS Crisis, Nov.

2002-Mar. 2003 -9% -10% -13%

Global Financial

Crisis, Oct.2007-

Nov. 2008

-41% -47% -60%

Table 1: Cumulative Total Returns, Index

performance during 3 most prevalent financial

crises

The ‘currency wars’ have also demonstrated

that the economies of the world are linked to a

great extent. With all the economies connected

by trade, no wonder all countries wish to

devalue their currencies to make exports

competitive. Taimur Baig, Deutsche Bank’s chief

economist for India, Indonesia and the

Philippines says that “the reason for the tight

attachment is not surprising. There exists

remarkably close linkage between regional

exports and consumption. Even investment

looks to follow the export cycle closely. In

recent years this linkage has not waned,

underscoring why the East Asia region remains

a strong beta to G3 growth.”(Baig, 2010)

Conclusion

From the above discussions, it is evident that

more research is needed to fully examine the

validity of decoupling thesis. It remains to be

seen if the current recovery will be a decoupled

24

one. Some of the likely scenarios in a decoupled

recovery are: (McDonald, 2010)

A differential of 4% or more between Asian

growth rates and that of West

Commodity price pressures for industrial

inputs

Rising inflation leading to higher interest

rates in Asia. This will to higher interest

rates in US to attract funds from Asia for

government debt.

An increase in intra-regional trade in Asia

leading to weakness in global shipping

levels

Stronger M&A activity within Asia

The increased globalization has also raised the

question if any decoupling is possible at all.

Asian economies are largely export driven, and

private consumption is still not a major portion

of GDP. The currency wars demonstrate that

emerging economies continue to rely on

exports to boost their growths. This raises

doubts on their ability to pull the world out of

recession and the dream of a decoupled world

seems still out of reach.

Another issue which might be of interest to

policymakers is whether decoupling is desirable.

A decoupled economy is less prone to

exogenous shocks, but is also bereft of the

positive effects of global investment. Myanmar

and North Korea are the most isolated Asian

economies, which has led to them being “worst-

off countries in the region”. With their

significant trade with China, they are decoupled

from the benefits of global recovery but are

vulnerable to effects of recession.(Emerging

Markets Monitor, 2009) The question that India

and China should be asking is: Do we want to be

decoupled from the global economy?

About the Author

Ankit Sinha is a 2nd year PGP student at IIM

Bangalore. He has done his graduation in

Chemical Engineering from IIT Kanpur. He

interned with Nomura in FX Options and Rates

trading. He can be reached at

ankit.sinha09@iimb.ernet.in

References

Anderson, J. (2007). Is China Export-Led? UBS Investment

Research.

Athukorala, P. C., & Kohpaiboon, A. (2009). Intra-Regional Trade in

East Asia: The Decoupling Fallacy, Crisis, and Policy Challenges.

ADBI Working Paper Series, No.177.

Baig, T. (2010). The Markets in 2011. Deutsche Bank.

Dooley, M., & Hutchison, M. (2009). Transmission of the U.S.

subprime crisis to emerging markets: Evidence on the decoupling–

recoupling hypothesis. Journal of International Money and

Finance, Vol. 28, Issue 8, 1331-1349.

Foster, A. (2010, December). Decoupling, Further Defined.

Retrieved january 2, 2011, from Asia Insight:

http://www.matthewsfunds.com/perspectives-on-asia/asia-

insight/default.fsIMF. (2010). World Economic Outlook Reports.

Retrieved January 2, 2011, from International Monetary Fund:

http://www.imf.org/external/pubs/ft/weo/2010/02/pdf/tables.p

df

Prakash, A. (2008, February 12). Decoupling or Recoupling?

Retrieved January 2, 2011, from Business Standard:

http://www.business-standard.com/india/news/akash-prakash-

decoupling-or-recoupling/313393/

Rossi, V. (2008). Decoupling Debate will return: Emergers

dominate in long run. Chatham House, IEP BN 08/01.

Xinzhen, L. (2010, december 27). The Engine of the World.

Retrieved january 2, 2011, from Beijing Review:

25

Future of Asian

Giants

Abstract

China and India showed resilience when the

developed nations were struggling hard. But

higher inflation rate and excess capital inflows

into these countries raise fear about possible

asset price bubble that may burst sometime in

the future. Quantitative easing measures by

USA and the bleak state of affairs in Euro zone

adds further apprehensions about the future

growth of these Asian Giants. These countries

have beaten the earlier forecasts and with

further reforms in India and structural changes

in China by fulfilling the domestic needs they

would continue to prove others wrong by

growing at higher rates in the future too.

The west nations turned to their east when they

heard the roar of the tigers from the east.

When the world was in crisis, the two countries

grew and showed their economic prowess. The

Question if the future of the world is in these

two countries remains to be answered. Will

they become the new super powers or else this

is just be an exaggerated story which may not

bring the dreams of the 2 country with more

than a billion people to come true.

The emerging economies in the world include

China, India, Brazil, Russia, South Africa and

Mexico among others. The two most populous

countries in the world were truly shining in the

last few years and were bringing the emerging

economy into the world stages. Chinese GDP

grew at a rate close to 11% and India grew over

8% in 2010. Chinese beat Japan in the second

Quarter output and thereby becoming the 2nd

largest economyi. But the doubt rises if these

factories would run out of steam soon.

Indian Scenario

India experienced its highest FII inflow of $28.4

billionii this year. Better corporate earnings and

higher growth rate of the net income led to

increased foreign investments and the SENSEX

increased by16.74 % over the previous year.

The influx of the funds is also attributed to the

higher returns from the developing nations than

the returns from developed nations. But fear

grips as the economists wonder whether this

growth is a bubble and may burst anytime soon.

The price of assets including the equity, gold

price and real estate properties are increasing

and the inflation rate is also high. Gold

increased by nearly 10% last year and increased

by further 20%iii since April this year. Real estate

prices have also peaked and even surpassed

pre-crisis levels in several places. The more

demand in the boom period would cause the

asset price to increase and if the supply couldn’t

be matched to the aggregate demand, then this

would lead to overheating.

The growth – inflation dilemma is a common

paradox that every central bank deals with. And

RBI made the right move to follow tightening

monetary policy to fight inflation even though it

hurts the growth. The repo and reverse repo

rates have been increased from 5 to 6.25% and

3.5 to 5.25 respectively and the following graph

shows the actual rates from March 2010 to

December 2010.

Following the RBI hike in the repo rate, the

banks increased the deposit rate and base rate.

(Base rate is the minimum rate for lending).SBI

increased its base rate by 40 basis points to

8%, ICICI Bank and Kotak Mahindra Bank also

26

02468

Policy rates in 2010

Repo rate Reverse Repo rate

followed SBI in hiking the lending rateiv. SBI and

IDBI also increased their deposit rate to

encourage more people to deposit and thereby

improving the liquidity in the systemv. These

measures helped in taming the inflation rate to

around 9% from over 15% in the beginning of

the year in the countryvi as the cost of

borrowing money is kept higher so the demand

for the goods is reduced.

Chinese Scenario

Inflation also hit China and the Chinese central

bank is fighting against it with tightening

monetary policy. The real estate price is also

soaring high to a dangerous situation. Chinese

Government resorted to increase the level of

reserves the banks must hold to curtail the

credit growth and increased the interest rates

so that people would save the money instead of

creating excess demand. But the Chinese

growth is attributed to its export driven

economy. The domestic needs are not met and

the country focuses more on exports. This is

unlike India which has current account deficit

implying higher level of imports than exports.

Yuan is kept at a very cheaper rate to promote

export and the domestic demand in China is not

met and the developed nations are exerting

enormous pressure on China to strengthen its

domestic currency. Strengthening of Chinese

Yuan would hurt the exporters and hence

would affect Chinese growth.

International Factors

Federal Reserve resorted to the Quantitative

easing in US in last November for the second

time since recession to keep its dollar at its

lower rate and to create liquidity in the system.

The central bank planned to buy $600 billionvii

in long-term Treasuries thereby increase the

dollar flow in the system. These excess funds

flow into the developing nation in the form of

FII’s. These funds could be withdrawn anytime

and hence they make the capital market system

in developing country unstable. Exposure of

these FII’s in Indian capital market is high and

hence there would higher volatility in the stock

price movement.

Fear of default of sovereign debts in euro zone

is on the raise. Greece and Ireland were bailed

out and the fate of Spain and Portuguese is not

encouraging. Portuguese would be the first

country this year in Europe to go for raising

money through bonds and the debt raising has

become difficult for them. The borrowing cost

of Portuguese increasing as the yield of the 10

year bond jumped from4.065% to 6.683% in

2010viii.

Collapse of one economy would affect the

others leading to a cascading effect of affecting

all the nations. This fear could also hurt the

growth of the India and China as foreign players

would hesitate to invest in these nations and

the outflow of FII’s would be higher because of

the economic crisis in Euro zone.

27

Future Outlook

These countries should keep in mind the Asset

bubble in Japan that collapsed in 1991 and it

severely affected the nation’s growth for more

than a decade. Consumer demand and private

investment in India would keep the economy

growing and the Asian development Outlook

predicts India’s GDP growth for next year to be

around 8.7%ix.

Both India and China should implement reforms

that boost the productivity and increase

competitiveness of the firms. Growth of FDI

instead of FII should be encouraged in these

countries. These countries should grow

domestically and the growth and profits from

the domestic firms would spur the growth of

the country.

If the country’s productive capacity is able to

keep pace with growing demand, then the high

levels of inflation could be avoided. Chinese do

have the structural problem of having too much

investment and too little domestic demand.

Sooner or later, it should stop relying on

domestic investment and external demand. To

keep FII inflows within the absorptive capacity

of the economy and to have stable currency

valuation, India could follow some of the

developing countries such as Thailand and

Korea to impose capital controls by levying tax

on foreign capital inflows.

The debate on overheating of economies is not

new. The debate is there for the last 4 years and

both the countries have proved that they have

removed the doubts of the investors and they

have grown fast in the hard times and have

become further stronger and they would still

continue to do so in the future as well.

About the author

Senthil Kumar V is a second year PGP student in

Indian Institute of Bangalore.

He completed his BE in the field of electronics &

communications in college of engineering, Anna

university and can be contacted at

senthil.kumar09@iimb.ernet.in

Contact number: 9916058201

References:

1http://www.newstatesman.com/economy/2010/08/japan-china-

gdp-economy

1http://www.livemint.com/2010/12/23182411/Record-FII-inflow-

in-2010-wil.html?atype=tp

1http://www.thehindubusinessline.com/2010/11/03/stories/2010

110352250100.htm

1http://www.moneycontrol.com/news/economy/banks-hike-

rates-loans-to-cost-more_509832.html

1http://www.deccanchronicle.com/business/banks-hike-deposit-

rates-362

1http://www.tradingeconomics.com/Economics/Inflation-

CPI.aspx?symbol=INR

1http://finance.ryahoo.com/news/Quantitative-easing-2-is-here-

cnnm-1729089799.html?x=0

28

Currency Dynamics in

the Emerging Market

Economies Abstract

Many of the emerging economies have

outperformed the advanced economies in its

recovery from the global economic slowdown.

As nations world over look to come out of this

economic shock as quickly as possible, the

epicenter of economic growth is surely shifting

into the hands of all the emerging nations. As

the world economic canvas is torn into two

camps with contrasting goals and growth

objectives, this article looks into the policies

employed by the various nations, including

India, with respect to their currency and foreign

exchange policy, as they look to assume

increased importance in the world economic

scenario.

Across the Globe The sheer enormity of the present day world

economy requires deep and liquid market in

multiple currencies. This view is consistent with

history. Prior to 1914, reserves of central banks

were majorly held in British Pound, French

Franc and the German Mark. Dollar and Pound

then shared primacy till 1930. Today, currencies

other than the Dollar account for more than

40% of international reserves. In the coming

years, the Dollar, Euro and Renminbi will share

the roles of invoicing currency, settlement

currency and reserve currency. This will make

the world a safer place financially as a

decentralized international monetary system is

what is required to prevent a replay of financial

crisis.

Monetary policy should aim at domestic price

stability while letting exchange rate float freely.

A strong domestic currency retains its

purchasing power by maintaining a low rate of

inflation. A competitive currency also requires

that other countries should not implement

policies that artificially depress its value in order

to promote their exports and deter their

imports. This gives enough reason for the US to

force China to set the Renminbi to float freely.

China’s position is that, to avoid the negative

impact of a stronger Renminbi on China’s

exports and hence employment, appreciation

must proceed in an autonomous, gradual and

controllable manner. But resisting the US can

result in hot trade disputes between the two

nations. China’s large and persistent current

account and capital account surpluses imply

that the Renminbi is highly undervalued.

Renminbi appreciation should have started

when China’s trade surplus was much smaller

and when its economical growth was much less

dependent on exports. Owing to the financial

crisis, China’s export growth in 2009 dropped by

34%. This drop makes the Chinese government

even more hesitant to let its currency float free.

In order to peg the currency, the People’s Bank

of China buys Dollars and sells Renminbi. But

the rapid deterioration in America’s fiscal deficit

and the continuous deterioration in its external

balance may tempt the US to inflate away its

debt burden and hence makes the Chinese

government hesitant to accumulate Dollars.

This dilemma is worsened by the overall

increase of price levels in China, causing

Renminbi to strengthen. If the Renminbi is

allowed to float, the net capital outflows will

rise drastically, pushing it upward, very similar

29

to what Japan experienced after the Plaza

Accord in 1985 and hence can prove disastrous

to the economy.

Though the American economy is adversely

affected by China pegging its currency, it cannot

expect to attain balance by a weakening Dollar.

The basic cause of the US imbalance is over-

consumption and over-borrowing. A weakening

Dollar may result in panic in the capital markets,

thus requiring higher risk premiums on Dollar

denominated assets, leading to a further

weakening of the Dollar and an economic

slowdown. Though the Renminbi appreciation

may displace Chinese goods sold in the US

market, if the US fails to narrow its savings gap,

its current account deficit will not reduce. Thus

what the American economy needs is

strengthening of the domestic economy.

But it is conventional wisdom that it is

impossible to fix both exchange rate and

domestic monetary conditions simultaneously.

The Asian financial crisis of 1997-1998

convinced the world that economies which

maintained exchange rates were able to sail

through better than those that did not.

Maintaining controls requires a high level of

reserves and higher reserves lead to higher

inflation related risk of the reserve currency.

Highly comparable to the Chinese economy in

terms of growth is the Indian economy. The

huge inflow of capital to the economy poses a

challenge in terms of the economy’s capacity to

absorb it. In the present scenario, it is

important that the RBI policies be such that the

overheating of the economy is curbed.

In India The expertise displayed by the Indian Central

Bank in handling the economy during the

economic crisis of 2008-09 was instrumental in

ensuring that India was able to come out of the

crisis scenario majorly unscathed. Emerging

economies have been the pivot point, playing a

major role in reviving the economy, and India

has played a vital part in leading the world into

this path of resurgence. The RBI has won the

respect of major economists world over for

having maintained austere policies prior to the

recession, and for having taken quick corrective

action in order to restrict the damage to its bare

minimum.

However, the woes of the Indian Central Bank

are far from over, as it looks to align its policies

to cater to conflicting goals of roping in the

constantly increasing inflation and parallel

ensure unbridled growth of the economy. As

the developed nations look to escape from the

abyss of recession by pumping in money into

their economy through quantitative easing, the

emerging nations, including India are faced with

increasing inflow of funds into their economy,

as foreign investors are attracted by the higher

interest rates in the EMEs, and gain increasing

confidence in their growth potential as well.

The outflow of cash from the developed nations

might not have much of an impact on the

developed countries, which are huge

economies. However, the volume of inflow

might be huge from the EME’s perspective,

given the smaller size of its economy. Given the

sudden spike in the inflow of money, the

inflation scenario of the country has remained

high throughout the financial year, with food

inflation rising to a 23-week high of 18.32%

during the last week of December, and

registering an overall inflation of 7.48% in

November. Given the ever-increasing inflation

rate, the RBI has been forced to increase its

policy rates numerous times over the past year.

30

All other emerging economies, including ones

like Brazil, have responded to this continuous

inflow by introducing this capital control

policies. The Indian Central Bank has been

criticized for being complacent regarding taking

a stance to prevent this excessive inflow.

Excessive capital inflow can be a cause of

concern as it can

Cause currency appreciation

Cause increase in asset prices

In addition to this, there also remains the

danger of inflow reversal as a lot of this inflow

could be short termed.

The million dollar question still remains as to

how much of capital inflow the economy can

actually absorb and whether inflow regulations

are as yet required. Given the projections of the

growth of the Indian economy, the RBI believes

that there is enough growth potential in India to

take in the capital inflow. However, the concern

remains that major of the inflows have been in

the form of FIIs, which are a lot more volatile

than its stable counterpart, i.e, FDIs. This has

been the major point of contention as far as the

necessity of control measures is concerned.

The possible actions that the RBI can take to

counter this are

Introduce restrictions on capital inflows,

like charging a percentage of tax

Prevent currency appreciation by indulging

in foreign exchange transactions

These steps, though they seem to be effective

at first glance, have their own negatives. The

introduction of capital controls haven’t been

effective and Brazilian currency has been

named as the most overvalued currency in the

world by Goldman Sachs. This is because a

majority of the investors look for long term

investing opportunities, and thus such steps

would prove useless in such a case.

The other possible course of action is by

intervening in the foreign exchange and trying

to control the Rupee from appreciating. This

can be highly relevant for India, especially for

the services sector, which is highly dependent

on exports for its growth and revenue. On the

flip side, such an intervention of pegging the

currency could cause an expectation of

appreciation in the future and thus attract

further future inflows. The logic is as follows: If

the Indian rupee is currently to be valued at 1$

to 40 rp, and is instead pegged at 1$ to 45 rp,

an investor would invest further in the economy

expecting the rupee to appreciate to a value of

40 rp per dollar in due course, thus giving a

return of more than 1$ to the investor. Thus,

even though in the short run, pegging the

currency could seem as a good option, this

could harm the country in the future and cause

further inflation.

Given these complex scenarios, RBIs current

policy stance seems to be the best one to

adopt, as it has let the exchange rate absorb

most of the capital inflow volatilities. Large

scale interventions have been indulged in by

countries like China, as it hadn’t been proactive

enough to do the regulation when its

dependence on trade balance was lesser. Since

such currency appreciations were not allowed

in the small scale, the increasing inflow amount

seemed too huge to handle, and further

interventions had to be made.

The current challenges facing the RBI include

balancing its policy to meet the dual goals of

Inflation control and sustained economic

growth, while also looking to maintain the

31

liquidity deficit value, as stated as one of its

additional objectives. These goals, though in a

way conflicting, need to be given equal

importance, as India aims to come out of the

recession dip completely and take the lead as

the dynamics of the world economic power has

been shifting away from the established

leaders, into the hands of the emerging

economies.

About the Authors

Annapoorni C S

Email - pg10annapoorni_c@mdi.ac.in

An engineer from Cochin University of Science

And Technology with outstanding performance

throughout academics, Annapoorni was an

active participant in extracurricular activities.

She worked as a software engineer in Nokia

Siemens Networks for 11 months and is

currently pursuing her masters in management

at MDI, Gurgaon.

Richa Gupta

Email – pg10richa_g@mdi.ac.in

Richa Gupta is a BE in Instrumentation and

Control from NetajiSubhas Institute of

Technology, Delhi. She worked in

AricentTechnolgies Ltd as software engineer for

8 months and as Design Engineer in Freescale

Semiconductors Ltd for 4 months and is

currently pursuing her masters in management

at MDI, Gurgaon.

Tisa Annie Paul

Email – pg10tisa_p@mdi.ac.in

A BTech in Electronics and Communication from

National Institute of Technology, Calicut, Tisa

worked for a year in Deloitte Consulting. She

has won awards for excellence throughout her

academic career. She is currently pursuing her

masters in management at MDI, Gurgaon.

References

[1] The Mint Report dated October 29, 2010

[2] www.rbi.org.in

[3] www.project-syndicate.org

a

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