A Deep Disconnect

A report by English economist Lord Meghnad Desai in November 2005 alerted the world to the possibility that large third world nations were “decoupling” from the key drivers of the world economy, the United States, Japan and Europe. He predicted that the fate of many Asian economies, particularly China and India, were becoming less dependent on the fortunes of developed nations. The report argued that if Gross Domestic Product was measured using purchasing power parity (or PPP) that represents the true value of a country’s output, India is the world’s fourth largest economy after the US, China and Japan. Moreover, China and India together accounted for roughly half of global GDP growth in 2005. According to IMF estimates, emerging markets and developing economies will grow at a rate of 8.1%, compared to the US’s 1.9% in 2008. But last week, to borrow a cliché, as soon as the US sneezed, India and most of Asia caught a cold.

The likely prospect of a recession in the US was enough to send the Bombay Stock Exchange’s 30-stock Sensitive Index (Sensex) tumbling. On January 21 and January 22, the market lost a quarter of its value (it recovered half that in the days that followed) due to a variety of external factors – the sub-prime mortgage crisis in the US, oil at $100 a barrel, the Iraq war and turmoil in credit markets. Despite US President George Bush’s announcement of a $150 billion economic stimulus plan to revive the economy, global markets have remained gloomy. Credit card defaults are rising in the US, a logical corollary of the mortgage defaults. When real estate prices fall spending becomes a casualty. US consumer spending has kept the world economy booming for five years, and reduced US spending could mean a global downturn.

Indian stock markets are increasingly being driven by foreign portfolio investments. The Sensex scaled 21,000 points this January from just 15,000 in July 2007 on the back of investments by Foreign Institutional Investors (FIIs) of $20 billion last year. According to NASSCOM, India’s information technology and IT services industries contributed 7% of GDP in 2005. The IT industry is driven by demand for their services from the West, particularly the US. Thus, India cannot remain immune to what happens in the US, the Euro Zone and the UK and yet maintain high growth rates. India's commerce minister Kamal Nath conceded as much at the World Economic Forum in Davos when he said no economy in the world can be fully insulated from a US recession.

But the fact remains that India and China are less dependant on the US economy than almost all their neighbours. In a recent article, The Economist pointed out that thanks to their large domestic consumption, just 8% of China’s GDP was dependent on exports to the US while in India’s case the corresponding figure was a miniscule 2%. Rating agency Standard and Poor’s latest report on the risk posed by a US recession to Asia’s economies underscores the same point. S&P says that unlike South Korea, Singapore, Malaysia, the Philippines and Thailand, which are “vulnerable” to a US downturn, India and China are “not vulnerable”.

So what explains the apparent disconnect? Why are Indian and Chinese stock markets reacting so readily to bad news from the US when their economies barely register a blink? In India’s case, the latest dip in stock prices could be one of timing a much as that of sentiment: The Rs 11,700 crore Reliance Power IPO has sucked out a plenty of liquidity as investors have sold stock to invest in one of India’s most valuable companies.

But there is a deeper reason, in fact a real “decoupling” between capital markets and economies. Stock markets operate on sentiment. Only over the long term can we discern a relationship between the real worth of companies and the prices at which their shares are traded. Markets are fundamentally propelled by emotion while economies are driven by hard information that every individual and firm base their actions upon. It’s when we confuse the world of stock markets for the real world that we get into serious trouble.

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