Lakshman Achuthan, Co-Founder & Chief Operations Officer, of ECRI just released an exceptional 9-page document on supply chains and decoupling called The Yo-Yo Years.
Here are a few snips but those bullish on emerging markets, commodity producers, as well as those who think the US is going to decouple from the global economy should take the time to read the entire document.
The idea of “decoupling” often comes up as a way for one part of the world to dodge weakness elsewhere. But, over the last two decades, a key driver of the greater coupling of economic cycles had been the increasing interdependence of world economies, with more openness in the flows of capital and trade – especially merchandise trade. Indeed, the export dependence of most economies has risen dramatically in this period. We see that export/GDP ratios have increased sharply since the early 1990s across all countries, which is evidence of the intensification of global integration through trade.
In the Asia-Pacific region, this proportion roughly doubled for Japan, more than tripled for India and Korea, and advanced to roughly 75% from 42% for Taiwan. In China, the share of exports relative to GDP had also doubled by about 2007. Since then, there has been a gradual decrease, with exports still accounting for about a quarter of Chinese GDP. Meanwhile, in the Eurozone, exports as a percentage of GDP have jumped to 44% from 26% in 1995. In the U.K. the proportion increased from 19% in 1990 to 30% at present. In the Americas, the proportion of Canadian exports increased from 25% in the early 1990s to 45% in 2000, before falling back to around 34%. Similarly, Brazilian exports almost doubled as a share of GDP from roughly 7% in early 1991 to around 14% in late 2006, only to fall back and settle at around 12% recently. Meanwhile, Mexican exports have tripled their share of GDP, while the U.S. ratio of exports to GDP has almost doubled from 7% in 1990 to nearly 14% now.
The implications of this increased interdependence based on trade linkages are magnified by the workings of the Bullwhip Effect.
The Bullwhip Effect
- End user demand is moderately cyclical.
- Supplier demand is more cyclical.
Supplier-to-supplier demand,furthest up the supply chain, is most cyclical. But supply is relatively insensitive, so prices become highly cyclical.
We agree with the consensus that developing economies have become a key driver of long-term secular global growth. But, in cyclical terms, developing economies are very much subject to the Bullwhip Effect, where small fluctuations in consumer demand growth get amplified up the supply chain into big swings in demand as we move away from the consumer. So, smaller shifts in end consumer demand growth translate into larger fluctuations in intermediate goods demand, and even bigger ones in input material demand, and especially, raw material prices.
Even a modest decline in consumer spending growth in developed economies like the U.S. and Europe can help trigger a significant downdraft in the level of demand from suppliers and, in turn, a serious downturn in the level of demand for “suppliers to suppliers.”
Meanwhile, the development of global supply chains and the rise of several economies, such as Taiwan, Korea and China, as supplier economies, and others such as Canada, Australia and Brazil as commodity suppliers to those economies, leaves them highly vulnerable to the Bullwhip Effect.
Indeed, a look at industrial growth cycles in the countries examined earlier suggests a good degree of synchronization across all country pairs. Essentially, cycles in industrial growth are highly synchronized, and this synchronization is likely to broaden and deepen as global supply chain networks expand further.
- More frequent recessions
- Decoupling is a mirage
- “Yo-yo years” for both developing and developed economies
So cyclical ups and downs in asset prices are hardly going away.
This warns against a complacent buy-and-hold mentality. In fact, the world is a much more dangerous place than many appreciate, but there are still going to be opportunities for investors, as long as they consider the timing of cyclical risk.
No BRIC Decoupling
I commend Achuthan for an excellent document.
His views are in agreement with those of Michael Pettis at China Financial Markets. Pettis is an excellent teacher about the dynamics of global trade.
Via email, Michael Pettis at China Financial Markets shared his outlook for China, Europe, and the world last August. The overall outlook is not pretty, and includes a breakup of the Eurozone, a major slowdown for China, and a smack-down of the much beloved BRICs.
Pettis Writes …
August is supposed to be a slow month, but of course this August has been hectic, and a lot crueler than April ever was. The US [debt] downgrade set off a storm of market volatility, along with bizarre concern in the US about whether or not China will stop buying US debt and the economic consequence if it does, and equally bizarre bluster within China about their refraining from buying more debt until the US reforms the economy and brings down debt levels.
What both sides seem to have in common is an almost breathtaking ignorance of the global balance of payment mechanisms. China cannot stop buying US debt until it engineers a major adjustment within its economy, which it is reluctant to do. Until it does, any move by the US to cut down its borrowing and spending will trigger a drop in global demand which will cause either US unemployment to rise, if the US ignores trade issues, or will cause Chinese unemployment to rise, if the US moves to counteract Chinese currency intervention.
The Big Picture
Rather than try to wade through all the news this month, much of which doesn’t seem to have much informational content, I thought I would duck out altogether and instead make a list of things I expect will happen over the next several years. We are so caught up in noise and market volatility – as the market swings first in one direction and then, as regulators react, in the other direction – that it is easy to lose sight of the bigger picture.
My basic sense is that we are at the end of one of the six or so major globalization cycles that have occurred in the past two centuries. If I am right, this means that there still is a pretty significant set of major adjustments globally that have to take place before we will have reversed the most important of the many global debt and payments imbalances that have been created during the last two decades. These will be driven overall by a contraction in global liquidity, a sharply rising risk premium, substantial deleveraging, and a sharp contraction in international trade and capital imbalances.
To summarize, my predictions are:
- BRICs and other developing countries have not decoupled in any meaningful sense, and once the current liquidity-driven investment boom subsides the developing world will be hit hard by the global crisis.
- Over the next two years Chinese household consumption will continue declining as a share of GDP.
- Chinese debt levels will continue to rise quickly over the rest of this year and next.
- Chinese growth will begin to slow sharply by 2013-14 and will hit an average of 3% well before the end of the decade.
- Any decline in GDP growth will disproportionately affect investment and so the demand for non-food commodities.
- If the PBoC resists interest rate cuts as inflation declines, China may even begin slowing in 2012.
- Much slower growth in China will not lead to social unrest if China meaningfully rebalances.
- Within three years Beijing will be seriously examining large-scale privatization as part of its adjustment policy.
- European politics will continue to deteriorate rapidly and the major political parties will either become increasingly radicalized or marginalized.
- Spain and several countries, perhaps even Italy (but probably not France) will be forced to leave the euro and restructure their debt with significant debt forgiveness.
- Germany will stubbornly (and foolishly) refuse to bear its share of the burden of the European adjustment, and the subsequent retaliation by the deficit countries will cause German growth to drop to zero or negative for many years.
- Trade protection sentiment in the US will rise inexorably and unemployment stays high for a few more years.
Click on above link to see detailed explanations of each of the above points.
For still further discussion of global trade imbalances, please see Hugo Salinas Price and Michael Pettis on the Trade Imbalance Dilemma; Gold’s Honest Discipline Revisited.
Decoupling Will Not Happen
I discussed why decoupling won’t happen yesterday in “Eurozone Slides Back Into Recession” Says Markit PMI News Release; Sharp Decline in German Export Business; Misguided Decoupling Theories.
In response to that post, a friend emailed Achuthan’s article.
Differentiating Between Difficult and Mathematically Impossible
Said Achuthan in his report…
The rising export dependence of these economies [China, India, Japan, Korea, Taiwan, Brazil and Germany], with growing involvement in global supply networks, makes it increasingly difficult for economies to decouple, especially for suppliers of early-stage goods that have embedded themselves further up the supply chain and farther away from the final consumer.
I would go even further than Achuthan, who says “increasingly difficult for economies to decouple” to a more stern “mathematically impossible”.
Let me put this another way: Greece cannot become more like Germany unless Germany becomes less like Germany.
In and of itself that is meaningless because Greece is too small to matter. However, this is also true: Greece, Spain, Portugal, Italy, and Ireland cannot become more like Germany unless Germany becomes less like Germany.
That does matter, and that is why rebalancing will be very painful to Germany, either by sovereign defaults of Spain, Portugal, Ireland, etc, or by the bottom falling out in German exports, perhaps a combination.
Two Key Principles
- Germany cannot possibly keep its vaunted export machine humming in the face of increased austerity in Spain, Italy, France, and Portugal
- Global trade imbalances are such that Spain, Italy, Portugal, and Greece cannot increase exports except at the expense of Germany
The believers that Ben Bernanke and Mario Draghi “saved” the world, are soon going to be in for a rude shock, when global trade sinks, the exporters take a hit, and countries respond with tariffs and other protectionist measures. Rebalancing is going to prove very painful, and the brunt will be borne on the trade