SERIOUS MONEY: As globalisation falters, the possibility of a 1930s-style meltdown cannot be dismissed

GLOBAL DECOUPLING emerged as a dominant investment theme 12 months ago among esteemed professionals as the developing world proved largely immune to the growing subprime virus in the US, enabling global growth to exceed 5 per cent in 2007, comfortably above the long-term average of 3.7 per cent.

The notion that the emerging economies of the Far East could withstand an economic recession in the western world was built primarily on the dubious logic that the sharp increase in intra-regional trade would lead to continued growth.

Advocates highlighted the fact that China had become the largest trading partner of several countries in the region; failing to observe the facts that painted a different picture altogether.

The raw data showed that the region’s vulnerability to a developed world recession had actually increased as the growth in intra-regional trade was concentrated primarily in intermediate goods, with roughly 80 per cent of the final demand stemming from the world’s largest economies.

The dependence on the West was compounded by the high investment rates in recent years, which were geared towards the satisfaction of export demand and not domestic consumption.

The perceived strengths that gave rise to the global decoupling thesis have proved false as the economic storm embracing the developed world has been accompanied by a de facto recession across the export-dependent Far East.

The world economy fell off a cliff during the final quarter of last year and Asia proved anything but immune as the economies of Hong Kong, Japan, South Korea, Taiwan and even China all came to a standstill.

All eyes are on China as 15 per cent of the total migrant labour pool is now unemployed while recent data suggests that the malaise continued through January. It is only a matter of time before the fears about financial system fragility and social instability long harboured by investors return to the fore.

Economic and financial turmoil in the western world has seen many analysts draw parallels to the 1930s, but few note the eerie similarities between the trade relations that existed as the Great Depression approached and those of today.

The US ran large trade surpluses with western Europe throughout the 1920s, which were driven in part by an undervalued exchange rate that stemmed from the return of several countries, most notably Britain, to the gold standard at pre-1914 rates.

Eighty years on and China runs the world’s largest trade surplus, which, just as in the 1920s, has been driven by an undervalued exchange rate.

The US regime collapsed following the 1929 stock market crash as external financing for the deficit countries evaporated.

Faced with significant excess capacity that coincided with a contraction in domestic demand, the US attempted to force the adjustment abroad and implemented the infamous Smoot-Hawley Act in 1930, which raised the effective tariff rate on imports to 20 per cent.

Retaliation to the passage of Smoot-Hawley was immediate and international trade collapsed. The adjustment was forced back on the US and combined with ineffective fiscal and monetary policy, factory closures and the numbers out of work soared. It took decades to undo the damage to trade relations.

Fast forward to today and international trade is expected to decline this year for the first time since 1982. The economic impact will undoubtedly be greatest for China. The scale of the adjustment facing it today is far greater than the US problem in the 1930s. China’s trade surplus is similar in magnitude to that of the US in 1929 at roughly half a percentage point of world GDP, but its economy is less than one-fifth the relative size of the US 80 years ago.

It will be difficult to absorb the problem domestically and the temptation to devalue the currency and export the adjustment may prove hard to resist. China faces additional problems that arise from its pro-cyclical exchange rate regime. Its quasi-fixed exchange rate vis-a -vis the dollar meant the authorities had to mop up significant speculative capital inflows in recent years through the sale of renminbi and the purchase of dollars.

The result was increased monetary expansion at a time of booming economic growth.

Unfortunately, recent foreign exchange reserve data suggest this process has now moved into reverse, with capital outflows of $120 billion during the fourth quarter of 2008.

Needless to say, the offsetting purchase of renminbi and sale of foreign currency required alongside the accompanying monetary contraction is hardly desirable when economic growth is well below potential and unemployment is on the rise.

China has plenty of scope to increase fiscal spending and has already announced significant stimulus measures, but its effectiveness remains in doubt. The incentive to devalue will continue to grow and rebates for several export sectors have already been introduced.

However, protectionist sentiment is growing elsewhere, notably in the US where the Treasury secretary Timothy Geithner has already declared his belief that China manipulates his currency while the Buy America clause in its stimulus package is cause for concern. The likelihood of a 1930s replay cannot be dismissed out of hand as the threat to globalisation grows.

charliefell@sequoia.ie