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When De-Coupling Can Get De-Coupled

Omkar Goswami

“De-coupling” is the new buzz-word among Asian fund managers. It means that most Asian economies — particularly China and India — are now less dependent on the fortunes of developed nations. The Asia of today is apparently far more immune to downturns in the US and EU business cycles than ever before; and that, led by China and India, Asia can maintain high growth rates irrespective of what happens to the United States, the Euro Zone and the UK.


Under normal times, there may have been some truth to this “de-coupling hypothesis”. If the US continued to grow at 3 per cent or more, the Euro Zone at over 2.6 per cent, and Britain at more than 3 per cent, then it would have augured well for a significantly higher (“de-coupled”?) growth for Asia led by its two economic giants. Unfortunately, the “if” part of the previous sentence is looking like a distant dream.


We have only seen the tip of the iceberg of the US sub-prime problem. Up to now, the publicly stated hit on account of collateralised debt obligations is $45 billion, most of which has been bad sub-prime debt. The hits are going to be much more. By 2005, sub-prime mortgage origination in the US was $625 billion, or 20 per cent of total mortgage volume, and over 80 per cent of the two-year fixed and 28-year floating rate, or 2/28,  home mortgage loans. The general sense is that up to a fourth of sub-primes will go sour — which implies additional write-offs between $150 billion and $200 billion during 2008.


If that were to happen, the entire financial market will freeze up. All holders of securitised high risk assets will want to sell, with few or no buyers; and all those in cash will want to flee to government securities and commodities. There will be no appetite for relatively risky equity, especially Asian scrips.


The process has begun in the US. The spread of BBB- mortgage backed securities vis--vis the LIBOR is now 28 percentage points — implying that there are no buyers for such assets. Even for AA grade mortgage backed securities, the spread is 15 percentage points; while for AAA grade, it is 5 percentage points. In plain English, nobody wants to buy mortgage-backed paper. The worry is whether delinquencies will spread to auto and credit card loans. The figures are up, and everyone is praying that it is just a blip.


Issuance of mortgage backed paper has also fallen dramatically. In 2006, $479 billion on non-prime mortgage backed securities were issued in the US. In the first 10 months of 2007, it was down to $194 billion. And the infection has spread to prime: from $580 billion issued in 2006, it was down to $352 billion in 2007. We are seeing the beginnings of a flight to safety, with a fairly sharp drop in US treasury yields for 10- and 2-year paper.


In this backdrop of financial fear, now factor in problems of the real economy. US housing starts are down 42 per cent from the peak in January 2006; the S&P Case Schiller home price index has fallen 7 per cent from January 2006, and is expected to fall another 8 percentage points before levelling off. Retail sales are down, month on month for the first 11 months of 2007. The consumer confidence index is down from 114 in July 2007 to 87.3 in November — a drop of 23 per cent in four months. The US economy is teetering.


Here’s my forecast. 2008 will see US GDP growth dropping to 1 per cent or even less; UK’s growth will diminish to 1.5 per cent; and the Euro Zone will see a fall in the growth rate from 2.6 per cent to under 1.6 per cent. It will be a synchronous slowdown, with a seizure in global capital markets and flight to commodities and safe gilt.


If these were to happen, who in their right mind would believe that the Indian and Chinese capital markets will remain “de-coupled” and merrily chug along? Only those who smoke Afghanistan’s major export in long curved pipes.

Published: Business World, December 2007


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