Decoupling Theory: How Well-Insulated Are Asia and Australia?

The Australian dollar reaching for parity with the U.S. dollar, marked by the horizontal green line near the top of the black screen. So close. As the U.S. economy slowed during the fourth quarter of 2007 and the first quarter of 2008, everybody knew that Canada would, sooner or later, be dragged down along with it. The two economies are intimately entwined—around 80% of Canadian exports, both commodities and manufactured products, head due south, and their northern neighbor is a bigger market for U.S. goods than all 27 members of the Eurozone combined. With these two nations particularly sensitive to each other’s economic sneezes, when the Federal Reserve began chopping interest rates with an ax, the Bank of Canada stood right behind them and hewed their own rates by 33% between December 2007 and April 2008.

During that same period of time, however, the Reserve Bank of Australia was raising interest rates to battle surging inflation and contain the effects of a huge influx of capital from soaring commodities prices and a 20% increase in their terms of trade. Flooding in Queensland coke mines and steady demand in Japan, India, South Korea and Taiwan caused the price of coal, Australia’s top export, to triple this year as fresh Chinese demand made it a seller’s market. Negotiated prices of iron ore, their second most important export, nearly doubled, again with Chinese impetus, and there’s really no reason to mention what happened to the prices for Australia’s other commodity goods, such as gold, crude oil, beef and copper.

Asia and Australia

Although there were clear signs the economic slowdown in the U.S. and Canada was spreading to the UK, it seemed that it would make no mark on the Australian and Asian boom, which had seemingly “decoupled” from the Western hemisphere’s problems. The demand surge for commodities in Asia, led by the insatiable maw of that newest kid on the block—you know, the one hosting the Olympic games—turned Australia’s trade deficit into a surplus in June 2008 and looked set to keep it that way for a long time.

After all, the reasoning went, 68.7% of Australia’s exports went to nations in the Asia-Pacific Economic Cooperation and another 12.8% went to China. Only 7.3% of all Australia’s exports went to the U.S., and that share was falling anyways. So if it declined further, well, there would be another hungry nation ready to take up the slack.

This decoupling theory for Australia and Asia gained popularity among traders who liked the down-under markets. In the second quarter of 2008, while credit market losses sent depository and investment banks reeling in the U.S. and UK, the Australian dollar embarked on an unbroken nine-week climb against the greenback. It looked amazingly similar to the Canadian dollar’s 17% surge against the U.S. dollar in 2007 that took it to parity and beyond, and foreign exchange traders confidently predicted the same would happen for the Aussie.

But something funny happened on the way to parity.

That creeping economic malaise from the U.S., Canada and the UK spread to their immediate trading partners, including the Eurozone and Japan, and from there it spread further as that other economic theory—globalization—reasserted itself. It took months because the U.S. slowdown began in the housing market, generally a domestic-only sector (not counting imported building materials), but the erosion of discretionary funds ate away at U.S. imports while the weak greenback made U.S. exports more affordable overseas, shifting the balance of trade in ever-spreading ripples across the globe. Partly due to these ripples, gross domestic product for Japan and the Eurozone are both expected to be in red ink for the second quarter of 2008, a point passed by the U.S. in the fourth quarter of 2007.

With global demand starting to fall, commodity prices slid to follow, and with such a large percentage of the Australian economy dependent upon commodity exports, it followed suit. On July 15, the exchange rate between the Australian dollar and the greenback touched 0.9848, a penny and a half beneath parity. Then on August 5, the Reserve Bank of Australia reached for the ax and announced that soon it would need to cut interest rates, too, like almost every other central bank around the world. The Aussie fell off the table, decoupled no more.

In the modern small market world, one might say, no economy is an island—not even Australia.

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