Dissecting the decoupling debate

Eswar Prasad, Christopher Otrok , M Ayhan Kose, 4 October 2008



Emerging markets have turned in a remarkable growth performance this decade, even as the advanced industrial economies were at best plodding along. This sparked a new conventional wisdom that emerging markets had become masters of their own destiny and “decoupled” from business cycles in industrial countries (see Helbling et al, 2007). Consistent with this view, the emerging markets seemed to have dodged the bullet of the sub-prime crisis. But there are now rising concerns that these economies, already beset by oil and food price shocks, may falter if the worsening financial crisis pushes the US into a deep and prolonged recession. In other words, emerging markets may still be riding on the coattails of industrial countries.

Which of these views about decoupling is true? The answer has implications not just for the emerging markets but also for world growth since these economies have now become major players on the global economic stage. New research that we have just completed (Kose, Otrok and Prasad 2008) reveals some surprising answers to this question. And it turns out that the issue has more subtleties than indicated by the popular discussion.

To begin with, why is there such a heated debate about decoupling? After all, economies around the world are becoming more interlinked through increasing flows of goods and money across national borders. Shouldn’t this make all economies closely tied together and more dependent on each other’s economic fortunes? Yes, but at the same time emerging market economies have become much larger and more self-reliant. As a group, they accounted for more than half of global growth during this decade. So far, these economies have shrugged off the effects of the financial crisis and, although their growth momentum has eased as industrial countries are taking in less of their exports, they are still growing rapidly.

Are business cycles around the world becoming more closely correlated or not? Our research shows that in fact business cycles are becoming more closely linked amongst industrial countries and amongst emerging markets. Remarkably, however, there is a decoupling of common business cycles between these two groups.

Decomposing the business cycle driving factors

We implement a relatively new econometric methodology for separating out the factors driving national business cycles into global, group-specific, and country-specific factors. This methodology is able to capture spillovers of business cycle fluctuations across countries without making any strong assumptions about the size, direction, or time pattern of the spillovers. The global factor represents fluctuations that are common to all countries and all three variables in each country. The group-specific factor captures fluctuations that are common to a particular group of countries.

The relative importance of global factors has waned over time for fluctuations in both industrial countries and emerging markets (see Figures 1 and 2). For industrial countries, the average contribution of the global factor falls dramatically, from 28% to 9%. The decline is also large for emerging market economies—from 13% to 4%. By contrast, group-specific factors have become more important in both of these groups, almost exactly offsetting the decline in the global factor's importance. The relative contributions of the group-specific factor rise from 17% to 31% for industrial countries and from 3% to 9% for emerging markets.

Figure 1. Average percentage of output variance explained by global factor

Note: Left vertical axis describes industrial countries; right vertical axis describes emerging markets and other developing countries.

Figure 2. Average percentage of output variance explained by group factor

Note: Left vertical axis describes industrial countries; right vertical axis describes emerging markets and other developing countries.

These findings suggest that emerging markets are standing on their own feet to a greater extent than before, even though many of them have not entirely shaken free of their dependence on exports to industrial countries. And the huge increase in flows of goods and money among emerging markets themselves (rather than just between them and industrial countries) has made their economies more dependent on each other. For instance, trade with other emerging markets now accounts for about two-fifths of emerging markets’ total trade flows, double the level of two decades ago.

Indeed, in a striking reversal of fortunes, continued strong growth in emerging markets might help stir the industrial economies out of their own malaise. There is a growing appetite for imported goods in emerging markets such as China and India, and their share of world GDP is only going to increase over time.

Real and financial decoupling

A second issue concerns the distinction between real and financial decoupling. Many observers argue that the decoupling hypothesis must obviously be wrong – after all, large swings in major countries’ financial markets almost immediately infect those markets in other countries as well. This is most evident in the increasing correlation of stock market fluctuations around the world. Steep drops in the Shanghai stock market now affect US stock markets. And the cataclysmic events on Wall Street are clearly roiling financial markets worldwide.

The big question is whether these financial spillovers affect the “real” economy – variables such as GDP, investment, and household consumption. Here the answers are less clear. So far at least, there seems to be a dichotomy between real and financial variables in emerging markets. Their stock markets have been infected by the turmoil in the US, inflation is rising on account of worldwide food and oil price shocks, but GDP growth continues at a reasonable clip in the major emerging markets.

How can this be? One possibility is that emerging markets have built up enough headwind that sheer momentum will carry them forward, so long as there isn’t a worldwide collapse of demand. However, there could simply be lags between financial market disturbances and real activity, so that the effects of global financial difficulties on domestic economic activity may soon start becoming apparent even in emerging markets. In this context, the spread of the housing price bust in the US to countries such as China does not bode well.

Another possibility is that financial markets in these countries are still relatively small and disconnected from the real economy. The flip side of this argument, however, is that their financial systems may not be strong enough to cushion these economies if more negative shocks hit them. So there could be trouble brewing.

One thing that is clear is that the structure of the world economy is changing in important ways, with effects that are difficult to predict. The past may no longer be a good guide to the future and relying too much on conventional wisdom – either old or new – may be dangerous.


Helbling, Thomas, Peter Berezin, M. Ayhan Kose, Michael Kumhof, Doug Laxton, and Nikola Spatafora, 2007, “Decoupling the Train? Spillovers and Cycles in the Global Economy,” World Economic Outlook, pp. 121–60.

Kose, M. Ayhan & Christopher Otrok & Eswar Prasad, 2008. "Global Business Cycles: Convergence or Decoupling?," IMF Working Papers 08/143, International Monetary Fund

Topics: International finance
Tags: business cycle, decoupling, emerging markets

M Ayhan Kose

Assistant to the Director in the IMF Research Department

Christopher Otrok

Associate Professor of Economics at the University of Virginia

Tolani Senior Professor of Trade Policy at Cornell University, Senior Fellow of the Brookings Institution and Research Associate, NBER