SERIOUS MONEYMARKET PRESSURES continue to escalate in the euro zone and an economic downturn across the region is all but certain at this juncture.

Strong global interdependence among economies, through fiscal interconnections and trade links, threatens to propagate the adverse shock across the world relatively quickly and could derail the upturn in global economic activity that began more than two years ago. Indeed, Chinese vice-premier Wang Qishan was recently reported as saying that a “long-term global recession is certain to happen” and that the downturn “caused by the international financial crisis will be chronic”.

Wang’s comments on the global economic outlook are the most bearish to date by a leading Chinese decision-maker but they have been dismissed by most observers as hyperbole. However, the dismantling of the global decoupling thesis at the height of the financial crisis three years ago suggests the downbeat forecast should not be taken so lightly.

The world economy is more integrated today than at any time in modern history and the emergence of global supply chains has magnified the impact of slowing final demand on trade.

The changing nature of the global competitive landscape in recent decades has seen international trade become much more than a simple exchange of merchandise between countries. Supply chains have become increasingly fragmented across several countries to take advantage of regional specialisations and low production costs in emerging countries.

Intermediate goods or components for further assembly are manufactured in a number of locations and shipped to a central hub for final assembly and eventual re-export to end-consumers in the rest of the world. These extended supply chains virtually ensure that a drop in demand in one region is transmitted relatively quickly to another.

Importantly, the so-called “bullwhip” effect means the negative shock is amplified through the supply chain into large swings in demand the further one moves away from the final consumer.

The bullwhip effect was first identified more than half a century ago by Ruth Mack, an economist with the National Bureau of Economic Research, in her landmark study of the shoe, leather and cattle hide sequence.

At the time of Mack’s study, the demand for shoes was moderately cyclical, where consumers often postponed purchase during challenging economic times and had their old shoes repaired instead.

The resulting slowdown in demand growth led to an excess supply of shoes and leather among shoemakers, which triggered production cutbacks and a decline in orders for leather which is made from cattle hides. The actual fall in the demand for leather translated to a sharp decline in the demand for, and the price of, cattle hides.

The Economic Cycle Research Institute notes that the bullwhip effect occurs when “relatively mild fluctuations in end demand are dramatically amplified up the supply chain, just as a flick of the wrist sends the tip of a bullwhip flying in a great arc”.

The crack of a real bullwhip is in fact “the sound of its tip breaking the sound barrier while travelling at over 1,500 km/hour”.

Prior to the financial crisis, it was widely believed that modern “just-in-time” inventory techniques had tamed the inventory cycle and thus, contributed to the observed moderation in economic volatility. The subsequent turmoil revealed that extended supply chains across borders had, in fact, revived the bullwhip effect. A decline in consumer demand in the developed world led to an unprecedented collapse in word trade and a sharp drop in industrial production in export-based economies across the emerging world.

The impact was particularly pronounced in developing Asia, where the region’s production-driven model had seen its export share of pan-regional GDP jump by more than 10 percentage points in less than a decade to a record high of 47 per cent in 2007. The export-led growth and its dependence on end-user demand in the developed world exposed the region to the worst of the potential demand destruction arising from the bullwhip effect.

Advocates of global decoupling – the idea that emerging Asia could withstand a recession in the developed world – highlighted the fact that intra-regional trade accounted for almost one-half of the region’s total exports in 2007, but failed to take account of the large trade in intermediate goods to a central hub for further assembly and subsequent export to the developed world. The facts showed that more than 70 per cent of end-user demand was generated outside Asia, with the US and Europe accounting for almost two-thirds of the external demand.

Evidence from the financial crisis reveals that it is wishful thinking to believe the emerging world can withstand a severe recession in the euro zone. Europe is the world’s top export destination and is the end-market for almost one-quarter of total Asian exports.

Investors should note that the global decoupling thesis is bunkum.

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