Neither the Indian nor the Chinese market looks much like a safe haven now. The MSCI China index was down 19.6% during the month, as of 21 November, compared with 8.3% for the world index.

Although the Indian index has so far fared better than most other markets, there has been persistent selling by foreign institutional investors.

But wait a bit. The Dow Jones Industrial Average closed at 12,799 on 21 November, lower than its closing value of 12,845 on 16 August, the low it had hit when the subprime mess first hit the markets. In contrast, the BSE Sensex closed at a low of 13,989 on 21 August and, at the time of writing, it’s more than 33% higher than that level. What’s more, despite its rapid slide in recent days, the Hang Seng is still 30% above its August low. But in times like this, that’s no consolation—in fact, it could well be a source of concern as investors worry about the distance still left to fall.

Predictably, the theory that investors would flock to the high-growth Bric (Brazil, Russia, India and China) economies, thus decoupling their markets from those of the US, is now getting bad press. The problem is, there was much fuzzy thinking behind the term, decoupling. The original theory talked about economic decoupling, rather than emerging markets charting their own course.

The International Monetary Fund (IMF) had a chapter on decoupling in its World Economic Outlook last April. After studying previous periods of slowdowns in the US and their impact on the global economy, IMF found that “past episodes of highly synchronized growth declines across the globe were not primarily the result of developments specific to the US, but were rather caused by factors that affected many countries at the same time."

As examples, it pointed to the oil shock of 1974-75 and the bursting of the tech bubble. Its conclusion was that, “Overall, compared with the 1970s and early 1980s, the world economy may thus continue to see less synchronized international business cycles at the global level unless it is subjected to the common disturbances that were the hallmark of earlier episodes."

Somehow, this theory got extended to the markets, which was always a bit suspect, primarily because financial markets are so closely linked together and also because emerging markets are so dependent on foreign fund inflows. The IMF report pointed out that stock prices and interest rates have tended to be more correlated across countries than GDP growth rates.

Does the credit crunch qualify as a “common disturbance" that will affect growth across the globe? While banks in some developing countries have been affected, the impact is nowhere as large as in the US and Europe.

The Asian Development Bank’s Asian Development Outlook 2007 Update says: “If growth in the US lurches down, developing Asia would not be immune. But the tremors from a downturn in the US are likely to be modest and short-lived even if it falls into recession. Available evidence suggests that, depending on timing, severity, and duration, a US recession could clip growth in developing Asia by 1–2 percentage points. If a synchronous steep downturn in the US, euro zone, and Japan were to occur—an event that currently seems improbable—growth in developing Asia would be at greater risk."

But even if emerging economies do well, what about their markets? The IMF study had a box on “Macroeconomic conditions in industrial countries and financial flows to emerging markets". The conclusion: Liquidity conditions in industrial countries are important to gauge flows to emerging markets.

In particular, the report cited two conditions—shifts in industrial countries’ monetary policy stance and exchange rate variations among industrial country currencies. Rising interest rates and an appreciating dollar are bad for flows to emerging markets. That’s the reason why emerging markets have tottered during the last four years every time there was an inflation scare in the US and the prospect of higher interest rates.

This time, interest rates are on their way down rather than up, and the dollar is depreciating. But the liquidity that is under threat in the industrial countries is market liquidity, funds that were being provided by the banks. This withdrawal of leverage is bound to have an impact on liquidity.

The question is: how much of an effect? The Organization for Economic Cooperation and Development (OECD) report on financial market trends says losses from the subprime crisis could add up to $300 billion (Rs11.87 trillion). Goldman Sachs has said they could be $400 billion and that that would force a cut in lending to the tune of a staggering $2 trillion. What’s more, the OECD also warned that “As adjustments have often occurred in waves, and as higher funding costs take typically several months to have their full impact on companies or consumers, it may well be that the recent correction is only a precursor of a more protracted downturn."

What could change this gloomy outlook? Immediate action by the central banks of the developed countries.

The withdrawal of market liquidity can only be made good by the central banks of the developed countries loosening monetary policy. The worry for the markets is that they may not oblige.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at