The sharp fall in the Shanghai market this month has made some analysts jittery, primarily because they believe that Chinese stocks have become a leading indicator of stock markets across the world. That’s a rather novel concept, since most of us are used to seeing our markets react to moves from the US markets.

Nevertheless, there’s a strong correlation between the Chinese and Indian markets because both of them are affected by the same trend in risk aversion and in capital inflows. The chart shows the close relationship between the Sensex and the Shanghai Composite index from 2006 onwards.

What’s more, the chart also shows that the Shanghai index started functioning as a leading indicator towards the end of the last bull run.

For instance, it topped out in October 2007, well before the Sensex. It also bottomed out in October 2008 and started moving up well before the Sensex. The worry is: Is the recent fall in the Shanghai index a precursor for a similar fall in the Sensex?

It’s clear that the Shanghai index was certainly not a leading indicator during the beginning of the last bull run and the index only started to move up in 2006. The case for the Shanghai index as a leading indicator rests with the fact that China is expected to be the main driver of global growth this year and in 2010. But India’s growth, too, is nothing to sneeze at and the liquidity squeeze in China has little to do with the Indian market. In fact, India may well be a beneficiary, as fund flows rotate out of China into India. As fund tracker EPFR Global points out, while fund flows to China turned negative in the week to 19 August and that had a knock-on effect on fund flows to Taiwan, the Indian market saw inflows.

Graphics: Ahmed Raza Khan / Mint

According to EPFR, “With questions about the loan books of Chinese banks intensifying, investors had a hard time visualizing Chinese capital flowing into Taiwan as a result of the recent improvement in cross-straits relations. Redemptions from Taiwan Equity Funds hit their highest level, in dollar terms, in over seven years as investors went looking for markets with more defensive stories. That benefited India and Indonesia Equity Funds, which recorded their eighth and seventh consecutive week of inflows, respectively." Trouble is, the long-term chart doesn’t seem to bear out this theory.

Perhaps the Shanghai index should be more closely correlated to the CRB commodities index? After all, China’s prodigious appetite for commodities is well known. And it’s well known that commodities have been going up as a result of Chinese demand.

A look at the chart, though, seems to indicate that while there is a link between the Shanghai index and the CRB index, it’s not all that close. For instance, the commodity index continued to rise long after the Shanghai index topped out. Nor is the rise in commodities as steep as the rise in stocks. It will take a revival of global demand to boost commodities.

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