The fall in the global equity markets has been blamed on the yen “carry trade” — borrowing in the yen, where the interest rate is low and investing the money in high-yielding assets, such as currencies of countries where the interest rate is high, like the New Zealand dollar and the Turkish lira, or in emerging market equities and other assets perceived to be “high-risk” and which therefore offer high returns. If you were to borrow in yen at 1 per cent per annum and invest in US treasuries at 5 per cent, that’s a gain of 4 percentage points. But when the yen falls from 121.9 to the dollar to 115.9 to the dollar in 10 days, that’s a fall of 4.3 per cent, more than enough to wipe out all your gains. The loss is more if you have to pay interest on your borrowings. Naturally, you exit the trade as fast as possible and sell whatever asset you have to pay for your losses.

But there’s a lot of controversy about the extent of this trade. For instance, Markus Rosgen, managing director, equity strategy at Citigroup, said at a conference in Mumbai recently that they had conducted a straw poll of hedge fund managers to find out how much money they had in the yen carry trade and it turned out that none of them had borrowed in yen. Nevertheless, as the chart shows, there’s a clear correlation between the movement of the MSCI World Equity index and the $/Yen exchange rate. Interestingly, the chart also appears to show that the equity index leads the exchange rate, ie a drop in the index is followed by a drop in the yen, rather than vice-versa. Perhaps it’s an indication that falling equity markets are leading to unravelling of the carry trade.

Cyclical downturn

The Indian market has been one of the worst hit by the carnage in the stock markets. Between 26 February and 16 March, the MSCI World index fell from 1145.307 to 1086.856, a drop of 5.1 per cent. The MSCI Emerging Markets index fell by 5.5 per cent, but the MSCI India index went down by 8.6 per cent over the period, a clear indication that volatility hits the Indian market more. One interpretation is that we gained the most when times were good and we lose the most when times are bad.

The other explanation is of greater concern. This justifies the bigger fall in the Indian markets by pointing out that a cyclical downturn is in the offing in India. As Ratnesh Kumar, research head at Citigroup, pointed out recently, we have so far had the best of all possible worlds, with companies being able to increase sales without expanding capacity. At the same time, because of cost-cutting measures taken earlier, companies’ profits were able to grow at a higher pace than sales. That gilded age is now coming to an end.

So what is a good forward valuation for the Indian market? Taking real growth in the manufacturing and services sector at around 10 per cent and adding inflation at 5 per cent, average growth in earnings should be at least 15 per cent for 2007-08. That gives a forward PE of about 15 as fair value. The sensex is around that level now.