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The Correlation Quotient

This could be a buying opportunity for investors who have been uncomfortable with the high valuations

In the early1990s, when India was opening up to foreign investors, one of the attractions was that it was a closed “out-of-step” economy. Indian financial markets didn’t move in tandem with world markets because India had little exposure in terms of either exports or imports.

For a portfolio investor, correlation, or the lack of it, are important. There is defensive value and stability in holding uncorrelated assets because in a balanced portfolio, some asset will always be generating positive returns.

By the time of the dot-com boom, the situation had changed. Indian markets were increasingly in step with the rest of the world. Exports grew very fast after1993 and until 2008-09, continued to grow much faster than overall GDP.

Around 28 per cent of India’s GDP is now tied to its exports. About 15 per cent ($180 bn in 2008-09) is merchandise exports, while services (software, tourism earnings) contribute around 13 per cent of GDP ($145bn). A third significant source of forex inflows is NRI remittances, which amounted to over $52 billion in 2008-09. If we factor in merchandise imports as well, around 55 per cent of Indian GDP is directly linked to overseas trade-flows. 

There has been a slowdown and reversal of the growth trend in 2009-10 due to the weak global economy. Both exports and imports have fallen. But the long-term relationship is clear — India is tied more closely to the global economy than it has ever been. The relationship is likely to get even closer once the global economy recovers. 

India has also seen strong expansion in both FDI and FII flows. By some estimates, FII exposures in Indian equity now amount to roughly 17-18 per cent of market capitalisation. Hence, although the Mexican peso crisis and the “Asian Flu” of the 1990s didn’t affect local markets much, global events in the 2000s have had serious impact. India was a major beneficiary of the global bull run between 2005-2007 and it suffered along with the rest of the world in 2008-09.

While the equity market movements are obviously linked, it’s not just the equity markets where the relationship is apparent. The Indian commodity exchanges also see fluctuations that  closely track movements on global commodity exchanges like the London Metals Exchange, New York Mercantile Exchange, Chicago Board of Trade, etc.

The Dubai crisis that is brewing could therefore, have serious implications. The UAE, of which Dubai is part, is one of India’s largest trading partners. Dubai itself is home to around 10 lakh Indian migrant workers, who are a major source of remittances. India exported about $23 bn to the UAE in 2008-09.

In concrete terms a crisis in Dubai means some migrant workers will lose jobs, (hence remittances will drop). Indian banks with UAE exposure (most Indian banks) could also take a hit. In addition, engineering and construction outfits and realtors with UAE projects, and exporters focussed on that region, will all see business contraction.

More than just the “real impact”, the meltdown may also cause a failure of confidence. It may lead to capital flight out of the Indian equity markets, affecting valuations of businesses unconnected with Dubai. Some of this effect is already apparent in that there’s been indiscriminate selling across banks, realty, engineering, etc.

It’s beyond our brief and frankly, expertise to judge how the crisis will pan out. A bail out of some description is guaranteed but the market may or may not approve of the fine print. Also, even if the debt now at stake is guaranteed, Dubai is likely to see drastic economic contraction as indeed, it has for over a year. It’s anybody’s guess how serious the ramifications could be.

However, this could be a buying opportunity for Indian investors who have been uncomfortable with the high valuations of the past few months. Sensex-Nifty stocks have been trading at an average PE of 22+. If the crisis causes a 20% drop as Mark Mobius has suggested, the PEs will reduce to more acceptable levels.

It would be optimistic to expect things to blow over immediately. However, a long-term investor shouldn’t be concerned about a fast rebound. The crisis creates a window for entering at relatively low valuations. Accept that, and wait for returns.