. . . and decoupling for that matter.

We’re being facetious, of course. A new academic paper from McGill University asks whether “…the potential for international diversification” is disappearing, but the answer is far more complicated than a straight yes or no.

From the abstract:

. . . Our results suggest that correlations have been signifi…cantly trending upward for both the developed markets [DMs] and emerging markets [EMs]. Further, the evidence clearly contradicts the decoupling hypothesis. Although the tail dependence is increasing through time for both EMs and DMs, the level of the tail dependence is still very low at the end of our sample period for EMs as compared to DMs. Therefore, while the correlation analysis suggests that the diversi…cation potential of EMs has largely disappeared, this is contradicted by our fi…ndings on tail dependence. Thus, even though diversification benefi…ts might have lessened in the case of DMs, the case for EMs remains intact . . .

Still charts like the below, from the paper, are pretty striking.

The top line for each developed country-graph represents correlation with the 15 other developed countries; the bottom line is correlation with 13 emerging markets; and the middle line is correlation with both DMs and EMs:

There’s a not-so-subtle dig at the developed world in all this. Things tend to blow up within EMs more frequently — the tail risk referenced by the paper — but when they do blow-up, they tend to do so in isolated spots:

. . . while the correlation analysis suggests that the diversi…cation potential of EMs has largely disappeared, this is contradicted by our fi…ndings on tail dependence. The underlying intuition for this finding is that while financial crises in EMs are frequent, many of them are country-specifi…c.

The corollary being that in the developed world crises tend to be, err, rather more correlated.

(H/T Paul Kedrosky)

Related links:
DM is the new EM and the contagion shoe is on the other foot – FT Alphaville
Sovereign risk and EM bulls and bears - FTAlphaville

This entry was posted by Tracy Alloway on Monday, March 22nd, 2010 at 8:15 and is filed under Capital markets. Tagged with correlations, Decoupling, developed markets, emerging markets, fat tails. Edit this entry.