What will happen to the Indian markets may well be determined in Japan.

When the financial markets are global, what happens in one market is often determined by things that happen in distant markets. So far, much of the blame for the latest selloff has been laid at the door of the US, where investors have reportedly been worried about either higher inflation, or lower growth or a combination of the two, depending on whom you listen to. But here?s some data from the other end of the world that indicates the issue could be very different.

Consider the Bank of Japan?s data on its monetary base. The data shows how the Japanese monetary base has been shrinking at an accelerating pace for the past three months. The decline started in March this year, with the monetary base shrinking by 1 per cent year-on-year. In April, it shrank by 7.9 per cent while in May, the decline was as high as 15.3 per cent.

What does this mean in terms of money? Japan?s monetary base went down from 103.578 trillion yen in April to 94.195 trillion yen in May, a drop of 9.282 trillion yen or about US $82 billion. That?s a lot of money that disappeared in one month. Small wonder markets around the world lurched.

This is the result of the ending of the Bank of Japan?s ?quantitative easing? policy, under which it supplied far more liquidity than required for years in an attempt to kickstart the Japanese economy, which was in the throes of deflation. The bank announced the policy change in March and since then it?s been sucking out liquidity from the system. The Japanese economy grew at an annualised rate of 3.1 per cent in the last quarter and the BoJ feels that the excess accommodation is no longer required.

Why is the BoJ?s policy important? Because under the old policy, investors and hedge funds used to borrow very cheaply in yen and use the money to buy assets across the world. This was known as the ?carry trade?. Now that the BoJ?s policy is sucking out liquidity from the system, borrowing in Japan will no longer be so cheap. That is the worry that is haunting markets worldwide, be they the developed or emerging or commodity markets.

There?s another way of seeing the BoJ?s tightening policy ? through its impact on the yen. As the BoJ tightened, the yen went up against the dollar. Taking interbank rates, the US dollar used to buy 117.68 yen on January 1, 2006. By the end of April, when the tightening policy got underway, the yen started strengthening and the dollar could buy only 113.880 yen by 30 April. The yen continued strengthening till 18 May, when it went as high as 109.7160. Interestingly, it fell after that and by 3 June was trading at 112.3790, which fits in with reports that the BoJ once again pumped in some money during May-end, after they realised the carnage they had caused in the world markets.