Watch out for the Fed tightening. That’s the message from the Institute of International Finance, the bankers’ club, to investors ploughing funds into emerging markets.

Speaking in Switzerland on his way to the World Economic Forum in Davos, IIF managing director Charles Dallara warned that investors had “underanticipated” sudden turns in monetary policy in the past – and might do so again. He said: “Are we adequately risk aware? Are we adequately risk sensitive?… I am not at all sure that we are.”

The IIF’s latest half-yearly review of capital flows into emerging markets says private sector flows have “revived strongly” thanks to investors’ taking a more risk-friendly view of the world since mid-2012.

The institute expects private sector flows to increase modestly in 2013 to $1,118bn, from $1,080bn in 2012 (2011 – $1084bn), with a further increase next year to $1,150bn.

With commercial bank lending constrained, flows are running at around 90 per cent of the peak levels hit in 2007 and at half the level in terms of share of the emerging economies’ GDP – at around 4 per cent versus over 8 per cent.

But the IIF’s report warns that, despite a new round of monetary easing, in which Japan seems eager to lead the way, an end to ultra-low interest rates could be in sight.

This could spell trouble:

[It raises] the possibility of a significant correction in both global interest rate markets and, if history is any guide, in capital flows to emerging economies. Policymakers in emerging economies may have a long enough memory to avoid some of the pitfalls associated with such a boom-bust cycle in flows, but not all may be quite so restrained, especially in capital-hungry low-income economies. Nor is it likely that investors will be quite so disciplined. The risk of market participants being unprepared for a reversal of rates is real and needs to be seriously considered to avoid disruption.

Or as the IIF’s chief economist, Phil Suttle, put it at a press conference: “There’s a boomy enviroment in the emerging markets.”

To give investors an idea of what might go wrong, the IIF has summarised the events of 1994, the last time the US Federal Reserve tightened monetary policy in a surprise change of course.

The results for financial markets were stunning. Far from anticipating a shift in direction from the Fed, market participants had locked into many “low for long” trades. As these trades began to lose money in a rising rate environment, there was a scramble to exit, which dragged down all major bond markets… emerging market asset prices (which had risen sharply in 1991-93) slumped (in two stages) through 1994 and early 1995; and, most importantly, private capital flows to Turkey and to Latin America – especially Mexico – collapsed, culminating in near default by Mexico in 1995 Q1.

Nobody knows when or where lightning might strike this time. But this chart of the impact of the 1994 tightening on Mexico should give investors and policy makers pause for thought:

Related reading:
Investors switch from dollar to local debt, FT
Pimco on emerging markets $ debt: beware the benchmark
, beyondbrics
EM corporate bonds: getting frothy? beyondbrics
Frontier markets: looking for gold, beyondbrics
EM bonds: time to sell?, beyondbrics

Get alerts on Emerging markets when a new story is published

Copyright The Financial Times Limited 2018. All rights reserved.

Follow the topics in this article