By Sujata Rao
LONDON (Reuters) - A growth-crushing downward spiral looks imminent for emerging markets, threatening to turn back the tide of foreign investment that flooded into developing countries on the premise of fast economic expansion.
Countries in Asia, Latin America and emerging Europe are being forced to raise interest rates sharply to stave off currency collapses and a wholesale exodus of foreign investors. Turkey, India and South Africa jacked up rates this week, heaping pressure on others to follow suit.
Whether these steps will steady the currencies is unclear, but one thing is sure - economic growth, developing countries' main trump card over their richer peers, will take a hit.
Analysts reckon Turkey's dramatic 425 basis point rate hike could almost halve this year's growth rate, to 1.7-1.9 percent, for example, while the South African Reserve Bank, which raised by half a point, cut its estimates for 2014 and 2015 growth.
Indonesia's economy last year probably grew at its slowest pace in four years, below its long-term average of above 6 percent, after 175 bps in policy tightening since June.
Even before the latest increases in borrowing costs, developing country growth rates were under the cosh.
Not only was the developing world's 4.7 percent growth last year almost a full percentage point under International Monetary Fund forecasts, its premium over growth rates in advanced countries has shrunk to its lowest in a decade.
In Brazil and Russia, growth is running below the levels forecast for Britain and the United States in 2014.
That is very bad news for the investment outlook, going by the findings of a recent IMF study that examined capital flows for 150 countries between 1980 and 2011.
Net capital flows to emerging economies, estimated at as much as $7 trillion since 2005, have tended to be highest during periods when their growth differential over developed economies is high, the paper found.
And investment flow is also "mildly pro-cyclical" with domestic growth rates, the paper said, meaning that as developing economies expand, they draw more investment.
"Investors are getting what they asked central banks for - higher interest rates. But there is no denying that there is a massive headwind to capital flows into emerging markets," said David Hauner, head of EEMEA fixed income strategy and economics at Bank of America Merrill Lynch.
"Historically the two main drivers of capital flows to EM (are) the difference between EM-DM growth... (and) real U.S. interest rates which are starting to go up."
Higher interest rates raise borrowing costs for the corporate sector and curb credit growth and consumer demand, thus hurting companies' profits. They also make fixed income assets less attractive.
Clearly then, bad news for bond and equity investors who, Thomson Reuters service Lipper says, have pumped almost half a trillion dollars into emerging assets in the past decade.
Add to that bank loans, merger and acquisition deals and direct investments by foreign companies into manufacturing and services, and the figure just since 2005 could be as large as $7 trillion, Institute of International Finance data show.
Like Hauner, Morgan Stanley analysts see the central bank moves as broadly positive, in that they raise inflation-adjusted, or real interest rates. That ultimately makes economies more competitive by slowing wage growth.
In the meantime though, emerging markets are exposed to the risk of a sudden stop in capital flows, highlighting potential ructions on credit markets, asset prices, economic growth and also politics as a result of the rate rises.
"Will we see an orderly slowdown, or a more disorderly unwind?" Morgan Stanley said in a note. "An orderly deceleration in growth will also be important in keeping political uncertainty at bay with elections ahead of us in many double-deficit countries."
India, Brazil, Turkey, Indonesia and South Africa are among key developing countries facing elections in 2014 and which are seen as vulnerable to the withdrawal of the Fed's cheap cash because of their budget or current account deficits.
NOT YET IN ASSET PRICES
Equity investors found out the hard way in China that fast economic growth doesn't equate with investment returns, enduring miserable stock market performance for two decades even as the economy grew at turbo-charged rates.
Slowing growth is at least partly driving heavy outflows from emerging markets, where funds tracked by EPFR Global shed over $50 billion in 2013 and over $8 billion so far this year.
But the growth allure is yet to completely fade, with many investors focusing on long-term positives such as demographics or low ownership of goods such as mobile phones or cars.
The question is when will asset prices reflect the inevitable growth-inflation hit these developing countries will take, says Steve O'Hanlon, a fund manager at ACPI Investments.
"Markets are pricing a pretty dire situation in emerging markets (but) is EM cheaper given potential future output? I wouldn't say so but it's getting there," O'Hanlon said.
"When currencies stop selling off, if (governments) produce real reforms, I will be investing in those markets. If you don't see any reforms, the rate hikes will just destroy growth, discourage investors and make the situation far worse."
(Additional reporting by David Gaffen in New York and Reuters bureaux in Latin America and Asia; Graphic by Vincent Flasseur; Editing by Catherine Evans)