Emerging market rate risk unnerves investors

Investors are pricing in big interest rate rises in emerging market economies this year, sparking fears of a stock market sell-off and prompting worries over the global recovery, which has been driven by the developing world. <?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

With the withdrawal of cheap central bank money in the industrialised world coupled with the increasing tensions in the eurozone because of the Greek debt crisis, sharp rate rises in emerging markets could deliver a further blow to the growth outlook.

Investors are concerned that emerging market central banks might be forced to tighten monetary policy quickly to keep a lid on the build-up of inflationary pressures.

“Although central banks are right to introduce policies to restrain inflation, they must not tighten too far, too fast,” says Nigel Rendell, senior emerging market strategist at RBC Capital Markets.

Significant rate increases are being forecast in <?xml:namespace prefix = st1 ns = "urn:schemas-microsoft-com:office:smarttags" />Brazil, Turkey, Mexico and India. Brazilian forward markets are pricing in a 256 basis point rate increase to 11.50 per cent by the end of the year.

Turkish markets, meanwhile, are pricing in a 186bp rise to 9.05 per cent and Indian markets a 119bp increase to 4.66 per cent. Mexican markets are currently pricing in a 115bp rise to 5.81 per cent by the year-end

In China, bank lending rates are not expected to rise sharply. But Beijing is restraining its economy by raising capital reserve requirements for commercial banks.

The renminbi is also expected to appreciate as much as 5 per cent against the dollar by the end of the year, slowing export growth.

A sharp tightening of monetary policy is normally seen as being bad news for equity investors as it takes the steam out of stocks.

Emerging market equities have rallied strongly in the past year, sharply outperforming the developed world, so many investors expect a correction.

Emerging market bond markets, which have seen spreads against US Treasuries tighten dramatically, could also suffer a pull-back.