Leading financial lobby group warns investors not to get caught short in emerging markets

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A member of Swiss special police forces stands on the roof of the Kongress Hotel next to the Congress Center, on the eve of the opening of the 43rd Annual Meeting of the World Economic Forum, WEF, in Davos, Switzerland, Tuesday, Jan. 22, 2013. THE CANADIAN PRESS/AP, Keystone, Laurent Gillieron

ZURICH - A leading lobby group for the world's financial institutions is warning investors not to get caught short in emerging markets if rich-country central banks end their stimulus measures.

The Institute of International Finance said Tuesday that the U.S. Federal Reserve and other central banks cannot continue to flood the market with cheap money through measures such as low rates indefinitely. This could lead to a "boom-bust cycle" in emerging markets if investors are unprepared, the institute warned.

"The risk of market participants being unprepared for a reversal of rates is real and needs to be seriously considered to avoid disruption," the IIF said.

The IIF sounded its warning in a report ahead of the World Economic Forum in Davos, Switzerland, where some 2,500 business and political leaders are gathering to discuss economic risks ahead this year.

The IIF predicted that falling unemployment and an improving economy in the United States may lead the Fed to start ending some of its easy money policies in 2014. In order to shore up the economy in the face of an acute banking crisis, the Fed has cut its main interest rate to near zero per cent. It has also pumped new money into the financial system through its purchases of financial assets such as government and mortgage-backed bonds.

Many other banks around the world have also cut their interest rates to record lows and backed policies to help solve one of the main problems of the global economy over the past few years — the drying-up of private-sector credit . Despite subdued economic recoveries around the world, many economists say such policy action prevented a worse downturn.

One effect of the low interest rates around the world is the increase in investments into faster-growing emerging countries — where money can earn a better return.

So far, there are few indications that the world's central banks are about to change course anytime soon. On Tuesday, the Bank of Japan bowed to pressure from government to raise its inflation target — a move that will likely mean it has to increase its money supply. Meanwhile, the European Central Bank and the Bank of England are both facing pressure to do more to help their ailing economies.

In its report on investment flows into emerging markets, the IIF said most emerging market governments may have the foresight to avoid the pitfalls of boom and bust. However, it said investors and some governments may not be so careful, leading to unexpected losses and market turmoil.

The institute suggested rich countries should co-ordinate rate policy — and that failure to do so risks undermining investor confidence and more market turmoil.

The rise in flows have made many uneasy in developing countries, since the inflows can lead to rising exchange rates for the countries that are on the receiving end. The higher exchange rates have the potential to hurt their exports.

The IIF said Tuesday that capital flows to Latin America and emerging Asian economies such as China, Indonesia and India are now 30 per cent above the level in 2007, before the global financial crisis.

It raised its figure for capital flows for 2012 to $1.080 trillion from $1.026 trillion estimated in October and said money movements picked up sharply in the last months of 2012 and will likely rise in 2013 to $1.118 trillion and again in 2014 to $1.115 trillion.

The IIF, which is based in Washington, D.C., has 450 members, including major global commercial and investment banks, insurance companies, investment funds, hedge funds, and other finance-related institutions.