By Natsuko Waki
LONDON, Nov 19 (Reuters) - A wave of capital controls being imposed by emerging economies to prevent hot money flooding their markets may well prompt global investors to think twice before extending already stretched bets on the developing world.
The official concern is that near-zero Western interest rates and a falling U.S. dollar are herding short-term speculators to high-growth economies and high-yielding markets.
And this is destabilising because its volatility complicates economic management; it risks driving local currencies to uncompetitive levels for exporters; and, in the case of fixed exchange rates, it fuels inflation via currency intervention.
What is more, they fear that the bigger these "bubbles" blow the greater the threat of destructive reversal once the world economic recovery triggers an exit from ultra-easy U.S. and European monetary policy and the dollar stabilises.
Over the past six weeks, governments from Brasilia to Moscow to Jakarta are moving beyond central bank intervention to curb these speculative flows.
Brazil announced on Wednesday its second such measure in a month by introducing a 1.5 percent tax on certain trades involving American Depositary Receipts issued by local firms. It imposed a two percent tax on new foreign purchases of local equities and bonds in October.
"It is a risk. Zero interest rates and quantitative easing, that money is creating bubbles in many asset categories. Those regarded as riskier assets have seen the biggest rebound," said Rob Hepworth, senior fund manager at insurer Ecclesiastical.
"It is cause for concern. I would look to keep pretty cautious investment strategies."
Illustrating the sheer scale of investor stampede into emerging economies, net inflows into emerging market equities this year are already at all-time highs, attracting around $60 billion, according to global fund tracker EPFR.
This more than reverses 2008 outflows of $49.5 billion and surpasses the previous record of $54.3 billion posted in 2007.
The record flows come even as emerging economies as a whole are expected by the International Monetary Fund to grow just 1.7 percent this year, compared with 6.0 percent and 8.3 percent in 2008 and 2007 respectively.
While this year's expected expansion far outstrips a forecast contraction of some 3.4 percent in developed economies, next year's likely growth rebound to about 5 percent still leaves it well below 2007 peak.
LEVERAGE ROLLERCOASTER
Investors have been lured partly to diversify their portfolios by adding assets that are supposed to be "uncorrelated" or decoupled from traditional markets. However, as the credit crisis showed, emerging markets may outperform or underperform but they remain hugely correlated with core markets and display far more volatility.
According to an article in Thursday's Financial Times by fund manager Richard Bernstein, total returns data over the past five years show some 75 percent correlation between MSCI's BRIC index (Brazil, Russia, India, China) and the S&P 500 -- with moves in the former 1.6 times that of the Wall St bellwether.
Emerging market stocks, measured by MSCI, rose 71 percent this year, after falling 54.5 percent in 2008. MSCI world equity index has risen just over 30 percent, after a 43.5 percent fall last year.
And this long-running leveraged rollercoaster is the essence of the problem many governments are trying to address -- especially now that many economies, such as Brazil, do not need the international capital in a way they did ten years ago.
"The problem emerging markets face is capital flows are never even. They experience either feast or famine and nothing in between," said Avinash Persuad, chairman of Intelligence Capital and an adviser to many governments on financial risk.
"This has proven over many years as unsustainable and has sown the seeds for what we have seen," he added. "As long as the new stance is just about smoothing capital flows, I don't think it's a retrograde step. But it is risky -- and the risk is they will turn capital away when they need it as the competition among governments for capital increases in the years ahead."
For now investors are happy to exploit correlations that have this year dominated all investment strategies from commodities to equities to currencies and alternatives.
"The bottom line is if you look at the world economy there is a limited amount of countries and geographies that are growing," said Veronica Pechlaner, asset manager at Ashburton.
"Until currency appreciation is allowed to happen it will attract even more flows. You have to make decision that whether returns are enough to offset the barrier that is put on you. It doesn't seem to be a huge deterrent yet."
Authorities are spending tens of billions of dollars to prevent local currencies from appreciating to keep export competitiveness. Kazakhstan bought over $2 billion to stop the tenge from appreciating, while Russia has bought nearly $25 billion since September to dampen rouble strength.
But this does risk stoking domestic inflation as central banks flood the domestic banking system with local currency in their attempts to prevent the exchange rate rising.
"Restricting inflows is perceived as one way of continuing to target currencies with incurring the inflation cost," Phil Poole, head of emerging markets research at HSBC said in a note.
"Expect more ad hoc measures from emerging governments and central banks both to restrict inflows and to limit their consequences."
(Additional reporting by Mike Dolan, Sebastian Tong and Carolyn Cohn; Editing by Victoria Main)