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A Chinese 100-yuan banknote is placed under a $100 U.S. banknote in this photo illustration.PETAR KUJUNDZIC/Reuters

After several years of riding high on foreign investment cash and commodity revenue, emerging markets are in for a shock.

The shift is already under way. Net capital inflows in emerging markets stood at $3.9-trillion (U.S.) between 2009 and 2012. Between 2004 and 2012, net capital flows in emerging markets were a staggering $7-trillion, slightly less than half the size of the annual U.S. gross domestic product.

The biggest concern today is that the quality of these investments has deteriorated over the past few years. The low-hanging fruit of the earlier years is gone, forcing investors to become more adventurous.

The other major development is that China, itself still an emerging economy, has become a major player in investing in emerging markets. It is estimated that as much as 30 per cent of capital inflows in emerging markets in 2012 came from China.

If the Chinese slowed down their investments now, that would be a big blow to emerging markets.

China's growing role in investing in other emerging markets in recent years was based on several strategic calculations. Prominent among them is the need to guarantee that China's appetite for commodities would be met and that it would not have to compete for the import of such products with other nations. The best way to secure that is to own a stake in, or lend to, commodity-producing companies abroad.

In contrast, U.S. investors went abroad in search of yield. They were responding to chronically low interest rates and several rounds of quantitative easing that flooded the U.S. economy with liquidity, while lucrative domestic investment opportunities have been scarce for years now.

But these incentives for U.S. and Chinese investors may suddenly reverse. Even in a sluggish economic recovery in the United States, ultra-loose monetary policy will come to an end.

The so-called tapering by the U.S. Federal Reserve Board – the reduction and ultimate termination of its program of buying assets, such as mortgage-backed securities – will lead to an increase of market interest rates in the United States.

That will happen even if the policy rate – the federal funds rate – remains unchanged. This changes the incentive for investors to take home their funds abroad, especially as the risk of their investments there has risen over time.

At the same time, China's economy might not grow at a greater rate than 7 per cent a year in the medium term, as it is facing multiple problems. These include challenges to its export-driven growth model, its exponentially greater economic base from which it must now grow, sluggish global demand and falling competitiveness with the fastest-aging population mankind has ever seen.

The common mantra that China must switch from an investment-driven growth model to a consumption-based growth model is easier said than done. However, this necessary evolution also reduces China's incentive to invest in emerging markets.

China will likely soon start to deploy more of its financial resources at home; for example, to recapitalize its banks and bail out highly indebted provinces and municipalities.

As if this double blow of slower investments from the United States and China was not bad enough, many of the affected emerging markets will also see the price of commodities – their major export products – slump. This is especially true for oil-exporting countries.

Having said all of that, the good news is that virtually all emerging markets have largely strengthened their international reserves to protect themselves against such shocks. Yet, important as these buffers are, panicky investors can quickly lead to a rapid depletion of those reserves.

That is a particular danger if such behaviour is preceded or accompanied by capital flight (i.e., domestic investors withdrawing their money and taking it abroad).

In looking forward to a world of much slower growth and a significant slowdown of capital flows into emerging markets, it is then important to assess which among them might be most affected.

There are three major factors that must be considered in that context. First, how dependent is the country on commodity exports, especially oil? Second, how large a role have capital inflows played in sustaining economic growth in the emerging economy? And third, how dependent is an emerging-market country on such inflows?

The latter two may seem measures of the same thing, but they are not.

A country may have a current account surplus and still benefit from large capital inflows, leaving it with a strong balance-of-payments position. By the same token, a country may have a very large current account deficit (also referred to as the savings/investment gap) and, hence, depend on foreign savings – meaning large capital inflows.

In assessing vulnerability to a combined "sudden stop" of capital inflows and a commodity price shock, the list of potentially vulnerable countries is large for different reasons.

Turkey, Romania, Morocco, South Africa and India stand out in this context as being especially vulnerable. They have all run large current account deficits and hence depend on inflows.

Brazil and much of Latin America are also at greater risk. They are vulnerable because of their dependence on exporting commodities and the fact that they have greatly benefited from record capital inflows over the past 10 years.

Emerging markets have done well for themselves over more than a decade. What lies ahead need not be catastrophic, but it will at a minimum require patience and deft policy management.

Uwe Bott is the chief economist of The Globalist Research Center. This article first appeared on The Globalist. Copyright The Globalist.

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