A rise in market expectations for U.S. interest rates as the Federal Reserve starts to normalize policy could cut capital inflows to emerging markets by as much as 45%, World Bank economists said in a paper published on Tuesday.
The Fed has left the door open to a modest rate rise on Thursday, although economists and investors are divided over whether policymakers will act now or later in the year.
The World Bank paper said although most expected a smooth tightening cycle from the Fed, there was a risk of a substantial hit to capital flows if investors started to expect more aggressive hikes and drove up long-term bond yields.
A 1 percentage point rise in U.S., euro area, UK and Japanese yields could cut capital inflows to emerging and frontier economies by 45% within a year, representing up to 2.2 percentage points of their combined economic output.
"Emerging and frontier market economies may hope for the best during the upcoming tightening cycle, but given the substantial risks involved, they would do well to buckle their seatbelts in case the ride gets bumpy," said Carlos Arteta, one of the paper's authors.