Fed balance sheet plan may equal three rate hikes for emerging markets: IIF

LONDON (Reuters) - The U.S. Federal Reserve's plan to reduce its $4.5 trillion balance sheet could exert the same squeeze on emerging markets next year as three interest rate hikes, an Institute of International Finance (IIF) study shows.

It said it also has the potential to reduce stock and bond flows by as much as $25 billion.

The Fed cemented expectations on Wednesday that it could start the mammoth downsizing process in September.

It plans to begin by not replacing maturing bonds -- Treasuries and mortgage-backed securities -- which it had bought to tackle the global financial crash.

According to calculations by IIF, one of the most authoritative trackers of global capital flows, this will slice just over $200 billion off the U.S. central bank's balance sheet next year, assuming it keeps reinvesting some of the money for the time being.

Sonja Gibbs, one of the IIF's senior directors, also estimates that just a $65 billion drop in the Fed's Treasury holdings would equate to a $6.5 billion to $7 billion drop in emerging market portfolio flows -- bond and equity purchases by foreigners -- all else being equal.

"That in turn is about equal to a 25 basis point (Fed) rate hike in terms of impact," Gibbs added.

She said the expected $200 billion reduction next year was therefore "more or less" equivalent to three normal U.S. rate hikes.

As the next set of graphics show, total EM portfolio flows were about $175 billion last year. In some years between 2011-2013, when Fed bond-buying was at its peak, inflows were as much as $300 billion.

So an estimated $20-25 billion drop in foreigners' bond and equity buying would be roughly 10 percent of the average recent flow of foreign investor cash into poorer countries.

But there could be an upside for emerging markets, too, the IIF says.

These markets are having a stellar 2017, with global borrowing costs and the dollar low, economic growth picking up and commodity prices recovering from troughs.

Their growth premium over richer, more developed countries also looks set to pick up again.

So the IIF doesn't necessarily expect emerging market investment flows to fall as much as the Fed move would imply, and might even rise.

Robust earnings growth, forecast at over 20 percent for the MSCI emerging equity index over the next year, is also supporting demand.

"We are not forecasting that (10 percent drop in portfolio flows) for 2018 because we expect various other factors to keep EM supported," Gibbs said.

"But you could argue that we would be more optimistic if it weren't for the fact you have this balance sheet reduction."