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Slower global economic growth has increased risks for developing countries, especially if the record levels of private capital that have flowed into these markets is reversed, the World Bank warned on Tuesday, reports Reuters.

In its annual Global Development Finance report, the bank said higher interest rates and emerging capacity constraints would slow the rapid growth of developing countries, with global growth falling to around 3.5 per cent in 2009 from 4 per cent in 2006.

In developing countries, growth is likely to moderate gradually to about 6 per cent in 2009 from 7.3 per cent in 2006, the report said.

Net private capital flows to developing countries reached a record $647bn in 2006, although their rate of growth slowed to 17 per cent from 34 per cent in 2005, the report said.

“Looking ahead, the key challenge facing developing countries is to manage the transition by taking pre-emptive measures aimed at lessening the risk of a sharp, unexpected reversal in capital flows,” the report said.

Mansoor Dailami, the report’s main author, told Reuters that the large foreign exchange reserves in many developing countries, especially in Asia, could be used as buffers in the event of financial shocks.

Lex cites similar findings at the IMF on slowing global growth to ask: can emerging markets do well when the global economy is slowing?

According to MSCI, emerging market equities have risen 181 per cent in dollar terms over the past five years and 10 per cent this year, hugely outperforming developed stock markets. Optimism about their prospects is widespread.

“Yet it is unusual for emerging stock markets to perform strongly when advanced economies are slowing”, notes Lex. The IMF expects global growth to slow from 5.4 per cent last year to 4.9 per cent this year and next, and in the advanced economies from 3.1 per cent to 2.5 per cent. This slowdown will undoubtedly affect demand for emerging market exports, warns Lex.

“And, as Citigroup points out, there is a close relationship between the rate of change of the G7 leading economic indicators and emerging equity markets. The G7 LEI index slipped into negative territory in February for the first time since July 2005.”

Even if export growth does slow, however, many analysts believe the performance of stocks focused on the domestic market will compensate, Lex says. “For benchmarked investors, this will be a challenge. Energy and related sectors, such as materials and industrials, account for more than a third of the MSCI emerging market free index. In emerging Europe, energy stocks represent more than 43 per cent. Although financials are a fifth of the global index, it seems optimistic to hope banks will perform well when global liquidity is tightening.”

Overoptimism also characterises earnings expectations: “Earnings per share, according to IBES consensus forecasts, are expected to grow 14.5 per cent this year, compared with just over 8 per cent for the world as a whole. Yet despite the bullish outlook on earnings, emerging market stocks still appear overvalued on a price-to-earnings basis. The MSCI EMF index is trading at 12.5 times forward earnings - 25 per cent above its long-term average.”

“Any shock to earnings - from a fall in commodity prices to a greater-than-expected global slowdown - and valuations will look even less appealing,” Lex concludes.