IMF: "Fickle" capital flows may slow when Fed hikes

WASHINGTON (Reuters) - The surge of hot money that has vexed many emerging markets may slow dramatically once the U.S. Federal Reserve begins raising interest rates, the International Monetary Fund said on Thursday.

The capital flows represent much-needed investment for fast-growing emerging economies, but they can also feed boom-and-bust cycles when money moves in and out too quickly.

The IMF is in the midst of an internal debate over the proper policy prescription to manage capital flows, and its members remain deeply divided over when and how countries ought to put up capital controls.

Many emerging markets have complained that the Fed's ultra-easy monetary policy -- particularly its current $600 billion bond-buying spree -- have sent even more hot money flooding into their economies, driving up inflation.

In its World Economic Outlook, the Fund looked at what might happen to those money flows when the Fed begins to normalize monetary policy.

The European Central Bank raised its benchmark interest rate on Thursday, but investors see only a slim chance that the Fed will follow this year.

IMF researchers examined 30 years of data on capital flows and studied how they change in response to tightening credit conditions. They then zeroed in on U.S. monetary policy and how it affects flows into different countries.

"These findings suggest that the eventual unwinding of globally accommodative financing conditions will, on the margin, dampen net flows to emerging market economies that have a direct financial exposure to the United States relative to those that do not," the IMF wrote.

Unexpected rate hikes had the biggest effect.

For an emerging market with average direct financial exposure to the United States, an unexpected rate hike led to an immediate drop in capital flows equal to 0.5 percentage point of gross domestic output, the IMF found. Over two years, the decline was equivalent to 2 percentage points of GDP.

To cope with "fickle" capital flows, emerging markets need to adopt policies that "preserve domestic economic and financial strength," the Fund concluded.

(Reporting by Emily Kaiser; Editing by Leslie Adler)