Global financial markets awash with liquidity, increased fiscal stability and the trend towards investment-grade ratings have made emerging markets less vulnerable to external market fluctuations and event risk. According to Arjuna Mahendran, chief economist Asia-Pacific at Credit Suisse, the fundamentals of emerging market economies look stable, with foreign capital continuing to flow at near record levels into Asian and other emerging stock and bond markets. Low yields in major markets have pushed traders and investors to be more creative in seeking new avenues of growth and increased return. Local corporate borrowers have turned to their increasingly stable domestic emerging market economies to meet their capital financing requirements. 'There is an enormous amount of liquidity sloshing around in global financial markets that needs to find a home, and in many situations it is emerging markets that are absorbing the excess. Our position at Credit Suisse is that the fundamentals of emerging markets look sound,' Mr Mahendran said. Emerging market equity funds weathered wild market swings in the first quarter, managing on average to squeeze out single-digit returns. Philip Poole, HSBC's global head of emerging markets research, said: 'The way in which the emerging markets asset class is viewed has undergone considerable change over the past few years. Ample supply of liquidity is the key. As a consequence, equity prices across the board have been driven up, currencies have grown stronger and deficit spreads have narrowed.' Many emerging market countries, especially South American, have stronger banking sectors, larger foreign reserves, lighter loan burdens and better economic polices, which make them more resilient to shocks and contagion. Mr Poole said the role of emerging markets in the global economy had grown significantly in recent years as countries had made fundamental improvements to their economies. Mr Poole, who is also HSBC's chief emerging markets economist, said the positive improvements looked set to continue. Emerging markets continued to offer investors an attractive alternative investment destination. Total capital flows into stocks and bonds, plus bank loans and business investment in 30 emerging markets reached nearly US$502billion last year, only slightly below the record US$509billion in 2005, and were tipped to remain high for the rest of this year. Portfolio equity flows to emerging markets have more than doubled over the past 10 years. They reached more than US$70billion last year (of which Asia accounted for US$40billion) and are expected to moderate only slightly to US$63billion this year. Investment in emerging bond markets is running at more than US$100billion a year, of which Asian emerging markets receive about a third. But emerging markets are far from bulletproof. 'There were local events that affected some emerging market countries negatively, but they seemed to have little overall effect on investors' perceptions of emerging asset markets,' Mr Poole said. In the short term, higher interest rates could prompt downward adjustments in the price of riskier assets, underscoring the need for vigilance by investors. This risk is further heightened by the low benchmark yields and environment for risk-taking. Spreads on emerging markets debt hit historical lows in the first two months of the year, while equity prices continued to increase. Emerging markets debt instruments versus US treasuries, viewed by many analysts as a measure of risk appetite, narrowed significantly. In some cases the spread tightened from more than 1,000 basis points to less than 200. 'The data coming through is still being determined, but looking at the figures we don't anticipate any major blow-up in the emerging markets sector. However, volatility is an inherent part of liquidity-driven asset price surges, and we don't see any indications that liquidity is breaking down. Therefore, the outlook is much the same. It is a mixed bag for investors, still frothy markets, but also strong fundamentals,' Mr Poole said. Trapped liquidity is a main driver behind credit growth and asset price increases in the mainland. Mr Poole said the economic performance in China had a significant spillover effect on the rest of the region and beyond. He said inflationary pressures could rise further as the mainland's economic expansion continued and it would need to be monitored closely. He said there was also a view that the inflexibility of exchange rates in the region, especially in the mainland, could present challenges. Strong external inflows could also be expected to add to inflationary pressures, especially in the absence of greater upward exchange rate flexibility. The Institute of International Finance (IIF) in Washington recently warned that investors who appeared to be taking a fairy tale view of continuing global economic stability could be in need of a wake-up call. The IIF warned that surging capital flows reflected abundant global financial liquidity, and this pool could shrink as central banks in Europe and Japan continued to tighten monetary conditions. Mr Poole said investors could become unstuck if banks tightened their monetary polices and they could find themselves over-leveraged through borrowing in low interest-rate currencies to invest in emerging markets.