Yesterday's 2 per cent slide in Hong Kong's Hang Seng Index came as a nasty reminder that the city's stock market may be living on borrowed time. The immediate cause of the sell-off was Friday's surprise decision by the Reserve Bank of India to raise interest rates by quarter of a percentage point. At first sight, it might seem strange that an interest rate increase by the Indian central bank should unnerve investors in Hong Kong-listed stocks. After all, the Indian rate hike came in response to a recent surge in local inflation rates, which saw local wholesale prices rise by 9.9 per cent and consumer prices shoot up by an uncomfortably high 16 to 18 per cent over the year to February. In contrast, consumer prices in Hong Kong edged up by a relatively modest 2.8 per cent last month. And much of that increase was the result of price distortions caused by the shifting Lunar New Year holiday. According to Denise Yam at Morgan Stanley, Hong Kong's underlying inflation rate averaged just 0.8 per cent over the first two months of the year. Yet the Indian rate hike still came as an unpleasant wake-up call. It reminded investors that for the last 18 months or so they have been enjoying the effects of abnormally easy monetary conditions, and that from here there is only one way global interest rates are going to go: upwards. That's a daunting prospect for Hong Kong investors. Last year's equity rally, which saw the Hang Seng Index double in value between March and November (see the first chart below), was propelled largely by massive inflows of liquidity which both pushed prices higher and squeezed out the market's volatility (see the second chart). Between September 2008 and the end of last year, the volume of foreign currency inflows into the local financial system was so great that the Hong Kong Monetary Authority was forced to sell a thumping HK$646 billion in the foreign exchange market to prevent the Hong Kong dollar from appreciating above the strong side of its permitted convertibility band (see the third chart). Most of that money went into bank deposits and Hong Kong's debt market, but a good portion went into equities, pushing prices sharply higher. Since late last year, however, the inflows have abated and according to the HKMA, some money may even have flowed out of Hong Kong again. As a result, the equity rally has run out of steam, with the Hang Seng retreating 9 per cent from its November high. The fear now growing among some investors is that as global central banks move towards unwinding their emergency measures and raising interest rates, the trickle out of the Hong Kong market could become a cascade, pushing prices significantly lower once again. For Hong Kong the threat comes from two fronts. As inflation pressure mounts on the mainland, expectations are growing that the authorities may be compelled to raise interest rates sooner rather than later. Analysts at Barclays Capital now expect the first rate hike at some point over the next three months, followed by a further two increases in the second half of the year. Although any increases are likely to be modest - just 0.27 of a percentage point each time - tighter monetary conditions would be likely to restrict the flow of mainland funds into the Hong Kong market. At the same time higher interest rates would be sure to dampen sentiment in the mainland property market, which would threaten to damage the earnings prospects of a swathe of Hong Kong-listed stocks, cooling international investors' enthusiasm for the market. Meanwhile, the US Federal Reserve is also moving towards withdrawing its own monetary stimulus measures. The end of the Fed's emergency programme of mortgage-backed security purchases, planned for the end of March, should have been priced in by investors long ago. But any change to the Fed's promise to keep interest rates low for 'an extended period' at next month's meeting of its rate-setting committee could easily spook investors and trigger a fresh sell-off in stock markets. That does not mean we are going to see a new bear market. Capital flows out of safe-haven money market funds should continue to provide support for prices. But it does mean that as central banks move towards tightening, the market will be heading into more volatile conditions. Yesterday's sell-off was just a taste of things to come.