LONDON Jan 31 Any spill-over damage to the developed world from a sell-off in emerging markets is likely to come through violent swings in financial flows rather than via lost trade, with Japan seen as most vulnerable.
Tokyo stocks, which rely heavily on fickle flows from foreigners, have seen the third worst start to a year in the past half century, partly as investors sought to make up for losses in emerging markets by pulling out of Japan.
The impact of the emerging market rout is also evident in the United States, where foreign central banks are cashing in Treasuries to spend at home. Further selling and related upward pressure on yields may prompt the Federal Reserve to maintain its monetary stimulus for longer.
In the euro zone, sharp falls in emerging currencies may aggravate disinflationary pressures by lowering import prices for goods manufactured in developing economies.
Emerging assets have come under pressure as concerns about a slowing China and the Federal Reserve's stimulus wind-down triggered an exodus of foreign capital.
A spike in global risk aversion and the corresponding surge in the safe-haven yen hit Tokyo stocks, which lost over 8 percent this month.
While Japan has a large savings base, domestic investors tend to hold more government bonds and their equity allocation tends to be buy-and-hold. According to the Tokyo Stock Exchange, 70 percent of the daily liquidity in its main section is driven by foreign investors.
This leaves Japan vulnerable to ebbs and flows of foreign capital, regardless of better economic fundamentals and the "Abenomics" reforms introduced by Prime Minister Shinzo Abe.
"Japan will be a hostage to issues that are affecting emerging markets. When there's risk aversion, Japan gets sold," said Jonathan Schiessl, investment manager at Ashburton.
"People flooded back into Japan with Abenomics but there's a risk of foreign capital withdrawal."
Trade channels are less likely to pose a threat to the developed economy. Gross exports to emerging economies are less than 5 percent of economic output in the United States, according to Goldman Sachs.
Developed market financial conditions could tighten, as a result of feedback via portfolio adjustments driven by the emerging turmoil.
In the case of the United States, foreign central banks may be forced to liquidate their Treasury holdings further to defend their currencies.
Friday's data showed overall foreign holdings of U.S. debt such as Treasuries, mortgage-backed securities and agency debt which are stored mainly by foreign central banks at the Fed fell to $3.325 trillion in the week ended Wednesday, the largest weekly decline since June.
The benchmark 10-year Treasury yield has fallen to a 2-1/2 month low of 2.67 percent as investors sought safe-haven Treasuries but a sustained sell-off from foreign central banks may push up the yield.
The related financial tightening may be enough to persuade the Fed to push back the timing of the first interest rate hike, or even slow the pace of its stimulus wind-down.
"Financial markets could transmit shocks directly, tightening DM financial conditions in the process... Investors use DM markets as hedging tools during times of stress or because pressures to reduce risk more generally force selling of more liquid assets," Goldman said in a client note.
"An undesirable tightening in financial conditions would probably ultimately be met by central bank responses."
Falling emerging currencies and weak demand in emerging economies as a result of financial shocks would be a disinflationary combination for developed economies, especially in Europe where inflation is on an alarming downward trend.
Friday's data showed euro zone consumer price inflation fell in January to 0.7 percent, reinforcing warnings from the IMF that deflation was a potential risk.
The ECB is expected to stay put until mid-2015 after cutting its key interest rate to a record low of 0.25 percent in November, but deflation risks could change the plan.
Europe is also at a higher risk from an emerging economic slowdown, given the exposure of its corporates to the developing world.
European companies derive more than 23 percent of revenues from emerging markets, compared with around 14 percent for Japanese and U.S. firms, according to MSCI.
"The euro area periphery could find itself under scrutiny again. Those who compete directly with countries whose currencies are falling sharply may also struggle more, with parts of the euro area periphery and commodity producers again the most likely to suffer here," Goldman said. (Editing by Janet Lawrence)