* Funds flowing back into markets such as India
* States must reform, rely less on foreign capital
* Governments reform during crises, ease off afterwards
By Natsuko Waki
LONDON, April 4 (Reuters) - A tentative recovery in emerging markets may paradoxically disappoint some investors who had hoped a sell-off earlier this year would push governments into making reforms to stimulate longer-term economic growth.
Higher asset prices and a return of portfolio investment flowing into countries such as India may mask the urgency for emerging economies to reduce their reliance on foreign capital and improve productivity at home.
Following an exodus of investors during most of the first quarter, emerging stocks are on track for a third consecutive week of gains. Emerging dollar debt has outperformed U.S. Treasuries and global corporate bonds so far this year as cheap valuations attract investors looking for a bargain.
While investors would normally welcome such gains, they believe reforms are vital for achieving lasting economic growth that can buoy markets in the longer term. Governments, however, tend to take action that might be unpopular with voters only during a crisis - and then ease off once it is over, they say.
“(Politicians) generally do the right thing after they’ve exhausted all the other measures. People reform under pressure, and they get lazy again,” said Austin Forey, investment manager at JP Morgan Emerging Markets Trust.
There is evidence that some of the riskiest economies, such as Ecuador, Pakistan and even Ukraine, aim to borrow again as market conditions improve despite the absence of significant economic reforms.
But governments cannot afford to slow down on measures such as diversifying economies that rely too heavily on commodity production, encouraging citizens to save more, loosening labour laws and scrapping costly price subsidies.
In the last few years, investors poured into emerging markets in search of better returns after the Federal Reserve drove down U.S. debt yields to stimulate the domestic economy.
However, the Fed is expected to scrap its main tool in this policy, buying bonds, this year and raise official interest rates in 2015, attracting investors back to U.S. markets.
Current gains on emerging markets appear fragile and remain modest compared with the earlier losses.
“The recovery we’ve seen is just a fraction of the sell-off and it’s more tactical. No one is thinking beyond three months on their horizon,” said Salman Ahmed, global fixed income strategist at Lombard Odier Investment Managers.
“For the next phase of foreign inflows ... you have to see an uptick in growth and it will not come from abroad. How do you generate domestic growth? Either you consume more by borrowing or increase productivity with reforms. The choice is very clear.”
Three countries with Caa1 credit ratings from Moody’s agency are looking to issue bonds..
Ecuador, which defaulted on its foreign debt in 1999 and again in 2008, begins meeting investors on Friday on raising up to $1 billion. Pakistan also wants to borrow dollars and even Ukraine hopes to tap the market, despite the dire state of its economy and Russia’s annexation of Crimea region.
“If you want things to be good in the future for emerging markets, then that may not work out if things are too good in the short term,” said Maarten-Jan Bakkum, emerging market strategist at ING Investment Managers. “Pressure has to increase before these people make any changes that will create growth in the future.”
More than $50 billion flowed out of emerging stock and bond funds in the first quarter of 2014 as concerns grew that rising U.S. bond yields would push investors away from higher-risk assets. Slowing growth and falling company profits in emerging economies were also to blame for the exodus.
But investors are returning to certain countries. Indian stocks, for instance, have hit record highs and the rupee is at 8-month peaks as almost $10 billion of foreign capital has flooded in since January.
Some of these gains are down to the government’s efforts to cut the budget and current accounts deficits, and some investors hope a reform-minded opposition party will form the next government after elections starting on April 7.
India’s position in BlackRock’s sovereign risk index - which uses different measures to track sovereign credit risk - has improved by 1 in the past three months to 39 out of 50.
But reform promises are not coming through quickly in other vulnerable economies such as Brazil and South Africa, both of which face general elections this year.
South Africa’s 2014 economic growth forecasts have been cut to just 2.6 percent, a result of labour unrest which costs the economy billions of dollars.
Russia’s long-delayed plans to privatise and diversify its economy have also stalled thanks to high oil prices and the government’s focus on the Ukraine crisis.
Economic reform can hurt populations but at JP Morgan Emerging Markets Trust, Forey predicts that voters - armed with social media and the internet - will ratchet up the pressure for change on their leaders.
“Particularly in governments that have failed to deliver a good system that developed markets have got, people know what they’re missing,” Forey said. “The aspect of information transmission poses long-term challenges.” (Additional reporting by Sujata Rao; editing by David Stamp)