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Unlocking the playing field for emerging markets

Dan Istitene | Getty Images

Since the 1980s, emerging markets have opened up to investment from the rest of the world. The combination of China's reforms under Deng, the collapse of the Soviet Union, and the end of dictatorships in Latin America, meant a raft of enactments of new investment-friendly legislation.

Yet in the past decade, momentum has slowed.

With strong economic growth, and concerns over foreign firms repatriating profits away from domestic economies, emerging markets' zeal for foreign direct investment (FDI) reform fell away. According to the UN, at the turn of the millennium, just 6 percent of new investment-related policies increased restrictions and regulations. This has since risen to 25 percent.

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With bulging emerging market current account surpluses for much of the decade, there was little need for external funding. Even those countries that required foreign investment, such as India, were attracting plenty of portfolio flows in any case.

A combination of superior emerging market growth, and ultra-low developed market interest rates sent investors on a 'hunt for yield,' which has pushed more than $200 billion in portfolio flows to emerging markets since 2005.

But this has now changed, and emerging markets will now need to unlock the playing field for FDI.

The first reason for this is that emerging markets now need the funding more than at any point in the past decade. Growing levels of domestic debt have caused current accounts to deteriorate, meaning large surpluses have evaporated. Some, such as Indonesia and Brazil have rising deficits.

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The second reason is that foreign portfolio flows are becoming increasingly unreliable. The prospect of incrementally tighter U.S. monetary policy has put an end to the 'hunt for yield.' Some $16 billion have been pulled from emerging market debt funds, and $24 billion from equity funds since May.

This has resulted in leading to tighter financial conditions for emerging market corporations and sovereigns alike.

A host of countries, including India, Indonesia, Turkey, and Brazil have been forced to raise interest rates to try and stem capital outflows and prevent inflation. These measures are necessary but higher rates will negatively impact growth.

And the latest IIF emerging market lending survey shows financial conditions for corporations are the tightest since the euro zone crisis in mid-2012.

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Emerging markets are now in a difficult position of needing more funding at the same time that less of it is available.

As an interim step, emerging markets can use foreign exchange reserves to stabilize their currencies while keeping interest rates low. But, in the face of potentially tighter U.S. monetary policy, this is a risky strategy that most are unwilling to undertake.

Even Brazil, with its $370 billion war chest, has preferred to primarily deal with capital outflows by raising interest rates rather than aggressively spending reserves.

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In the long run, the only sustainable solution is to make renewed efforts to reform FDI. Such measures will likely prove politically contentious, but will be necessary if emerging markets want to keep stable currencies, low funding costs, and consequentially maintain their economic growth trajectories.

India has made steps to embark down this path already, with the government announcing this month it will open up FDI in a dozen sectors of its economy, but regulations remain overly complex, and it is telling that despite a huge domestic consumer base, no retailer has applied for a license since the sector opened up to FDI in 2012.

(Read more: Four reasons not to 'throw in the towel' on India)

Elsewhere in Asia, FDI into Indonesia grew at the slowest pace in three years in the second quarter, and regulatory uncertainties ahead of the 2014 elections could mean this slows further still.

To prevent a major drop-off in FDI, which created 62 percent of the country's new jobs in the second quarter, politicians will need to provide more clarity on the future investment climate. Meanwhile, to ensure sustainable and efficient growth in the future, China will need to open up further to FDI in its domestic and service economy, and not just in trade-related sectors that have spurred its economy so far.

Continental neighbors such as Korea, Hong Kong, Singapore, and Taiwan all offer examples of economies that have become developed markets while remaining open to trade. It is time for other emerging markets to follow this path. From here, it is the only way forward.

Previously, Alex was the former Chief Financial Officer of the Bill & Melinda Gates Foundation and a member of the foundation's management committee. Friedman joined the foundation following Warren Buffett's historic gift in late 2006 and served as CFO during a period when the foundation more than doubled in size. Friedman also managed a private investment vehicle, Asymmetry, served as a senior advisor to Lazard, the international investment firm, and on the Supervisory Board of Actis, the global emerging market private equity firm. In his current role, Alex has been regularly interviewed by international media such as Financial Times, Bloomberg, CNBC, The Economist etc and contributes byline articles to the Financial Times.

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