Emerging Asia’s capital markets have shown great resilience over the past year, but the recent sharp sell-offs in response to economic uncertainty in the US and eurozone underscore the need for stronger policies to boost investor confidence and reduce excessive volatility, says a new report from the Asian Development Bank (ADB).

“Emerging Asian markets remain vulnerable to abrupt changes in global investor sentiment,” said Iwan Azis, Head of ADB's Office of Regional Economic Integration, which prepared the report. “The knock-on effects from events in the US and Europe will go far beyond portfolio returns, as a weakening global economy will hurt our exports.”

The Asia Capital Markets Monitor, ADB's annual assessment of the performance and outlook for the region's equity, bond and currency markets, says the global financial environment has become more volatile in recent months—with investors unnerved by the weakening global economy, US and European debt troubles, and political unrest in the Middle East and North Africa.

While emerging Asia’s markets have not been immune to these developments, the region’s strong fundamentals and interest rate differentials with advanced economies are expected to reignite capital inflows to the region later this year.

“While freer capital mobility is welfare-enhancing in theory - as it promotes better and more efficient allocation of financial resources -large and volatile capital flows are risks and present challenges to emerging market economies,” warns Mr. Azis.

Large short-term capital flows have historically disrupted domestic monetary policy, destabilized financial systems and dented economic growth.

The Asia Capital Markets Monitor covers 11 economies of emerging Asia: the People’s Republic of China; Hong Kong, China; India; Indonesia; the Republic of Korea; Malaysia; the Philippines; Singapore; Taipei,China; Thailand; and Viet Nam.

Fears of a global growth slowdown and worries over US and European debt have seen credit spreads on emerging Asian sovereign bonds widen since March. However, the appetite for sovereign debt paper remains resilient given the region’s relatively sound fiscal positions and positive growth outlook. Emerging Asian borrowers issued $29.5 billion of G3 currency-denominated bonds in the first quarter of 2011, up from $24.5 billion over the same period in 2010.

Equity markets continued to rebound from the global economic crisis, supported by upbeat prospects for the regional economy, strong corporate profits, and a lack of attractive yields in advanced economies. In 2010, most of emerging Asia’s currencies appreciated - their biggest gains since 2006 - aided by strong capital inflows attracted by the prospect of widening growth and interest rate gaps with advanced economies. The Malaysia ringgit led the gains with an 11% rise against the US dollar. Despite some recent moderation, the report says the upward trend should continue.

While noting growth in emerging Asia is forecast at a robust 7.9% in 2011 and 7.8% in 2012, the report warns that downside risks loom large as monetary authorities across the region step up their fight against inflation amid increased global economic uncertainty and heightened financial volatility.

Despite visible improvement in the depth and breadth of emerging Asia’s capital markets, persistent vulnerabilities to external shocks suggest the region’s collective efforts are necessary to enhance market resilience. “Providing deep and liquid markets with strong market infrastructure is essential to support the region’s financial development and integration,” he said.