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After Last Year's Stock Rally, Asia Braces for Some Volatility

Stocks in Asia surged last year, thanks to a massive inflow of capital into the region. But as economies recover, those funds could easily move to seek higher returns elsewhere, creating volatility in the markets.

In recent weeks, Asian stock markets have seen some sharp drops. Hong Kong's Hang Seng index has dropped about seven percent so far this year. Elsewhere in Asia, Japan's Nikkei index and the Shanghai Composite index dropped six percent.

Last year, these markets surged from their lows in late 2008. The Hang Seng index, for instance, ended 2009 up 45 percent.

Garry Evans, head of strategy of HSBC Global Banking and Markets, said in the bank's latest investment commentary that stocks are unlikely to rise the way they did last year.

"The fundamentals of the economy are picking up. What you always have to remember is that the stock market moves in anticipation of that. So the stock market rise last year came down to the fact that the market was anticipating the economy being very good this year," he said.

Stocks last year surged in part because of the stimulus measures governments across the region began to fight the recession and because of low interest rates. Over the past year, billions of dollars in foreign funds flooded into Asia.

But as state spending slows down and as central banks start to tighten credit and raise interest rates, financial experts say investors may move from stocks to other assets, and that could lead to volatility in the stock markets.

Typically, Evans says, stocks suffer sharply during the first round of interest rate increases.

China's central bank says it is important for countries to coordinate stimulus exits because once major developed economies end those programs, capital flows may shift to other assets and economies. And that could mean asset prices, especially in emerging markets like China, may see volatility.

China's curbs on rapid credit growth have triggered selling in Hong Kong's stock market in recent weeks. The territory relied on the mainland's economic stimulus to help it ride out the global slowdown last year.

Hong Kong Monetary Authority Chairman Norman Chan says the city is at risk of capital flight, because more than $82 billion came in over the past year, mostly spent on stocks and property.

"The timing of exit strategy and stability of financial markets, all these will have an impact on the capital flow in the asset markets," said Chan.

Much of the money that flowed into Hong Kong came through stock offerings by Chinese companies. Chan says it will eventually be repatriated to the mainland.

"And therefore such funds would flow out of Hong Kong. But the pressure for capital inflows might persist if equity fund raising remains active and U.S. interest rates remain low," he said.

The danger comes if investors exit the stock market at the same time. But financial analysts say it is unlikely there will be a major disruption because Asia still offers better investment opportunities than do other markets.

Jan Brockmeijer, the deputy director of the monetary and capital markets department of the International Monetary Fund, said a recent briefing that the flow of funds into Asia appears to be "fairly stable." And, he says, not much of it is based on debt or invested in complex, and risky assets.

"The impression we have is that most of it is what they call real money investment and not so much leveraged in nature. That is an important consideration because the extent of leverage to some extent determines also the extent of contagion if markets start reversing," said Brockmeijer.

Many market analysts, such as HSBC's Evans, say investors go to markets where there is still potential for growth, and this year that could be in the U.S. and Britain or in smaller Asian markets like Taiwan.