This assumption was always based on the belief that as inflation was not a problem, there was no need for the Fed to be overly aggressive on tightening. It could take its time (which it has), and most observers had felt that we were very close to the end of the current Fed tightening cycle.

A series of negative data points on inflation, as well as comments by the new Fed Chairman, implying that he wished to strongly establish his anti-inflation credentials, have combined to shake investors' comfort on the outlook for inflation and global growth.

There is now a growing view that Bernanke (new Fed Chairman) will overshoot in his quest to establish his anti-inflation credentials, and thus raise interest rates by more then necessary, impacting growth and potentially pushing the US into a serious growth slowdown if not outright recession. Many observers feel that inflation is actually not a problem, and thus fear that the Fed. will overreact to a series of
cyclically negative data.

If Bernanke were to go down this path, the European Central bank and the Japanese monetary authorities are very likely to follow, and thus tightening would continue globally.

This move towards excessive tightening of liquidity and rising rates will inevitably dampen global growth and lead to a slowdown in corporate profits.

This is what investors fear is now happening, and thus the intense focus on any and all inflation data globally. Leading indicators of global growth are turning down across financial markets and in the real economy as well.

Emerging markets are still seen as leveraged plays on global growth, and if the global growth outlook comes under a cloud, this will be seen as negative for the emerging markets asset class.

The news coming out of China is also worrying investors as the authorities there seem determined to slow down run away credit growth and dampen capital spending. Various measures have been announced by the authorities, including a hike in reserve requirements and steps to cool real estate.

Thus in investors' minds both the drivers of global growth, US consumption and Chinese capital spending are under attack from their respective monetary authorities, and both will slow, the question is of only how much and how soon.

Many savvy investors in fact are convinced that the current obsession with inflation will soon turn into constant fretting about global growth and the speed and extent of the coming global growth slowdown. Don't be surprised if in 4-6 months, inflation fears turn into recession fears and the people calling for rate hikes today start talking about rate
cuts.

Be that as it may, the global economy seems to be at an inflection point, growth may have peaked globally and liquidity clearly has, this is not an environment in which emerging markets historically do well. Whenever investors start fretting about global growth, emerging markets will take a knock, that is just the nature of the beast.

The steep fall of 25 per cent today is because of the extent and duration of the rise in the asset class over the past four years. Many investors who have no need or indeed even mandate to be in these markets have been in the asset class playing momentum. At the first signs of trouble and a break in the momentum they will naturally bolt.

We have had two similar market breaks like the current one, (for the emerging markets asset class) in 1994 and 2004. In 1994, after a strong run, markets declined by 20 per cent in two months, they then retested their highs within four months, but that marked the peak for the asset class for the whole decade.

In 2004, markets dropped 20 per cent in five weeks, were range bound thereafter for 3-4 months and then continued powering ahead. Which path will the asset class follow today, post this fall, is a critical question, have we formed a long-term peak ala 1994, or are we just in pause mode like in 2004?

The difference between the two episodes, one marking a peak and the other only a short-term hiatus, can be linked to valuation and macro fundamentals. In 1994, the EM asset class was trading at 30 times and macro fundamentals across countries were weak, in 2004 the markets were cheap and macro economic indicators had never been better.

Given the valuations for emerging markets and the strength in macro indicators, one tends to feel that we will follow the 2004 path and that this is not a long-term peak in the asset class.

As for India, there is grave worry among many investors about our current account deficit and the inflation/interest rate dynamics. Investors are convinced that interest rates will keep rising, as the RBI worries about inflation and we simply lack adequate domestic savings to support both GDP growth of 7.5-8 per cent and high fiscal deficits.

Rising domestic rates, can be a killer to consumption (Indian consumer far more levered today then ever before) as well as dampen high P/E multiples. Thus India does look vulnerable, but the hype factor around our country remains high (witness the article in TIME last week), and FII's on a net basis have still not really sold off in a big way, indicating to me that long-term money for the country is still available and on the sidelines waiting to come in.

I think the critical variable investors will track in India our progress in attracting FDI. We will always need to attract foreign capital to grow at 7-8 per cent, we have been very successful in getting FII money over the last 3 years, but in today's more volatile global scenario this has to be supplemented by strong FDI flows. If we can attract $10-15 billion in FDI flows on a regular basis, then all the worries investors have of local liquidity and growth being held hostage to global financial markets will dissipate.

India is seen today as being possibly the most leveraged market globally to financial market flows, as they impact both the real economy and financial markets in our country. In a time of uncertain global markets this vulnerability and dependence has to reduce.

The only way this can happen is to supplement financial flows with more sticky non-financial capital. We need to be able to put in place the policy frameworks to attract FDI of this magnitude, if we want to sustain our growth. There seems to be little alternative.

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