The dollar and emerging market vulnerabilities

One of the effects of a strengthening dollar is the shift of capital flows out of emerging markets. There are two factors that influence the dynamics of this shift. The first is a reversal of capital flows. This is important because some emerging markets are heavily reliant on foreign inflows to fund fiscal or current account deficits.

The IMF says that between 2009 and 2013, emerging markets received about US$4.5 trillion of gross capital inflows, representing roughly half of all global capital flows in that period. If investors perceive that returns in the United States will probably be more attractive, international capital flowing away from emerging markets could accelerate and make funding the “twin deficits” more difficult.

This may already be happening, even before the Fed hikes rates. Let me explain; financial markets do not move on events but on expectations. And expectations of an acceleration in interest rates increases in the US is changing the relative expectations of returns between the two regions.

The second factor is the less visible, but probably more important, threat of US dollar denominated debt. Emerging market governments, corporations and banks took...