Emerging Markets and the Dollar That Won't Let Them Go

Emerging markets have spent the last several years caught in a bind that is not of their making. Their growth prospects depend on global capital, and global capital moves according to the interest-rate decisions of a handful of central banks in the developed world. When those rates rise, capital retreats to the safety of the dollar; when they fall, capital returns in search of yield. The emerging-market cycle is, more than ever, a function of monetary policy the markets themselves do not control.

The current moment is one of cautious recovery, and the caution is warranted. Several of the structural constraints that held emerging markets back remain in place, and the recovery that is underway is uneven — strong in some economies, fragile in others, and dependent on a global environment that could shift again.

The dollar constraint

The single most powerful force on emerging-market fortunes is the dollar. A strong dollar raises the cost of dollar-denominated debt, drains capital from emerging economies, and suppresses the commodity revenues on which many of them depend. A weak dollar does the reverse. The markets that have navigated the recent cycle best are those that reduced their dollar exposure — building reserves, restructuring debt, or developing local-currency debt markets that insulate them from the exchange-rate swings that once destabilized them.

Not all have managed this. The markets that remain exposed — with high external debt, thin reserves, or persistent current-account deficits — are vulnerable to the next dollar swing, and the recovery they are experiencing now could reverse quickly if global rates move against them. The differentiation between emerging markets has become sharper, and the broad-brush category that once treated them as a single bloc no longer reflects the reality.

The recovery that depends on the global cycle

The recovery underway is not, in most cases, the product of domestic reform. It is the product of a global rate cycle that has eased the dollar pressure and returned capital to the search for yield. That kind of recovery is real but contingent, and the markets experiencing it are aware that the conditions producing it could change. The reforms that would make the recovery durable — governance improvements, investment climate, diversification — have progressed unevenly, and where they have not progressed, the recovery is built on sand.

The markets that have used the breathing room to push through difficult reforms are the ones positioned to sustain the recovery. The markets that have used it to defer reform are setting up the next crisis, and the distinction between the two will become visible the moment the global cycle turns.

The investment that differentiates

For investors, the lesson of the cycle is that "emerging markets" is no longer a single trade. The dispersion in performance between the best-managed and the worst-managed economies has widened, and the returns have gone to those who distinguished between them rather than those who treated the category as homogeneous. The index-tracking approach that captured a broad emerging-market recovery has given way to a more selective one, in which the country and the reform trajectory matter more than the category.

The recovery that depends on the dollar is a recovery that can be taken away. The recovery that depends on reform is one the market itself can sustain. The emerging markets of the current moment are a mix of both, and the next several years will sort them accordingly — rewarding the ones that used the cycle to change, and exposing the ones that did not.