By Ira Iosebashvili, Josh Zumbrun and Julie Wernau 

A resurgent dollar is exposing weaknesses in the developing world, pushing investors to unwind long-held bets on emerging-market stocks, bonds and currencies.

Ripples from the dollar's comeback have spread. Indonesia's central bank on Thursday raised interest rates for the first time in four years to arrest a drop in its currency; Hong Kong's monetary authorities last week stepped in to prop up the territory's weakening dollar. The Turkish lira fell to fresh lows against the U.S. dollar, while Brazil's real declined to its weakest level in more than two years. The MSCI Emerging Market Index, which measures stock performance, is down 11% from its January highs as of Friday.

Investors have piled into emerging-market stocks and bonds for the last several years, often glossing over important macroeconomic or political issues as they sought returns that dwarfed those found in the developed world. Now that the dollar is strengthening and U.S. yields rising, those shortcomings are becoming more glaring. A rising dollar makes it more difficult for countries to service debt denominated in the U.S. currency, while rising yields diminish the attractiveness of foreign assets.

"The markets are now realizing they have to pay attention to fundamentals and assessing which countries are the most vulnerable," said Mark McCormick, North American head of FX strategy at TD Securities.

Investors are particularly nervous about nations with large current-account deficits, which comprise goods and services, trade and investment income, and those that rely on foreign investment to finance government spending, or fiscal deficits. Their dependence on the rest of the world for trade and government finances leaves them badly exposed when the dollar rises.

Argentina, whose currency and stock market plunged in recent weeks amid fears of a brewing financial crisis, carries both a current-account and a fiscal deficit. Other emerging markets with large current-accounts gaps include Turkey, with a deficit that stood at 5.5% at the end of 2017, as well as Colombia, South Africa, Indonesia, India and Mexico.

The current-account deficit "captures living beyond your means," said Robin Brooks, chief economist at the Institute of International Finance.

Politics are another worry. Mexico's peso, a top performer last quarter, has been dogged by concerns over the renegotiation of the North American Free Trade Agreement and a looming presidential election. Even the recent climb in oil prices has barely helped the currency of oil-producing Russia, where worries of fresh U.S. sanctions against Moscow have dented the ruble.

As volatility spreads throughout emerging-market assets, investors who had arrived relatively recently are looking toward the exits, said Tim Atwill, head of investment strategy for Parametric Portfolio Associates.

"There is this large amount of new investors who have only experienced the good days. They'll start leaving. They're not used to the riskiness, " he said.

Jumps in the dollar and U.S. yields have burned emerging-market investors before. Many developing countries borrowed heavily in dollars and kept their currencies tightly pegged to the U.S. currency in the 1990s. A swift dollar rally forced them to raise interest rates and push up their own currencies to unsustainable levels, damaging exports, hurting growth and eventually setting off the Asian financial crisis in 1997.

Developing countries had largely loosened their currency pegs and built up reserves by 2013. Still, many swooned that year when yields shot higher after then-Federal Reserve Chairman Ben Bernanke indicated the central bank might wind down its bond-buying program in an episode known as the "taper tantrum."

Today, some emerging economies may be at least partially shielded by robust growth rates, analysts said. The IMF's April forecasts, made before the recent turmoil, projected India's growth at 7.4% and expected both Indonesia and Malaysia to grow by 5.3%.

And others have shored up their finances. Countries including South Africa, Mexico and Brazil have narrowed their current-account deficits, and some have promised or launched economic and political reforms.

Still, that may not be enough. While Asia's economies are growing briskly, others are struggling: Argentina is expected to grow at just 2% this year, Mexico at 2.3%, Colombia at 2.7%, Brazil at 2.3%, and South Africa at 1.5%.

Plus, some analysts believe a continued rise in the dollar and U.S. yields will punish comparatively healthy emerging markets alongside more vulnerable ones. In 2013, for example, fears of a slowdown in China and a drop in commodity prices sparked a three-year drop in the MSCI Emerging Markets Index.

The stronger dollar "is slowing the flow of loose money floating around the world, looking for something to do with itself," said Kit Juckes, a strategist at Société Générale. "The world tends to be a much happier place when the dollar is not going up."

Write to Ira Iosebashvili at ira.iosebashvili@wsj.com, Josh Zumbrun at Josh.Zumbrun@wsj.com and Julie Wernau at Julie.Wernau@wsj.com

(END) Dow Jones Newswires

May 21, 2018 05:44 ET (09:44 GMT)

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