Karin Strohecker & Sujata Ro

LONDON, (Reuters) – Emerging markets are struggling to recover from a 2-year period of COVID. As the dollar’s two-decade-highs tighten the screws, they now face capital flight and inflation.

The dollar’s strength was the root cause of almost all previous emerging market crisis. To prevent their currencies from falling, the developing nations must increase their monetary policies as the dollar increases. Inflation would be exacerbated and servicing dollars-denominated debts will become more expensive if this is not done.

Despite all of the advancements of the past decades, these equations remain broadly valid and the recent rally of the dollar is leaving behind a trail that has caused much destruction.

The tumble in and escalating commodity prices add to the complexity.

The cracks are growing. It’s no surprise that emerging markets face problems when a strong Dollar intersects with high commodity price,” Manik Narain from UBS, Head of Emerging Market Strategy.

“And when the yuan falls, there are no losers in EM.”

CURRENCY CONUNDRUM

An emerging currency index has fallen 3.5% to an 18 month low this year due to dollar appreciation. However, that doesn’t account for larger losses of 9%-15% on currencies like the zloty in Poland and the pound sterling. In April losses also increased, which coincided with the downturn in the Yuan.

The flexibility of exchange rates helps to protect developing countries from repeat crises in the 1990s.

The surge in U.S. Treasury yields and U.S. currency first caused Mexico’s 1994 Tequila Crisis. It then sent shockwaves throughout Asia, Russia, Brazil and the world as all dollar pegs crashed one-by-one.

A stronger dollar means more import inflation, particularly considering the 30%-40% increase in oil and food prices. The recent outflows of heavy investments from emerging markets may have been triggered by currency declines.

The glimmer is starting to fade from Latin America’s shining spot, commodity-exporting Latin America. Copper-dependent Chile’s peso grew 8% during the first quarter and has fallen 10% over the past three months.

GROWING PAINS

In order to contain inflation and maintain a sufficiently high inflation-adjusted bond yield, the central banks of developing countries have raised interest rates cumulatively by hundreds.

According to the World Bank, this means that emerging economies will expand by 4.6% in 2015, as opposed to 6.3% earlier.

The dollar’s strength may also slow growth, as it can tighten financial conditions. This is a measure of credit availability and how difficult it is to access it. A Goldman Sachs emerging market financial conditions index (NYSE:), is close to the tightest since 2008. It has increased by 300 bps.

DEBT DEMISE

Rising Treasury yields mean higher capital costs globally. They are particularly painful for those countries that have absorbed a lot of dollars.

JPMorgan’s emerging sovereign bond index EMBIGD yields has risen to more than 7%

Investors fear that the combination of higher debt costs and economic mismanagement has pushed Sri Lanka into a full-blown crisis.

Many emerging market governments and businesses are being discouraged from accessing international bond markets by higher borrowing rates. It is a popular month for bond issuance. However, April 2015 was a quiet year with just $6.9 Billion in sales.

Trang Nguyen at JPMorgan, emerging markets strategist, predicted that bonds sales will pick up. However, this may come at a more expensive price as some countries will need to close their financing gap.

INFLATION STATIONS

Inflation accelerates when the dollar is strong and weakens in domestic currency.

Although emerging markets have started tightening cycles before their developed counterparts, inflation has always exceeded our expectations.

The rates are staggering: In Argentina, the annual rate of inflation is over 50% and in Turkey it’s at 70%. Double-digit inflation is even occurring in wealthier emerging countries such as Hungary.

International Monetary Fund projects that inflation in emerging markets will average 8.7%, which is 2.8 percentage points more than was predicted in January.

Turkey, Egypt and Ghana are some of the countries that could be at greatest risk. This is due to high hard-currency foreign debts, large current account deficits, heavy reliance upon food imports and heavy dependency on energy and other imported goods.

UBS’ Narain stated that commodity prices were a critical axis for vulnerability. “If we see an increase in oil and food, then we might see more casualties.”