London: A sell-off precipitated by global recession fears and the deepening euro zone debt crisis has resurrected the spectre of capital flight, a threat that still haunts emerging markets for all their vaunted strengths.

Three years after the collapse of Wall Street giant Lehman Bros sparked a stampede out of higher risk assets and sent emerging economies reliant on foreign funding into shock, such fears have resurfaced in recent days amid heavy emerging equity and bond losses accompanied by sharp currency weakness.

Persistent hopes that developing economies can defy a Western downturn are set to be dashed the second time in four years, once again threatening to wrong foot investors who have bet big on the resilience of these markets.

“The process has just begun as real money investors haven’t yet exited....All the ingredients are in place for a similar crisis to occur. The question is what magnitude," said Benoit Anne, head global emerging markets strategy at Societe Generale.

Since 1 Aug, emerging stocks have tumbled 22% to underperform world markets, down 15%. Sovereign hard-currency bonds are at their weakest in over two years while local-currency debt year-to-date returns have turned negative in dollar terms.

Evoking memories of 2008 when investors offloaded emerging assets for more liquid securities such as US Treasuries, this latest wave of foreign-led selling has been especially punishing on recent market darlings Indonesia, South Korea and Russia.

In the last seven weeks, the Korean won has skidded 12% lower while Russia’s rouble has dropped 13% versus its dollar-euro basket . Brazil has lost 14% of its value against the dollar this month, chalking up its biggest one-day falls since October 2008.

This sudden exchange-rate weakness has unnerved investors, who have until now regarded currency appreciation as an added sweetener to returns generated by emerging stock and bond bets.

Record allocations to emerging debt in the last 21 months have mostly been unhedged as investors confident of currency appreciation shorted the dollar and euro to buy bonds in rand or reais. But the latest flight to the dollar has shattered the assumption that emerging-currency appreciation would be steady.

“It’s become expensive to hedge currency exposure now and many investors are exiting unhedged local-currency positions, just as they had exited equity positions weeks earlier," said Murat Toprak, emerging markets strategist at HSBC.

Not-so-safe havens?

Overall positioning in emerging assets is still heavy, suggesting prices may still have further to fall. Bank of America-Merrill Lynch’s latest survey found a third of investors remain overweight emerging stocks this month.

“Institutional investors are keeping emerging markets as their last overweight but if they see more redemptions, they will be forced to sell to raise additional cash," said BA-ML global equities strategist Kate Moore.

Jitters are also growing over emerging debt, among the few asset classes along with gold and US Treasuries that data from funds tracker EPFR shows attracting new money in the febrile markets of recent months.

“My sense is that the real money is still quite complacent about positioning. People are not well prepared for a huge cash outflow from emerging markets. So far we’ve only seen a speculative position washout," said Kieran Curtis, a debt portfolio manager at Aviva Investors.

Much of the new cash since the Lehman crash comes from so-called crossover investors such as pension funds who are only just beginning to venture into emerging markets - their tolerance for volatility in these markets remains untested.

JPMorgan notes that the Brazilian real has been a major beneficiary of inflows from dedicated overlay funds sold to Japanese retail investors since 2009 and there is “significant uncertainty" how they will react to further market turbulence.

Foreign ownership of some local bond markets are at all-time highs, raising their sensitivity to global risk appetite.

“In some markets - Indonesia, Hungary, Malaysia and Mexico, for instance - foreign investor exposure has grown disproportionately quickly to the size of the market.

Duration in these markets is thus most at risk from an unwind of global real money flows," UBS said in a note.

Quicker recovery?

But many argue that the longer term structural shift of portfolio allocations in favour of emerging markets will moderate the magnitude of the current selldown.

“When it comes to portfolio money, you have pension funds looking at 2% returns on US 10-year debt and no great likelihood of great equity performance," said Charles Robertson, global chief economist at Renaissance Capital.

Emerging local bonds offer yields of 5-12 %.

Given the rude health of their public finances, these markets could rebound quickly when the global backdrop improves as evident following the Lehman bust. Net capital flows to emerging markets, for instance, jumped from $715 billion in 2009 to $1.1 trillion in 2010, data from the Institute of International Finance (IIF) show.

“If recovery is quicker and stronger, you don’t want to sell out everything," said Renaissance’s Robertson.

Since 2007, developing economies have cut external debt issuance by a third, IIF said. In the private sector, the stock of external debt owned by foreign private creditors has fallen 26% in the last three years.

Lower reliance on foreign cash may prevent a repeat of 2008 when capital flight sent countries such as Ukraine and Romania to the IMF for emergency loans and necessitated recapitalization of Russian and Kazakh banks.

But that may not be enough to stem near-term fears stalking the markets.

“My problem is not with the fundamentals but the fact that a lot of emerging assets are in the hands of people who will panic," said Alia Yousuf, portfolio manager at ACPI Investment.

“Are we really at the stage when people would rather hold Kazakhstan than the US? I don’t think so."