By Steven C. Johnson and Julie Haviv
NEW YORK (Reuters) - Investors bracing for the U.S. Federal Reserve to wind down its monetary stimulus have fled emerging markets in recent months, and while the impact of slow capital flows is likely to be felt for some time, some countries will fare much better than others.
The U.S. central bank is expected to begin trimming its massive $85 billion bond-buying program as early as next week. That will mean fewer Fed-created dollars sloshing around the global financial system.
Markets like Brazil and India, which must import capital to finance spending, will feel the squeeze. Mexico and South Korea, to name two, are less dependent and won't get hit as hard.
As a consequence investors hungry for the higher yields offered by emerging market stocks and bonds can no longer sink their money in the developing world indiscriminately, experts say. They will have to become much more selective.
For years, "many emerging markets have just had to sit back and watch the capital flow in. They haven't had to try very hard to attract it," said Morgan Stanley strategist James Lord. "Now they're going to have to work harder. That means reforms."
The MSCI Emerging Market Index fell some 12 percent between May and September. That was the worst four-month stretch in more than a year for the stock index, which did regain some ground in recent sessions. All told, investors have yanked $3.3 billion out of emerging bond funds since late May, according to Lipper, a Thomson Reuters company.
So far the pain has been most acute in places such as India, Turkey and Brazil. Those countries and others are also struggling with rising inflation and sluggish growth.
Other markets, while not untouched, have suffered less.
The Mexican peso and South Korean won have weakened about 2 percent each against the dollar this year, compared with 11 percent for Brazil's real and 18 percent for India's rupee.
Likewise, central banks in Indonesia, Turkey, Ukraine and India have seen the fastest erosion of foreign currency reserves since late May, according to Morgan Stanley calculations.
"When the hot money is gone, the tide will retreat and we will see who is naked on the beach," said Anjun Zhou, who helps manage $33 billion as head of asset allocation research at Mellon Capital Management.
"With less liquidity we will be more cognizant of which countries we pick, focusing more on their growth potential," she said, adding she favors Mexico, Russia and South Korea and is avoiding India and Brazil.
Ray Dalio, chairman and chief investment officer at Bridgewater Associates, one of the world's largest hedge funds, warned investors last week against wading into emerging markets in the near future. He said the sharp reduction in capital flows to countries such as India may lead to a crisis.
That's not to say investors will turn their backs on the developing world. While few emerging markets are growing at double-digit rates these days, they are still sure to outpace advanced markets for years to come. Some argue that most emerging countries are better prepared to weather the storm than they were during the emerging market crisis of 1997.
The International Monetary Fund still expects emerging market growth of 5 percent this year, about four times quicker than advanced economies, and 5.4 percent next year.
More flexible exchange rates and a larger stash of currency reserves - about $7.5 trillion as of March compared with about $600 billion in 1997 - also provides a cushion. Deficits and foreign currency debt, while worrisome, are not as large.
"The reality is things are going to be more challenging" for a lot of countries," added Andres Calderon, who helps oversee $4.4 billion in assets at Hansberger Global Investments. "But I would be very surprised if this turns into another crisis."
That said, simply muddling through by spending reserves and raising interest rates to prop up currencies won't be enough in the long run, especially for countries that need affordable access to foreign capital to service their deficits.
"These are temporary measures that can buy time," Lord said. "They're not a sustainable way of rebalancing the economy."
A better approach, investors said, is to get serious about long-term structural reforms.
Calderon said Brazil should focus on a more flexible labor market and major infrastructure reforms to attract foreign and local private capital.
Sean Lynch, global investment strategist at Wells Fargo Private Bank, said India could start helping itself by easing restrictions on foreign corporate ownership, a move that would attract stabilizing foreign direct investment.
Many investors urge policymakers to imitate Mexico, where the government has committed to sweeping reforms of the state-dominated energy sector, education and telecommunications.
While Mexico's IPC stock index <.MXX> has lost 6 percent this year, indexes are down by double digits in Brazil and Turkey, both current account deficit countries.
Still, it took a multi-year slump in the United States, Mexico's most important trading partner, to force action.
"Mexico felt a lot more pressure to tackle structural reform, and that put them ahead of the curve," said Calderon. "But I don't think they stand out as being uniquely enlightened. They just faced the pressure earlier."
Even so, it's all paying dividends now.
In Asia, capital is shifting from south to north, toward countries like China, South Korea and Taiwan, which could see trade gains as U.S. growth rebounds. Meanwhile commodity producers such as Indonesia and Malaysia have seen their finances worsen as metals prices have eased.
Peter Kohli, president of DMS Funds, said he launched two U.S.-listed mutual funds this year focused on Poland and the Baltic states - new European Union members with healthy finances and a commitment to reform.
"These markets are looking a lot more attractive," he said. "These countries seem to have their act together."
"A lot of countries have talked about reform but haven't delivered much," said Wells Fargo's Lynch, who helps oversees $170 billion in assets. "But I think the longer we see weakness in emerging markets, the more they will be forced to make meaningful reforms."
(Additional reporting by Carolyn Cohn and Sujata-Rao Coverley in London; Editing by Frank McGurty and David Gregorio)