Indisputably, a weakening dollar has worked to the advantage of emerging markets. Since March, global investors have regained their appetite for riskier assets such as equities and property, spurred into action by the extraordinary monetary and fiscal stimuli measures adopted by governments around the world. Nowhere has the enthusiasm been more visible than in Asia.

Bloomberg estimates that an unprecedented net $47 billion flooded into equities in India, Indonesia, the Philippines, South Korea, Taiwan and Thailand in the past three quarters.That eclipsed the previous full-year high of $33 billion in 2005, it reports.

Across Asia, stocks have gained an average 60 per cent since March.

There could be an interest rate differential between Asia and the US but that may not be the main motivating factor behind investment flowsJyoti Narasimhan, Research director, Country Intelligence Group – India

Yet all this excess money has been exerting inexorable pressure on the region’s currencies, most of which are maintained within a trading band. Right now, monetary authorities from India to Indonesia are working overtime to ensure currencies don’t rise too sharply against the dollar and hurt export prospects. The most common method has been to buy dollars and sell the local currency. But stronger measures are coming into effect: in early November, Taiwan banned foreign investors from putting money in time deposits, saying that what was currently invested – about $16 billion – was five times the acceptable level.

The effective peg of the Chinese yuan at 6.8 to the dollar since mid-2008 is making matters worse. Most of the region’s nations are heavily export-dependent but China’s currency remained relatively stable even as most regional currencies have risen by 10-15 per cent (the South Korean won and the Indonesian rupiah have appreciated more) this year.

Because Asian currencies have been unable to appreciate to the full extent warranted, many experts believe the burden so far for adjusting to the dollar’s depreciation has fallen squarely on the euro’s shoulders, she says. One euro was equivalent to $1.26 in March, now you need $1.49 to buy a euro. Yet a surging euro is the last thing the trade-oriented eurozone needs, which barely managed to limp out of recession with 0.4 growth in the third quarter. “Because it is a fully convertible currency, the euro’s adjustment to the dollar’s fall has been much more than what is warranted by the eurozone’s economic fundamentals,” says IHS Global Insight’s Narasimhan. “But it’s the Asian currencies that should be adjusting more.”

It’s a catch 22 situation for Asia: they could remove some of the local liquidity by raising interest rates, but that would only encourage foreign investors to pour in more money to take advantage of the interest rate differentials between Asia and the developed world. Unfortunately, as growth rebounds across the region, the choices for central bankers are getting limited. An economically buoyant Australia has already raised interest rates; South Korea and India are expected to go next.

Will that drive even more flows into already-flooded Asia? “It’s definitely possible that there could be an interest rate differential between Asia and the US but that may not be the main motivating factor behind investment flows,” says Narasimhan. “It also reflects increasing confidence in Asian economies vis-a-vis the US in the short term.”

Even as Asian monetary authorities struggle to soak up the liquidity deluge using reserve build-ups as sandbags, trouble is brewing on another front. Global investors have been using the dollar as the carry-trade currency to invest in emerging markets. A carry trade involves borrowing in a low interest-rate currency and investing in high-yielding assets. The yen used to be the preferred carry trade currency until 2008, but extremely low interest rates in the US (0-0.25 per cent) and plentiful liquidity have propelled the dollar forward as the carry trade favourite of 2009.

There will be a huge problem, if as most experts expect, the dollar starts to recover next year. It could spark a reversal of those carry trades and lead to a pull-out from emerging equities. But that’s far from certain, argue some experts. Economically, Asia is in a vastly better position than either the US or the eurozone. Unlike the developed world where debate still continues on whether countries will experience a U-shaped (very slow and steady growth) or a W-shaped (erratic growth which could fade after a few quarters before picking up again) recovery, there’s little argument on the alphabet used to describe Asia’s rebound - V (sharp and quick). With such superior growth prospects, it will be difficult for investors to say no to emerging markets, believe some economists. “I certainly expect some positive sentiment for the dollar next year but whether that takes away funds from emerging markets is difficult to predict,” says IDEAglobal’s Gunaratna. “I would think the emerging markets story is well entrenched. If there is a reversal of risk capital, it may be more at the expense of the eurozone, the UK and Japan.”

That’s a view endorsed by BBH’s Chandler: “Until a few years ago, many investors viewed emerging markets opportunistically. Now investors in the US, Japan and the eurozone are embracing emerging markets as a permanent part of their portfolios. With growth now rebounding in these regions, arguably, we may see emerging markets do well even if the dollar recovers.”

That also suggests a reversal of the current negative co-relation between the value of the dollar and equity gains (stocks have gained as the dollar has fallen). It’s possible, say experts. “That co-relation is very changeable,” points out IDEAglobal’s Gunaratna. “If rates are raised because signs of growth are becoming more visible in the US, markets will take that as a good sign and we can easily see the dollar and equities rise simultaneously.”

Not everyone agrees. Russell Napier, London-based consultant to CLSA and author of the 2005 book Anatomy of a Bear offers a more pessimistic view. “A strong dollar is bad in the short term for non-US equities,” he says. “Leveraged investors will be forced to liquidate primarily emerging market equities so they will not do well in this period.” But even he acknowledges that it may not necessarily be bad for US stocks. “If the rise in the dollar is due to credit growth and reflation in the US, then US equities and the dollar should rise simultaneously,” he adds.

For now, it’s wait and watch for Asia investors.