By Jamie McGeever

Challenges for Emerging Economies

ORLANDO, Florida (Reuters) – A strong U.S. dollar and high Treasury yields are creating significant challenges for emerging economies, leaving policymakers with few options to counter this powerful one-two punch.

American exceptionalism overshadows other nations, causing many emerging markets (EM) to experience:
– Weaker currencies,
– Increased costs for servicing dollar-denominated debt,
– Depressed capital flows or capital flight,
– Diminished local asset prices,
– Slower growth.

The uncertainty surrounding the incoming U.S. government's proposed tariff and trade policies adds to these challenges.

Historical Context

Historically, when such trends grip emerging markets, they can form vicious cycles that accelerate rapidly and are challenging to break. Unfortunately, no simple roadmap exists to navigate these issues.

Divergent Paths: China and Brazil

Take China and Brazil as examples of differing strategies:
– China is easing monetary and fiscal policy to stimulate its economy.
– Brazil is committing to significantly higher interest rates while trying to stabilize its fiscal situation.

Despite their contrasting approaches, both nations share stagnant growth and weakening currencies. Brazil's real is at an all-time low, while the yuan hovers near 17-year troughs.

Potential Risks of Yuan Depreciation

China is considering allowing the yuan to weaken against rising U.S. tariffs, with analysts predicting it could fall to 8.00 per dollar. However, a depreciating yuan risks exacerbating capital outflows and igniting competitive devaluations across Asia.

With capital flows projected to decline by 24% next year, from $944 billion to $716 billion, the Institute of International Finance emphasizes significant downside risks remain.

Tightening Financial Conditions

Emerging markets face rising U.S. bond yields as financial conditions tighten. Total emerging market debt nears $30 trillion, about 28% of the global bond market. Increasing borrowing costs directly affect these economies, resulting in the tightest financial conditions in five months.

Real interest rates are significantly higher now than during Trump's initial presidency. However, many countries may struggle to lower rates without destabilizing their currencies.

On a positive note, EM countries possess substantial foreign exchange reserves, particularly China, which holds $3.3 trillion of the world’s $12.3 trillion in reserves. Policymakers may soon need to rely on these reserves to navigate the challenging landscape.

(The opinions expressed here are those of the author, a columnist for Reuters.)