Since US President Donald Trump announced his “reciprocal” tariffs on April 2, the sharp rise in treasury yields, coupled with a weakening dollar, has prompted a broad re-evaluation of global assets. Some investors have turned to emerging market assets to hedge against financial volatility, diversify their portfolios and boost returns.

Emerging market assets’ growing appeal also partly reflects the economic recovery of countries like Argentina and Mexico. But investors should beware: emerging economies can be uniquely vulnerable to escalating trade tensions and a depreciating dollar in at least three ways.

First, the spike in US treasury yields has raised the cost of issuing dollar-denominated debt for emerging market governments, especially those seeking to issue new bonds or refinance existing obligations – now at significantly higher interest rates.

This trend persists despite narrowing emerging market bond spreads. Since late March, the yield difference between emerging market bonds and 10-year US treasuries has fallen from roughly 219 basis points to around 175. But the sharp increase in treasury yields has more than offset the benefits of tighter spreads, resulting in a net increase in borrowing costs for many developing economies.

These rising costs are especially concerning, given that emerging market sovereign debt has ballooned to more than US$1 trillion in recent years. While emerging economies typically issue less dollar-denominated debt than their developed-country counterparts, the emerging market debt asset class now accounts for roughly 11% of the global bond market.

A key structural shift may help mitigate this risk. Despite the rapid expansion of emerging market assets over the past two decades, a growing share of sovereign debt is now issued in local currencies. Major economies like Brazil, China and India have successfully issued government bonds in their national currencies, reducing their dependence on dollar-denominated financing.

In addition to insulating emerging markets from shifts in US monetary policy, this trend could limit the risk of widespread debt defaults and financial contagion – key drivers of systemic shocks in the 1980s and 1990s, including the 1997 Asian financial crisis to the sovereign-debt crises in Mexico and Russia.

That said, localized risks persist. For example, Turkey’s external debt rose to a record US$525.8 billion in September 2024, up from US$512.8 billion in the previous quarter and more than 25% higher than in mid-2020.

To be sure, a weaker dollar can also benefit emerging markets by reducing the local currency cost of outstanding dollar-denominated debt. But this is offset by higher US interest rates, which increase borrowing costs on any new debt.

Whether these developments are ultimately good or bad depends on several factors: the size and maturity of outstanding legacy dollar debt, the dollar’s value, interest rate changes, and the need to find a balance between issuing new debt in dollars and in local currencies.

Trump’s tariff hikes will also likely weigh on global trade, the second source of vulnerability for emerging market economies. Tariffs act as a tax on tradable goods and services, raising costs and suppressing demand. With American consumers facing higher prices due to tariffs, shrinking demand will erode the revenues of major emerging-market exporters, particularly those dependent on dollar-priced commodities. These losses could be compounded by exchange rate fluctuations when revenues are converted back into local currencies.

Nigeria is a prime example. In 2023, the country’s total export revenues reached US$63.1 billion, driven by crude oil, petroleum gas, gold, nitrogenous fertilizers and cocoa beans. Since the United States is one of Nigeria’s top export destinations, the naira’s 3% appreciation against the dollar since mid-May could reduce the local currency value of its dollar-denominated earnings.

It is reasonable to expect that the scope of US tariffs on a country will reflect the strategic importance of its exports to American interests. Therefore, countries exporting non-strategic goods may be more vulnerable, while those providing critical inputs that the US cannot easily obtain elsewhere, such as rare earth minerals from China, are likely to face fewer restrictions.

Lastly, the dollar’s recent decline has eroded the value of reserves held by foreign central banks. While a weaker dollar means that emerging-market economies now need less domestic currency to purchase dollar-priced goods and services, the declining value of dollar-denominated reserves and assets poses serious risks. China, for example, holds nearly US$3.4 trillion in non-gold foreign reserves, while India’s total is US$600 billion and Brazil has US$327 billion.

Notably, the dollar’s share of central banks’ foreign exchange reserves has declined from more than 70% in 2000 to below 60% today. Consequently, the impact of US interest rate shifts and currency fluctuations on individual economies ultimately depends on their exposure to dollar-denominated assets and how opposing forces, like rising borrowing costs and falling import prices, interact.

These risks can and must be actively managed. Still, the combination of rising treasury yields, higher financing costs, tariff-related revenue losses, and a weakening dollar could spell trouble for many emerging economies.

Emerging market debt has underperformed over the past 15 years, largely owing to the dollar’s strength. For a long time, low treasury yields enabled emerging economies to borrow in dollars at attractive interest rates. But rising yields, lower US imports and a declining dollar signal the end of an era.

Dambisa Moyo is an international economist.

Copyright: Project Syndicate