Over the past year the real trade-weighted dollar index has appreciated 6.88% because of a combination of interest rate differentials, strong growth and expectations of reduced regulation, lower taxes and increased government spending.
The dollar’s rise will cause challenges around the world, with those in emerging markets facing greater adjustment problems.
With these trends showing no sign of easing, the greenback will most likely continue to appreciate against the major trading currencies.
This rise in the dollar will cause economic challenges around the world, with those in the emerging markets likely to face greater adjustment problems as they face a rising cost of external debt paid in dollars.
With the Mexican peso having declined by 16% over the past year and the Brazilian real down by 20%, it does not take much of an imagination to estimate where problems will arise if the dollar were to overshoot reasonable valuations.
The J.P. Morgan Emerging Market Currency Index fell by 9% in 2024, losing 5% since September in this latest rush of dollar strength. We see three areas of concern that would further weaken the currencies of emerging markets and add to the dollar’s strength: policy decisions, disruptions to trade and the global debt crisis.
Mexico, Brazil and South Africa offer examples of market responses to those concerns.
Mexico
The markets have expressed concerns regarding Mexico’s political and regulatory risks.
The peso peaked in April before Mexico’s election in June. The newly elected president, Claudia Sheinbaum, is thought likely to extend the policies of her predecessor regarding regulation, wages and judicial reform. Since April, the peso has declined by about 23%.
Against this background is the threat of dismantling of the United States-Mexico-Canada Agreement, which would disrupt Mexico’s trade with the United States, its largest trading partner, and cause economic harm throughout the trading bloc.
Brazil
The market’s reaction to Brazil’s announcement of spending measures and tax reform was to weaken its currency further, pushing the real above 6.0 per dollar for the first time. Brazil’s fiscal framework has long been a concern, and the market’s reaction suggests another insufficient response to a significant problem.
South Africa
South Africa’s rand is having what looks to be a brief uptrend after decades of losing value.
The election in May ended the majority rule of the African National Congress (ANC), once led by Nelson Mandela, and began the broad coalition rule of the Government of National Unity (GNU), of which the ANC is a member.
The market’s response to the election was a nearly 10% increase in the rand’s value from June to late September, before giving back 4% of those gains by mid-December.
S&P Global Outlook holds a positive outlook for South Africa, maintaining its BB-/B foreign currency and BB/B local currency long- and short-term sovereign bond ratings.
The S&P outlook points to increased political stability and the impetus for reform that could boost private investment and growth.
Read more of RSM’s insights on the global economy and the middle market.
The outlook also finds that the broad coalition of 11 political parties under the GNU is leading to improved debt yields and portfolio inflows, easing financing conditions and strengthening the currency.
Other observers find that while the international outlook for South Africa might have been positive, the domestic situation is anything but.
The International Monetary Fund expects real GDP to expand from 1.1% growth in 2024 to 1.7% in 2025. Yet strikes, a 33% rate of unemployment and the lack of a comprehensive policy from the GNU all suggest a different picture.
China
Finally, the global economy is about to witness the outcome of China’s domestic debt crisis, which is likely to include allowing the yuan to devalue, further strengthening the dollar. This is the time for the emerging markets to address their fiscal imbalances.
The state of play
Following the shocks of the past five years, we would expect drastic changes in asset and commodity prices, as well as a shake-up of the global supply chain.
As early as 2022, Reuters pointed to rising borrowing costs, inflation, and debt, and listed the countries it considered at risk of default.
That list included Argentina, Belarus, Ecuador, El Salvador, Ethiopia, Ghana, Kenya, Nigeria, Pakistan and Tunisia.
As the U.S. dollar has strengthened and the costs of food and energy, all priced in dollars, have surged, emerging economies have faced significant costs.
The value of the dollar has been bolstered by increased transaction demand for goods traded in dollar terms as well as portfolio demand for the higher rates of return on U.S. financial assets.
As measured by the DXY—the U.S. dollar index—the dollar has increased by 17.2% against developed economies since the pandemic. The euro, by contrast, has lost 13.3% of its value.
Japan, which is entirely dependent on imports for its oil, has had a currency loss of 30.9%, which pushed its inflation rate as high as 4% after decades of deflation.
To be sure, the advanced economies are unlikely to collapse; they have the wherewithal and resources to rethink their economic situations.
But emerging economies, which are saddled with higher commodity costs and the increased cost of credit, are more likely to fail a stress test.
If another shock were to occur, the stress will come from having to draw from insufficient holdings of foreign exchange reserves to pay for imports and for debt issued in U.S. dollar terms.
We have limited our trade and debt analysis to the 32 emerging economies identified as having issued external debt.
Currency losses and rising commodity costs
While a strong dollar makes exports of emerging-market resources more attractive, these countries remain dependent on imports of oil, food and foreign investment, all priced in dollar terms.
Oil prices increased by 41% from the end of 2020 to December 2024, while the CRB Foodstuffs index increased by 46%. Those prices were compounded by currency losses among the emerging economies.
There are few exceptions to the currency losses. Georgia is an oil producer. Bolivia, El Salvador and Ecuador have pegged their currencies to the dollar, which comes at the cost of making their exports expensive for other trading partners.
And then there is Costa Rica, whose currency strength, according to one observer, can be attributed to central bank intervention and the flow of funds into the country for laundering purposes.
External debt obligations
Most emerging markets have yet to develop domestic bond markets adequate to finance their growth. This has resulted in emerging-market economies issuing debt payable in a foreign currency, known as external debt.
The World Bank Group publishes the external debt positions of 36 economies, including the developed economies of the U.S., Switzerland, Germany, and New Zealand, and 32 emerging and developing markets.
Three of the larger emerging-market economies—Turkiye, India and Mexico—are responsible for 30% of the external debt obligations issued by all emerging-market economies.
We expect India, which has become a center of economic growth, to ride out further shocks. We can say the same for New Zealand and the scattering of European Union members that could seek protection from their member states. Mexico faces the prospect of tariffs and friction with the United States over immigration.
That leaves the smaller emerging nations vulnerable to disruptions to global trade or to an attack on their currency or a devaluation.
Import obligations
Products are imported either by choice or by necessity. While the U.S. is by far the world’s biggest importer, it is self-sufficient in most respects. It is dependent on goods from emerging economies, which in turn rely on U.S. financial markets and U.S. households that buy those goods.
For lower-income households in emerging markets, imports of energy and other commodities are a necessity.
For that reason, the monetary authorities of emerging markets would be expected to hold enough foreign exchange reserves to meet monthly obligations of imports.
These reserves are an insurance policy in the event of an economic collapse or a currency devaluation.
Dividing the amount of reserves by the monthly cost of imports gives the number of months that a country could maintain the cost of imports should a calamity occur.
So Switzerland has enough foreign exchange reserves to pay for imports for 25.9 months. Reserves held by the Slovak Republic, by contrast, are enough to pay for less than one month of imports.
Mitigating factors
Certain trends could ease these threats to emerging economies.
One is the development of trade agreements among neighboring countries, and the development of local bond markets among members of the Association of Southeast Asian Nations. This group includes Brunei Darussalam, Cambodia, Indonesia, Lao People’s Democratic Republic, Malaysia, Myanmar, the Philippines, Singapore, Thailand and Vietnam.
A robust bond market should reduce dependence on bond markets in the U.S., Japan and Europe, which would reduce currency risk.
The second trend is the stabilization of interest rates among the emerging markets. Yield spreads between emerging markets and the U.S. bond market since the financial crisis of 2008−09 have averaged 350 basis points, with the exception of the flight to safety during the pandemic.
The Emerging Market Bond Index spread fell to 300 basis points in recent months, helped along by the increase in U.S. yields in anticipation of monetary easing and increased U.S. economic activity, which should benefit exports from emerging markets.
The takeaway
Emerging economies have moved away from an overreliance on dollar-denominated debt, and the emergence of local debt markets has created conditions for a less volatile global economy.
Reliance on dollar-denominated debt was a good idea when U.S. interest rates were near zero and exchange rates were more stable.
Issuers need to consider the effect of currency changes on debt repayment even under the improved conditions of recent years.
But the appreciation of the dollar will create challenges for countries that lack adequate currency reserves or have weak financial systems.
