Latest / The Emerging Markets Podcast with Fexingo: Developing Economies, Growth, and Investment / How the Strong Dollar Is Reshaping Emerging Market Debt
Transcript
- Lucas: The trade-weighted US dollar index just hit 119.3 — that's its highest level in over two decades. And for anyone tracking emerging markets, that number is a lot more than a currency statistic. Luna: Because a stronger dollar directly raises the cost of servicing debt for countries that borrowed in dollars. And a lot of EM governments did exactly that. Lucas: Exactly. The classic concept is what economists call 'original sin' — the inability of many developing countries to borrow in their own currency on international markets. So they issue bonds denominated in dollars, euros, yen. And when the dollar strengthens, their debt burden swells in local-currency terms. Luna: We're seeing this play out in real time. Egypt, Pakistan, Kenya — all of them have seen their debt service costs jump over the past year. And it's not just a problem for the most distressed names. Lucas: Right. Even relatively stable emerging markets like Indonesia and Mexico are feeling the squeeze. Indonesia's rupiah has weakened about 6 percent against the dollar this year. That means the interest payments on its dollar bonds now eat up a bigger share of government revenue. The IMF has been warning about this for months. Luna: And the timing is tricky because many of these countries were already dealing with higher inflation and slower growth. The dollar strength just compounds the pressure. Lucas: Let's look at the numbers. The EM bond ETF, ticker symbol e m b, has lost about 4 percent year-to-date. But that masks a bigger divergence: local-currency debt ETFs have actually held up better, while hard-currency sovereign debt ETFs have taken a bigger hit. Investors are repricing risk. Luna: So the message is: if you're a bond investor in emerging markets, currency exposure matters as much as credit quality. Lucas: Absolutely. And this is where the conversation gets interesting. Some economists argue that the era of 'original sin' is slowly ending — more countries are now able to issue local-currency debt to international investors. India and Brazil have made progress. But the shift is slow, and for now, most EM sovereign debt is still dollar-denominated. Luna: What about the role of the Fed? If the Fed starts cutting rates later this year, does that ease the pressure? Lucas: It helps, but it's not a cure. A rate cut would likely weaken the dollar somewhat, which would relieve some of the debt service burden. But the structural issue remains: these countries need to develop deeper local capital markets. Until they do, they're vulnerable to dollar swings regardless of what the Fed does. Luna: There's also a political dimension. When debt payments spike, governments have less fiscal space for infrastructure, health, education. That can fuel social unrest. Lucas: We saw that in Sri Lanka in 2022, and we're seeing early warning signs in parts of sub-Saharan Africa now. Kenya, for example, had to introduce new taxes last year to meet IMF targets, which triggered protests. The dollar isn't the only factor, but it's a major amplifier. Luna: So for investors, what's the play? Avoid dollar-denominated EM bonds entirely? Lucas: Not necessarily. But the playbook has changed. You can't just buy EM debt for yield anymore without thinking about currency hedging. Some funds now explicitly hedge dollar exposure back into local currencies. Others focus on countries with stronger external balances — like Peru or Uruguay — that are less reliant on foreign-currency borrowing. Luna: And what about the IMF? They've been stepping up lending programs, but those come with conditions. Lucas: The IMF has approved more than $60 billion in new programs for EM countries since the start of 2025. Egypt alone got a $12 billion package. But those programs require fiscal consolidation — cutting subsidies, raising taxes — which is politically painful. The question is whether the adjustment is enough to restore market confidence. Luna: It's a tough cycle. The stronger the dollar gets, the more countries need IMF help. And the more they need IMF help, the more their bonds get downgraded by ratings agencies. Lucas: That's the vicious circle. And it's why this topic matters beyond just bond traders. The dollar's strength influences the cost of capital for entire economies. It affects everything from the price of imported goods in Nairobi to the viability of solar projects in Vietnam. Luna: Speaking of which, we've talked a lot about the risks. Any silver lining? Lucas: There is one. The dollar strength is forcing a long-overdue reckoning. Countries that manage to issue local-currency debt and build deeper domestic bond markets will come out stronger. Brazil's real-denominated bonds now attract significant foreign demand. India's government bond market is being included in global indices. The trend, while slow, is real. Luna: So the pain today might drive better policy tomorrow. Lucas: That's the hope. But in the meantime, the dollar index at 119.3 is a number every EM investor — and every EM policymaker — is watching very closely. Luna: If walking through the economy with us has made something click, we'd love your support. It's what keeps this show ad-free and independent. Lucas: Yeah, listener support really makes a difference. If you find yourself using our episodes to understand markets or just to start a conversation, you can help us keep doing that. Luna: It's easy — just head to buy me a coffee dot com slash fexingo. That's all one word, fexingo. Lucas: And we really appreciate it. So, back to the dollar story — one thing I want to flag is that the dollar's strength isn't uniform across EM. Some currencies have actually held up okay. Luna: Like which ones? Lucas: The Mexican peso and the Indian rupee have been relatively resilient, thanks to strong domestic demand and foreign investment. But currencies in Turkey, Argentina, and Nigeria have been hammered. That divergence creates interesting relative value plays for currency investors. Luna: So the old EM trade — just buy the whole basket — doesn't work anymore. You really need to be selective. Lucas: Exactly. And that's where the opportunity lies. The countries that are implementing reforms, building reserves, and diversifying their debt markets are likely to outperform. The ones that aren't will continue to struggle. Luna: It's almost like a stress test for emerging market policy. Lucas: Right. And the results are coming in. This is not a short-term phenomenon — the structural shift in global capital flows will take years to play out. But for now, the dollar at 119.3 is a signal that the old rules no longer apply.