Latest / The Emerging Markets Podcast with Fexingo: Developing Economies, Growth, and Investment / How the Strong Dollar Is Squeezing Emerging Market Debt
Transcript
- Lucas: The U.S. dollar is trading at 120.5 on the trade-weighted index as of last Friday. That's not a record, but it's in the top percentile of the last twenty years. And for a lot of emerging markets, that number is the single most important number in the room right now. Luna: Because so much of their debt is denominated in dollars. If the dollar gets stronger, their debt gets heavier. Lucas: Exactly. It's a classic squeeze. Let's say Indonesia issued a ten-year bond in dollars at a 5 percent coupon. If the rupiah weakens against the dollar by ten percent, the effective cost of servicing that bond just went up by ten percent overnight, even if the coupon hasn't changed. And we're seeing that play out across emerging markets right now. Luna: The numbers are stark. The U.S. trade deficit widened to $77.6 billion in May, down from $54.6 billion the previous month. That's a huge swing. It suggests imports are surging, which usually means the dollar is strong because the U.S. is buying more. Lucas: And when the dollar strengthens, capital tends to flow back into U.S. assets. That puts pressure on emerging market currencies, which makes their dollar-denominated debt even more expensive. The IMF has warned about this repeatedly. But the data is catching up with the warning. Luna: Right. And the response from emerging market central banks has been interesting. Some are hiking rates to defend their currencies. Others are selling U.S. Treasuries from their reserves to prop up their own currency. Lucas: We did an episode on that a few weeks ago — episode 128, central banks dumping Treasuries. But the bigger story is that this is a systemic risk. The Bank for International Settlements estimates that emerging markets have about $4 trillion in dollar-denominated debt outstanding. That's bonds, loans, trade credit. And a 10 percent appreciation of the dollar adds about $400 billion to the effective debt burden. Luna: That's not a rounding error. And it's not just countries. It's companies. A lot of corporate borrowers in emerging markets borrowed in dollars because it was cheaper. Now they're getting squeezed from two sides: higher interest rates globally and a stronger dollar. Lucas: Look at Brazil. The EWZ ETF is up 3.7 percent over the past five days, which on the surface seems like good news. But that's partly because investors are betting that the central bank will cut rates soon to stimulate growth. The real problem is that Brazil's dollar-denominated corporate bonds have been under pressure. A stronger dollar makes it harder for Brazilian exporters to compete, even as commodity prices remain elevated. Luna: Yet the market is pricing in a recovery. The iShares MSCI Emerging Markets ETF, EEM, is up 1.2 percent over five days. So investors seem to be looking past the dollar headwind. Lucas: I think they're betting on two things: first, that the dollar rally has peaked, and second, that emerging market central banks have learned from past crises. The taper tantrum of 2013 taught them to build bigger reserves and extend debt maturities. But that doesn't mean they're immune. Luna: What about China? The yuan is at 6.78 per dollar, basically flat. That's relatively stable. But if the dollar keeps strengthening, China might let the yuan depreciate to protect exports. That would trigger a wave of competitive devaluations across Asia. Lucas: That's the nightmare scenario for emerging markets. A weaker yuan hurts other Asian exporters because they lose competitiveness. It's a race to the bottom. And it would also make dollar debt even heavier for countries that peg their currencies to the dollar, like Hong Kong, or those that manage their currencies closely, like Vietnam. Luna: The trade-weighted dollar index has been above 120 for most of 2025 and now 2026. That's a long time for emerging markets to live with a strong dollar. Normally, these cycles last 12 to 18 months before the dollar peaks. Lucas: Right. And the question is whether the Fed will cut rates later this year. If they do, the dollar weakens, and emerging markets get some relief. If they don't, because inflation stays sticky, then the squeeze continues. The latest data shows the U.S. current account deficit widened to $226.8 billion in the first quarter, which suggests the dollar might be overvalued. But the market tends to ignore that until something breaks. Luna: Something like a default. We haven't seen a major emerging market default yet in this cycle, but there are a few vulnerable spots. Ghana defaulted in 2022. Zambia restructured. Sri Lanka. The next candidate could be Kenya or Pakistan. Lucas: Kenya's dollar bonds are trading at distressed levels. And Pakistan's reserves cover less than two months of imports. These are the places where a strong dollar becomes a humanitarian issue, not just a financial one. Luna: Talking about the real economy, that's why we do this show. I know it's a cliche, but walking through the economy with someone who can explain it clearly does make a difference. And we deliberately don't run ads on these episodes. If that choice resonates with you, the link to support it is buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing, but it keeps us independent. We don't have to tailor the content for sponsors. So if you've gotten value from episodes like this one, consider throwing a few dollars in the virtual jar. No pressure. Luna: Totally. Alright, back to the dollar. One thing I want to flag is that not all emerging markets are equally vulnerable. Those with large current account surpluses, like Saudi Arabia or Russia, actually benefit from a strong dollar because their oil revenues are priced in dollars. But the importers, the commodity consumers, they're the ones hurting. Lucas: India is a perfect example. India imports about 85 percent of its oil. A strong dollar makes oil more expensive in rupee terms, which widens the trade deficit and puts pressure on the rupee. The rupee has been hitting record lows against the dollar this year. That feeds into inflation, which forces the central bank to keep rates higher, which slows growth. It's a vicious cycle. Luna: And yet, India's stock market has been doing well. The iShares MSCI India ETF, INDA, is down only 1 percent over five days, so it's been resilient. But that's partly driven by domestic investors who are less sensitive to dollar movements. Lucas: Right. The divergence between the real economy and the stock market is something we see a lot in emerging markets. The stock market reflects expectations of future earnings, often in local currency. But the debt market reflects the dollar burden directly. So you can have a situation where equities are stable while the bond market is signaling distress. Luna: And that's exactly what we're seeing now. The spreads on emerging market dollar bonds have widened, but not to crisis levels. The JPMorgan Emerging Market Bond Index is yielding about 7.5 percent, which is elevated but not catastrophic. Lucas: That's the key question: is this a slow bleed or the precursor to a crisis? My view is that it's a slow bleed for now, but the risk of a sudden stop—where capital flows reverse sharply—is real. If the Fed surprises with a hawkish stance, or if there's a geopolitical shock, the dollar could spike further and trigger a wave of defaults. Luna: And we already have geopolitical shocks. The Houthis striking Saudi oil tankers this week pushed oil above $90, which adds another layer of cost for oil-importing emerging markets. Lucas: Exactly. So you've got a triple whammy: stronger dollar, higher oil prices, and still-elevated global interest rates. For a country like Turkey or Egypt, that's an incredibly difficult environment. Turkey's lira has lost about 30 percent of its value against the dollar over the past year. Inflation is running above 50 percent. The central bank has been hiking rates, but it's an uphill battle. Luna: And Egypt? They devalued the pound multiple times and signed a deal with the IMF, but the dollar shortage persists. The strong dollar doesn't help. Lucas: It's a reminder that the dollar's dominance is a double-edged sword for the global economy. It gives the U.S. the exorbitant privilege, as Valery Giscard d'Estaing called it, but it also exports monetary policy to the rest of the world. When the Fed tightens, emerging markets have to tighten too, regardless of their domestic conditions. Luna: So what's the one takeaway for someone trying to understand where this is heading? Lucas: I'd say watch the dollar index. If it breaks above 122, that's historically been the threshold where emerging market stress becomes acute. And watch the trade deficit. As long as the U.S. keeps running a large deficit, the dollar is being recycled into dollar-denominated assets abroad, which supports the system. But if the deficit starts to shrink because the U.S. slows down, then dollars become scarce, and the squeeze intensifies. Luna: So the paradox is that a strong dollar hurts emerging markets, but a sudden collapse in the dollar could also hurt them if it triggers a U.S. recession. Lucas: That's the tightrope they're walking. No easy answers, but knowing the numbers gives you a map. And that's all we can do here—provide the map.