Sharp increases in US interest rates contribute to the rising foreign exchange value of the dollar, and implicitly spill over into EMDE borrowing costs. But the link between US interest rates and emerging markets is more nuanced and deserves special attention. Capital outflows, increased financial market volatility, elevated debt servicing costs, and imported inflation are only some of the challenges facing EMDEs.

Let’s examine what all this means and attempt to find the light at the end of this tunnel.

US dollar strength and debt

Over the past decade, EMDE corporations have accumulated about 90% of foreign-currency debt, mostly in US dollars. Against the current backdrop of geopolitical tensions and the Trump administration’s tariff tangoing, this has raised concerns within the expert community.

On a macro level, economists have raised the alarm about the possibility of intensifying debt pressures fueled by an increasingly stronger US dollar. These pressures are felt more in countries with an elevated dollar-denominated debt.

In May 2025, the Federal Reserve launched its tightening cycle, broadly marked by a series of interest rate hikes. When it convened on 7 May, the Fed decided to maintain its interest rates in the ballpark of 4.25%-4.50%. Reverberations of this will likely be felt in emerging markets, particularly Asia.

Many of the region’s developing economies are tightly linked to global trade and the US dollar, hence their vulnerability to higher volatility and potentially negative growth as the greenback strengthens. Having accumulated substantial dollar-denominated debt over decades, these countries face a high risk of default if the cost of their debt rises relative to the value of their local currency.

When the Fed hikes interest rates, US Treasury yields edge higher, making dollar-pegged assets more appealing to investors seeking higher returns with potentially lower risk. This dynamic spurs capital migration from emerging markets with a perceived higher degree of risk to the US, bolstering the dollar and weakening EM currencies.

This is particularly relevant to Asia’s EMDEs due to their exposure to foreign capital inflows. Central banks in these countries are often caught in the crosshairs of doubt: to hike or not to hike interest rates to rein in inflation, driven higher by the more expensive buck.

For example, Indonesia’s rupiah plunged to multi-month lows despite the central bank’s efforts to raise interest rates above the set 6% target. This is not a singular case, and it underscores how external factors like the US monetary policy can thwart domestic policy efforts.

Capital outflows and financial market volatility

On the back of high inflation and a stronger dollar, capital outflows and increased financial market volatility threaten stability across Asia’s EMDEs. Higher US interest rates reduce the appeal of emerging market bonds and equities, triggering portfolio withdrawals. This capital outflow can lead to a sharp depreciation in EM currencies and destabilize financial markets.

Countries like Indonesia and India, which are heavily reliant on foreign investment, are especially vulnerable. For instance, India, which has a large current account deficit and relies on US dollar inflows, saw its rupee plummet in late 2024 as investors recalibrated risk amid Fed monetary policy tightening. Similarly, Indonesia witnessed significant capital outflows despite strong fundamentals. These are two examples of how volatility in capital inflows can feed through into domestic currency valuation and impact the overall economic climate in a country.

Trade challenges

Rising interest rates in the US and a strong dollar can also erode demand for emerging market exports, making EM goods more expensive globally. This is critical for countries reliant on exports, such as Vietnam, Thailand, Malaysia, South Korea, Japan, and China.

While export reliance varies across these nations, depending on their nuanced relationships with the US and each other, one thing is clear: exports are a key growth driver for these economies.

Additionally, US tariffs and regulatory changes could further pressure these countries’ supply chains, potentially disrupting the economy.

Imported inflation

Domestic currency depreciation increases the cost of imported goods and raw materials, raising inflationary pressures. Corroborated with global commodity price volatility forces the hand of central banks to tighten monetary policy.

However, hiking interest rates to control inflation can slow down economic growth and increase unemployment. This risky trade-off complicates policy decision-making and can lead to stagflation, characterised by stagnant growth and soaring inflation.

Outlook for 2025: Is there still hope?

Despite the undeniable challenges that the Fed’s stance to keep rates “higher for longer” poses to Asian emerging and developing economies, they also create opportunities:

● Lower export prices hold the potential to increase the attractiveness of Asian goods globally by making them more cost-competitive. Countries with diversified manufacturing hubs like Malaysia and Vietnam could attract foreign firms looking to steer away from China amid geopolitical turmoil.

● Emerging economies focusing on structural reforms to stimulate the business sector can attract foreign direct investment (FDI). FDI tends to be more stable and less sensitive to US monetary policy headwinds, underpinned by long-term fundamentals.

● Amid geopolitical unrest and economic uncertainty, more Asian emerging and developing economies are seeking regional trade agreements and financial cooperation mechanisms to reduce their dependence on the US dollar. Initiatives like the Regional Comprehensive Economic Partnership (RCEP) and currency swap arrangements among ASEAN countries help cushion the impact of dollar volatility. By stimulating trade and investment in local currencies while encouraging trading partner diversification, these programs can enhance resilience against external shocks and reduce currency risk.

Final considerations

Without a doubt, rising US interest rates will likely create high volatility in Asia’s emerging markets. Although the risks are significant, with the potential to touch every aspect of the economy, from domestic business to employment and international trade, there are also opportunities to be seized in the long term. Lower stock prices can offer cost-effective portfolio diversification to investors seeking competitive advantages across the global markets.

Navigating these opportunities in such a volatile environment requires comprehensive risk management and a nuanced understanding of the local economy.

“Although U.S. President Donald Trump has just declared a 90-day freeze on most of the harsh tariffs announced a week ago and applied a 10% blanket tariff in their place, the April baseline represents the economic toll they will have should they eventually go ahead in full,” Moody’s Analytics said in a note.

The U.S., one of India’s largest trading partners, slapped 26% tariffs on the country last week, but President Trump paused most of the hefty duties he had announced in the previous week.

Gems and jewellery, medical devices and textile industries will be among the worst hit, said Moody’s.

However, overall growth is likely to be relatively insulated since external demand only makes up a relatively small portion of India’s gross domestic product, it added.

Trump’s latest tariff hike brings additional China rate to 145%: W.House

The Reserve Bank of India (RBI) lowered its key repo rate on Wednesday for a second consecutive time and changed its monetary policy stance to “accommodative”, signalling room for more cuts ahead, as it seeks to boost the sluggish economy in the face of fresh U.S. tariffs.

The tariffs have exacerbated uncertainties, but quantifying the impact on growth is difficult, central bank Governor Sanjay Malhotra had said in his monetary policy statement.

Moody’s Analytics expects the RBI to cut the repo rate to 5.75% by the end of 2025. That, along with the tax incentives announced earlier this year, should help boost the domestic economy and dampen the tariff shock on overall growth relative to other vulnerable economies, it said.

Urban demand is “poised for a recovery,” the Reserve Bank of India (RBI) said. A decline in inflation as well as a boost to disposable incomes from the “sizeable” income tax relief announced in the Union Budget 2025-26 will help urban consumption, it said.

“Strong rural demand is expected to receive a further fillip from the robust performance of the agriculture sector,” it added.

The Indian economy is seen expanding at the slowest pace in four years in 2024-25, after GDP growth fell to 5.4% in the July-September 2024 quarter from 6.7% in the previous quarter.

Indian economy to grow at around 6.5% in FY25, government says

The central bank’s internal models, based on high-frequency data, suggest growth improving to 6.6% in the January-March quarter this year.

“Domestic demand is also expected to benefit from the repo rate cut by the Monetary Policy Committee,” the report added.

The central bank has forecast growth at 6.7% in 2025-26, at the higher end of the government’s forecast of 6.3-6.8%.

The RBI expects inflation to ease to 4.2% in the next financial year, but flagged continuing risk to prices.

“While core inflation remains muted, uncertainty in global financial markets, volatility in energy prices and adverse weather events present upside risks to the inflation trajectory,” it said in the bulletin.

Commenting on global risks, the central bank said a strong dollar and trade policy pivots “could exacerbate capital outflows from emerging economies, push risk premiums higher, and intensify external vulnerabilities.”

The IMF said the board’s decision on May 10, should help broaden the use of SDRs, while increasing the attractiveness of the SDR as a reserve asset.

It comes as the IMF and other international financial institutions are under pressure to increase resources available to help developing countries and emerging markets grapple with rising global challenges, such as climate and food security.

Currency values in terms of Special Drawing Rights

The IMF’s board set a cumulative limit of $20 billion for such use of SDRS to address possible liquidity risks, and said it would review the new usage of SDRs once member contributions surpassed $13.2 billion, or in two years, whichever came first.

Members can already use their SDRs - which are allocated to IMF members in proportion to their IMF quotas - to settle obligations, loans, pledges to other IMF instruments such as the Poverty Reduction and Growth Trust, transfers as security for financial obligations, swaps, forward operations and donations.

The IMF has been reviewing the legal issues involved with the decision for some time. The Inter-American Development Bank (IDB) and the African Development Bank (AfDB) began developing plans for the additional use of the SDRs in April 2021 after the IMF approved allocation of $650 billion in new SDRs to help member countries cope with the COVID-19 pandemic.

The board’s decision means that IMF members can channel their SDRs to an approved list of 20 institutions, including the World Bank, the IDB, the AfDB and other “prescribed holders” which would use them to issue hybrid capital instruments.

Members that transferred SDRs to these institutions in a sale of hybrid capital instruments would still be able to count them as reserve assets, the IMF said.

A hybrid capital instrument, or hybrid bond, is a financial instrument that combines both debt and equity features to leverage loans.

Chaired by India’s Finance Minister Nirmala Sitharaman, broad areas for debate include the health of the global economy and “sustainable finance and infrastructure”, hosts said.

Key on the two-day agenda will be efforts to tackle debt distress, with the world’s poorest countries bearing the brunt of the global debt crisis – at a time when they need more cash than ever to fight climate change.

But China, the world’s second largest economy and a major lender to several stressed, low-income countries in Asia and Africa, has so far resisted a common multilateral understanding on the issue, officials said.

Australia upbeat on global tax talks at G20 in India

US Treasury Secretary Janet Yellen, speaking on the sidelines of the G20 talks on Sunday in the Indian city of Gandhinagar, cited debt restructuring progress in Zambia, which she had discussed when visiting Beijing this month.

Yellen said the Zambia deal had taken “too long to negotiate”, and added she hoped debt treatments for Ghana and Sri Lanka could be “finalised quickly”.

“We should apply the common principles we agreed to in Zambia’s case in other cases, rather than starting at zero every time,” Yellen said. “And we must go faster.”

More than half of all low-income countries are near or in debt distress, double the case in 2015, Yellen added.

A top official from G20 chair India said there had been a “not so encouraging response” from Beijing on shared debt understanding.

Several economies struggling following the double blow of the coronavirus pandemic and fallout from Russia’s war in Ukraine – which hit global fuel and commodity prices – are “reaching a cracking point”, the official added.

China is a major creditor in some of these cases and has faced criticism for its stand on nations’ debt restructuring.

Climate finance

The Group of 20 major economies will also discuss multilateral development banks’ reform, cryptocurrency regulations, and making access to financing to mitigate and adapt to the impacts of climate change easier for the poorest nations.

“In the Global North, climate change means emissions reductions,” World Bank chief Ajay Banga said in an op-ed ahead of the meeting.

“But in the Global South, it is a matter of survival, because hurricanes are stronger, heat-resistant seeds are in short supply, drought is destroying farms and towns, and floods are washing away decades of progress.”

A newly agreed first step on a fairer distribution of tax revenues from multinational firms reached by 138 countries last week is also set to be delivered.

Multinationals, especially tech firms, are currently able to shift profits easily to countries with low tax rates even though they carry out only a small part of their activities there.

But there is also concern that developed G7 member countries’ focus on Russia’s invasion may derail a final consensus agreement, although Yellen has said she would “push back” on criticism that there was a tradeoff between aid to Ukraine and developing nations.

Japan’s Finance Minister Shunichi Suzuki on Sunday “reconfirmed the G7’s unshakeable support” to Ukraine, adding that Moscow should also “pay long-term reconstruction costs”.

Any discussion on Ukraine is awkward for G20 host India, which has not condemned Russia’s invasion but is also part of the Quad grouping alongside Australia, the United States and Japan.

Addressing the 5th United Nations conference on the LDCs in Doha, Prime Minister Shehbaz Sharif said that the earlier agreed upon Istanbul programme of action needs to be revisited. The Istanbul programme of action aims at overcoming the structural challenges of the LDCs through building their human and productive capacities.

Meanwhile, the Doha programme of action for the LDCs is a UN action plan to tap the full potential of the LDCs helping them make progress on the road to prosperity.

“Despite progress in some areas, implementation of the Istanbul program of action has remained insufficient and uneven. Only four countries were able to graduate out of the least developed status. In fact, the Least Developed Countries (LDCs) were victims of the pandemic of inequality, unavailability of vaccines, technologies, finance and opportunities,” said PM Shehbaz.

“Multiple crisis have taken a heavy toll on LDCs, their GDP growth has plummeted, international trade has shrunk, poverty and food insecurity has risen, and inequality has widened.

“Due to these factors developing countries like Pakistan have also suffered a severe setback to their developmental goals,” he said.

He said LDCs continue to be affected by the climate crisis and highlighted that they make up 14% of the global population but account for only 1.3% of the global GDP, 1% of the global trade and 1.4% of global FDI.

Poor nations’ leaders unleash anger, despair

The PM expressed Pakistan’s full support and solidarity with developed countries for social progress and economic prosperity.

“As we move towards the implementation of the Doha program of action, Pakistan will continue to advocate several specific steps to advance sustainable development including in the LDCs.

“However meeting its ambitious targets will require revitalised global partnership based on effective means of implementation in the following priority areas,” said PM Shehbaz.

“First, we must address vaccine inequity through adequate and timely access to safe and effective vaccines for LDCs. Second, the historic commitment of ODA comprising 0.7% of the GNI of OECD countries must be fulfilled, of which 0.15 to 0.2% must be allocated to the LDCs.

“Third, we must address the increasingly unsustainable debt burden of many LDCs. It is a matter of great concern that 6 LDCs are classified as suffering from the debt burden, while 17 are at high risk of debt distress,” said the prime minister.

“Fourth, we must provide universal access to social protection in order to support the needy and vulnerable. Fifth, we also need to reform the unequal international financial architecture, make it people-centric and be designed to address the special needs and weaknesses of the LDCs.

UN chief slams rich countries’ treatment of poor states

“Lastly, an international technology compact aligned with the SDGs should be adopted, it should offer easy access to the developing countries to relevant advanced technologies to develop their productive capacities and bridge the digital divide,” said the premier.

PM Shehbaz lauded measures of the Doha action plan such as an online university, an international investment support centre and a system of food stocks for the LDCs.

“Pakistan will actively support the implementation of the Doha program of action including within the framework of South-South corporation,” concluded Shehbaz.