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FT editor Roula Khalaf selects her favorite stories in this weekly newsletter.
The author is a senior fellow at the Brookings Institution and former chief economist at the Institute of International Finance.
The US election may be the start of a massive dollar rally, but markets haven’t realized that yet. In fact, without much clarity about what is to come, markets are retreading the price action after Donald Trump’s victory in 2016. Expectations of looser fiscal policy are raising growth expectations, boosting the market for securities, while rising US interest rates against the rest of the world boost the dollar.
But if the president-elect follows through on the tariffs, bigger changes are coming. In 2018, after the United States imposed a 25 percent tariff on half of everything it imported from China, the renminbi fell 10 percent against the dollar, in what was almost a one-for-one offset. As a result, prices for dollar-denominated imports in the United States changed little and tariffs did little to alter the low-inflation equilibrium before the Covid pandemic. The lesson of that episode is that markets negotiate tariffs as if they were an adverse shock to the terms of trade: the currency of the country subject to tariffs falls to compensate for the blow to competitiveness.
If the United States imposes additional and perhaps much larger tariffs, the case for a depreciation of the renminbi is urgent. This is because China has historically struggled with capital flight when expectations of depreciation take hold among its population. When this happened in 2015 and 2016, it caused huge outflows that cost China $1 trillion in official foreign exchange reserves.
Restrictions on capital flows may have tightened since then, but the main lesson of that episode is to allow a large early decline in the renminbi, so that households cannot anticipate depreciation. The higher the US tariffs, the more important this justification becomes. Take the case of a 60 percent tariff on all imports from China, a figure the president-elect raised during the campaign. Taking into account tariffs already in place since 2018, this could require a 50 percent drop in the renminbi against the dollar to keep prices for US imports stable. Even if China imposes retaliatory tariffs, which will reduce this figure, the scale of the required renminbi depreciation is likely to be unprecedented.
For other emerging markets, such a large depreciation will be seismic. Currencies across Asia will fall along with the renminbi. That, in turn, will drag down emerging market currencies in the rest of the world. Commodity prices will also fall for two reasons. First, markets will see a tariff war and all the instability that comes with it as negative for global growth. Second, global trade is denominated in dollars, meaning emerging markets lose purchasing power when the dollar rises. In fact, financial conditions will tighten, which will also affect raw materials. That will only increase depreciating pressure on the currencies of commodity exporters.
In such an environment, the large number of dollar-linked rates in emerging markets are especially vulnerable. Depreciating pressure will become intense and many pegs will be at risk of explosive devaluations. Notable pegs include Argentina, Egypt and Türkiye.
In all of these cases, the lesson is the same: this is a uniquely bad time to be tied to the dollar. The United States has more fiscal space than any other country and seems determined to use it. That is positive for the dollar. Tariffs are just one manifestation of deglobalization, a process that shifts growth from emerging markets to the United States. This is also positive for the dollar. Finally, high geopolitical risk is making commodity prices more volatile, increasing the incidence of economic crises. That makes fully flexible exchange rates more valuable now than in the past.
The good news is that the policy prescription for emerging markets is clear: allow their exchange rates to float freely and act as a buffer for what could be a very large external shock. The downside to this idea is that large depreciations can drive inflation, but emerging market central banks have gotten better at addressing this. They mostly weathered the Covid inflation shock better than their G10 counterparts, raising their rates earlier and faster. The bad news is that another major rise in the dollar could cause lasting damage to local currency debt markets across emerging markets.
These economies have already suffered because the huge rise in the dollar over the past decade wiped out returns for foreign investors by converting them back into their local currencies. Another big rise in the dollar will further damage this asset class and raise interest rates in emerging markets. This makes it even more imperative that these economies budget intelligently and preventively.