Emerging Markets Face Capital Flight as Tariffs Loom

The Institute of International Finance (IIF) has warned that foreign cash inflows to emerging markets are set to drop by nearly a quarter in 2025, driven by U.S. President Trump's threatened tariffs and a stronger U.S. dollar. This reduction in capital flows could have significant implications for the liquidity and stability of emerging market currencies, as well as potential spillover effects on other asset classes and sectors within these markets.

According to the IIF, the reduction in foreign cash inflows is primarily due to the U.S. President's threatened tariffs and a stronger U.S. dollar. The IIF projects that capital flows to emerging markets will fall to $716 billion in 2025, down from $944 billion this year. This decline is expected to be driven by weaker flows to China, which is anticipated to experience a $25 billion outflow in portfolio flows.

The reduction in foreign cash inflows could impact the liquidity and stability of emerging market currencies. A study by Žemaitytė and Urbšienė (2020) found that solely due to the U.S.-China trade war, the U.S. trade balance improved by 0.21% of real GDP, while imports from other countries increased by 0.22% of real GDP. This shift in trade patterns could lead to a decrease in demand for foreign currencies, potentially weakening them. However, the IIF also notes that emerging markets outside China are expected to attract "robust" inflows in bonds and equities, led by resource-rich economies in the Middle East and Africa. This suggests that while some emerging market currencies may face challenges, others could remain relatively stable or even strengthen.

The potential reduction in foreign investment could also impact the economic growth and stability of vulnerable emerging markets. The IIF warns that a stronger and swifter implementation of tariffs could exacerbate downside risks, disrupting global trade and supply chains, and placing additional strain on emerging market capital flows. The most at-risk sectors in emerging markets due to a decrease in foreign investment are those heavily reliant on trade and exposed to tariff threats, such as the automotive, agriculture, and technology and electronics sectors.

Investors should monitor these sectors closely and consider diversifying their portfolios to mitigate risks associated with tariff threats and decreased foreign investment in emerging markets. While the reduction in foreign cash inflows presents challenges for emerging markets, the IIF's projections also highlight opportunities for resource-rich economies in the Middle East and Africa. As the global economy continues to evolve, investors must remain vigilant and adapt their strategies to capitalize on emerging opportunities while managing potential risks.