The Ripple Effects of U.S. Fiscal Policy: Geopolitical Risks and Emerging Market Vulnerabilities

The United States' fiscal trajectory has become a linchpin of global economic stability-or instability. An Econofact analysis projects public debt will surpass 135% of GDP by the end of the decade, and the U.S. faces a fiscal path that not only challenges domestic sustainability but also reverberates through international institutions and emerging markets. These spillovers are amplified by geopolitical risks, creating a complex web of vulnerabilities that investors and policymakers must navigate.

U.S. Fiscal Policy and International Institution Funding: A Fractured Commitment

The U.S. has long been the largest contributor to multilateral development banks and peacekeeping operations. However, recent fiscal constraints have led to significant shortfalls in funding commitments. For instance, the FY2025 House Appropriations bill allocated only $1.55 billion for international institution contributions-$380 million less than the White House's requested $1.93 billion, according to the Bank Information Center. This underfunding includes critical programs like the International Development Association's (IDA20) replenishment, which supports low-income countries. Such delays weaken U.S. influence in shaping global governance and reduce the capacity of institutions to address crises, from climate adaptation to conflict resolution.

The consequences are stark. The United Nations, for example, faces a liquidity crisis due to U.S. arrears and proposed cuts to peacekeeping funding, threatening to reduce its peacekeeping force by 25%, according to Reuters. This erosion of institutional capacity undermines global stability, particularly in regions reliant on UN interventions, such as South Sudan and the Democratic Republic of Congo.

Geopolitical Risks and Emerging Market Spillovers

The interplay between U.S. fiscal policy and geopolitical risks has created a volatile environment for emerging markets. Rising U.S. Treasury yields-driven by large deficits and inflation-have tightened global financial conditions. That Econofact analysis also finds a 1 percentage point increase in the U.S. primary fiscal balance is linked to an 11 basis point rise in term premia globally. For emerging markets, this translates to higher borrowing costs and reduced access to capital.

Geopolitical tensions further exacerbate these challenges. A ScienceDirect study finds that U.S. portfolio investments in emerging markets decline sharply when geopolitical risks rise in those countries. This sensitivity is amplified by weak institutional quality and limited fiscal buffers in many emerging economies. For instance, conflicts in regions like Ukraine and Gaza have driven risk aversion, increasing risk premiums and depressing asset valuations in markets such as Turkey and Argentina, as noted in Larry Swedroe's Substack.

Case Studies: Fiscal Policy, FDI Shifts, and Systemic Risks

The reallocation of U.S. foreign direct investment (FDI) underscores the geopolitical dimensions of fiscal policy. A Federal Reserve note documents that, as firms de-risk supply chains, U.S. investment has shifted from China to countries like Mexico and Vietnam. While this reflects strategic diversification, it also creates imbalances. Emerging economies reliant on U.S. FDI-such as Vietnam-face heightened exposure to U.S. fiscal and monetary shifts. A sudden tightening of U.S. policy could trigger capital outflows, destabilizing local currencies and sovereign debt markets.

Another case is the African Development Bank (AfDB), where U.S. underfunding has constrained its ability to finance infrastructure projects. This not only hampers economic growth in Africa but also weakens the U.S.'s diplomatic leverage in a region increasingly courted by China and Russia.

The Path Forward: Mitigating Systemic Risks

For investors, the implications are clear: portfolios must account for the dual pressures of U.S. fiscal uncertainty and geopolitical volatility. Emerging markets with strong fiscal buffers, diversified trade relationships, and robust institutions are better positioned to weather shocks. Conversely, economies with high external debt and weak governance face elevated risks.

Policymakers, meanwhile, must address the root causes of fiscal unsustainability. Proposals from the Penn Wharton report-such as tax code simplification and Social Security reforms-offer a blueprint to reduce deficits by 38% by 2054. Without such measures, the U.S. risks ceding influence in global governance and deepening vulnerabilities in emerging markets.