America’s protectionist trade policy will prove economically and politically very disruptive to financially distressed developing economies, less so emerging economies, even if Washington decides not to follow through with its reciprocal tariff policy or lowers announced trade restrictions over time. US trade policy has created significant economic and financial uncertainty, which will increase economic and financial risks as well as weaken political stability risks, particularly in financially distressed, commodity export dependent developing economies. Developing economies that have significant bilateral trade surpluses with the United States face increased risks due to the higher reciprocal tariffs they will face once the temporary suspension expires in early July. Here is why:
First, higher across-the-board tariffs in the guise of 10% and additional reciprocal tariffs based on size of bilateral goods trade surplus will hurt the exports of emerging and developing economies. The greater their dependence on the U.S. market, the more they will suffer by way of reduced exports and lower foreign-currency revenues. Lower export revenues will lead to a growth-reducing import compressions, falling foreign-currency reserves or politically painful currency depreciation, or all of them combined. Many already financially distressed developing economies facing financing problems are at particular risk of financial instability.
Second, higher US tariffs, directly and indirectly, will also impact US and global economic growth due to higher U.S. import prices, lower exports by tariffed countries and a general decline in consumer and investor sentiment due to heightened uncertainty. Lower global economic growth is also likely to weigh on commodity prices. While lower energy prices may benefit selected emerging economies, such as Turkey or Egypt, developing economies generally depend on commodity exports, and deterioration of terms of trade will further depress export and foreign-currency revenues, particularly in commodity-dependent sub-Saharan Africa.
Third, to the extent that US tariffs lead to higher US inflation, they are likely to keep U.S. interest rates higher for longer, even in the context of slowing U.S. economic growth. Moreover, increased global investor risk aversion will make it more difficult, particularly for financially challenged countries to issue debt in international capital markets, while concessional borrowing also remains relatively, given higher risk-free U.S. interest rates.
Fourth, if increased global economic and financial uncertainty leads to a stronger dollar, this will further increase financial distress due to the higher financing costs in local currency terms. Contrary to the historical pattern, this time the dollar has in fact weakened in the wake of increased economic and financial uncertainty, at least it has done so in trade-weighted terms. Individual developing economies, however, are faced with currency depreciation and hence dollar appreciation.
Fifth, US protectionism will lead to trade diversion, meaning that countries that cannot export to the United States will seek to redirect exports to other markets. To the extent that emerging economies, for example, compete with Chinese manufacturers, domestic producers and the economy will be faced with increased competition from Chinese and other countries’ imports. This may be less of an issue for developing economies whose domestic industries typically compete less directly with Chinese or EU exports. But emerging markets may see increased imports and this may lead to increased trade restrictions targeting trade diversion, this raising the risk of further trade conflict.
All this means that as global growth weakens, interest rates stay higher than they would otherwise have done, export revenues decline and capital inflows fall, emerging and especially developing economies will face significant economic and financial headwinds. Many developing economies and some emerging economies are already in financial distress or at heightened risk of financial distress. The outlook for developing economies is further exacerbated by the reduction in US foreign aid. The adverse economic and financial development will force them to implement even more forceful, but politically controversial macroeconomic adjustment and reform, including a reduction of government spending, including subsidies, and an increase in taxes. If balance of payments pressure force countries to devalue their currencies, inflation and the cost of living will increase. All this has the potential to increase domestic pollical tensions and increases the risk of social protests in developing economies.
It remains to be seen whether to what extent and on whom tariffs will be imposed once suspension of reciprocal tariffs expires in early July. Countries running trade deficits with the United States will be better positioned than its competitors faced with higher reciprocal tariffs. To what extent they will be able to take advantage of this situation, however, depends not just on relative tariff levels but also in their export structure. A commodity-exporting country that faces lower reciprocal tariffs may find it difficult to take advantage of the decline of a manufacturing export from countries facing high U.S. tariffs. Moreover, Washington has imposed and will impose further sectoral tariffs, such as on steel and aluminum, autos, copper, lumber, critical minerals, pharmaceuticals, semiconductors and so on. As these sectors are generally exempt from reciprocal tariffs, countries that export these goods will not be able to take advantage of differential tariffs.
Finally, the trade war during the first Trump administration led to the emergence of so-called connector economies that attracted trade and investment by (Chinese) companies seeking to circumvent U.S. trade restrictions on China. This time, only very few, if any countries will be able to take advantage of U.S. tariffs, as tariffs are much more broad-based and there is greater uncertainty as how long they will remain in place, which will make companies less willing to set up production facilities in connector economies. Washington is also more likely to take measures targeting connector economies.
Regardless, few, if any countries will be better off, as global macro impact will outweigh relative competitiveness gains. US trade policy is broadly negative for emerging and especially developing economies. Financial distressed countries, mostly in sub-Saharan Africa, but also IMF countries, such as Pakistan, Sri Lanka, Bangladesh, Egypt, will be forced to implement more forceful policy adjustments. This will prove politically contentions, particularly if accompanied by lower global growth, reduced capital flows and lower export revenues, and currency depreciation.