May 7, 2025
The global economy is facing significant challenges as the US effective tariff rate has reached levels not seen in over a century, leading to increased uncertainty in trade policy and geopolitics. According to the World Economic Outlook's reference scenario, these tariffs are projected to reduce both global and emerging market (EM) output growth by approximately 0.5 percentage points compared to forecasts before April.
"Countries imposing high tariffs, or those that are heavily dependent on trade with those countries, will be hit the hardest," states the report. It notes that no country is likely to escape unscathed, with downgraded forecasts for 127 countries accounting for 86 percent of global GDP.
Inflation impacts vary across regions. For countries facing higher tariffs on exports, these act as a negative demand shock exerting mild downward pressure on inflation. Conversely, for countries like the United States imposing higher tariffs, they function as an adverse supply shock boosting inflation while reducing growth.
Despite improved monetary policy frameworks since the late 1990s, EM central banks face unique challenges due to weaker monetary policy transmission compared to advanced economies (AEs). "Monetary policy transmission appears noticeably weaker in EMs than in AEs," says research by De Leo, Gopinath and Kalemli-Özcan (2024), highlighting dependency on global financial conditions.
Emerging markets have become more reliant on external financing from foreign nonbank financial institutions such as insurance companies and investment funds. This shift raises vulnerabilities due to sensitivity to the global financial cycle. Additionally, crypto assets play an increasing role in cross-border financial intermediation and payments in many EMs.
Another issue is the relatively weaker credibility of EM monetary policies in delivering low inflation compared to AEs. Inflation expectations tend to be less well-anchored in EMs, resulting in a higher passthrough of cost shocks into inflation.
Furthermore, exchange rates have a larger impact on price and financial stability within EMs than AEs. Foreign exchange mismatches increase risks from currency depreciation despite efforts by many EMs to reduce these mismatches through derivatives markets.
In response to these challenges, it is recommended that "EM central banks should respond forcefully to upside inflation risks if they materialize." Foreign exchange intervention can also help address disorderly market conditions undermining financial stability but should not target specific exchange rate levels.
Building financial resilience through strengthened prudential policies is advised alongside developing comprehensive legal frameworks for crypto assets. Fiscal policy plays a crucial role too; ensuring sustainable debt paths provides buffers against downturns and lowers financial stability risks.
Lastly, improving central bank communication and governance can bolster public confidence while adapting policy strategies focusing more on risk management considerations rather than relying solely on central forecasts.
To conclude: "EMs have made major strides... enabling several of them to respond effectively... They are now being tested again as the global economic order resets."