Can Emerging Economies Withstand the Next Credit Squeeze as Global Rates Tighten Again?

Emerging economies are entering a particularly difficult time. The question of whether policymakers from São Paulo to Nairobi can withstand another squeeze is looming as global credit tightens once more. The landscape has changed, but the sense of caution is familiar. Even though many of these countries are significantly stronger now than they were during previous crises, the risks are remarkably more complex and interconnected.

The economic underpinnings of emerging markets have significantly improved over the last ten years. Inflation targeting has stabilized expectations, central banks have gained credibility, and fiscal authorities have learned to respond more quickly when stress increases. Today, nations like Mexico and Indonesia have more developed domestic bond markets, which lessens their reliance on foreign debt. Because it enables governments to borrow domestically without immediately exposing themselves to external rate shocks, this structural advancement is especially advantageous.

However, the current tightening cycle presents a unique challenge. Borrowing costs have increased to levels not seen in 20 years due to the global interest rate boom, which was spearheaded by the U.S. Federal Reserve. Attracted by the security of U.S. Treasuries with higher yields, investors have begun pulling money out of riskier markets. This abrupt loss of liquidity feels like the financial equivalent of a drought striking an already parched field for frontier economies that are already having difficulty repaying their debt.

This squeeze affects a number of economies. The financial collapse of Sri Lanka and Ghana’s debt default were warning indicators rather than isolated incidents. A precarious combination of excessive borrowing, lax fiscal restraint, and foreign debt exposure was evident in both cases. Similar pressures are being faced by Kenya, Tunisia, and Pakistan as they negotiate with the IMF while juggling fiscal austerity and internal unrest. The shared challenge is strikingly obvious: political fragility exacerbates financial stress when capital becomes scarce.

Nonetheless, a few significant economies have proven resilient. With record-high foreign reserves and a strong digital infrastructure that boosts domestic demand, India, for example, has established an incredibly effective defensive position. Brazil has also been able to stabilize inflation and draw capital back into its domestic debt markets following years of policy instability. These illustrations demonstrate the continued importance of discipline and foresight. Investor confidence and a stronger currency cushion are now advantages for nations that responded quickly to tighter conditions.

But the situation is more dire for smaller countries. In just ten years, Sub-Saharan Africa’s debt levels have almost doubled, and export earnings are trailing behind. Government budgets are increasingly being used to meet these commitments, leaving less money for healthcare, education, and climate adaptation. High interest rates are gradually reducing the public sector’s capacity to make growth-oriented investments, resulting in a vicious cycle from which it is getting harder to break.

The lending role of China is a major complication. Through its policy banks, China has financed ports, railroads, and energy projects, making it the largest bilateral creditor to developing nations over the last fifteen years. However, that pipeline has drastically shrunk since 2020. These days, Chinese banks are hesitant to lend or reorganize, especially when projects don’t work out. Due to this hesitancy, a number of nations, including Zambia and Sri Lanka, are now torn between China’s cautious negotiations and the IMF’s reform requirements. Recovery has been delayed by the excruciatingly slow debt diplomacy surrounding these cases.

Though its implementation has been slow, the G20’s “Common Framework” for debt resolution was intended to avoid such deadlock. Ghana’s restructuring is still in progress, whereas Zambia’s took years to complete. This protracted procedure deters investors and keeps nations mired in uncertainty. On the other hand, nations like Ecuador that adopted transparency and took prompt action were able to restore their reputation more quickly and access markets with cheaper borrowing costs.

At the same time, the equation is completely shifting due to the increasing impact of climate risk. According to Moody’s research, physical climate damage could cost emerging economies almost one-fifth of their GDP by 2050, which is twice as much as advanced economies are expected to lose. This increases the vulnerability of nations like Bangladesh, the Philippines, and Brazil. Natural catastrophes drive already precarious economies closer to collapse by destroying infrastructure, uprooting populations, and increasing budget deficits.

However, these difficulties are also spurring creativity. For instance, Barbados, led by Prime Minister Mia Mottley, has been at the forefront of debt-for-climate swaps, which link repayment relief to investments in the environment. Her government’s strategy has been especially creative, combining climate action and fiscal restraint in a way that is changing the discourse on sustainable debt. Similar to this, Brazil’s framework for sovereign sustainable bonds has drawn billions in green funding, suggesting that environmental credibility may be a new source of financial strength.

Similar steps are being taken by Indonesia and India, who are utilizing digital infrastructure to increase financial inclusion and create robust domestic capital bases. These nations have greatly decreased inefficiencies that previously turned off investors by incorporating technology into governance and finance. Their development provides a powerful lesson: economic resilience now involves adaptability within global shocks rather than isolation from them.

Not all emerging economies will be equally affected by the credit squeeze. The best-positioned countries to handle the volatility are those with open fiscal systems, robust reserves, and flexible exchange rates. Frontier markets with low policy credibility and a heavy reliance on external borrowing bear the brunt of the risks. Unless outside assistance picks up speed, these countries may be forced to endure austerity or painful restructuring as long as interest rates remain high.

Even organizations like the World Bank and IMF admit that outdated instruments might not be sufficient, despite their continued pivotal role. Global finance’s next stage will probably call for hybrid solutions that combine innovation and policy discipline. Climate resilience funds, sustainability-linked bonds, and blended finance models are increasingly crucial tools for sustaining fragile economies without escalating debt traps.

Financial history demonstrates that while crises do not recur, they frequently rhyme. One lesson from the 1997 Asian Financial Crisis, the 1980s Latin American debt crisis, and the COVID-era borrowing boom is that complacency is risky. Emerging economies have a much better chance of recovering from the next shock if they continue to be proactive, diversify their sources of funding, and uphold public confidence.

The prepared will be separated from the reactive by the impending credit squeeze. Not only will these nations endure, but they will also take the lead if they embrace reform, make investments in sustainability, and establish institutional credibility. Those who, instead of being afraid of the squeeze, use it as an opportunity to reset and rebuild with extraordinary clarity and confidence may be the ones who usher in the next era of economic strength.