Hot money increasingly dominates emerging markets financing, raising risks, IMF says

LONDON – Emerging market nations now get the bulk of their foreign financing from the likes of hedge funds, pension funds and insurers, leaving them vulnerable to rapid outflows during crises, the International Monetary Fund said in a report.

The share of the cash flowing into emerging market debt from portfolio investors has doubled over the past 20 years to 80%, the report found, as banks backed away from lending following the 2008 financial crisis. Since then, emerging markets have received cumulative inflows of close to USD 4 trillion, according to the report.

In a chapter of its Global Financial Stability report released on Tuesday, the IMF said this source of money “significantly benefits emerging markets”, as ample global liquidity had allowed them to raise money with longer-term and lower-cost debt.

However, it also warned that portfolio investors had become even more skittish since 2008—and prone to pull their cash quickly when global financial conditions shift.

Countries and companies relying on them are “particularly vulnerable to global financial shocks”, the report said.

Hedge funds and investment funds were far more reactive to risk than other portfolio investors, it noted, and warned that the risks were amplified in emerging nations with shallower financial markets and more limited policy capacity.

“A sudden drop in these flows could intensify external financing pressures, widen corporate and sovereign spreads, and trigger sharp currency depreciations.”

The IMF estimated that external portfolio debt liabilities averaged about 15% of gross domestic product in emerging markets. Portfolio equity liabilities averaged around 7% of GDP, but “represent an economically meaningful share of stock market capitalization in some emerging markets.”

Foreign portfolio holdings are particularly large for the likes of Hungary’s forint currency, which propelled it to 20% gains against the US dollar last year.

The forint has wilted since the Iran war began in late February, with money flows into emerging markets falling after more than a year of stellar performance.

The IMF added that cross-border private credit and stablecoin flows into emerging markets were also “expanding rapidly“, with the latter closely tied to crypto market dynamics.

In order to limit the outflows of portfolio funds, the Fund urged countries to improve institutional quality, build better buffers such as foreign exchange reserves and ensure public debt remains sustainable.

(Reporting by Libby George; Editing by Dhara Ranasinghe and Janane Venkatraman)