The International Monetary Fund (IMF), in a report published, said that the bulk of foreign financing for emerging market nations now comes from hedge funds, pension funds and insurers, leaving them exposed to a fast exit in crises.
As banks pulled back from lending in the aftermath of the 2008 financial crisis, the share of the cash flowing into emerging market debt from portfolio investors doubled over the past 20 years to 80%, the report found, and emerging markets have received nearly USD 4 trillion in cumulative inflows since 2009.
The IMF said this source of funds “has clearly been beneficial for emerging markets”, which have been able to tap into global liquidity to raise longer-term, lower-cost debt.
But it also cautioned that portfolio investors had become even more skittish since 2008, and prone to withdraw their cash at the first sign of a shift in global financial conditions.
The report said countries and companies that rely on them are “especially vulnerable to global financial shocks,” noting that hedge funds and investment funds are far more responsive to risk than other portfolio investors, and that the risks are greater in emerging nations with shallower financial markets and more limited policy capacity.
Sharp reductions in these flows could exacerbate external financing pressures, increase corporate and sovereign spreads, and lead to abrupt currency depreciations.
According to the IMF, external portfolio debt liabilities averaged approximately 15% of GDP in emerging markets, while portfolio equity liabilities averaged approximately 7% of GDP, although they represent an economically significant share of stock market capitalisation in some emerging markets.
For example, the forint currency of Hungary had especially high foreign portfolio holdings, and as a result, the forint gained 20% against the US dollar last year, but since the war with Iran started in late February, the forint has wilted, as money flows into emerging markets have fallen after more than a year of stellar performance.
The IMF also noted that cross-border private credit and stablecoin flows into emerging markets were growing rapidly, and that stablecoin flows are linked to crypto market dynamics.
The fund recommended that countries enhance institutional quality to reduce the outflows of portfolio funds, accumulate buffers such as foreign exchange reserves and ensure that public debt is sustainable.