Hot money fuels EMs

EMERGING market (EM) economies are looking at a future in which volatile “hot money” could dictate their access to global capital, raising the prospect of sharper swings in sovereign borrowing costs and currency values if global sentiment shifts.

In a chapter of its upcoming “Global Financial Stability” report, the International Monetary Fund (IMF) indicates that portfolio investors such as hedge funds, pension funds and insurers now provide the bulk of foreign financing to EM nations – a marked shift from two decades ago that brings both fresh opportunity and new risk.

The IMF notes that investors pulled back from cross‑border lending after the 2008 financial crisis, leaving a vacuum that market‑based capital has filled.

According to the report, the share of capital flowing into EM debt from portfolio investors has doubled over the past 20 years to 80%, as banks backed away from lending following the financial crisis.

Since then, EMs have received cumulative inflows of close to US$4 trillion.

The IMF’s analysis underlines the benefits of ample global liquidity and diversified financing.

For many governments and corporates in emerging economies, access to a broad base of global investors has meant lower borrowing costs and the ability to issue longer‑dated debt.

As the IMF puts it, this source of money “significantly benefits EMs”.

However, the same flows that have supported strong financing conditions could become a source of instability when risk appetite wanes.

Flighty capital

The IMF highlights that portfolio investors have grown “even more skittish since 2008 – and prone to pull their cash quickly when global financial conditions shift”.

This characteristic makes countries and companies that rely heavily on market‑based financing “particularly vulnerable to global financial shocks”.

Hedge funds and investment funds, in particular, are described as being far more reactive to risk than other portfolio investors.

In markets with shallower financial systems and constrained policy capacity, these dynamics could amplify swings in asset prices and financing costs.

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

The report estimates that external portfolio debt liabilities average about 15% of gross domestic product in EMs, while portfolio equity liabilities total an average of around 7%.

Equities may represent an “economically meaningful share of stock market capitalisation in some EMs”, according to the IMF.

These holdings can have real‑world effects: foreign portfolio investors have substantial positions in certain currencies, such as the Hungarian forint, which surged 20% against the US dollar in the previous year before weakening again amid heightened geopolitical tensions linked to the Iran conflict.

Beyond traditional flows

The IMF also flags the rapid expansion of other non‑bank capital flows, including cross‑border private credit and stablecoin transactions.

These developments reflect broader trends in global finance, but they may add opacity and complexity to risk assessments.

Stablecoin flows, closely tied to crypto market dynamics, have grown sharply, the IMF notes, adding new dimensions to the monitoring of capital movements.

Private credit markets – where non‑bank lenders provide direct financing to companies – are similarly expanding.

While these sources can increase financing options, they often operate through opaque structures with limited regulatory oversight, making systemic risks harder to gauge.

To address the vulnerabilities posed by heavy reliance on cross‑border portfolio flows, the IMF urges EM policymakers to strengthen institutional quality and build resilience at home.

Among the key recommendations are building larger foreign-exchange reserve buffers and keeping public debt at sustainable levels to minimise sudden pressure on financing conditions.

“To reduce volatility in cross-border portfolio flows, countries – especially those reliant on more risk-sensitive investors – should strengthen macroeconomic fundamentals and institutional quality, build robust fiscal and external buffers, and pursue proactive risk management,” it says.

“International cooperation is essential to close regulatory gaps in nonbank financial intermediation and limit the cross-border propagation and amplification of global financial shocks,” it adds.

Further, the IMF points out that more comprehensive disclosure and enhanced international data sharing on non-bank exposures and vulnerabilities could strengthen market surveillance and improve risk management practices.

In its analysis, the IMF places particular emphasis on the composition and structure of non‑bank investor bases, noting that sensitivity to global risk depends “critically on the composition and structure of the investor base”.

Investment funds, especially passive mutual funds and exchange‑traded funds, are identified as among the most sensitive to shifts in global risk sentiment.

By contrast, insurance companies and pension funds tend to be relatively more stable, although vulnerabilities remain.

The fund argues that countries with stronger institutions, ample reserve buffers and lower fiscal risks can mitigate the impact of adverse global shocks.

“Robust policy frameworks can mitigate the impact of adverse global shocks,” it states, underscoring the importance of credible governance in attracting stable, long‑term investors.

The IMF also recommends more rigorous stress testing of domestic financial systems to gauge resilience to sudden capital flow reversals.

For business leaders and policymakers, the IMF’s findings highlight a pivotal challenge: maintaining access to global capital markets while managing the risks that come with a mobile and often unpredictable investor base.

As global monetary conditions evolve and geopolitical uncertainties persist, countries that strengthen their policy frameworks and diversify their investor bases are likely to fare better in absorbing shocks.

But with nearly US$4 trillion in cross‑border portfolio flows at stake and the share of hot money continuing to rise, the balance between opportunity and risk in EM finance has never been more delicate.