Hedge fund borrowing exposes emerging markets to greater Iran war risk, says IMF

Emerging economies are at greater risk of higher interest rates and currency shocks resulting from the Iran war because of increased reliance on market investors such as hedge funds, the International Monetary Fund has warned.The IMF’s analysis shows that a cumulative $4tn flowed into Emerging Markets last year from outside the formal banking sector – including from hedge funds and investment funds.In a blogpost, IMF economists argue that this can bring benefits, but also risks, as these funds are more likely than traditional bank financing to be withdrawn suddenly in times of financial stress.“Market-based finance can help firms integrate into global value chains, a key driver of exports, by easing access to funding for trade, working capital, and other needs that increase their productive capacity,” it says.But it warns that these investments “tend to be more volatile than bank flows and are increasingly sensitive to global risk conditions”.During global financial shocks, the IMF says, “abrupt retrenchments can intensify external financing pressures, raise borrowing costs, and trigger sharp currency depreciations, leading to financial strains that weigh on economic growth.”Some countries are already experiencing these challenges, it warns: “These risks have come to the fore in the context of the war in the Middle East, as several Emerging Markets are experiencing a reversal of capital flows from nonresident nonbank investors.”Analysing the behaviour of different categories of investor when market volatility rises, it found hedge funds and mutual funds have the highest propensity to withdraw, with pension funds and insurers tending to be more circumspect.The IMF also highlights growing flows of stablecoins – cryptocurrencies pegged to a currency, usually the dollar – into emerging economies, warning that these tend to be vulnerable to wider fluctuations in cryptocurrency markets.Emerging economies have not been untouched by the recent boom in private credit – direct lending to companies from investors such as private equity firms – either.The IMF estimates that this opaque sector’s investments in Emerging Markets have increased fivefold over the past decade to perhaps $50-100bn, and warns regulators to be wary.“While private credit can broaden access to capital, gaps in transparency and data availability may make it hard to quickly identify vulnerabilities or potential risks to financial stability,” it warns.The IMF’s analysis, drawn from a chapter of its upcoming Global Financial Stability Report, was published as the world’s finance ministers and central bankers prepare to gather for the lender’s spring meetings in Washington next week.The economic impact of the war is likely to be at the top of the agenda, with many policymakers already wrestling with soaring fuel prices and the prospect of slower growth.The IMF’s managing director, Kristalina Georgieva, warned on Monday that as a result of the conflict, “all roads now lead to higher prices and slower growth,” adding, “even if the war is to stop today, there would be a lingering negative impact to the rest of the world.”