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Emerging markets have become much more vulnerable to global shocks such as the Iran war because of their increased reliance on “flighty” sources of capital such as hedge funds in recent years, the IMF has warned.
Purchases of emerging market stocks and bonds by foreign investors have increased eightfold since the 2008 global financial crisis, with cumulative inflows approaching $4tn in 2025, mostly in the form of debt, the fund said in an analysis published ahead of its annual spring meetings in Washington next week.
Debt held by foreign investors now averages 15 per cent of GDP in emerging markets, up from 9 per cent in 2006, the IMF said. Four-fifths of this capital comes from non-bank sources such as hedge funds and investment funds, double the share seen two decades ago.
These flows “tend to be more volatile than bank flows and are increasingly sensitive for global risk conditions”, IMF staff said in a blog published alongside the analysis on Tuesday, adding: “These risks have come to the fore in the context of the war of the Middle East”.
The IMF’s warning comes as a number of emerging economies struggle to deal with the economic fallout of the Middle East conflict. The Egyptian pound has fallen almost 15 per cent against the dollar since the start of the war as foreign investors have pulled an estimated $8bn from the local debt market. Turkey’s gold reserves have shrunk as its central bank stepped in to support the lira.
Sharp retrenchments in foreign capital “can intensify external financing pressures, raise borrowing costs and trigger sharp currency depreciations, leading to financial strains that weigh on economic growth”, the IMF said.
Hedge funds, which often use leverage to boost returns, are among the flightiest sources of capital, the IMF analysis showed. A jump in the Vix volatility index of about 7 percentage points — on the scale seen after the US Federal Reserve began raising interest rates in 2022 — led to a 1.3 per cent fall in hedge funds’ holdings of emerging market securities.
This compared with a 0.6 per cent decline in mutual funds’ holdings, and no significant change in the holdings of insurance companies and pension funds.
The IMF also pointed to “additional challenges” from the rapid growth of private credit in emerging markets: it estimated that direct lending to companies by non-bank investors had increased fivefold over the past decade, to some $50bn-$100bn.
Its warning follows a similar caution last week from the Bank of England, which drew attention to the risks posed by hedge funds’ activity in sovereign bond markets.
Many advanced economies’ sovereign bond markets were “characterised by a relatively high use of leverage by a small number of hedge funds pursuing similar strategies across jurisdictions”, the BoE said, meaning that stress in one market could easily spill over to others.
