IMF flags rising risks as $4trn nonbank flows reshape emerging-market finance

Emerging-market firms and governments are increasingly turning to nonbank sources of external financing, a shift that has unlocked deeper pools of capital but is also heightening exposure to sudden reversals in global investor sentiment, according to the International Monetary Fund (IMF).

In a blog accompanying its latest Global Financial Stability Report, IMF economists said portfolio flows to emerging markets have surged dramatically since the global financial crisis, rising eightfold to about $4 trillion in cumulative terms, far outpacing the growth in traditional bank lending.

These inflows are largely debt-based, with portfolio debt liabilities now averaging about 15 percent of gross domestic product across emerging markets, up from roughly 9 percent in 2006.

Nonbank financial institutions, including investment funds, hedge funds, pension funds and insurance companies, now account for about 80 percent of this capital, double their share from two decades ago, underscoring a structural shift in how emerging markets access global finance.

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The growing reliance on market-based financing has delivered clear benefits. Increased access to capital has helped lower borrowing costs, supported investment, and strengthened productivity growth. It has also enabled firms to integrate more effectively into global value chains by improving access to trade and working capital financing, while contributing to the long-term development of domestic financial systems.

However, the IMF warned that these gains come with rising vulnerabilities, as portfolio flows tend to be significantly more volatile than bank-based lending and are increasingly sensitive to global risk conditions.

Periods of heightened uncertainty can trigger abrupt capital outflows, intensifying external financing pressures, driving up borrowing costs, and weakening currencies.

These risks have become more pronounced amid ongoing geopolitical tensions, including the war in the Middle East, which has already led to a reversal of capital flows from nonresident nonbank investors in several emerging markets.

The IMF’s analysis shows that a spike in global risk appetite, measured by a one-standard-deviation increase in the CBOE Volatility Index (VIX), similar to levels seen during the US Federal Reserve’s rate hikes in early 2022, can lead to portfolio debt outflows equivalent to about 1 percent of quarterly GDP in emerging markets. Outflows from investment funds alone can be roughly twice that magnitude.

Countries with weaker economic fundamentals, including higher public debt, lower foreign reserve buffers, and weaker institutional frameworks, are particularly vulnerable to such shocks.

The volatility of these flows is closely tied to the behavior of different investor groups. Investment funds, which dominate portfolio flows to emerging markets, are often exposed to sudden redemption pressures that can force rapid asset sales.

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Passive investment strategies and exchange-traded funds can exacerbate this dynamic, as portfolio adjustments linked to benchmark changes may trigger synchronised selling across markets.

Hedge funds, another increasingly important source of capital, often employ leverage to boost returns, making them more sensitive to market swings. Rising volatility can prompt margin calls and risk-limit breaches, forcing further asset sales and amplifying price declines.

In contrast, longer-term investors such as pension funds and insurance companies tend to be more stable. The IMF found that while hedge funds’ holdings of emerging market securities could decline by about 1.3 percent during volatility spikes, and mutual funds by around 0.6 percent, the response from pension and insurance investors is not statistically significant.

The report also highlighted the rapid growth of private credit, a relatively opaque segment of nonbank finance that involves direct lending to companies.

Assets under management in this space have increased fivefold over the past decade to an estimated $50 billion to $100 billion in emerging markets.

While this expansion broadens access to financing, limited transparency and data gaps could make it harder to detect emerging risks to financial stability.

The shift toward nonbank financing has also been shaped by post-2008 regulatory reforms that constrained the risk-taking capacity of global banks, pushing riskier borrowers toward alternative funding sources.

While this has reduced the sensitivity of bank lending to global shocks, it has increased the exposure of market-based financing to shifts in investor sentiment.

To manage these risks, the IMF urged policymakers in emerging markets to strengthen macroeconomic fundamentals, including maintaining adequate fiscal and external buffers and improving institutional quality.

Monitoring the composition of the investor base is also critical to understanding potential vulnerabilities.

A mix of policy tools, including monetary policy adjustments, exchange rate flexibility, and, where necessary, foreign exchange interventions, can help mitigate the impact of volatile capital flows.

Macroprudential measures and system-wide stress testing can further enhance resilience by ensuring financial institutions maintain sufficient capital and liquidity buffers.

The IMF also called for stronger international cooperation to address regulatory and data gaps, warning that without coordinated oversight, the growing dominance of nonbank financing could amplify the cross-border transmission of financial shocks.