Heavy inflows of portfolio investment funds into emerging and advanced economies are creating an “illusion of liquidity” that could disappear in the event of a market shock, the IMF warned yesterday.
A key development in recent years has been “emerging markets becoming an important destination of portfolio [flows from] advanced economies,” said financial counsellor Jose Vinals.
“Advanced economies now have more than $4tr in the portfolio investments of emerging market assets. And that is about 13% of their total investments — a share which has doubled over the past decade.
“What this means is that there are now much more closer financial interlinkages between advanced economies and emerging markets and that shocks emanating from advanced economies have the potential to more quickly propagate in emerging markets,” Vinals said.
“The good news is that capital markets are now in a position to provide more financing to the economy, and that is a very welcome development. But, at the same time, what we are seeing is that there is a shift of the locus of risks to the shadow banks and that is the not-so-good news.”
Credit in the form of mutual funds — funds which invest in fixed income assets — has seen strong asset inflows and has collectively become one of the largest holders of US corporate bonds and foreign bonds, Vinals noted.
“The problem is that these massive fund inflows have created an illusion of liquidity in fixed income markets,” he said. “The liquidity promised to investors in good times is likely to exceed significantly the liquidity which is available and provided by markets at times of stress, especially as banks have now less capacity to do market-making activities.
“So, people think they have much more liquid assets than they really have when the market turns around.”
The liquidity illusion in markets and the closer interconnectedness between advanced economies and emerging markets are “factors which will amplify the impact of shocks on asset prices. And if shocks are adverse, this will lead to sharper price falls and more market stress,” said Vinals.
“Such an adverse scenario is something that would take a toll on the economy by hurting wealth and demand, but also at the limit could even compromise global financial stability.”
He said a chain reaction could be triggered by a variety of shocks such as geopolitical flare-ups or a bumpy normalisation of US monetary policy.
Vinals was presenting the IMF’s latest Global Financial Stability Report which said that “prolonged monetary easing has encouraged the build-up of certain excesses in financial risk taking.
“This has been reflected in elevated asset prices across a range of financial assets; credit spreads which are now too low to compensate for the full risks in some market segments; and until recently record low volatility.”