The Reserve Bank of India (RBI) today expressed concern over investments by hedge funds in the stock markets and raised questions over the longer term sustainability of such investments worldwide.

In its first quarter review of the annual monetary policy for 2007-08, the RBI has described how the hedge funds are facing solvency threats in the wake of continued slump in the US housing markets and said the “contagion” could spread to other credit and corporate bond markets, in a spiral of repricing, tighter mortgage & borrowing conditions, falling house prices and slower consumption growth.

“With greater risk aversion going forward, with credit quality deteriorating and with the widening of credit spreads, the potential fragility of hedge funds could pose significant risks to financial market stability and to the prospects for financing and growth in the EMEs (emerging market economies),” RBI said.

At present, hedge funds cannot invest directly in the Indian markets. However, they could invest through PNs issued by Sebi-registered FIIs.

As per official data, the PNs account for 35 per cent of FII inflows. In 2007 thus far, the FIIs have invested a net Rs 42,954.20 crore ($10.2 billion).Market estimates, however, say more than 40 per cent of the FII money come through PNs. No official data on hedge funds’ contribution to PNs is available.

“The hedge funds industry is passing through a tough time. Indian companies as well as investors are not aware of investment strategies of these pools of money, whose source is not known. Following the quick appreciation of Rupee, the Indian markets’ attractiveness for these players could go up as they may chose to hedge their risks in these markets. The RBI has given a timely warning regarding this,” Bhaskar Ghosh, managing director, IndusInd Bank said.

“Indian money markets are partly reflecting the result of the still-opaque thinking on capital inflows and the rupee. The government continues to encourage capital inflows, including overseas borrowing by Indian companies, but doesn’t appear desirous of further rupee appreciation, and is also concerned about higher sterilization cost,” Rajeev Malik of JPMorgan Chase Bank, Singapore, said in his report over the policy.