Hot money
Encyclopedia
Hot money is a term that is most commonly used in financial market
s to refer to the flow of funds (or capital) from one country to another in order to earn a short-term profit on interest rate
differences and/or anticipated exchange rate
shifts. These speculative capital flows are called "hot money" because they can move very quickly in and out of markets, potentially leading to market instability.
in the United States is 0.95%. In contrast, China's benchmark one year deposit rate is 3%. And it is widely believed that the Chinese currency
(renminbi) is seriously undervalued against world's major trading currencies and therefore would appreciate against the US dollar in the coming years. Given this situation, if an investor in the US deposits his/her money in a Chinese bank, the investor would get a higher return than that in the situation in which he/she deposits money in a US bank. This makes China a prime target for hot money inflows. This is just an example for illustration. In reality, hot money takes many different forms of investment
Furthermore, the following vivid description of hot money help further illustrate this phenomemon: "one country or sector in the world economy experiences a financial crisis
; capital flows out in a panic; investors seek more attractive destination for their money. In the next destination, capital inflows create a boom that is accompanied by rising indebtness, rising asset prices and booming consumption-for a time. But all too often, these capital inflows are followed by another crisis. Some commentators describe these pattern of capital flow as “hot money” that flows from one sector or country to the next and leaves behind a trail of destruction.". However it should be noted that such normative comments notwithstanding, these types of flows and any destructive results are rooted in and properly attributed to the extra market activities of central bank market manipulations that in fact cause such persistent conditions of disequilibrium and insulates them against free market forces that otherwise would quickly eliminate the incentive for such flows.
The types of capital
in the above categories share common characteristics: investment horizon is short; they can come in quickly and leave quickly.
(or deficit) and its net flow of foreign direct investment (FDI)
from the change in the nation’s foreign reserves
.
Hot Money (approx) = Change in foreign exchange reserves - Net exports - Net foreign direct investment
economies such as India, Brazil, China, Turkey, Malaysia etc. Although the specific causes of hot money flow is somewhat different from period to period, but generally, the following could be considered as the causes of hot money flow:
As described above, hot money can be in different forms. Hedge fund
s, other portfolio investment funds and international borrowing of domestic financial institutations are generally considered as the vehicles of hot money. In the 1997 East Asian Financial Crisis and in the 1998 Russian Financial Crises, the “hot money” chiefly came from banks, not portfolio investors.
countries should be welcomed. Because foreign capitals can finance investment and stimulate economic growth, thus helping increase the standard of living in the developing world. Capital flows can increase welfare by enabling households to smooth out their consumption over time and achieve higher level of consumption. Capital flows can help developed countries achieve a better international diversification of their portfolios.
However, large and sudden inflows of capital with short term investment horizon have negative macroeconomic effects, including rapid monetary expansion, inflationary pressures, real exchange rate appreciation and widening current account
deficits. Especially, when capital flows in volume into small and shallow local financial market
s, the exchange rate tends to appreciate, asset prices to rally and local commodity prices to boom. These favorable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weakness in the domestic bank sector. When global investors' sentiment on emerging markets shift, the flows reverse and asset prices give back their gains, often forcing a painful adjustment on the economy. The following are the details of the dangers that hot money presents to the receiving country's economy:
Furthermore, hot money could lead to exchange rate appreciation or even cause exchange rate overshooting. And if this exchange rate appreciation persists, it would hurt the competitiveness of respective country's export sector by making the country's exports more expensive compared to similar foreign goods and services.
However, some economists and financial experts argue that hot money could also play positive role in countries that have relatively low level of foreign exchange reserves, because the capital inflow may present a useful opportunity for those countries to augment their central banks' reserve holdings .
, but because of hot money's negative effects on the economy, they are instituting different policies to stop the "hot money" from coming into their country and to eliminate the effects of the hot money.
Different countries are using different method to prevent massive influx of hot money. The following are the main methods of dealing with hot money .
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
s to refer to the flow of funds (or capital) from one country to another in order to earn a short-term profit on interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
differences and/or anticipated exchange rate
Exchange rate
In finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
shifts. These speculative capital flows are called "hot money" because they can move very quickly in and out of markets, potentially leading to market instability.
Illustration of hot money flows
The following simple example illustrates the phenomenon of hot money: In the beginning of 2011, the national average rate of one year certificate of depositCertificate of deposit
A certificate of Deposit is a time deposit, a financial product commonly offered to consumers in the United States by banks, thrift institutions, and credit unions....
in the United States is 0.95%. In contrast, China's benchmark one year deposit rate is 3%. And it is widely believed that the Chinese currency
Chinese currency
The Renminbi is the official currency of the People's Republic of China . It is the legal tender in mainland China, but not in Hong Kong and Macau. It is abbreviated as RMB, and the units for the Renminbi are the Yuan , Jiao , and Fen : 1 Yuan = 10 Jiao = 100 Fen. Fen have almost disappeared, so...
(renminbi) is seriously undervalued against world's major trading currencies and therefore would appreciate against the US dollar in the coming years. Given this situation, if an investor in the US deposits his/her money in a Chinese bank, the investor would get a higher return than that in the situation in which he/she deposits money in a US bank. This makes China a prime target for hot money inflows. This is just an example for illustration. In reality, hot money takes many different forms of investment
Furthermore, the following vivid description of hot money help further illustrate this phenomemon: "one country or sector in the world economy experiences a financial crisis
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
; capital flows out in a panic; investors seek more attractive destination for their money. In the next destination, capital inflows create a boom that is accompanied by rising indebtness, rising asset prices and booming consumption-for a time. But all too often, these capital inflows are followed by another crisis. Some commentators describe these pattern of capital flow as “hot money” that flows from one sector or country to the next and leaves behind a trail of destruction.". However it should be noted that such normative comments notwithstanding, these types of flows and any destructive results are rooted in and properly attributed to the extra market activities of central bank market manipulations that in fact cause such persistent conditions of disequilibrium and insulates them against free market forces that otherwise would quickly eliminate the incentive for such flows.
Types of hot money
As mentioned above, capital in the following form could be considered hot money:- Short-term foreign portfolio investmentPortfolio investmentThe purchase of stocks, bonds, and money market instruments by foreigners for the purpose of realizing a financial return, which does not result in foreign management, ownership, or legal control.Some examples of portfolio investment are:...
s, including investments in equitiesEquity (finance)In accounting and finance, equity is the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. If liability exceeds assets, negative equity exists...
, bondsBond (finance)In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...
and financial derivativesDerivative (finance)A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S... - Short-term foreign bank loans
- Foreign bank loans with short term investment horizon
The types of capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
in the above categories share common characteristics: investment horizon is short; they can come in quickly and leave quickly.
Estimates of total value
There is no well-defined method for estimating the amount of “hot money” flowing into a country during a period of time, because “hot money” flows quickly and is poorly monitored. In addition, once an estimate is made, the amount of “hot money” may suddenly rise or fall, depending on the economic conditions driving the flow of funds. One common way of approximating the flow of “hot money” is to subtract a nation’s trade surplusBalance of trade
The balance of trade is the difference between the monetary value of exports and imports of output in an economy over a certain period. It is the relationship between a nation's imports and exports...
(or deficit) and its net flow of foreign direct investment (FDI)
Foreign direct investment
Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
from the change in the nation’s foreign reserves
Foreign exchange reserves
Foreign-exchange reserves in a strict sense are 'only' the foreign currency deposits and bonds held by central banks and monetary authorities. However, the term in popular usage commonly includes foreign exchange and gold, Special Drawing Rights and International Monetary Fund reserve positions...
.
Hot Money (approx) = Change in foreign exchange reserves - Net exports - Net foreign direct investment
Sources and causes
Hot money is usually originated from the capital rich, developed countries that have lower GDP growth rate and lower interest rates compared to the GDP growth rate and interest rate of emerging marketEmerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
economies such as India, Brazil, China, Turkey, Malaysia etc. Although the specific causes of hot money flow is somewhat different from period to period, but generally, the following could be considered as the causes of hot money flow:
- sustained decline of interest rates in the highly industrialized, developed countries. The lower interest rates in the developed nations attract investors to the high investment yields and improving economics prospects in Asia and Latin America.
- general trend toward international diversification of investments in major financial centers and toward growing integration of world capital marketCapital marketA capital market is a market for securities , where business enterprises and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year, as the raising of short-term funds takes place on other markets...
s. - emerging marketEmerging marketsEmerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
countries began to adopt sound monetary and fiscal policies as well as market-oriented reforms including trade and capital market liberalization. Such policy reforms, among others, have resulted in credible increase in the rate of return on investments.
As described above, hot money can be in different forms. Hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
s, other portfolio investment funds and international borrowing of domestic financial institutations are generally considered as the vehicles of hot money. In the 1997 East Asian Financial Crisis and in the 1998 Russian Financial Crises, the “hot money” chiefly came from banks, not portfolio investors.
Impact
Capital flows from rich and developed world to developing and emerging marketEmerging markets
Emerging markets are nations with social or business activity in the process of rapid growth and industrialization. Based on data from 2006, there are around 28 emerging markets in the world . The economies of China and India are considered to be the largest...
countries should be welcomed. Because foreign capitals can finance investment and stimulate economic growth, thus helping increase the standard of living in the developing world. Capital flows can increase welfare by enabling households to smooth out their consumption over time and achieve higher level of consumption. Capital flows can help developed countries achieve a better international diversification of their portfolios.
However, large and sudden inflows of capital with short term investment horizon have negative macroeconomic effects, including rapid monetary expansion, inflationary pressures, real exchange rate appreciation and widening current account
Current account
In economics, the current account is one of the two primary components of the balance of payments, the other being the capital account. The current account is the sum of the balance of trade , net factor income and net transfer payments .The current account balance is one of two major...
deficits. Especially, when capital flows in volume into small and shallow local financial market
Financial market
In economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
s, the exchange rate tends to appreciate, asset prices to rally and local commodity prices to boom. These favorable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weakness in the domestic bank sector. When global investors' sentiment on emerging markets shift, the flows reverse and asset prices give back their gains, often forcing a painful adjustment on the economy. The following are the details of the dangers that hot money presents to the receiving country's economy:
- inflow of massive capital with short investment horizon (hot money) could cause asset price to rally and inflationInflationIn economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
to rise. The sudden inflow of large amounts of foreign money would increase the monetary base of the receiving country, which would help create credit boom. This, in turn, would result in such a situation in which "too much money chase too few goods". Consequences of this would be inflation.
Furthermore, hot money could lead to exchange rate appreciation or even cause exchange rate overshooting. And if this exchange rate appreciation persists, it would hurt the competitiveness of respective country's export sector by making the country's exports more expensive compared to similar foreign goods and services.
- sudden outflow of hot money, which would alway certainly happen, would deflate asset prices and could cause the collapse value of the currency of respective country. This is especially so in countries with relatively scarce internationally liquid assets. There is growing agreement that this was the case in the 1997 East Asian Financial Crisis. In the run-up to the crises, firms and private firms in South Korea, Thailand and Indonesia accumulated large amounts of short term foreign debt (a type of hot money). The three countries shared a common characterestic of having large ratio of short term foreign debt to international reserves. When the capital starts to flow out, it caused a collapse in asset prices and exchange rates. The financial panic fed on itself causing foreign creditors to call in loans and depositors withdraw funds from banks, all of these magnified the illiquidity of the domestic financial system and forced yet another round of costly asset liquadations and price deflation. In all of the three countries, the domestic financial institutions came to the brink of default on their external short term obligations.
However, some economists and financial experts argue that hot money could also play positive role in countries that have relatively low level of foreign exchange reserves, because the capital inflow may present a useful opportunity for those countries to augment their central banks' reserve holdings .
Control
Generally speaking, given their relatively high interest rates compared with that of the developed market economies, emerging market economies are the destination of hot money. Although the emerging market countries welcome capital inflows such as foreign direct investmentForeign direct investment
Foreign direct investment or foreign investment refers to the net inflows of investment to acquire a lasting management interest in an enterprise operating in an economy other than that of the investor.. It is the sum of equity capital,other long-term capital, and short-term capital as shown in...
, but because of hot money's negative effects on the economy, they are instituting different policies to stop the "hot money" from coming into their country and to eliminate the effects of the hot money.
Different countries are using different method to prevent massive influx of hot money. The following are the main methods of dealing with hot money .
- Exchange rate appreciation: exchange rate could be used as a tool to control the inflow of hot money. If exchange rate is believed to be undervalued, that would be a cause of hot money inflow. In such circumstance, economists usually suggest a significant one-off appreciation rather than gradual move in foreign exchange. Because gradual appreciation of the exchange rateExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
would attract even more hot money into the country. One downside of this approach is that exchange rate appreciation would reduce the competitiveness of the exportExportThe term export is derived from the conceptual meaning as to ship the goods and services out of the port of a country. The seller of such goods and services is referred to as an "exporter" who is based in the country of export whereas the overseas based buyer is referred to as an "importer"...
sector. - Interest rate reduction: countries that adopt this policy would lower their central bank's benchmark interest rates to reduce the incentive for inflow. For example, on December 16, 2010, the Turkish Central BankCentral Bank of the Republic of TurkeyThe Central Bank of the Republic of Turkey is the central bank of Turkey and is founded as a joint stock company with the exclusive right to issue banknotes in Turkey. The preparations to establish a central bank began in 1926, but organization was established on 3 October 1931 and opened...
surprised markets by cutting interest rates at the time of rising inflation and relatively high economic growthEconomic growthIn economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
. Erdem Basci, deputy bank governor of Turkish Central Bank argued that gradual rate cuts were the best way to prevent excessive capital inflows fuelling asset bubbles and currency appreciation . On February 14, 2011, Mehmet Simsek, the Turkish Finance Minister said: “more than $8 billion in short-term investment had exited country after the central bank cut rates and took steps to slow credit growth. The markets have got the message that Turkey does not want hot money inflows” - Capital controls: some policies of capital controls adopted by China belong to this category. For example, In China: the government does not allow foreign funds directly invest in its capital market. Also, the central bank of ChinaPeople's Bank of ChinaThe People's Bank of China is the central bank of the People's Republic of China with the power to control monetary policy and regulate financial institutions in mainland China...
sets quotas for its domestic financial institutionFinancial institutionIn financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...
s for the use of short-term foreign debt and prevent banks from overusing their quotas. In June 1991, Chilean government instituted a non-remunerated (non-paid) 20 percent reserve requirement to be deposited at the Central Bank for a period of one year for liabilities in foreign currency, for firms which are borrowing directly in foreign currency, a . - Increasing bank reserve requirements and sterilization: some countries pursue fixed exchange rateFixed exchange rateA fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime wherein a currency's value is matched to the value of another single currency or to a basket of other currencies, or to another measure of value, such as gold.A fixed exchange rate is usually used to...
policy. In the face of large net capital inflow, those countries would intervene in the foreign exchange marketForeign exchange marketThe foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
to prevent exchange rate appreciation. Then sterilize the monetary impact of intervention through open market operations and through increasing bank reserves requirements. For example, when hot money originated from the U.S. enters China, investors would sell US dollarsUnited States dollarThe United States dollar , also referred to as the American dollar, is the official currency of the United States of America. It is divided into 100 smaller units called cents or pennies....
and buy Chinese yuanChinese yuanThe yuan is the base unit of a number of modern Chinese currencies. The yuan is the primary unit of account of the Renminbi.A yuán is also known colloquially as a kuài . One yuán is divided into 10 jiǎo or colloquially máo...
in the foreign exchange marketForeign exchange marketThe foreign exchange market is a global, worldwide decentralized financial market for trading currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends...
. This would put upward pressure on the value of the yuan. In order to prevent the appreciation of the Chinese currency, the central bank of China print yuan to buy US dollars. This would increase money supply in China, which would in turn cause inflation. Then, the central bank of China has to increase bank reserve requirements or issue Chinese government bonds to bring back the money that it has previously released into the market in the exchange rateExchange rateIn finance, an exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency...
intervention operation. However, like other approaches, this approach has limitations. The first, the central bankCentral bankA central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
can't keep increasing bank reservesBank reservesBank reserves are banks' holdings of deposits in accounts with their central bank , plus currency that is physically held in the bank's vault . The central banks of some nations set minimum reserve requirements...
, because doing so would negatively affect bank's profitability. The second, in the emerging market economies, the domestic financial marketFinancial marketIn economics, a financial market is a mechanism that allows people and entities to buy and sell financial securities , commodities , and other fungible items of value at low transaction costs and at prices that reflect supply and demand.Both general markets and...
is not deep enough for open market operations to be effective. - FiscalFiscalFiscal usually refers to government finance. In this context, it may refer to:* Fiscal deficit, the budget deficit of a government* Fiscal policy, use of government expenditure to influence economic development...
tightening: the idea is to use fiscal restraint, especially in the form of spending cuts on nontradables, so as to lower aggregate demand and curb the inflationary impact of capital inflow.