Updated July 17, 2023
What is Hot Money?
The term “hot money” refers to the investment strategy wherein the investors move their capital from one country (or financial institutions) to another to take advantage of favorable movement in interest rates. The name comes from the fact that investors can move their money so quickly and easily. Besides creating short-term liquidity for the recipient country, it can also influence its capital flow and currency exchange rate.
Explanation of Hot Money
Hot money is the type of money that can flow freely and quickly from one part of the world to another in the search for earning a better rate of return. Such money is usually invested in assets expected to appreciate in the near term or deposited in accounts that offer a better real interest rate. Typically, these investments are high-risk and short-term, with the ability to generate sizeable payouts. The most common avenues include stocks, deposits, bonds, commodities, currencies, and derivatives.
How Does Hot Money Work?
Financial institutions usually attract investments from hot money investors by issuing various investment instruments (such as certificates of deposit) that offer competitive interest rates. For instance, when a bank reduces its rate of interest such that it offers a lower rate than its peers, then the investors immediately take out their funds from the bank with the lower rate and deposit the funds with any bank that offers a higher interest rate.
A similar concept is also relevant for economies wherein the investors move their capital from one country to another with the intention of taking advantage of the favorable interest rate differentials.
Examples of Hot Money
Let us look at some of the examples to understand how it works:
- Example #1: The year 2011 saw a significant amount of hot money flow from the eurozone to Switzerland. This happened because of the Eurozone crisis back then. Since the European investors saw Switzerland as a safe haven, there was a rapid appreciation in the value of the Swiss Franc as a large number of investors wanted to purchase Swiss Francs.
- Example #2: Chinese economy is one of the prime examples. During the period from 2006 to 2014, the foreign currency reserve in China increased multiple times to reach a balance of $4 trillion. It is believed that a significant portion of the foreign reserve came in the form of hot money wherein investors were attracted by stocks with high return potential and bonds with lucrative interest rates.
- Example #3: Let us take the example of David, who is a hot money investor from the UK. Presently, he has a savings account in the UK that earns him an interest of 1.2% p.a. He learned that banks in the US had increased their interest rates to 1.8%. He immediately decides to withdraw the money from the UK bank and move it to some US bank to take advantage of the interest rate differential.
Types of Hot Money
There is hardly any difference among the various forms of hot money as they all exhibit the same characteristics – short-term investment and frequent movement. Nevertheless, it can still be classified into two major heads based on the form of investment:
- A short-term loan in a foreign bank
- Short-term investment portfolio in a foreign country
Uses
- Investors employ this strategy to earn as much money as possible in a fairly short period of time.
- The countries attract hot money investors to boost their liquidity and foreign currency reserve.
- The banks use it to control the fluctuation in currency exchange rates.
Impact on Economy
Beneficiary Economy
- A large influx of capital driven by short-term objectives can trigger a surge in asset prices and contribute to inflationary pressures. Additionally, this influx of capital could expand the monetary base and create conditions for a credit boom.
- Its inflow could result in the appreciation of the currency exchange rate or cause the exchange rate to overshoot. If this persists, it could adversely impact the country’s export business as its goods and services would become more expensive than similar products from other countries.
Benefactor Economy
- The sudden outflow of hot money would definitely result in the deflation of asset prices and depreciation of the currency’s value.
Hot Money Flows
Hot money flows imply the flow of capital from a country with lower interest rates to a country with higher interest rates or from one country to another due to a favorable currency exchange rate differential. Investors are able to generate substantial gains from such flows between different countries. However, it can result in a massive impact on the economy of both the beneficiary and benefactor economies, which has already been discussed in the previous section.
Advantages
- Hot money investors can earn substantial gains by employing the funds in a strategic manner.
- The developed countries can use the capital inflow to achieve better diversification of international investors in their portfolios.
Disadvantages
- The hot money investors would be the first ones to desert a business at times of adversity, which can further accentuate the liquidity stretch.
- Such sudden capital inflow with a shorter investment horizon may negatively influence the economy, such as rapid monetary expansion, widening current account deficits, and inflationary pressures.
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