According the definition in Wikipedia; Hot money refers to funds which flow into a country to take advantage of a favorable interest rate, and therefore obtain higher returns. Hot money usually flows from low interest rate yielding countries into higher interest rates countries. (10 year Treasury Rates in the US is 3% in India it is 8%)Hot money flows into an economy looking for opportunities it can either be Interest rate differences, Currency valuation or Stock Valuation.
Why we need to be bothered; Hot Money is an opportunist it flows in and out of countries looking for short term profit/opportunities and inconsistencies. The fact is because the capital involved is huge they could significantly affect smaller economies with their movement and the kind of positions they take. The Asian crises were actually attributed towards the volatile movement of Hot money. Sudden inflow of Funds into an economy like India can appreciate its currency significantly making exports costlier and reducing the countries competitiveness. It could also lead to creation of asset bubbles, like what is happening in Hong Kong and china property market. Stocks markets can have exceptional short term outburst like what happened in India post elections. But sudden outflow of these funds due to their short term nature can significantly collapse the economy as well.
The accepted fact right now is there is capital in the world than can move from on market to another in a millionth of a second. Developed countries have a lot of capital in their hands waiting to be deployed due to lack of opportunities in their domestic economies (Low treasury yields, almost negative GDP growth rate, flat property market and high currency value). Coupled with this is the respective governments are trying to prop up their economies by keeping rates at artificially low price hoping the cheap money will stimulate demand but the fact of the matter is all this cheap money is flowing towards emerging markets and creating a affecting their balance of payment and unduly stimulating inflation.
US - The source of HOT MONEY
The Fed is holding short-term interest rates near zero. Investors and speculators borrow dollars cheaply and use them to buy various assets -- stocks, bonds, gold, oil, minerals, foreign currencies. Prices rise. Huge profits can be made. But this can't last; the Fed will eventually raise interest rates. Or outside events (a confrontation with Iran, fear of a double-dip recession, War in Pakistan, Intervention in Korea) will change market psychology. Then investors will rush to lock in profits, and the sell-off will trigger a crash. Stock, bond and commodity prices will plunge. Losses will mount, confidence will fall and the real economy will suffer. The Fed and other policymakers seem unaware of the monstrous bubble they are creating in assets all around the world. The longer they remain blind, the harder the markets will fall.
As the US Fed decides how much money they will spend to help jump start economic growth at home, the impact of that decision on emerging economies like India is a new wave of hot money flowing into the nation's equity markets. "The second round of quantitative easing of the monetary policy in the US will pump more hot money into emerging countries. Quantitative easing involves increasing the money supply by printing more money. It can also include buying government bonds to reduce long- term interest rates and encouraging private banks to lend more.
Current Situation
Curbs by countries to control hot money Emerging economies will need capital controls to manage flows of ‘hot money’ and ensure economic stability in the wake of the United States’ ultra-easy monetary policy. Some emerging countries, such as Brazil, Thailand, Korea & Malaysia have implemented some capital control measures to restrict a huge influx of liquidity, especially since the United States unleashed a second round of quantitative easing.
Stiglitz, who won a Nobel Prize in economics in 2001, said the way to ensure economic stability was for countries to curb speculative inflows, but allow long-term investment that creates jobs. Some countries could learn from China on controlling speculative inflows to stabilise its economy, now the world’s second-largest, he said.
Stiglitz, who won a Nobel Prize in economics in 2001, said the way to ensure economic stability was for countries to curb speculative inflows, but allow long-term investment that creates jobs. Some countries could learn from China on controlling speculative inflows to stabilise its economy, now the world’s second-largest, he said.
“China has had capital controls on short-term flows that have worked, not perfectly, but have worked to stabilise these short-term flows. But at the same time, it’s been very open to long-term investments,” he said.
South Korea is preparing fresh measures aimed at curbing volatility in cross-border capital inflows, in addition to restrictions unveiled in June on currency derivatives trades by banks.
In India we are still debating how much intervention in the market we should have. And there are people who say in India we shouldn’t have capital controls, even though Brazil’s done it, China’s done it.”
Indian context The ratio of volatile capital flows defined to include cumulative portfolio inflows and short-term debt (Hot Money) to the country’s forex reserves increased to 58.1% in March 2010 compared to last year’s 47.9%. According to the Reserve Bank of India (RBI), the ratio of short-term debt to the foreign exchange reserves declined from 146.5% in March 1991 to 12.5% in March 2005, but increased slightly to 12.9% in 2006. However, with expansion in the coverage of short-term debt, the ratio increased to 14.8% in March 2008, to 17.2% in March 2009 and 18.8% in March 2010. 88% of the Hot Money comes from Mauritius.
For the Inquisitive Investor
Hot money is very sensitive and any small tremors could affect its flow and change. The short term perspective itself of the fund makes it a dangerous ally for economies who sometimes take their help to prop up currency and stock markets. A lot of hot money has entered our stock markets and hence as investors we need to be wary of their mood swings. Any negative impact could erode around 3000 points from the SENSEX in a couple of days. Due to the herd mentality of hot money, negative news spreads like wild fire and with the sophisticated technology under their control the impact they can make is significant. By technology I meant the speed at which they can make their transactions and pull out billions out of our Indian stock market. My suggestion would be to be wary of this beast, be smart in booking your profits or in making exit calls.
People who have a knack of analyzing movement of FII flows or have first hand information of these investor sentiments are at an advantage and we tend to trust them. But these brokerage houses or individuals can similarly work with FII’s in distorting our views of the market and hence I would suggest caution in blindly following foreign investor hints and jumping into conclusions when you see FII participation in derivatives and cash markets.
