What is Hot Money?

Hot money is the “purely speculative money,” which enters into an economy or an economic sector in order to earn a short-term and/or huge profit and leave quickly, as long as it finds more profit elsewhere.

Hot money refers to funds that net speculators move, the professional speculators, who spend 24/7 looking for an opportunity to obtain more and more profits.

Incidentally there is no consensus among economists, even among government authorities, on the advantages and disadvantages of speculation.

There is no consensus either on the difference between “positive” speculation and the “net”, professional, speculation. Although after the 2008 crisis and the current crisis in the developed world an increasing number of people seem to be against the latter.

Regarding the first, some academics argue that speculation is a positive element of the market and economic growth and that without risk taking there is no economic progress. Most of them reject the idea of a tax on the financial activity in general; arguing that many countries need risk capital and other ones liquidity and that such tax would discourage capital inflows for investment.

As to the second one, common sense leads us to recognize there is no advantage for any economy under such transactions, except for individuals that speculate.

Among the first ones are those who bet that a particular asset or bond will rise, and make their investment, and if the increase does not occur they lose their money and their profit.

For the second ones, on the contrary, there are neither risks nor losses. They have created risk transfer mechanisms such as the complex derivatives that imploded in the crisis of U.S. toxic assets, or “exit” mechanisms that allow them to avoid all losses. They are those that impel the runs on sovereign bonds, and afterwards buy them at bargain prices and then negotiate to be part of bailout agreements at a nominal value or they transfer them under these agreements to levels above the purchase price.

Maybe some “investors” lose, but not the “traders“, because they have not a performance business; their millionaires “bonuses” or compensations are linked to the funds they get to invest, and not to the results of such investments.

With the market liberalization and the free flows of capital, the investors bet in all or almost all markets all over the world, as long as it is allowed by the respective regulation. In general the speculation is more profitable in cross-border operations, than in domestic markets.

IMF

For decades, the IMF and multilateral credit organizations were strong promoters of full open capital markets as well as strong opponents of any kind of controls on them, and even imposed on member countries under the “Article IV consultations” and the adjustment and reform programs, the elimination of such controls. But now that the developed world is cornered by speculation, that recipe has changed and they advise now the use of controls on capital flows.

Given the current technology and market knowledge is not difficult to distinguish between a medium or long-term risk investment and a short-term speculative operation. Among these latter are all the overnight operations and the very short-term ones, with derivatives, or default swaps and the purchase of sovereign bonds by non-regulated financial institutions or by hedge funds, to mention just a few.

In some markets there are no restrictions for any kind of operation, in others short selling or short-term capital exits are regulated and in others governments allow foreign fund flows for direct investment, but not in the capital markets. Although in the latter case, speculators manage to come in and out of these markets.

Too many years of speculation and greed make it difficult to change this behaviour among financial operators. It is unlikely that they would accept to reduce the level of their profits so easily obtained. The only solution is to control it, tax it and punish it globally. The sooner the better, given the European and American crisis, but at this point there is no certainty about it.

CHINESE PERSPECTIVE

It is worth recalling some of the comments about hot money problem in the emerging economies made by Liu Wei, Director-General of the General Affairs Department of the SAFE (China’s State Administration of Foreign Exchange), in a January 2011 interview posted on the SAFE website.[1]

Here a selection of Liu Wei’s remarks on the Chinese perspective:

Hot money has become a hot topic in the emerging economies.

As for the emerging markets, due to their steady economic growth, interest rate spreads between the home currency and foreign currencies, and expectations for an RMB appreciation, China has become a magnet for international capital.

Not all incoming capital falls into the category of hot money. While continuously trying to facilitate trade and investment, China still keeps an eye on capital controls and has put in place a series of policy measures to curb the inflow of short-term speculative arbitrage funds. Therefore, there is no room for legal inflows of hot money in China.

The hot money that manages to enter China for speculative purposes and without a real trade or investment background usually takes advantage of the highly open and channels with minimal procedures, such as cargo trade, service trade, and direct investment. The violators cover up their illegal purposes with seemingly legal transactions, breaking or sidestepping the regulations in their chameleon ways.

The hot money in China shares the following common features: First, it comes in under disguise. Because hot money is not allowed to flow freely, its entry and exit is usually achieved by violating or bypassing the laws and regulations under the pretence of legal trade or investment or other available means of disguise.

Second, it is very complicated. Some aim to gain the differences between domestic and foreign interest rates or exchange rates in the short term, whereas others are more interested in the short-to-medium term profits from asset price increases.

Third, it comes in diverse forms, making it difficult to determine the true nature of the underlying transactions. But the movements of hot money leave behind traces that can be used as clues to track down its whereabouts and to reveal its disguise.

The speculative nature of hot money determines that it is always in hot pursuit of profits, wherever they are, and to follow the extent of profits, the violation of the laws is only a small price to pay.

To prevent and combat hot money, we must adopt a two-pronged approach. While robustly promoting the facilitation of trade and investment, we must strengthen our monitoring and early-warning of capital flows, adopt measures to stop cross-border arbitrage activities, prevent the devastating impacts of fluctuations in domestic asset prices and the aggravated financial risks caused by the massive entry or exit of hot money.

Developing countries are once again the destination for speculative capital flows with inflows reaching pre-crisis levels, leading to currency appreciation and asset bubbles. Many of these nations are deploying prudential capital regulations to stem these flows. However, this may only be a partial remedy to the problem – such measures should be coupled with action by the developed countries in order to fully steer capital to productive use and to avoid future crises.

 

By Raúl de Sagastizabal