Hot money refers to a short-term investment strategy that typically involves the rapid and frequent movement of money from one country to another to profit from higher interest rates.
Discover how hot money works, how it got its name, and whether this type of investment strategy fits into your investing comfort zone.
Definition and Example of Hot Money
While there is no official definition of the term “hot money,” it refers to something that happens in financial markets. It refers to the flow of funds (or capital) from country to country so investors can take advantage of higher interest rates. The term got its name because money can rapidly flow into a country’s economy and exit just as quickly.
- Alternate name: Speculative money
- Alternate definitions: As a slang term in law enforcement, “hot money” can refer to stolen money
Hot money sometimes is called “speculative money” because the funds switch quickly from one currency to another. Investors then attempt to maximize profits based on the interest rate differences or the expectation that the country’s currency value will appreciate soon.
Let’s say that China’s interest rates jumped to 2% higher than the U.S. In that situation, hot-money investors would swiftly move their funds from U.S. investment assets to purchase assets in China.
How Hot Money Works
Hot-money investing typically involves the frequent flow of funds from an economy with lower interest rates to an economy with higher interest rates. The primary purpose of using a hot-money strategy is to make as much money as possible in the shortest time possible. In addition to interest rates, hot-money investing can also take advantage of the increasing value of currency within an emerging market.
“Emerging markets” are developing countries with rapidly growing industries and economies. They include Brazil, Russia, India, China, and South Africa (BRICS).Countries attract hot-money investors by offering above-average interest rates to bring in capital and support economic growth.
Since hot-money investors constantly seek profits, funds are frequently transferred between countries. As a result, money typically never stays in the same place for very long. That makes the money “hot.” Hot-money investments can include mutual fund investments as well as simply buying foreign currency and depositing it into bank accounts to cash in on the interest payments.
Estimating Hot Money
Since the flow of hot money is quick and poorly monitored, the method for estimating the amounts that flow into a country’s economy is not well-defined. Besides, hot-money totals are subject to sudden changes. The inflow of capital can rise or fall rapidly, depending on the economic conditions driving the flow of money.
The most common way of estimating a country’s hot-money flow is by subtracting the economy’s trade surplus (or deficit) and its net flow of foreign direct investment (FDI) from the change in the country’s foreign reserves.
Drawbacks of Hot Money
Hot-money investments are a double-edged sword because while they can be beneficial for bringing money into an economy, they can also leave behind a trail of destruction. Such rapid money movement in and out of financial markets can lead to market instability. For instance, if economy “A” takes a dip in its interest rates, hot-money investors begin to panic and jump ship. This can create a sudden and rapid outflow of money from that economy as investors seek more attractive destinations for their funds.
Meanwhile, the very nature of hot money means that a rapid outflow from one economy typically leads to a sudden inflow of capital into another economy. Interestingly, this can produce some unwanted consequences for the economy receiving capital inflows. For example, it can fuel inflation, cause systemic overinvestment, and overextend the banking system. To alleviate these adverse effects, countries may attempt to impose capital controls.
Capital controls are monetary policies and restrictions that countries put in place to gain control over hot-money inflows and outflows to the economy.
In 2008, China received a sharp inflow of hot money from investors seeking short-term profits. During that time, the U.S. Federal Reserve lowered interest rates to 2%, while China’s interest rates rose to 4.14%. This sparked investors to move their investments out of the U.S. into China to earn higher returns. According to Chinese estimates, the amount of incoming hot money totaled somewhere between $500 billion and $1.75 trillion.
As a result, some economists blamed the sudden influx of capital for exacerbating China’s already existing inflation problems. The large flow of hot money created a sharp rise in China’s money supply, which caused prices to increase on things such as food. China’s attempts to slow the inflow of hot money by selling bonds only resulted in even higher interest rates that attracted even more hot money. Coupled with the slow U.S. economy and appreciating value of China’s currency, they were caught in a “Catch-22” situation.
What It Means for Individual Investors
Hot-money investing is not for the faint of heart. This risky strategy can lead to significant gains, as well as huge losses.
Whenever there is any sign of a market dip, hot-money investors are the first to act and move their funds to more favorable markets. That means this investing strategy requires regular monitoring of investment portfolios and staying abreast of market happenings at all times.
Pros and Cons of Hot Money
Emerging markets bring in cash
Promotes economic growth, creates jobs
Investors can quickly earn profit
Investors can face sudden monetary policies
When it comes to advantages for emerging markets, hot money helps bring in cash quickly to help promote economic growth and create jobs. For investors, the most significant advantage is earning the highest profits as quickly as possible on their investments.
On the other hand, the disadvantage for emerging markets is inflation, overvaluation of currency, and market instability. For the investor, a big disadvantage comes when monetary policies are put in place to prevent the easy flow of hot money into and out of emerging economies.
- “Hot money” refers to a short-term investment strategy to make as much money as possible in a short time.
- Hot-money investing involves frequently and rapidly moving money from a country with lower interest rates to a country with higher interest rates.
- Sudden inflows of hot money can have unwanted consequences, such as inflation.
- Hot money can have other unofficial meanings that refer to stolen money or placing bets.