Hot Money

Hot money is short-term capital that flows rapidly between countries, currencies or markets to take advantage of interest rate differences, expected exchange rate moves or quick price gains. Typical examples are foreign purchases of short-dated government bills, bank deposits, money market instruments and listed shares that can be sold at short notice. Because these investors can leave as quickly as they arrived, hot money can turn a country's good fortune into a sudden crisis.

Hot money is usually contrasted with foreign direct investment, such as building factories, which is long-term and hard to reverse. It is closely related to the carry trade, to capital flight when residents move money out, and to the wider study of capital mobility. Emerging markets with high interest rates are its most common destinations.

Imagine savers who move their money to whichever bank in town pays the highest rate this month, and move it again the moment another bank offers more or a rumour spreads. A bank that attracts them looks flush with cash, but it cannot lend that money out for years, because it may vanish next week.

Countries face the same problem. When global investors pour short-term money into a country offering high rates, its currency rises and borrowing looks cheap. When rates elsewhere rise or fear spreads, the money rushes out together, the currency falls and the country may struggle to pay its bills.

An investor who borrows in a low-rate currency and invests in a high-rate one expects to earn roughly:

• $i_{\text{target}}$ is the interest rate earned in the destination country.
• $i_{\text{funding}}$ is the rate paid on the borrowed or home currency.
• $\Delta e^{\text{exp}}$ is the expected percentage depreciation of the target currency over the period.

If a country's treasury bills pay 12% a year, dollar funding costs 4% and investors expect the local currency to fall 3% against the dollar, the expected return is $12 - 4 - 3 = 5\%$. If the currency instead drops 10%, the return becomes $12 - 4 - 10 = -2\%$, and investors may sell, pushing the currency down further. This interest rate differential logic explains both the arrival and the sudden departure of hot money.

• Mexico (1994–95). Short-term dollar-linked government debt, the tesobonos, became hard to roll over once investors fled.
• Asian financial crisis (1997–98). Thailand, Indonesia and South Korea had borrowed heavily in short-term foreign currency; outflows forced devaluations of the baht, rupiah and won.
• Taper tantrum (2013). When the Federal Reserve signalled it would slow bond buying, money left emerging markets such as Brazil, India, Indonesia, Turkey and South Africa.
• March 2020. As the pandemic hit, foreign holders sold emerging market bonds in record amounts; Pakistan, for example, saw much of the foreign money that had bought its treasury bills in 2019 leave within weeks, putting pressure on the rupee.

Sudden inflows can also do damage: they push up the currency, fuel credit expansion and asset prices, and can create an asset bubble. Reversals then cause a currency crisis or a credit crunch.

• Building reserves. Central banks accumulate foreign exchange reserves to cushion sudden outflows.
• Capital flow measures. Countries can tax or limit short-term inflows. Brazil imposed a financial transactions tax (IOF) on foreign portfolio inflows from 2009, and Chile required unremunerated reserve deposits on inflows in the 1990s. These are forms of capital controls, which the IMF now calls capital flow management measures.
• Macroprudential rules. Limits on banks' foreign-currency borrowing reduce the build-up of risk.
• Flexible exchange rates. A floating exchange rate makes one-way bets riskier, discouraging speculative inflows.

Supporters of open capital accounts argue that portfolio inflows lower borrowing costs, deepen local markets and discipline governments, and that controls are easy to evade and can deter long-term investors. Critics, including many economists after the Asian crisis, argue that unrestricted short-term flows bring more volatility than benefit to smaller economies. The IMF, which once pushed capital account liberalisation, adopted an "institutional view" in 2012 accepting that temporary controls on inflows can be appropriate in some circumstances, and reviewed it in 2022, keeping its core premises while giving more room for pre-emptive measures where large foreign-currency debts create risks. Proposals such as a Tobin tax on currency transactions aim to slow hot money globally, but have not been adopted.

• International Monetary Fund: Review of the Institutional View on the Liberalization and Management of Capital Flows (2022)