Hot Money

The term “hot money” in an economic or financial context refers to money that quickly shifts between financial markets in search of the highest short-term interest rate or rate of return. “Hot money investors” are investors who jump into and out of short-term investments, sometimes driven to act in mass by a seemingly herd mentality. The term does crop up in criminal investigations where it refers to marked bills or new currency with consecutive serial numbers. Such currency bears the name “hot money” because it can be easily identified and linked to a specific crime.

In today’s world of globalization and financial liberalization, the term “hot money” in the popular media usually refers to the use of the term in an economic or financial context. Even from the economic and financial perspective, “hot money” can carry different shades of meaning. Banks often think of deposits from foreign and institutional investors as being hot money because these deposits are large and may be suddenly and unexpectedly withdrawn. Questions about a bank’s solvency or higher interest rates in other places can cause a mass exodus of these deposits. To a buffer against the volatility of hot money, banks may cultivate a large base of consumer and household deposits.

As trading strategies of investors and speculators have grown in complexity, the influence of hot money has been felt in markets normally outside the sphere of risky speculation. In 2006, observers expressed concern about the influx of hot money in to the U.S. municipal bond market, one of the drabber and quieter financial markets (Pollock, 2006). Usually investors in these bonds are U.S. investors because the interest rate paid by these bonds, although lower that the interest rate paid on other bonds, is exempt from federal taxation. Foreign investors began investing in these bonds after they found a way to place leveraged bets on a divergence between the prices of municipal bonds and non–tax-exempt bonds. Some investors feared that than a mass exodus of foreign investors would cause the market for these bonds to plummet.

In 2005, some analysts and investors saw hot money behind a large run up of oil prices and the greater volatility in oil prices (Sesit and Reilly, 2005). They blamed hedge funds making use of large computer programs, organizations that unlike airlines and utilities had no direct need to purchase oil.

Hot money is often cited as a disruptive factor in international capital flows, allowing sudden shifts that can spark contagious financial crises. In 2008, Chinese officials expressed concern about the excess inflow of hot money (McMahon, 2008). Foreign investors depositing money in China gained in two fronts. First, Chinese interest rates stood nearly twice U.S. levels. Secondly, between January and May of 2008, Chinese currency gained in value 4.2 percent relative to the U.S. dollar. Observers had credited hot money for drastic fluctuations in China’s booming stock market and real estate market. Unlike many countries, China has strict controls on foreign capital movements that should restrain inflows and outflows of hot money, but foreign investors have found ways to get around the controls. One way of getting around the controls involves inflating receipts of legitimate trade and investment transactions. Chinese officials have no way of knowing exactly how much hot money has entered China. China’s case is interesting in that it shows that controlling movements of hot money can be difficult.