What Is Hot Money?

Hot money signifies currency that quickly and regularly moves between financial markets, that ensures investors lock in the highest available short-term interest rates. Hot money continuously shifts from countries with low-interest rates to those with higher rates. These financial transfers affect the exchange rate and potentially impact a country's balance of payments. Hot money can also refer to stolen money that has been especially marked, so that it may be traced and identified.

Key Takeaways

  • Hot money is capital that investors regularly move between economies and financial markets to profit from highest short-term interest rates.
  • Banks bring hot money into an economy by providing short-term certificates of deposit with higher-than-average rates.
  • The Chinese economy is an example of a hot money market that turned cold following investor flight.

Understanding Hot Money

Hot money not only relates to currencies of different countries, but it may also refer to capital invested in competing businesses. Banks seek to bring in hot money by offering short-term certificates of deposit (CDs) with higher-than-average interest rates. If the bank lowers its interest rates, or if a rival financial institution offers higher rates, investors are apt to move hot money funds to the bank offering the better deal.

In a global context, hot money can flow between economies only after trade barriers are removed and sophisticated financial infrastructures are established. Against this backdrop, money flows into high-growth areas that offer the potential for outsized returns. Conversely, hot money flows out of underperforming countries and economic sectors.

China as a Hot-and-Cold Money Market

China's economy provides a clear example of the ebb and flow of hot money. Since the turn of the century, the country's rapidly expanding economy, accompanied by an epic rise in Chinese stock prices, established China as one of the hottest hot money markets in history. However, the flood of money into China quickly reversed direction following substantial devaluation of the Chinese yuan, coupled with a major correction in the Chinese stock market. The Royal Bank of Scotland's chief China economy analyst, Louis Kuijs, estimates that during the brief six months from September 2014 to March 2015, the country lost an estimated $300 billion in hot money.

The reversal of China's money market is historic. From 2006 to 2014, the country's foreign currency reserves multiplied, creating a $4 trillion balance, partially accrued from long-term foreign investment in Chinese businesses. But a significant chunk came from hot money, when investors bought bonds with attractive interest rates and accumulated stocks with high return potential. Furthermore, investors borrowed heaps of money in China, at cheap rates, in order to purchase higher interest-rate bonds from other countries.

Although the Chinese market became an attractive destination for hot money, thanks to a booming stock market and strong currency, the influx of cash slowed to a trickle in 2016, because stock prices peaked to the extent that there was little upside to be had. Additionally, since 2013, the fluctuating yuan also caused broad divestments. During the nine-month period between June 2014 and March 2015, the foreign exchange reserves of the country plummeted more than $250 billion.

Similar events occurred in 2019, when according to estimates by the Institute of International Finance, more than $60 billion in capital was taken out of China's economy between May and June of that year, due to increased capital controls, plus the devaluation of the yuan.

Hot money activity is generally funneled towards investments with short horizons.