What Is Hot Money?

Hot money is currency that moves regularly, and quickly, between financial markets, so investors ensure they are getting the highest short-term interest rates available. Hot money continuously shifts from countries with low-interest rates to those with higher rates; these financial transfers affect the exchange rate if there is a high sum and also potentially impact a country's balance of payments. Hot money can also refer to money that has been stolen but is specially marked so it can be traced and identified.

Key Takeaways

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

Understanding Hot Money

Hot money exists not only in regard to currencies of different countries but also in reference to capital invested in competing businesses. Banks seek to bring in hot money by providing investors short-term certificates of deposit (CDs) with interest rates that are higher than average. Once the bank lowers its interest rates, or another financial institution offers higher rates, investors withdraw hot money funds and move them to take advantage of the higher interest rates.

Within the context of the global economy, hot money is able to flow between economies only after trade barriers are removed and a sophisticated financial infrastructure is developed. In this manner, money can flow into areas of the economy which are high-growth or have potential for outsized returns. Conversely, hot money flows out of underperforming sectors of an economy or out of countries with economies that are weak or in danger of slowing down.

China as a Hot, and Then 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 began to reverse direction following a substantial devaluing of the Chinese yuan and a major downside correction in China's stock markets. The Royal Bank of Scotland's chief China economy analyst, Louis Kuijs, estimates that in only a six-month time period, from Sept. 2014 to March 2015, the country lost somewhere in the neighborhood of $300 billion in hot money.

The reversal of China's money market is historic. From 2006 to 2014, the foreign currency reserves in the country multiplied, leaving the balance at $4 trillion. Part of the balance was accrued from foreign investors buying into long-term investments in China, such as factories, companies, and other businesses. A large portion, however, came from hot money; investors bought bonds selling at a promising rate and stocks that proposed a fast and significant return. Investors also borrowed money in China, at a cheap rate, to purchase high-rate bonds in other countries.

Onlookers around the world viewed the Chinese market as a great deal for hot money because of its booming stock market and strong currency. In 2016, however, the bloom came off the rose. China quickly lost favor, specifically among investors with hot money to spend. Stock prices increased to the extent there was no upside. The up and down of the yuan, since the end of 2013, also caused investors to pull out of the country and bred hesitancy among potential investors. During the nine-month period between June 2014 and March 2015, the foreign exchange reserves of the country dropped more than $250 billion.

Something similar occurred in 2019. According to estimates by the Institute of International Finance, more than $60 billion in capital was taken out of China's economy within two months—May and June—of that year. Several reasons were offered for the outflow, from capital controls to devaluation of the yuan.