Hot Money - Control

Control

Generally speaking, given their relatively high interest rates compared with that of the developed market economies, emerging market economies are the destination of hot money. Although the emerging market countries welcome capital inflows such as foreign direct investment, but because of hot money's negative effects on the economy, they are instituting different policies to stop the "hot money" from coming into their country and to eliminate the effects of the hot money.

Different countries are using different method to prevent massive influx of hot money. The following are the main methods of dealing with hot money.

• Exchange rate appreciation: exchange rate could be used as a tool to control the inflow of hot money. If exchange rate is believed to be undervalued, that would be a cause of hot money inflow. In such circumstance, economists usually suggest a significant one-off appreciation rather than gradual move in foreign exchange. Because gradual appreciation of the exchange rate would attract even more hot money into the country. One downside of this approach is that exchange rate appreciation would reduce the competitiveness of the export sector.
• Interest rate reduction: countries that adopt this policy would lower their central bank's benchmark interest rates to reduce the incentive for inflow. For example, on December 16, 2010, the Turkish Central Bank surprised markets by cutting interest rates at the time of rising inflation and relatively high economic growth. Erdem Basci, deputy bank governor of Turkish Central Bank argued that gradual rate cuts were the best way to prevent excessive capital inflows fuelling asset bubbles and currency appreciation. On February 14, 2011, Mehmet Simsek, the Turkish Finance Minister said: “more than $8 billion in short-term investment had exited country after the central bank cut rates and took steps to slow credit growth. The markets have got the message that Turkey does not want hot money inflows”
• Capital controls: some policies of capital controls adopted by China belong to this category. For example, In China: the government does not allow foreign funds directly invest in its capital market. Also, the central bank of China sets quotas for its domestic financial institutions for the use of short-term foreign debt and prevent banks from overusing their quotas. In June 1991, Chilean government instituted a non-remunerated (non-paid) 20 percent reserve requirement to be deposited at the Central Bank for a period of one year for liabilities in foreign currency, for firms which are borrowing directly in foreign currency, a.
• Increasing bank reserve requirements and sterilization: some countries pursue fixed exchange rate policy. In the face of large net capital inflow, those countries would intervene in the foreign exchange market to prevent exchange rate appreciation. Then sterilize the monetary impact of intervention through open market operations and through increasing bank reserves requirements. For example, when hot money originated from the U.S. enters China, investors would sell US dollars and buy Chinese yuan in the foreign exchange market. This would put upward pressure on the value of the yuan. In order to prevent the appreciation of the Chinese currency, the central bank of China print yuan to buy US dollars. This would increase money supply in China, which would in turn cause inflation. Then, the central bank of China has to increase bank reserve requirements or issue Chinese government bonds to bring back the money that it has previously released into the market in the exchange rate intervention operation. However, like other approaches, this approach has limitations. The first, the central bank can't keep increasing bank reserves, because doing so would negatively affect bank's profitability. The second, in the emerging market economies, the domestic financial market is not deep enough for open market operations to be effective.
• Fiscal tightening: the idea is to use fiscal restraint, especially in the form of spending cuts on nontradables, so as to lower aggregate demand and curb the inflationary impact of capital inflow.