Hot Money - Impact

Impact

Capital flows from rich and developed world to developing and emerging market countries should be welcomed. Because foreign capitals can finance investment and stimulate economic growth, thus helping increase the standard of living in the developing world. Capital flows can increase welfare by enabling households to smooth out their consumption over time and achieve higher level of consumption. Capital flows can help developed countries achieve a better international diversification of their portfolios.

However, large and sudden inflows of capital with short term investment horizon have negative macroeconomic effects, including rapid monetary expansion, inflationary pressures, real exchange rate appreciation and widening current account deficits. Especially, when capital flows in volume into small and shallow local financial markets, the exchange rate tends to appreciate, asset prices to rally and local commodity prices to boom. These favorable asset price movements improve national fiscal indicators and encourage domestic credit expansion. These, in turn, exacerbate structural weakness in the domestic bank sector. When global investors' sentiment on emerging markets shift, the flows reverse and asset prices give back their gains, often forcing a painful adjustment on the economy. The following are the details of the dangers that hot money presents to the receiving country's economy:

• Inflow of massive capital with short investment horizon (hot money) could cause asset price to rally and inflation to rise. The sudden inflow of large amounts of foreign money would increase the monetary base of the receiving country (if the central bank is pegging the currency), which would help create credit boom. This, in turn, would result in such a situation in which "too much money chase too few goods". Consequences of this would be inflation.

Furthermore, hot money could lead to exchange rate appreciation or even cause exchange rate overshooting. And if this exchange rate appreciation persists, it would hurt the competitiveness of respective country's export sector by making the country's exports more expensive compared to similar foreign goods and services.

• Sudden outflow of hot money, which would always certainly happen, would deflate asset prices and could cause the collapse value of the currency of respective country. This is especially so in countries with relatively scarce internationally liquid assets. There is growing agreement that this was the case in the 1997 East Asian Financial Crisis. In the run-up to the crises, firms and private firms in South Korea, Thailand and Indonesia accumulated large amounts of short term foreign debt (a type of hot money). The three countries shared a common characterestic of having large ratio of short term foreign debt to international reserves. When the capital starts to flow out, it caused a collapse in asset prices and exchange rates. The financial panic fed on itself causing foreign creditors to call in loans and depositors withdraw funds from banks, all of these magnified the illiquidity of the domestic financial system and forced yet another round of costly asset liquadations and price deflation. In all of the three countries, the domestic financial institutions came to the brink of default on their external short term obligations.

However, some economists and financial experts argue that hot money could also play positive role in countries that have relatively low level of foreign exchange reserves, because the capital inflow may present a useful opportunity for those countries to augment their central banks' reserve holdings.