What is hot money? Definition and meaning

The definition and meaning of hot money may refer to speculative money – capital that is held in one currency or type of investment, but is liable to suddenly and rapidly switch to another currency or investment in search of better profits. With this meaning, the amount of hot money zipping across the globe today is massively greater compared to twenty or thirty years ago.

The term is also used to describe money that can be easily identified if somebody steals it, for example, $100 bills that have consecutive serial numbers or a mark on them.

Most lay people on hearing ‘hot money’ would probably think it meant money that has not yet been laundered – profits made from illegal activity.

Hot MoneyThe term ‘hot money’ has several different meanings.

In betting, hot money is the largest amount of money staked on a horse in a race, as in “The hot money is on Admiral Nelson to win the 2:30.”

If somebody says “But the hot money is on the Fed raising interest rates next month,” it means what people who know much about a subject think will occur. It has the same meaning as “All bets are on the Fed raising interest rates next month.”

It can also mean discretionary income: a portion of somebody’s, a company’s, or any entity’s income that is available for spending on non-essential items or for saving. The total amount of discretionary income in a country is a key indicator of its potential GDP (gross domestic product) growth, and is the target of all commercial advertising.

According to ft.com/lexicon, by definition hot money is:

“Money that moves from one currency to another or one asset class to another as investors (including speculators) seek the best possible yields.”

Hot Money OriginHot money usually starts off in the rich countries, and moves in the direction of the emerging economies. However, when a developing nation has a crisis, the outflow goes toward the advanced economies.

Hot money from country-to-country

In economics, hot money often refers to the flow of capital (money) from one economy to another (country to another), the aim being to earn a short-term profit on interest rate differences or expected exchange rate shifts.

The term is used in such cases because the money can move extremely rapidly in and out of markets, potentially triggering instability.

In January 2011, the national average rate of a certificate of deposit – one year – in the USA was 0.95%. Contrastingly, China’s benchmark one-year deposit was three percent. The renminbi (China’s currency) was undervalued against all other major trading currencies, and therefore was likely to rise in value against the US dollar in the years to come.

If a US investor deposited his or her money in a bank in China, he or she would obtain a higher return than investing in a bank in the US. This made China a major target for hot money inflows. This real life example is one of many different possible hot money scenarios.

Hot money quoteThis ‘hot money’ quote came from The San Francisco Call in 1935. It was a newspaper that served San Francisco in California, that due to a succession of mergers came to be called the San Francisco Bulletin, The San Francisco Call & Post, and the News-Call Bulletin. (Image: adapted from Wikipedia)

Hot money and its trail of destruction

Hot money often leaves a trail of destruction in its wake. Imagine Country A experiences a financial crisis. Money flows out of that economy as investors, companies and even individuals people panic. They all seek a more attractive destination for their funds.

The money goes mainly to Country B. In Country B, capital inflows create a boom, during which personal and commercial debts increase considerably, asset prices rise, and consumption booms … for a while.

However, all too often, these mega capital inflows are followed by a giant crisis. Country B’s economy deteriorates considerably, mainly because of the hot money that had flowed into it.

Estimating amounts of hot money

It is virtually impossible to make an accurate estimate of how much hot money flows into a country during a specific period. As this type of money flows rapidly, it is poorly monitored.

Often, when an estimate is made, the amount may suddenly decline or increase, depending on the economic conditions that drive the flow of funds.

A common way of approximating the flow of this type of money is to subtract a country’s trade surplus or deficit and its net flow of FDI (foreign direct investment) from the change in the country’s foreign reserves.

Approximating Hot Money

Hot Money = Change in foreign exchange reserves – Net Exports – Net FDI

Origin of hot money

Hot money typically originates from the capital-rich, advanced economies that have smaller economic growth rates and lower interest rates compared to those of the emerging nations such as China, India, Brazil, Russia, Mexico, etc.

Some of the reasons for the fast movement of such money across borders are:

Interest Rates in the advanced economies decline over a long period. The lower interest rates encourage investors to move their funds to the emerging economies of Asia and Latin America, where rates are considerably higher.

International Diversification is a general trend among most investors across the world, especially as world capital markets become more integrated.

Sound Monetary & Fiscal Policies adopted by many emerging economies, as well as capital market liberalization, have made it easier and more appealing for investors to move there money there.

Video – Controlling hot money – Definition and Meaning

Should we control hot money? As this Real News video shows, many economists think we should. If the US were to start imposing controls, the move would be unprecedented.