India to keep vigilant for ‘Hot Money’ inflows

  • India’s recent inclusion in JPMorgan’s developing market debt index represents a key milestone for the country’s financial markets.
  • However, this inclusion raises the prospect of erratic capital flows, particularly ‘hot money,’ which can put pressure on currency and bond markets.

What is ‘Hot Money’?

  • Definition: ‘Hot money’ refers to funds managed by investors seeking short-term gains. It refers to the movement of funds from one country to another in order to profit from short-term interest rate discrepancies.
  • Typical Investments: Investors frequently seek high-interest, short-term options, such as certificates of deposit (CDs).
  • Foreign portfolio investment (FPI): FPI is also known as “hot money” since it tends to flee when an economy experiences its first signs of turmoil.

The mechanics of ‘Hot Money’

  • To attract “hot money,” banks provide short-term CDs with higher-than-average interest rates.
  • When interest rates fluctuate, investors quickly withdraw funds and transfer them to institutions offering greater returns.
  • Cross-Border Movements: Investors may move funds between nations to take advantage of low interest rates.

Economic risks posed by Hot Money

  • Volatility: Hot money produces price swings that jeopardise market stability.
  • When speculative bubbles burst, their inflated asset prices cause market crashes.
  • Currency Depreciation: Large influxes of money can generate currency value swings, reducing export opportunities.
  • Interest Rate Volatility: Hot money flows may make it difficult for central banks to keep interest rates stable.
  • Financial Instability: Herd behaviour from hot money can trigger market panics.
  • Capital Flight: Short-term hot money outflows strain a country’s financial reserves.
  • Speculative attacks: Profit-driven investors target hot money inflows.
  • Macroeconomic Imbalances: Overreliance on hot money results in unsustainable economic patterns.

RBI’s Position

  • Monitoring Foreign Fund Flows: India will rigorously monitor foreign fund inflows to prevent an excessive influx of ‘hot money’.
  • Regulating Interest Rates: Interest rates will be managed to discourage short-term speculative investments.
  • Maintaining Financial Stability: Proactive efforts are intended to minimise excessive volatility in the currency and bond markets.
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