- 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.
Source: https://m.economictimes.com/small-biz/sme-sector/interim-budget-2024-fishery-announcements-could-help-generate-more-employment-say-industry-stakeholders/articleshow/107319330.cms#:~:text=Sitharaman%20also%20talked%20about%20blue,activities%20for%20blue%20economy%202.0.