Capital Markets: Challenges and Developments

India to stay alert for ‘Hot Money’ inflows

Note4Students

From UPSC perspective, the following things are important :

Prelims level : Hot Money

Mains level : Read the attached story

Introduction

  • India’s recent inclusion into JPMorgan’s emerging market debt index marks a significant milestone for its financial markets.
  • However, with this inclusion comes the risk of volatile capital flows, particularly ‘hot money,’ which can exert pressure on currency and bond markets.

What is ‘Hot Money’?

  • Definition: ‘Hot money’ refers to funds controlled by investors seeking short-term returns. It is the flow of funds from one country to another to earn a short-term profit on interest rate differences.
  • Typical Investments: Investors often seek high-interest, short-term opportunities like certificates of deposit (CDs).
  • Foreign portfolio investment (FPI): FPI is often referred to as “hot money” because it tends to flee at the first signs of trouble in an economy.

Mechanics of ‘Hot Money’

  • Attracting ‘Hot Money’: Banks offer short-term CDs with above-average interest rates to attract ‘hot money.’
  • Rapid Movement: Investors swiftly withdraw funds and transfer them to institutions offering higher rates when interest rates change.
  • Cross-Border Movements: Investors may shift funds between countries to capitalize on favorable interest rates.

Economic hazards posed by Hot Money

  • Volatility: Hot money causes rapid price swings, risking market stability.
  • Speculative Bubbles: Inflated asset prices lead to market crashes when bubbles burst.
  • Currency Depreciation: Hot money influxes can cause currency value swings, harming exports.
  • Interest Rate Volatility: Central banks may struggle to stabilize rates due to hot money flows.
  • Financial Instability: Herd behavior from hot money can cause market panics.
  • Capital Flight: Short-term hot money exits strain a nation’s financial reserves.
  • Speculative Attacks: Hot money inflows attract attacks from profit-driven investors.
  • Macroeconomic Imbalances: Over-reliance on hot money leads to unsustainable economic patterns.

RBI’s position

  • Monitoring Foreign Fund Flows: India will closely monitor inflows of foreign funds to prevent excessive ‘hot money’ influx.
  • Regulating Interest Rates: Measures will be taken to manage interest rates to discourage short-term speculative investments.
  • Maintaining Financial Stability: Proactive measures aim to prevent excessive volatility in currency and bond markets.

Back2Basics: Hot Money vs. Cold Money

Hot Money Cold Money
Nature Short-term capital that flows in and out of markets quickly. Long-term investments that remain stable and less volatile.
Movement Rapid movement, often driven by short-term profit opportunities. Relatively stable movement, focused on long-term returns.
Risk High risk due to volatility and susceptibility to market changes. Lower risk as it is less influenced by short-term market fluctuations.
Purpose Often seeks quick returns, capitalizing on market trends and speculation. Invested with long-term objectives, such as retirement planning or wealth preservation.
Impact on Markets Can create volatility and instability, leading to sudden market fluctuations. Provides stability and liquidity, contributing to long-term economic growth.
Examples Hedge funds, currency traders, speculative investors. Pension funds, mutual funds, long-term investors.

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