Illustration of Hot Money Flows
The following simple example illustrates the phenomenon of hot money: In the beginning of 2011, the national average rate of one year certificate of deposit in the United States is 0.95%. In contrast, China's benchmark one year deposit rate is 3%. And it is widely believed that the Chinese currency (renminbi) is seriously undervalued against world's major trading currencies and therefore would appreciate against the US dollar in the coming years. Given this situation, if an investor in the US deposits his/her money in a Chinese bank, the investor would get a higher return than that in the situation in which he/she deposits money in a US bank. This makes China a prime target for hot money inflows. This is just an example for illustration. In reality, hot money takes many different forms of investment.
Furthermore, the following vivid description of hot money help further illustrate this phenomemon: "one country or sector in the world economy experiences a financial crisis; capital flows out in a panic; investors seek more attractive destination for their money. In the next destination, capital inflows create a boom that is accompanied by rising indebtness, rising asset prices and booming consumption-for a time. But all too often, these capital inflows are followed by another crisis. Some commentators describe these pattern of capital flow as “hot money” that flows from one sector or country to the next and leaves behind a trail of destruction." However it should be noted that such normative comments notwithstanding, these types of flows and any destructive results are rooted in and properly attributed to the extra market activities of central bank market manipulations that in fact cause such persistent conditions of disequilibrium and insulates them against free market forces that otherwise would quickly eliminate the incentive for such flows.
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