Monday, December 7, 2009

The Danger of Hot Money

Dubai shook the world last week with a potential default. The country, until recently, with $60 billion foreign debt has been the rising star in emerging markets in the recent years. On Wednesday, Dubai said it would ask creditors of state-owned Dubai World and Nakheel, the builder of its palm-shaped islands, for a standstill agreement as a first step toward restructuring billions of dollars of debt. Influential bank analyst Richard Bove said in a note "it does not appear that American banks have any major direct impact from this event."

Dubai’s problem may not have direct impact on the global economy. However, Dubai’s crisis is just a tip of an iceberg of a potential global calamity. Since the eruption of subprime crisis that originated from the United States, historic low interest rates and weak economic recovery in the United States and Japan have led to massive carry trade. Arbitrageurs borrow “cheap money” at very low interest rates from countries like the United States and Japan in search for higher returns in many emerging markets.

China's foreign currency reserves rose $141 billion from July to September alone, up 20 percent from the same period in 2008. The China International Capital Corporation estimates that $50 billion in speculative capital flowed into China in the third quarter. In the meantime, Southeast Asian countries are growing increasingly concerned about strong inflows of hot money that could lead to asset bubbles in the region, says the Asian Development Bank (ADB). Noritaka Akamatsu, senior adviser at ADB’s Office of Regional Economic Integration, said that some regional governments are thinking of limiting capital inflows in the “short-term, liquid side of the market” as they could destabilise financial systems. “Last week, Indonesia’s central bank said that it was “studying” possible limits on foreign ownership of short-term debt but has no plans for controls on capital or the currency. The South Korean government plans to hold talks on what can be done to handle inflows financed with cheap US-dollar loans. Outside Asia, Russian Finance Minister Alexei Kudrin said that he was alarmed by the amount of hot money flooding into Russia and would support 'soft measures' to stop speculators from inflating the value of the stock market.

Hot money is speculative and destabilizing short-term capital flow. Its elusive and abrupt reversal characterized many previous financial crises such as the Asian Currency Crisis in 1997. Should carry trade unwind due to monetary policy tightening of the United States and/or sudden heightened risk aversion among foreign investors, a financial calamity in emerging markets is foreseeable in the absence of preemptive actions to slow down hot money.

1 comment:

Anonymous said...

And everything, and variants?