What is "hot money" and why does it matter for the exchange rate?

Hot money is money invested in an economy by foreign investors. Unlike FDI, it is not a long-term investment, quite the opposite. Hot money is a short-term concept that revolves around speculation of interest rates and exchange rates.

We can see that flows of hot money affected the economies of Spain and Greece in 2009 as they had a period of negative real interest rates fuelled by a low base rate (set by the ECB) and high levels of inflation which led to a reduction in foreign investment as their money was de-valuing. This could have contributed to their economic decline.

Hot money tends to be invested by rich developed countries in poorer countries that have higher interest rates in order to capitalise on the increased returns from banks etc. Speculation is the key to determining the flows of hot money, and if interest rates are expected to rise, then more people will invest. This means that the flows are erratic and difficult to predict. This can affect the balance of payments by making it much more unstable, as economies can react badly to huge changes in capital flows. Sudden inflows of capital in the short term can lead to appreciation of the exchange rate which can, if persistent, lead to a lack of competitiveness of their exports.