Hot Money Crisis Painted as Liquidity Crisis


As a consequence of the transfiguration and transmission of US financial crisis into a full blown economic crisis across the globe, the Indian foreign exchange market also nosedived into new abyss. The exchange rate plummeted from Rs 39 per US dollar on the beginning of January 2008 to Rs 49 by early October 2008. The Sensex also dovetailed from 20,000 to 10,000 during same period which accentuated the role of volatile movements in the capital market upon exchange rates. Dissecting further, FII or the hot money component in the Indian capital market was quite high during this period and FIIs took away $11.1 billion during the first nine-and-a-half months of calendar year 2008, of which $8.3 billion occurred over the first six-and-a-half months of financial year 2008-09 (April 1 to October 16). It is this highly volatile hot money component that rendered Indian capital market so capricious which eventually pulled down the exchange rate to the new abyss of Rs.49-50 per US dollar.

When FIIs all around the globe pumped money into the capital market The Indian government rolled out red carpet welcome to these forces of market fundamentalism. They all showered praises for the Globalisation and liberalisation policies of the government and then and there pointed out that it was because of the strong Macro economic fundamentals of the nation. But when exchange rate appreciated as the supply of foreign exchange increased due to this FII inflow, the government and market fundamentalists did not let things to the so called omnipotent market mechanism (forces of market demand and supply). Instead, they intervened in the market, a position that these market fundamentalists loathe when interventions are made for improving the life of people, and purchased all the foreign exchange brought by the FIIs through various measures. The consequence was that when RBI purchased the foreign exchange it resulted in pumping liquidity into the system. All private players and the pro-market government were so delighted in that economic situation.

US Financial Crisis, Capital Market and its consequences

But things changed dramatically consequent of US financial crisis. FIIs took away all their money and as a sequel, Sensex and exchange rate dovetailed to find all new low lying areas. Exactly the opposite of the events followed and liquidity was squeezed out. The economy witnessed the clamour from all quarters and from roof tops that the system is facing a new threat of ‘liquidity crisis’ which should be avoided at any cost. RBI came with its instruments of monetary policy and made several attempts to pump liquidity (money supply) into the system by reducing CRR etc.

Now the question is whether this fall in liquidity due to the outward movement of hot money—is a liquidity crisis or just a ‘hot money crisis’ alone? Why did the RBI again intervened in the market to pump money into the system when the so called so efficient market mechanism is in overdrive? The very same pro-market fundamentalists pontificated that there should not be any sort of intervention the market as market, when let free, by itself will find out the most ideal solution and outcome! These incidents clearly unmasked the real agenda of market fundamentalists. They do want to follow the rules of free market and not ready to accept its outcomes. They but pontificate the virtues of market only to avoid all sorts of government intervention in the economy (Santhosh, 2008) . When the private players and their self-interest face a crisis they conveniently shed the market philosophy and implement all sorts of intervention only to save corporate self-interest for ever high profits.

Precisely because of this reason it is widely publicised that the economy is facing a liquidity crisis and the economy must be saved from its ominous consequences. The creation of an enabling environment for intervention for helping the private self-interest was the objective for this deliberate campaign. Why did not the market fundamentalists who crave for free market operation let the outflow of foreign exchange due to the fickle hot money component of capital market and the consequent fall in money supply (or liquidity) be corrected by the market itself. Recall, the very same people pontificated the benefits of free market operation repeatedly from all roof tops.

Factors that Influence Money Supply

Simple economic theory says that monetary authorities implement monetary policy by setting the interest rates and letting the money stock be determined by how much is demanded at that interest rate. But to complete the picture we need to understand the influences on demand for money. The three important factors that influence short term variations in nominal quantity of money demanded are nominal rate of interest, real GDP and the price level. The relation with the first is negative and the other two are positive. Real GDP and price level mainly depend upon production of goods and services in the economy. Movements in nominal rate of interest have bearing upon the movements in price level which is basically related to the production of goods and services in the economy. In short all the major factors that influence the nominal quantity of money demanded are basically related to the production of goods and services in the economy. As a matter of fact, the supply and demand for money have an important bearing upon the level of production in the economy.


“Hot Money Crisis” or “Hot Money Induced Liquidity Crisis”


But the above said events viz. the massive outflow of foreign exchange due to the fickle hot money component of the capital market and the consequent fall in money supply has nothing to do with the production in the economy. Hence, this fall in money supply is simply not a fall in liquidity or a liquidity crisis of the economy. Put other wise, this fall in liquidity is not a demand side phenomenon, ie., not due to a sudden rise in demand for money consequent to increased production of goods and services in the economy. As such, it is fall in money supply or liquidity due to the capricious element of hot money rather than any dramatic fall in the level of economic activity. Whatever be the phenomenon, it must convey the underlying features and characteristics of the phenomenon with its name. Hence the crisis under consideration must also convey its true colours that it must be referred as “hot money crisis” or at least “hot money induced liquidity crisis”.

But the market fundamentalists loathe this reference as it will eventually dig its on grave as general public will realise the manipulations done by the arms of government for fortifying the private self-interest of big corporates. Further more, it sends the clear message that these private players not all like the outcomes of market mechanisms even though they swear loudly every time about the multifarious advantages of free markets! They like market as long as it showers private benefits but at the moment when the market shows its true colours all these private players would take volte-face and beg for intervention by the arms of government as covertly as possible. Hence they popularise the general term of liquidity crisis for this “hot money crisis”.

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