The Color of Hot Money

All these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruins things.

- Mahathir Mohamad, prime minister of Malaysia, January 1998

TOO DARN HOT

Mahathir's flamboyant rhetoric may be his alone, but his views have gained respectability in the wake of the recent financial crises in Russia and Asia. Famous for moving large sums of money in and out of countries quickly, hedge funds are frequently blamed for destabilizing economies and impoverishing the innocent. As their detractors see it, these funds routinely gamble vast sums of money in shadowy, overleveraged investments, unimpeded by government supervision. And this high-stakes financial poker, critics argue, sparked the volatile "hot-money" flows that undermined emerging markets in 1997 and 1998.

But skeptics thinking about imposing capital controls or otherwise curtailing the activities of hedge funds and other portfolio investors should pause. Those investments were not the prime cause of the volatility of global capital flows. In fact, the hot money in the recent crises came mostly from bank lending, not from hedge funds or other nonbank investments such as pension and mutual funds. International bank lending to emerging markets has often been more volatile than portfolio investments in equities and bonds -- because the vast majority of bank lending has taken the form of short-term loans between banks, not long-term project financing. As capital markets continue to grow, eventually replacing traditional bank lending as the primary source of international financing, capital flows are likely to become less volatile. Moreover, despite all the focus on hedge funds, they remain small when compared to other market players.

These facts reshape the entire global financial debate, which should instead center on how to help countries shift from bank financing to capital markets where the transition has just begun -- while ensuring that their governments and global financial institutions adequately protect investors.

FOLLOW THE MONEY