After emerging from the economic doldrums, developing economies are now confronted with a new danger—a flood of international hot money. But how has the speculative capital circumvented regulatory controls and what are the consequences concerning the stability of the developing world? Zhao Zhongwei, a senior researcher with the Institute of World Politics and Economics at the Chinese Academy of Social Sciences, discussed these issues in an article recently published in the China Securities Journal. Edited excerpts follow:

As markets begin to calm across the globe, financiers are regaining their appetites for risky investments and speculations. Scouring the world for opportunities, investors see emerging markets as a favorable choice since their economic upticks offer a higher yield level.

For instance, the balance in Hong Kong's banking system, together with foreign exchange fund notes, hit a record high of more than HK$500 billion ($64.5 billion), the flight of which has triggered worries over regional financial volatility. The Dubai debt crisis should also serve as a reminder that today's inflows can become tomorrow's outflows.

The reasoning for the accumulation of hot money in emerging economies is simple: Since the West's credit freeze has yet to thaw, speculators are turning their eyes to emerging countries where a loose monetary environment makes it easier to obtain financing. Their rising asset prices and enormous demands for commodities also provide opportunities for arbitrage plays. More importantly, emerging economies lack a flexible exchange rate system to respond to capital inflows. The expected appreciation of the renminbi, for example, has been a magnet for speculators seeking a risk-free source of profit.

A number of methods exist to cash in on the economic booms of emerging markets, such as buying shares of enterprises listed overseas. One contributor to the liquidity explosion in Hong Kong was a flood of speculative capital gobbling up shares of profitable mainland state-owned enterprises.

Of course, foreign investors prefer direct investments and financial gambles on the stock and property markets. Take China for instance. The country's newly added foreign exchange reserves are now much higher than the combined trade surplus and foreign direct investment (FDI). The difference was widely believed to be caused by the hot money that found its way around regulatory controls and into the country—usually through companies overstating their FDI or over-invoicing exports.

While much of the money hinges on bullish commodities and capital markets, some is expected to flow into private equity investments targeting start-up businesses with greater growth potential. These are the most difficult to track down due to a lack of regulation.

The impact of hot money on the financial security of emerging economies is obvious. They force up prices of international commodities, which translate into mounting inflationary pressures, and help fuel potentially destabilizing asset bubbles in the stock and property markets, sowing the seeds for a possible price crash. Worse still, an abrupt withdrawal of the capital would send the economies reeling.

All in all, it is imperative for emerging economies to keep a vigilant eye on their financial systems and stem the tide of speculative capital inflows as they see necessary.