International Capital Flows Essay

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International capital flows include all transactions  by residents  of one country  that involve financial claims on and liabilities to residents of another country. International capital flows are divided into various categories, including foreign direct investment (FDI), foreign portfolio  investment  (FPI), reserve  asset  flows, and other flows such as bank loans and export and import credits. International capital flows were vigorous before World War I, resumed in the 1920s, came to a virtual stop after the Great  Depression,  and were restricted under the Bretton Woods system that defined the international  economy  between  World  War  II and 1973. Since the collapse of the Bretton Woods system, international capital flows have been a catalyst of increasing integration in the world economy.

International capital  flows began  to  play a major role in the world economy during the second half of the 19th century. Britain, France, and Germany were major sources of financial funds to the rest of the world during this period. The majority of international capital flows were in the form of portfolio investment; debt and equity securities financed governments  in the periphery as well as large-scale infrastructure projects such as railroad construction. The volume of international capital flows relative to gross domestic product (GDP) was substantial. World War I disrupted this pattern  of high capital mobility. International bank lending and portfolio investment  resumed  in the 1920s under the leadership  of the  United  States. However, the  Great Depression put an end to this wave of rising international capital flows. As autarky became the norm in the 1930s, the volume of international capital flows stood at depressed levels.

The  international  economic   system  established after World War II (named after the Bretton Woods conference)  was hostile  to  the  free flow of capital across  borders;  industrialized   as  well  as  developing  countries  restricted   international  capital  flows by adopting  binding capital controls.  Private capital flows resumed only in the 1960s, with the emergence of the Eurodollar markets. As the Bretton Woods system collapsed in 1973, the abolition of capital controls and of restrictions  on domestic financial intermediation began in the early 1970s. The United States took the leading role in abandoning  capital controls  and was followed by other major industrialized  countries in the late 1970s and the 1980s.

The growth of international capital flows since the late  1970s has  been  remarkable.  According  to  the recent  studies conducted  by the IMF, gross international capital flows stood at approximately 5 percent of world GDP in 1980. While  international capital flows have  occasionally  decreased  during  times  of major financial crises (such as the developing country debt crisis in the early 1980s and the 1994 Mexican crisis), the  overall trend  has been  upward.  In 2005 gross international capital inflows were $6.4 trillion, which was close to 15 percent of world GDP.

Due to growing capital flows, international financial integration  has risen significantly over the last three decades. As Philip Lane and Gian Maria Milesi-Ferretti showed, the sum of foreign assets and liabilities as a percentage of GDP increased from approximately 50 percent  in the early 1970s to more than 300 percent in 2004 in industrial countries. Furthermore, the rate of the increase itself has been rising, with major acceleration   of  global  financial  integration   in  the 1990s and 2000s (despite a brief slowdown after the Asian financial crisis). Financial integration in emerging and developing market economies has also been strong, although it did not reach the level observed in industrial countries. In emerging economies, the sum of foreign assets and liabilities as a percentage of GDP was approximately 150 percent in 2004.

The recent  growth  of international capital flows was  driven  mostly  by  the  expansion  of  banking flows, derivative transactions,  and cross-border investment  in debt  securities.  Indeed,  these  flows now constitute  the majority of international capital flows. An important component of this growth is the surge in foreign exchange reserves among emerging economies.  These reserves reached  unprecedented levels in recent years. The foreign exchange reserves accumulated  by emerging market economies are predominantly invested in industrial countries, especially in U.S. Treasury debt securities.

The main implication of this pattern is that emerging and  developing  economies  (especially in Asia) are now the  net  creditors  in world  financial markets. Indeed,  while emerging  and developing market  countries  receive  significant  inflows of equity investment   (both   FDI  and   portfolio   investment in  equity  securities),  the  outflow  of their  foreign exchange reserves to debt securities in advanced industrialized  countries  (mainly the United  States) exceeds capital inflows. In other words, capital flows from less advanced to more  advanced countries.  It should  be observed that  the net outflow of capital from emerging and developing economies to industrial economies is a paradox for standard  economic theory (because it asserts that capital would flow to places where the rate of return  is greatest).

While international capital mobility due to increasing flows of financial funds across borders  has been increasing, capital is far from being perfectly mobile across borders.  In contrast,  the financial assets and liabilities of industrial, emerging, and developing economies  show that  there  is still a marked  preference for holding  portfolios  biased toward  domestic debt and equity securities. This well-documented phenomenon is known  as “home  bias” in  international portfolio selection. A related stylized fact is the high correlation between domestic saving and investment (known as the Feldstein-Horioka puzzle), which challenges the expectation  of small correlation  ratios under high capital mobility. While the findings of Martin Feldstein and Charles Horioka are confirmed in subsequent studies, there are disputes on the methodology of measuring  saving-investment  correlation and on what this correlation means. Nevertheless, the Feldstein-Horioka  puzzle is often seen as a proof of imperfect international capital mobility.

The growth of international capital flows from the late 1970s until recently has been remarkable.

Bibliography:   

  1. Bala Batavia and Parameswar Nandakumar, Globalization, Capital Flows, Competition and Regulation (APF Press, 2007);
  2. Thomas William Dorsey, The Landscape of Capital Flows to Low-Income Countries. IMF Working Paper, WP/08/51.  (International Monetary  Fund,  Policy Development  and  Review Department,  2008);
  3. Barry  Eichengreen, Capital Flows and Crises (MIT Press, 2003);
  4. Martin Feldstein  and  Charles  Y. Horioka,  “Domestic Saving and International Capital Flows,” Economic Journal (v.90, 1980);
  5. International Monetary Fund, Global Stability Report (April 2007);
  6. Maurice Kugler and Hillel Rapoport, “International Labor  and  Capital  Flows:  Complements or Substitutes?” Economic Letters (v.94/2, 2007);
  7. Philip R. Lane and Gian Maria Milesi-Ferretti, “The External Wealth of Nations Mark  II: Revised and  Extended  Estimates  of Foreign Assets and Liabilities, 1970–2004,” Journal of International Economics (v.73/2, 2007);
  8. Alexander Ludwig, Dirk Krueger, and  Axel Börsch-Supan,  Demographic Change, Relative Factor Prices, International  Capital  Flows, and Their Differential  Effects on  the  Welfare  of Generations (National  Bureau of Economic Research, 2007);
  9. Maurice Obstfeld and Alan M. Taylor, Global Capital Markets: Integration, Crisis, and Growth (Cambridge University Press, 2004);
  10. Cédric Tille and Eric Van Wincoop, International Capital   Flows (Centre   for  Economic  Policy  Research, 2008).

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