International Capital Flows Essay ⋆ Business Essay Examples ⋆ EssayEmpire

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:

Bala Batavia and Parameswar Nandakumar, Globalization, Capital Flows, Competition and Regulation (APF Press, 2007);
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);
Barry Eichengreen, Capital Flows and Crises (MIT Press, 2003);
Martin Feldstein and Charles Y. Horioka, “Domestic Saving and International Capital Flows,” Economic Journal (v.90, 1980);
International Monetary Fund, Global Stability Report (April 2007);
Maurice Kugler and Hillel Rapoport, “International Labor and Capital Flows: Complements or Substitutes?” Economic Letters (v.94/2, 2007);
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);
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);
Maurice Obstfeld and Alan M. Taylor, Global Capital Markets: Integration, Crisis, and Growth (Cambridge University Press, 2004);
Cédric Tille and Eric Van Wincoop, International Capital Flows (Centre for Economic Policy Research, 2008).

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