Net Capital Outflow Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Net capital outflow is a situation wherein the amount of money country A invests in other countries exceeds the amount these countries invest in country A. When this happens, the net capital outflow is positive. If the opposite is the case—when the investment by other countries in country A exceeds A’s investment in other countries—the net capital outflow is negative. These investments include foreign direct investment (when, for example, Ford Motor Group acquires a plant in Britain) and portfolio investment (for example, the purchase of British company shares by American residents).

Positive net capital outflows mean that the funds owned by a country exceed its domestic investment requirements and this surplus is invested abroad. Net capital outflows are determined by net exports (the surplus of exports over imports). If a country’s net exports are positive, its trading partners have a corresponding trade deficit; they are demanding more goods than they produce. To finance this deficit, they borrow money from a country with a positive trade surplus. Consequently, the country with the surplus acquires assets in the countries with the deficit.

The relationship between capital outflows and net exports is important for the balance of payments on capital account. The capital account records transactions involving international movements of ownership of financial assets and includes, for example, ownership of company shares, bank loans, and government securities. When a country has a deficit on its capital account, its investment in foreign assets exceeds foreign investment in its own assets; the opposite applies when a country has a surplus on its capital account. Consequently, a country that has a positive net capital outflow (deficit on its capital account) will have a surplus on its trade account; conversely, a country with a negative net capital outflow (surplus on its capital account) will have a deficit on its trade account.

In addition to these capital flows, significant and unpredictable flows of funds often occur between countries that may not be directly related to net exports. These are sometimes referred to as “hot money.” Hot money is money that moves at very short notice from one financial center to another to take advantage of higher short-term interest rates for the purposes of arbitrage or because its owners are concerned about future political intervention in the money market. As a result of greater integration of world capital markets and greater access to, and dissemination of, financial information, significant and destabilizing flows of hot money can occur. For example, George Soros, the global financier, is reputed to have made a $1-billion profit by speculating that the Great Britain pound (GBP) would be devalued in 1992.

The key determinant of the speed and volume with which capital flows between financial centers depends on the degree of capital mobility. Perfect capital mobility occurs when domestic and foreign assets are perfect substitutes and when adjustment to interest rate differentials is instantaneous. In other words, a slight difference in interest rates between two centers is eliminated immediately. This process works because the inflow of money reduces interest rates, whereas the outflow of money from other centers increases interest rates. Imperfect capital mobility means that interest rate differentials between centers may persist for longer periods of time. This can occur when assets are not perceived to be perfect substitutes, for example, when there are differences in risk associated with each asset. Imperfect capital mobility can also occur when governments impose restrictions on capital inflows and outflows, for example, via exchange controls.

Net capital flows do not occur for the same reasons as “capital flight.” Capital flight is frequently associated with developing countries and occurs when domestic capital is exported in response to largely political risks, for example, fears that a government will be overthrown or that civil war is likely. When capital is exported for these reasons, the outflow has no relation to the trade balance but occurs because the owners wish to avoid sequestration of their assets.

Bibliography:

Itay Goldstein, Assaf Razin, and Hui Tong, Liquidity, Institutional Quality and the Composition of International Equity Outflows (National Bureau of Economic Research, 2008);
Paul J. J. Welfens, Innovations in Macroeconomics (Springer, 2008).

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