8.3 Capital flows and financial account
3 min read•july 22, 2024
Capital flows are the lifeblood of the global economy. They come in various forms, from long-term to short-term portfolio investments, each with unique impacts on host countries.
Understanding these flows is crucial for grasping international economics. They affect exchange rates, , and financial stability. Capital flows can bring both opportunities and risks, shaping the economic landscape of nations worldwide.
Types and Impacts of Capital Flows
Types of capital flows
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- (FDI) involves long-term investment in physical capital such as factories (manufacturing plants) or real estate (office buildings) which increases the financial account balance and contributes to capital formation in the host country
- refers to short-term investment in financial assets including stocks (shares of publicly traded companies) and bonds (government or corporate debt securities) which can be more volatile than FDI potentially leading to sudden but also increases the financial account balance
- encompasses loans (bank lending), currency and deposits (bank accounts), and trade credits (short-term financing for international trade) that can be short-term or long-term and may provide more stability compared to portfolio investment while increasing the financial account balance
- are foreign exchange reserves held by central banks (US dollars, euros, yen) with changes in these reserves affecting the financial account balance as they are used to intervene in foreign exchange markets and manage exchange rates
Factors in international capital flows
- play a key role as higher interest rates (5% vs 2%) attract seeking better returns while lower rates encourage outflows in search of higher yields abroad
- Economic growth and stability are important considerations since stronger economic performance (higher GDP growth) and (stable government) attract capital inflows from investors seeking opportunities in thriving economies
- influence capital flows as expected currency appreciation (rising value of the yuan) attracts inflows speculating on further gains while depreciation expectations (falling value of the peso) lead to outflows to avoid losses
- such as the quality of institutions including property rights (legal protections for ownership) and contract enforcement (reliable court system) shape the attractiveness of a country for international capital flows
- reflects changes in investors' appetite for risk (bullish vs bearish market sentiment) which affects capital flows to emerging markets (Brazil, Indonesia) that are often viewed as riskier than developed markets
Risks vs benefits of capital flows
- Benefits:
- Capital inflows can finance investment (construction of new factories) and support economic growth (higher GDP)
- Access to allows countries to diversify their funding sources beyond domestic savings
- Portfolio investment can improve market efficiency (price discovery) and liquidity (ease of buying and selling assets)
- Risks:
- Sudden capital outflows can lead to (stock market crashes) and (sharp depreciation)
- Excessive reliance on short-term capital flows increases vulnerability to external shocks (global financial crisis)
- FDI may result in foreign control over domestic assets (foreign ownership of natural resources) and potential political tensions
- Capital inflows can contribute to (housing market booms) and financial imbalances (excessive debt)
Financial account for current account imbalances
- deficit arises when a country's imports of goods (oil), services (tourism), and transfers (remittances) exceed its exports requiring financing through a financial account surplus or net capital inflows (foreign borrowing)
- occurs when a country's exports of goods (cars), services (IT outsourcing), and transfers (foreign aid) exceed its imports leading to a financial account deficit or net capital outflows (overseas investment)
- states that the sum of the current account balance, financial account balance, balance, and errors and omissions must equal zero implying that current account imbalances are offset by corresponding financial and capital account imbalances
Key Terms to Review (40)
Asset price bubbles: Asset price bubbles occur when the prices of assets, like real estate or stocks, rise significantly above their intrinsic value, often driven by speculative behavior. These bubbles can lead to economic instability when they burst, resulting in sharp declines in asset prices and potential financial crises. Understanding how capital flows influence these bubbles is crucial, as excessive inflows of investment can fuel unsustainable price increases in asset markets.
Balance of Payments: The balance of payments is a comprehensive record of a country's economic transactions with the rest of the world over a specific period, including trade in goods and services, capital flows, and financial transfers. It provides insight into a nation’s economic standing, reflecting how much it is earning and spending internationally.
Balance of payments identity: The balance of payments identity is an accounting equation that shows the relationship between a country's trade balance, capital flows, and financial transactions. This identity reflects that all transactions in an economy's balance of payments must balance, meaning that a deficit in the current account must be offset by a surplus in the capital and financial account, ensuring the overall balance is zero. Understanding this identity is crucial for analyzing how capital flows affect an economy's overall health and international economic relations.
Capital Account: The capital account is a component of a country's balance of payments that records all transactions involving the purchase and sale of assets, including foreign direct investment, portfolio investment, and other capital transfers. It plays a crucial role in understanding the flow of financial resources across borders, which is essential for evaluating a country's economic stability and its engagement in the global economy.
Capital controls: Capital controls are measures implemented by a government or regulatory authority to regulate the flow of foreign capital in and out of a country's economy. These controls can take various forms, such as taxes, tariffs, or restrictions on currency exchange, aimed at stabilizing the economy by managing capital inflows and outflows. They are particularly relevant in contexts where there are significant current account imbalances and can influence capital flows that affect the financial account.
Capital Controls: Capital controls are government-imposed restrictions on the flow of capital in and out of a country. These measures can include limits on foreign investment, restrictions on currency exchange, and regulations on bank transactions to manage the economic stability and protect domestic industries. By influencing capital flows, governments can respond to volatile financial conditions, maintain exchange rate stability, and address balance of payments issues.
Capital flight: Capital flight refers to the rapid movement of large sums of money or financial assets out of a country, often triggered by economic or political instability, high taxes, or unfavorable business conditions. This phenomenon can severely impact a country's economy, leading to decreased investment, currency depreciation, and increased borrowing costs. It highlights the importance of capital flows in the financial account and its connection to current account imbalances and the broader implications of globalization.
Capital inflows: Capital inflows refer to the movement of money into a country from foreign investors seeking to invest in that country's assets, such as stocks, bonds, or real estate. These inflows can enhance a country's financial stability and growth prospects by providing the necessary funds for investment in infrastructure, business expansion, and overall economic development.
Capital Mobility Theory: Capital mobility theory explains the movement of financial capital across borders in response to differences in interest rates, investment opportunities, and economic conditions. This theory suggests that capital is highly responsive to changes in relative returns, leading to a fluid and dynamic financial environment where investors seek the highest yields regardless of geographic constraints.
Capital Outflows: Capital outflows refer to the movement of money or financial assets out of a country, typically for investment or savings purposes in foreign markets. This can occur when investors seek higher returns abroad, leading to a decrease in domestic capital availability. Capital outflows can significantly impact a nation's economy, influencing exchange rates, interest rates, and overall financial stability.
Currency crises: Currency crises occur when a country's currency experiences a sudden and severe depreciation, leading to a loss of investor confidence and often resulting in economic instability. These crises can arise from various factors, including excessive capital inflows and outflows, unsustainable fiscal policies, or external shocks, impacting the broader economy and international financial systems.
Currency interventions: Currency interventions are actions taken by a country's central bank or government to influence the value of its national currency in the foreign exchange market. These interventions can be aimed at stabilizing or altering the exchange rate, often in response to economic conditions or to achieve certain economic objectives, such as controlling inflation or supporting exports. By buying or selling their own currency against others, authorities can affect capital flows and thus impact the financial account of a nation.
Currency restrictions: Currency restrictions are government-imposed limitations on the amount and types of foreign exchange transactions that individuals and businesses can conduct. These measures are often implemented to control capital flows, stabilize the national currency, and protect the economy from external shocks. By regulating currency access, countries can influence their financial accounts and manage their overall economic stability.
Current Account: The current account is a key component of a country's balance of payments, which records the flow of goods, services, income, and current transfers into and out of a country over a specific period. It provides crucial insights into a nation's economic position by showing whether it has a surplus or deficit in its transactions with the rest of the world. This account connects directly to key economic indicators, balance of payments components, capital flows, exchange rates, and the evolution of the international monetary system.
Current account surplus: A current account surplus occurs when a country's total exports of goods, services, and income exceed its total imports. This situation indicates that a nation is selling more to the rest of the world than it is buying, contributing positively to its balance of payments. A sustained current account surplus can signal economic strength, as it reflects strong domestic production and competitiveness in international markets.
Economic Growth: Economic growth refers to the increase in a country's output of goods and services over time, typically measured by the rise in real Gross Domestic Product (GDP). This growth is essential for improving living standards, reducing poverty, and enhancing overall economic stability, while being influenced by various factors like globalization, investment flows, and international financial dynamics.
Equities: Equities represent ownership in a company, commonly in the form of stocks, allowing shareholders to claim a portion of the company’s assets and profits. Investing in equities can drive capital flows into markets, impacting both domestic and international financial accounts by facilitating investment and influencing economic growth.
Exchange rate: An exchange rate is the price at which one currency can be exchanged for another, determining how much of one currency is needed to purchase a unit of another currency. It plays a critical role in international trade and finance, affecting capital flows, investments, and economic policies. Fluctuations in exchange rates can influence financial account balances and reflect changes in economic conditions and market perceptions.
Exchange rate expectations: Exchange rate expectations refer to the anticipations that investors and traders have regarding future movements in currency exchange rates. These expectations can significantly influence capital flows and the financial account, as they shape decisions on investments, trade, and currency speculation. If investors expect a currency to strengthen, they may increase demand for that currency, impacting its value and affecting international financial transactions.
Exchange rate risk: Exchange rate risk refers to the potential for financial loss resulting from fluctuations in the exchange rate between two currencies. This risk impacts businesses and investors engaged in international transactions or investments, as changes in currency values can alter the expected return on investments and the cost of goods and services. Understanding exchange rate risk is crucial for managing capital flows and navigating currency systems such as managed floats and currency boards.
Financial instability: Financial instability refers to a situation where the financial system is unable to efficiently allocate resources, leading to a sudden collapse or significant disruptions. It often arises from excessive risk-taking, asset bubbles, or rapid changes in capital flows, which can create imbalances and ultimately impact the economy's overall health.
Fiscal Policy: Fiscal policy refers to the government's use of spending and taxation to influence the economy. It involves adjusting government expenditures and tax rates to manage economic fluctuations, stimulate growth, and achieve macroeconomic objectives such as full employment and price stability. The effectiveness of fiscal policy can vary depending on the exchange rate regime, capital flows, and overall economic conditions.
Foreign direct investment: Foreign direct investment (FDI) occurs when a company or individual invests directly in business operations in another country, typically by acquiring a substantial ownership stake in a foreign enterprise. This form of investment is a critical component of globalization as it fosters cross-border economic integration and can lead to significant changes in local economies and industries.
Foreign Direct Investment: Foreign direct investment (FDI) is the investment made by a company or individual in one country in business interests in another country, often through establishing business operations or acquiring assets. FDI plays a crucial role in the global economy, influencing trade patterns, capital flows, and economic development across nations.
Global risk sentiment: Global risk sentiment refers to the overall attitude of investors and market participants toward perceived risks and uncertainties in the global economy. It can shift rapidly, influenced by various factors such as economic indicators, geopolitical events, or financial market fluctuations. A change in global risk sentiment can lead to significant movements in capital flows and impact the financial account balances of countries.
Institutional factors: Institutional factors refer to the formal and informal rules, norms, and structures that govern economic interactions within a society. These factors significantly influence capital flows and financial accounts by shaping the behaviors of investors, businesses, and governments, determining how resources are allocated, and affecting overall economic stability and growth.
Interest Rate Differentials: Interest rate differentials refer to the difference in interest rates between two countries or economies, which can significantly influence capital flows and currency values. A higher interest rate in one country compared to another tends to attract foreign capital, as investors seek higher returns on their investments. This dynamic plays a crucial role in exchange rate determination, the financial account of balance of payments, and international portfolio investment decisions.
International Capital Asset Pricing Model: The International Capital Asset Pricing Model (ICAPM) extends the traditional Capital Asset Pricing Model (CAPM) by incorporating international factors, allowing investors to assess expected returns on assets while considering global risk exposure. It highlights the role of exchange rates, interest rates, and the correlation of returns across countries, providing a more comprehensive view of how global capital markets function.
International capital markets: International capital markets refer to the global financial arenas where financial instruments such as stocks, bonds, currencies, and derivatives are traded across national borders. These markets facilitate the flow of capital between countries, enabling investors to access a wider range of investment opportunities and providing countries with the necessary funds for development and growth.
International Monetary Fund: The International Monetary Fund (IMF) is an international organization that aims to promote global economic stability and growth by providing financial assistance, policy advice, and technical support to its member countries. It plays a crucial role in the international monetary system, facilitating exchange rate stability, fostering economic cooperation, and helping countries manage their balance of payments.
James Tobin: James Tobin was an influential American economist known for his work on portfolio selection and financial markets. He is most recognized for developing the Tobin Tax and the Tobin's Q theory, which have significant implications for understanding capital flows and the financial account in international economics.
Monetary Policy: Monetary policy refers to the actions taken by a country's central bank to manage the money supply and interest rates to achieve macroeconomic goals such as controlling inflation, consumption, growth, and liquidity. It plays a crucial role in determining exchange rates and influences capital flows, especially in fixed or floating exchange rate systems, while also impacting the IS-LM-BP model which illustrates how economic activity is influenced by these policies.
Official reserve assets: Official reserve assets are foreign assets held by a country's central bank that can be used to settle international debts, influence the value of its currency, and ensure financial stability. These assets include foreign currencies, gold, special drawing rights (SDRs), and reserves held at the International Monetary Fund (IMF). They play a crucial role in a country’s balance of payments and overall economic health.
Official Reserve Assets: Official reserve assets are foreign assets held by a country's central bank that can be used to finance trade deficits or stabilize the national currency. These assets typically include foreign currencies, gold, Special Drawing Rights (SDRs), and other reserve items that provide liquidity to the economy. They play a crucial role in a country's balance of payments and are integral to capital flows and financial account management.
Open economy macroeconomics: Open economy macroeconomics is a branch of economics that studies how international trade and financial interactions influence a country's economy. It emphasizes the role of capital flows, exchange rates, and foreign investment in shaping economic performance and policy decisions. Understanding these dynamics is crucial for analyzing how economies interact in a global context and how various factors affect economic stability and growth.
Other Investment: Other investment refers to various financial transactions that fall outside the categories of direct investment and portfolio investment, typically encompassing loans, currency deposits, trade credits, and other claims. It plays a significant role in the financial account of a country's balance of payments, reflecting the movement of capital that does not fit neatly into equity or debt securities, and helps in understanding how countries finance their international activities.
Political stability: Political stability refers to the durability and integrity of a government and its ability to maintain order and effective governance without experiencing significant disruptions, such as revolutions, civil wars, or major political crises. A stable political environment is crucial for fostering investor confidence, promoting economic growth, and ensuring that a country can effectively engage in international trade and financial activities.
Portfolio investment: Portfolio investment refers to the purchase of financial assets, such as stocks and bonds, in foreign markets, without seeking to exert control over those assets. This type of investment is typically motivated by the potential for capital gains and income generation while maintaining a degree of liquidity and flexibility. Portfolio investments are crucial for understanding international capital flows, their impact on exchange rates, and the broader economic consequences tied to globalization.
Sovereign Risk: Sovereign risk refers to the risk that a government will default on its debt obligations or fail to meet its financial commitments. This can lead to significant financial consequences for investors and countries that have invested in that government's bonds or other securities. The perception of sovereign risk is crucial in assessing capital flows and the financial account, as it influences investment decisions and the overall stability of a country's financial environment.
World Bank: The World Bank is an international financial institution that provides loans and grants to the governments of low and middle-income countries for the purpose of pursuing capital projects. It aims to reduce poverty and support development by providing financial and technical assistance, making it a crucial player in global economic stability and growth.