INTERNATIONAL MOVEMENT

INTERNATIONALCAPITAL

MOVEMENT

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CHAPTER 1

INTRODUCTION TO CAPITAL

In economics, capital goods, real capital, or capital assets are already-

produced durable goods or any non-financial asset that is used in production of goods or

services. Additionally, some accounting systems recognize the concept of a Triple bottom

line which takes into account natural capital and social capital, thus including ecosystems

and social relations in the definition of capital.

Control and protection of capital obtained through jobs is the primary means

of accumulating wealth in the modern economy. If a broader definition of wealth is used (say

including health or well-being) then a broader definition of capital is appropriate.

In all systems of accounting and in all definitions of asset types, the capital

goods are not significantly consumed, though they may depreciate in the production process.

How a capital good or asset is maintained or regrown or returned to its pre-production state

varies based on the type of capital involved.

Manufactured or physical capital is distinct from land (or natural capital) in

that capital must itself be produced by human labor before it can be a factor of production. At

any given moment in time, total physical capital may be referred to as the capital stock

(which is not to be confused with the capital stock of a business entity.)

In a fundamental sense, capital consists of any produced thing that can

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capital for a caveman who can use it as a hunting instrument, and roads are capital for

inhabitants of a city. Capital is an input in the production function. Homes and personal autos

are not usually defined as capital but as durable goods because they are not used in a

production of saleable goods and services. The division between capital and durable goods is

set in an accounting regime and depends on the types or styles of capital that are recognized

as capital assets and the types of goods and services that are recognized as economic. For

instance natural capital produces one yield of agricultural output and social capital

substitutes significantly for financial in developing economies, and triple bottom line

accounting recognizes this. In classical economic schools of thought, particularly in Marxist

political economy, capital is money used to buy something only in order to sell it again to

realize a financial profit.

For Marx capital only exists within the process of economic exchange—it is

wealth that grows out of the process of circulation itself, and for Marx it formed the basis of

the economic system of capitalism. In more contemporary schools of economics, this form of

capital is generally referred to as "financial capital" and is distinguished from "capital

goods".

Modern types of capital

Detailed classifications of capital that have been used in various theoretical or

applied uses generally respect the following division:

• Financial capital , which represents obligations, and is liquidated as money for trade,

and owned by legal entities. It is in the form of capital assets, traded in financial

markets. Its market value is not based on the historical accumulation of money

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invested but on the perception by the market of its expected revenues and of the risk

entailed.

• Natural capital , which is inherent in ecologies and protected by communities to

support life, e.g., a river that provides farms with water.

• Social capital , which in private enterprise is partly captured as goodwill or brand

value, but is a more general concept of inter-relationships between human beings

having money-like value that motivates actions in a similar fashion to paid

compensation.

• Instructional capital , defined originally in academia as that aspect of teaching and

knowledge transfer that is not inherent in individuals or social relationships but

transferrable. Various theories use names like knowledge or intellectual capital to

describe similar concepts but these are not strictly defined as in the academic

definition and have no widely agreed accounting treatment.

• Human capital , a broad term that generally includes social, instructional and

individual human talent in combination. It is used in technical economics to define

balanced growth which is the goal of improving human capital as much as economic

capital. A far less common term, spiritual capital, refers to the power, influence and

dispositions created by a person or an organization’s spiritual belief, knowledge and

practice, which is also an aspect of human capital that may not be easily captured as a

component social, instructional or individual element.

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CHAPTER 2

DEFINITION OF CAPITAL MOVEMENT

International movements of capital

•Is not a physical movement of capital but more of the financial transaction between

countries.

•Refer to the borrowing and lending between countries

Example:

–A Taiwanese bank lends to a Thai firm

–Japanese residents buy stocks in Thailand

–U.S. firm invest through its Vietnamese subsidiary.

The transfer of capital between countries either by

the import or export of securities, dividend payments or interest payments. For instance,

when Japanese investors purchase American securities, the payment will be in dollars.

Hence, a demand for the dollar is created, necessitating an increase in the dollar's exchange

rate. Conversely, an American company would have to buy yen in order to pay its creditors.

This would cause a demand in yen and the price of yen would increase in terms of dollars.

The movement of money for the purpose of investment, trade or business production.

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Capital flows occur within corporations in the form of investment capital and capital

spending on operations and research & development. On a larger scale, governments direct

capital flows from tax receipts into programs and operations, and through trade with other

nations and currencies. Individual investors direct savings and investment capital into

securities like stocks, bonds and mutual funds. 

Capital flows are aggregated by the U.S. government and other organizations

for the purpose of analysis, regulation and legislative efforts. Different sets of capital flows

that are often studied include the following:

• Asset-class movements – measured as capital flows between cash, stocks, bonds, etc.

•Venture capital – investments in startup businesses

• Mutual fund flows – net cash additions or withdrawals from broad classes of funds

• Capital-spending budgets – examined at corporations as a sign of growth plans

•Federal budget – government spending plans

Capital flows can help to show the relative strength or weakness of capital

markets, especially in contained environments like the stock market or the federal budget.

Investors also look at the growth rate of certain capital flows, like venture capital and capital

spending, to find any trends that might indicate future investment opportunities or risks.

Capital flows can help to show the relative strength or weakness of capital

markets, especially in contained environments like the stock market or the federal budget.

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Investors also look at the growth rate of certain capital flows, like venture capital and capital

spending, to find any trends that might indicate future investment opportunities or risks.

In traditional economics, capital movements, were treated merely as

international balancing items in a country's balance of trade. It was held that, a creditor

country having a surplus in its current account in order to balance out its total payments

account will invest or lend capital to deficit or debtor countries.

Apparently, debtor countries with deficit in current account will borrow from

the surplus countries in order to even out their balance of payments. Consequent upon

foreign capital movements, thus, a credit in current account of a surplus country, there will

be a corresponding lender position or its capital account, while to a deficit country there will

be a corresponding borrower position on its capital account.

Modern economists, however, are of the view that capital movements are

much more than merely balancing items. In reality, all international capital movements are

not dependent upon the balance of payments deficit and surpluses.

A significant portion of capital flow may also be independent of the balance of

trade position which, in fact, is based on the judgements, financial decisions and discretions

of lenders and borrowers in the international money markets.

Where a country has a surplus in its current account, there will be an outflow

of capital funds to deficit countries, hence, its holdings of short-term capital and its foreign

and banking reserves will be depleted, while a deficit country will find an improvement in

these holdings on account of the inflow of capital.

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Again, if a country has invested its capital abroad, it receives income in the

form of interest, dividends, etc., which can be profitably used to finance its current deficits,

which thus, help in balancing its balance of payments account.

It has also been maintained that unrestricted international capital movements

tend to equalise the rates of interest and profits between countries. As a matter of fact,

discrepancies in the rate of interest induce international flow of capital. When there are no

checks on the movements, capital tends to flow from a capital-surplus nation to capital-

deficit nation on account of high yields in the latter.

Eventually, interest rates in the capital-exporting country will be enhanced,

while in the capital-importing country it will decline. A condition of equilibrium in the

international flow of capital exists when interest rates and profit yields in different countries

are equalised.

In practice, however, there are always some restrictions on an impediment to

the free movement of capital which prevent such complete equilibrium to emerge. Moreover,

apart from the rate of return on investment, many other factors such as risks involved,

industrial and general economic policy of the foreign government, political relations between

countries, international treaties and agreements on trade and commerce, etc., influence the

investment decisions on foreign capital.

Indeed, capital movement, especially direct investment and foreign aid, plays

an important role in the economic development of backward countries. External assistance is

an important source of capital formation and finance resource for planning of project in a

capital-deficit poor country.

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TYPES OF INTERNATIONAL CAPITAL MOVEMENT

1. Direct Movement:

The flow of direct capital movement means that the concern of investing

country exercise holding a specified position over the assets of other country. setting up a

corporation in a investing country for specific purpose for assembling the parent product, its

distribution , sale and exports or creation of fixed assets by investing in infrastructures like

power, railways and highways etc.

2. Indirect Movement/portfolio investment:

The movement of indirect capital means investment in other country by

purchasing securities, shares or debenture.

3. Private and Government Capital:

Private capital movement means lending or borrowing from abroad by private

individuals and institutions. Private capital is generally guaranteed by the government or the

central bank of the borrowing country. Profit motive is the principal factor behind such

investment

On the other hand, government capital movements imply lending and

borrowing between governments. Such capital movements are under the direct control of

government.

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In fact government is important international lender they make stability loan,

loan to finance exports and imports and to finance particular projects.

4. Home and foreign capital:

Home capital is concerned with investments made abroad by residents of the country.

Thus home capital refers to the out flow of capital,

On the other hand, foreign capital implies investments made by foreigners in the

country. Foreign capital is concerned with the inflow of capital.

5. Foreign Aid:

It refers to public foreign capital on hard or soft terms, in cash or in kind and

inter- government grants. Foreign aid is tied or untied .aid may be tied by project and by

commodities untied loan is a general purpose aid and is known as non-project loan

6. Short- term and Long- term Capital:

Short- term capital movements are for a period of less than one year maturity

while long- term capital movements are of more than one- year maturity.

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FACTORS AFFECTING INTERNATIONAL CAPITAL MOVEMENT

The following factors affecting international capital movements:

1. Interest Rates:

The most important factor which effect international capital movement is the

difference among current interest rates in various countries. Rate of interest shows rate of

return over capital. Capital flows from that country in which the interest rates are low to

those where interest rates are high because capital yields high return there.

2. Speculation:

Speculation related to expecting variations in foreign exchange rates or interest

rates affect short capital movements. When speculators feel that the domestic interest rates

will increase in future, they will invest in short- term foreign securities to earn profit. This

will lead out flow of capital. On the other hand if possibility of fall of in domestic interest

rates in future, the foreign speculator investing securities at a low price at present. This

will lead to inflow of capital in the country.

3. Expectation of profits:

A foreign investor always has the profit motives in his mind at the time of

making capital investment in the other country. Where the possibility of earning profit is

more, capital flows into that country.

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4. Bank Rate:

A stable bank rate of the central bank of the country also influences capital

movements because market interest rates depend on it. If bank rate is low, there will be

out flow of capital and vice versa.

5. Production Costs:

Capital movements depend on production costs in other countries. In countries

where labor, raw materials, etc are cheap and easily available, more private foreign capital

flows there. The main reasons of huge capital investment in Korea, Singapore, Hong

Kong, Malaysia and other developing countries by MNCs is low production cost there.

6. Economic Condition:

The economic condition of a country, especially size of the market,

availability of infrastructure facilities like the means of transportation and communication,

power and other resources, efficient labor, etc encourage the inflow of capital there.

7. Political Stability:

Political stability, security of life and property, friendly relation with other

countries, etc. encourage the inflow of capital in the country.

8. Taxation Policy:

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The taxation policy of a country also affects the inflow or outflow of capital.

To encourage the inflow of capital, Soft taxation policy should be followed, give tax relief

to new industries and foreign collaborations, etc.

• Foreign capital policy:

The government policy relating to foreign capital affects capital movements.

Provision of different facilities relating

• to transferring profits

• dividend, interest etc to foreign investors will attract foreign capital

Similarly fiscal and monetary policy of a country also affects capital inflow and

outflow.

• Marginal efficiency of capital: MEC is directly related with the inflow of capital.

Investors usually compare MEC in different countries and like to invest in a country

where MEC is high comparatively.

THE ECONOMICS OF CAPITAL INFLOWS TO DEVELOPING COUNTRIES

•Many developing counties have received extensive capital inflows from abroad and now

carry substantial debts to foreigners.

If national saving fall short of domestic investment, the difference equals the current

account deficit.S –I = CA

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By running down CA deficit, a country can obtain resource from abroad to invest in

profitable activity.

•Developing country borrowing can lead to gains from trade that make both borrowers and

lenders better off.

Foreign Direct Investment

Refers to international capital flows in which a firm in one country creates or expands

subsidiary in another

Involves not only a transfer of resources and capital but also the acquisition of control

The subsidiary does not simply have a financial obligation to the parent company

It is part of the same organizational structure.

The subsidiary does not simply have a financial obligation to the parent company

It is part of the same organizational structure.

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TRENDS IN INTERNATIONAL CAPITAL FLOWS

International capital flows have increased dramatically over time, despite a

temporary contraction during the global crisis. Gross cross border capital flows rose from

about 5% of world GDP in the mid1990s to about 20% in 2007, or about three times faster

than world trade flows Prior to the crisis, the dominant components were capital flows

among advanced economies and notably cross border banking flows. The crisis resulted in a

sharp contraction in international capital flows, after reaching historical highs in mid2007.

The contraction affected mainly international banking flows among advanced economies and

subsequently spread to other countries and asset classes. Capital flows have rebounded since

the spring of 2009, driven by a bounce back in portfolio investment from advanced to

emerging market economies and increasingly among emerging market economies.

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CHAPTER 3

CAPITAL FLOWS, SUDDEN STOPS, AND INTERNATIONAL RESERVES

International financial flows can bring substantial economic benefits to both

lending and borrowing countries. However, they have proved too often be unstable, with

capital flow surges being followed by sudden stops. Both phases of this instability can

impose high costs on the receiving countries. In the inflow stages such flows can generate

unwanted pressures for currency appreciation and/or domestic inflation and on the outflow

stage they can contribute to currency and financial crises that impose great economic costs.

Only a portion of this instability can be explained by changing economic conditions. Thus

we need to look beyond the popular economic models based on far sighted rational

expectations. Our studies of financial contagion during crises find, on the other hand, that

irrational panic does not provide a full explanation either.

Thus one major focus of our research in this area is to develop a better

understanding of international capital flows based on such factors as rational herding where

information is limited and costly, the role of popular mental models, moral hazard, internal

incentive structures, and the various explanations being developed in the literature on

behavioral and neuro finance. The latter literature has focused primarily on domestic finance

while we have been one of the leading research groups looking at their implications for

international financial flows.

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Of course we are also concerned with the adoption of policies to reduce the

problems generated by capital flow surges and sudden stops by researching the development

of better early warning systems, policies to deal with capital flow surges, and to limit the

frequency and costs of sudden stops.

One of the most important policies with respect to the latter objectives is the

buildup of adequate levels of international reserves. It is clear that the levels of international

reserves in relation to their short term external debt was a major determinant of how hard

different Asian countries were hit during the crisis of 1997-98 and while initial studies have

reached conflicting results we expect that this will also prove to be a significant factor with

respect to how hard countries were hit during the recent global financial crisis.

One of the results of the Asian crisis was the dramatic increase in international

reserves held by the Asian countries. The initial phase of this build up is easily explained by

the need to acquire adequate levels of international reserves. This in turn has led to a major

surge in research on the determinants of optimal reserve levels. The traditional approaches to

this issue had been developed in a world of limited capital mobility and needed to be

rethought for today's world where we have moved to a substantial degree from current

account to capital account crises. In this new world large capital inflows instead of being a

sure indicator of a crisis proof economy are sometimes a precursor of a currency crisis. In

such a world which economist now often analyze with what are called second generation

crisis models adequate international reserve levels can not only help finance balance of

payments deficits but also reduce the probability of crises. Furthermore the size of reserves

needed to cushion adequately such crises can no longer be predicted from the previous

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variability of the balance of payments as was done in the original models. This has led us to

develop new models based on estimates of the size of potential capital outflows during a

crisis. We have also developed arguments that for policy purposes the old types of measures

of capital flow volatility based on standard deviations or coefficients of variation need to be

replaced with measures of the size of capital flow reversals. We have also applied such

concepts to the study of whether some types of capital flows are more prone to reversals than

others.

While there as yet not general agreement on the best ways to measure reserve

adequacy in today's world it became clear that by the middle of the first decade of this

century that countries such as China had accumulated far more internal reserves than called

for by any of the models of reserve adequacy. This has led to frequent charges that China and

a number of other countries have reverted to old style mercantilism where maintaining a

large current account surplus has become a major objective of policy and this in turn has led

to popular discussions of the threat of emerging currency wars. We have offered an

alternative explanation that if correct suggests that international economic conflicts will be

less severe than implied by the mercantilist view. In our interpretation countries like China

are not striving to keep large surpluses but rather a limiting the appreciation of their

currencies and thus continuing to accumulate more reserves in order to reduce the domestic

political pressure that would be generated by influential groups such as exporters that would

be hurt in the short run by substantial currency appreciation.

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CAPITAL FLOWS TO DEVELOPING COUNTRIES AND THE REFORM OF THE

INTERNATIONAL FINANCIAL SYSTEM

Recent financial crises, whose effects have been particularly severe in

developing countries, have led to a wide-ranging debate on international financial reform.

This debate has had to confront the implications of the huge growth of international capital

movements, one of whose consequences has been the increased “privatization” of external

financing for developing countries. The paper begins with surveys of major features of the

post-war evolution of the system of governance of the international financial system and of

the principal trends in capital flows to developing countries during the past three decades.

These set the stage for a selective review of appropriate policy responses to international

financial instability, with the main focus on proposals for remedying structural and

institutional weaknesses in the global financial architecture through such means as greater

transparency and improved disclosure, strengthened financial regulation and supervision,

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more comprehensive and even-handed multilateral policy surveillance, and bailing in the

private sector by arrangements for orderly debt workouts. In view of the continuing

absence of effective measures at the global level for dealing with financial instability, the

paper puts special emphasis on the maintenance by developing countries of national

autonomy regarding policy towards capital movements.

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I. INTERNATIONAL INSTITUTIONS AND

THE GOVERNANCE OF CAPITAL FLOWS

The ideas underlying approaches to improving the governance of the

international financial system since 1945 have understandably been heavily influenced by

the experience of the recent past. Thus the arrangements which emerged from planning

during World War II and the negotiations following it reflected the searing impact on

thinkers and policy makers of the 1930s – the devastating declines in employment and

incomes of the Great Depression and the associated contraction in international trade, the

recourse to competitive devaluations and multiple currency practices, and the proliferation

of bilateral trade arrangements and exchange controls.

Similarly, much of policy makers’ energy immediately after the war

was focused on the international financing and payments requirements of the economic

reconstruction of Western Europe. The very concepts used in discussion of policy issues

involving the international financial system tended to be based, explicitly or implicitly, on

assumptions about its functioning which reflected to a great extent the commonest

categories of cross-border financial transaction and prevalent rules and norms. The

concepts of international liquidity and of the various possible instruments for its provision

in this discussion, for example, were closely connected to their use for international trade

in goods and services and for the still relatively restricted categories of capital transaction

which could be undertaken within the rules of the national regimes of most developed

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From the 1950s onwards there was an expansion of the international capital

markets, driven partly by the flows of international investment linked to post-war economic

recovery but also stimulated by the development of offshore currency markets where

financial transactions were subject to much lighter control.

Countries were periodically (and from the second half of the 1960s

increasingly frequently) subjected to pressures due to surges of short-term capital flows

between major currencies surges which eventually overwhelmed the Bretton Woods system

of exchange rates. Henceforth, while problems associated with the financing and payments

arrangements of trade and other current-account transactions have remained an important

concern in consideration of the functioning of the international financial system (a

statement which for obvious reasons applies a fortiori to matters associated with

developing countries participation in this system), increasing attention has been devoted to

ways of handling, controlling and responding to capital movements as these have continued

to grow in size, unshackled as they increasingly have been owing to the progressive

liberalization of capital-account transactions in the major industrial countries and to some

extent elsewhere.

As is documented in the following section, this trend in the functioning

of the international financial system towards increased importance for private actors was

eventually paralleled by an analogous one in the character of developing countries’ external

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financing, with a rapid increase in the importance of private flows during the 1970s and the

1990s (though one which experienced a setback owing to the debt crisis in the 1980s).

The progressive integration of developing (and more recently transition)

economies into the network of international financial markets has had the consequence that

the benefits and costs of this increased “privatization” of these economies’ external

financing has become a much more important topic in debate concerning the international

financial system. Moreover, developments in the 1990s, especially the destabilizing

spillovers on financial markets and firms of industrial countries from the financial crises in

Russia and East Asia and Russia, have provided additional impetus to this tendency, so that

the omission of the problems posed by capital movements for countries with “emerging

financial markets” is no longer conceivable in serious consideration of systemic reform of

international financial governance.

The planning for the post-war world during World War II envisaged a set of

organizations which would deal with currency stability and international payments,

economic reconstruction and the advancement of less developed economies, and

international trade and investment. The negotiations associated with this process eventually

gave rise to the IMF, the World Bank, and the GATT. But the triad which emerged from

Bretton Woods and its aftermath are merely the monoliths of a set of about 300

international organizations dealing with economic matters with memberships varying from

the near universal to the purely regional, some of which antedate World War II. Of the

organizations other than those which emerged from Bretton Woods the most important in

the context of the governance of international capital flows are the OECD, the EEC/EU,

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and the BIS Responsibility for international capital movements is not neatly assigned under

this institutional structure.

Indeed, the original structure did not include a global regime for capital

movements, and no such regime has yet emerged. Instead at the global level there is a

patchwork of rules and agreements bearing directly or indirectly on several aspects of

international investment and other financial flows but one which still accommodates a

considerable measure of national policy autonomy for the majority of countries. More

comprehensive regimes, designed to liberalize international financial flows, have been

agreed in arrangements involving limited groups of countries such as the OECD, the

EEC/EU, and the BIS.

The only global regime applying to cross-border monetary transactions

is that of the IMF but the most important obligations in its Articles of Agreement relate to

current and not capital transactions (being set out in Articles VIII and XIV). Concerning

capital movements Article IV contains the statement that one of the essential purposes of

the international monetary system is to provide a framework facilitating the exchange of

capital among countries, a statement which is included among general obligations

regarding exchange arrangements. The more specific references to capital transfers in

Article VI permit recourse to capital controls so long as they do not restrict payments for

current transactions, and actually give the Fund the authority to request a member country

to impose contracts to prevent the rise of funds from its general Resources Account to

finance a large or sustained capital outflow.

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The World Bank has no direct responsibility for governance of the

international financial system. However, it has participated as a source of financing in a

number of the international bail-outs put together in response to recent financial crises, and

has provided financial and technical assistance (often as a major ingredient of programmes

linked to structural adjustment lending) to several countries as part of their efforts to

upgrade and reform their financial sectors and their regimes of regulation and supervision

(now considered an important part of policies for preventing financial crises, as explained

below).

Until 1994 GATT likewise was assigned only very limited responsibility

regarding the functioning of the international financial system: Articles XII–XV and

section B of Article XVIII of the Agreement permit the use of quantitative restrictions on

imports by countries facing balance-of-payments problems but in this context the

judgement of the IMF is sought as to the validity of the reasons advanced to support the

imposition and maintenance of these restrictions. The WTO agreement, while not giving

the new institution a major role in global financial governance, has nevertheless extended

its remit regarding international investment, in particular through the inclusion of the

commercial presence of (and thus the FDI of) services suppliers in the GATS. Since the

sectors covered by the GATS include financial services, both the pace and the nature of the

expansion of the global network of financial markets will henceforth be significantly

affected by commitments as to market access and national treatment made in WTO

negotiations Of the organizations or arrangements with more limited memberships both the

OECD and the EEC/EU have established regimes for capital flows. The OECD Code of

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Liberalization of Capital Movements dates from 1961 and reflects the generally favourable

view of its member states concerning the free movement of capital.

The Code discriminates between two sets (or Lists) of capital

movement, and member countries authorize transactions in the two Lists subject only to

reservations listed in an Annex to the Code, and to derogations granted in certain

circumstances such as the onset of serious balance-of-payments problems. One of the two

Lists covers transactions generally regarded as more sensitive owing, for example, to their

short-term and potentially more speculative character, and is consequently subject to

greater flexibility as to the right to enter reservations. In the EEC/EU a 1988 directive

abolished restrictions on capital movements between residents of EEC/EU countries

subject only to provisos concerning the right to control short-term movements during

periods of financial strain and to take the measures necessary for the proper functioning of

systems of taxation, prudential supervision, etc.

The directive also stated that EEC/EU countries should endeavor to

attain the same degree of liberalization of capital movement’s vis-à-vis third countries as

with other member countries. Under the directive governments retained the right to take

protective measures with regard to certain capital transactions in response to disruptive

short-term capital movements but, since the introduction of the single currency, for the

countries adopting it such measures may only be taken towards capital movements to or

from third countries. The EEC/EU also made available to member countries various types

of external payments support both for the purpose enabling participants in its exchange-rate

mechanism (ERM) to keep their currencies within prescribed fluctuation limits and for

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other circumstances threatening orderly conditions in the market for a member country’s

currency. Since the introduction of the single currency the application of these

arrangements has been substantially restricted but experience of their use remains of

interest to other regional groupings contemplating the establishment of mechanisms for

mutual external financial support.

The BIS was established in 1930 “to promote the cooperation of central

banks and to provide additional facilities for international financial operations; and to act as

trustee or agent in regard to international financial settlements entrusted to it”. Since the

1970s the BIS has become the principal forum and provided the secretariat support for a

number of bodies established to reduce or manage the risks in cross-border banking

transactions.

The best known of these bodies is the Basle Committee on Banking

Supervision established to promote banking stability through the promotion of

strengthened regulation and improved cooperation between national supervisors. Others

include the Committee on the Global Financial System (until February 1999 known as the

Euro-Currency Standing Committee established to monitor international banking

developments and to disseminate data on the subject from national creditor sources (a

source of warnings as early as 1996 concerning the dangers of the increased short-term

borrowing of certain East Asian countries), and the Committee on Payment and Settlement

Systems, the principal focus of whose work is the timely settlement of large-scale financial

transfers but which has also more recently begun to devote attention to the implications of

electronic money. While the Basle bodies are not responsible for setting rules for

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international capital movements as such, their work is designed to strengthen the defences

of financial firms both individually and in the aggregate against destabilization due to

cross-border transactions and risk exposures.

In its work on financial firms’ involvement in securities transactions

the Basle Committee on Banking Supervision has often collaborated with the International

Organization of Securities Commissions (IOSCO), which has a membership consisting of

securities regulators and exchanges and which has gradually extended its remit from one

concentrating primarily on information sharing to the setting and promulgation of standards

for the functioning of exchanges and securities firms and for surveillance of cross-border

securities transactions. One other recently established body, the Financial Stability Forum

(which is describes in more detail below), has a secretariat located in Basle, and is chaired

by the General Manager of the BIS. Other regional organizations have remits bearing in

various ways on international capital movements: various groups of banking supervisors

other than the Basle Committee (both regional and comprising offshore financial centers)

deal with regulatory issues affecting their members, typically maintaining close contact in

this context with the Basle Committee; and in Asia there are institutions and arrangements

which may eventually come to play roles similar to those of the EEC/EU in the areas of

mutual consultation and external payments support, namely the Executive Meeting of East

Asia and Pacific Central Banks (EMEAP) (which, inter alia, monitors foreign exchange

markets in the region), swap mechanisms among ASEAN countries, and a web of bilateral

repurchase agreements between monetary authorities of the region under which an

authority may exchange its United States Treasury securities for dollars needed to support

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its currency. A great many features of the current international financial system have a

significant (even if often only indirect) bearing on international capital flows.

Thus proposed reforms of this system can generally be expected to

affect the scale and character of these flows. Any discussion such as that which follows is

necessarily selective, and many readers may feel that important ideas have been only

touched upon or completely omitted. The survey here concerns policies which have been at

the centre of discussion (particularly concerning economies with emerging financial

markets) since the East Asian crisis of 1997 but even so is not comprehensive. Some

readers may feel disappointed at the absence of discussion of exchange-rate regimes, of

proposals for tighter control of international lending and portfolio investment at the source,

or of the tax on foreign-exchange transactions originally proposed by James Tobin as an

instrument for limiting the volatility of currency markets and capital movements.

Concerning the latter the authors had expressed their scepticism on a number of occasions

before the outbreak of the East Asian crisis, which has not changed their views. Regarding

tighter controls on external financial flows at their source the more ambitious proposals

would appear typically to have features which are an obstacle to their adoption, while the

ameliorative ones which might face less resistance are unlikely to so reduce financial

instability as to eliminate the need for other major changes on the agenda of reform.

As to exchange-rate regimes, for reasons explained at greater length

elsewhere, the authors are not convinced, unlike many other commentators, that this crisis

furnished decisive arguments against managed flexibility for currencies (so long as it is

accompanied by effective management of external liabilities). The way in which currency

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regimes were managed in certain East Asian countries (in effect through pegging to the

United States dollar) doubtless played a role in the unfolding of the crisis. But in conditions

of high capital mobility no exchange-rate regime can guarantee stable and competitive

rates. Freely floating exchange rates and rigidly fixed ones (currency boards) each impose

costs of their own, the one introducing considerable uncertainly into a country’s relations

with its trading and investment partners and the other sharply (and almost certainly for

many countries unacceptably) reducing national policy autonomy. As is implicit in the

remarks opening this section, ideas concerning international financial reform have a way of

always being provisional owing to their susceptibility to being at least partly overtaken by

developments on the ground. Cross-border financial transactions – current as well as

capital – have been greatly transformed by financial innovation in recent years, and this

process can be expected to continue.

Derivatives are often cited in this context owing to the way in which

they can be used to get around the spirit, if not the letter, of regulation of capital-account

transactions. In the not too distant future it is possible that new techniques of payment and

settlement of cross-border transactions made possible by computer technology will be a

source of new challenges to techniques of monetary policy and to tax systems. These

challenges may involve the design of rules for the new arrangements for such payment and

settlement, techniques of valuation for instruments such as financial assets other than

money used for this purpose, and the intervention in the markets for financial and possibly

other assets required to avoid levels of price instability capable of disrupting these

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arrangements. The challenges will inevitably affect both regimes for international capital

movements and the agenda for international financial reform.

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INTERNATIONAL CAPITAL FLOWS, FINANCIAL STABILITY AND GROWTH

The explosion of capital flows to emerging markets in the early and mid-1990s

and their reversal following the crises in Asia, Latin America and the transition economies

have reignited a heated debate on the benefits and drawbacks of financial globalization.

Many have argued that globalization has gone too far and that international capital markets

have become extremely erratic, with “excessive” booms and busts in capital flows triggering

bubbles and financial crises and magnifying the business cycle. In contrast, the traditional

view asserts that international capital markets enhance growth and productivity by allowing

capital to flow to its most attractive destination.

Even if international capital flows do not trigger excess volatility in domestic

financial markets, it is still true that large capital inflows can spark off inflation in the

presence of a fixed exchange-rate regime. Moreover, transitory capital inflows may distort

relative prices, with the domestic economy losing competitiveness as a result of the

appreciation of the real exchange rate. Therefore, it is no wonder that policy makers have

used a variety of tools to manage these flows, especially flows of the “hot money” type.

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INTERNATIONAL FINANCIAL FLOWS ON INDIA’S ECONOMIC GROWTH – IN

VIEW OF CHANGING FINANCIAL MARKET SCENARIO

INTRODUCTION

International capital flows have significant potential benefits for economies

around the world. Countries with sound macroeconomic policies and well-functioning

institutions are in the best position to reap the benefits of capital flows and minimize the

risks. Countries that permit free capital flows must choose between the stability provided by

fixed exchange rates and the flexibility afforded by an independent monetary policy.

International capital flows have increased dramatically since the 1980s. During the 1990s

gross capital flows between industrial countries rose by 300 per cent, while trade flows

increased by 63 percent. Much of the increase in capital flows is due to trade in equity and

debt markets, with the result that the international pattern of asset ownership.

The integration of debt and equity markets should have been accompanied by

a short period of large capital flows as investors re-allocated their portfolios towards foreign

debt and equity. After this adjustment period is over, there seems little reason to suspect that

international portfolio flows will be either large or volatile. The prolonged increase in the

size and volatility of capital flows observed that the adjustment to greater financial

integration is taking a very long time, or that integration has little to do with the recent

behavior of capital flows. Capital flows have particularly become prominent after the advent

of globalization that has led to widespread implementation of liberalization programme and

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financial reforms in various countries across the globe in 1990’s. This resulted in the

integration of global financial markets. As a result, capital started flowing freely across

national border seeking out the highest return. During 1991 to 1996 there was a spectacular

rise in net capital flows from industrial countries to developing countries and transition

economies. This development was associated with greatly increased interest by international

asset holders in the emerging market economies to find trend toward the globalization of

financial markets (Singh, 1998; 2002). The global financial markets can gradually create a

virtuous circle in which developing and transitional economies strengthen the market

discipline that enhances financial system soundness. At present, however, there are important

informational uncertainties in global market as well as major gaps and inefficiencies in

financial system of many developing countries.

Looking at the composition of capital flows, net foreign direct investment

represents the largest share of private capital flows in the emerging markets. Net portfolio

investment is also an important source of finance in the emerging markets, though these

flows were more volatile after 1994 (Rangarajan, 2000). Until 1997 a market shift, in the

composition of capital flows to domestic financial market with a significant increase in net

private capital inflows to financial markets and a decline in the share of official flows.

Foreign Direct Investment (FDI) is the most stable capital. Both net portfolio investment and

banking flows were volatile. Portfolio flows are rendering the financial markets more volatile

through increased linkage between the domestic and foreign financial markets (Kohli, 2001,

2003).

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Capital flows expose the potential vulnerability of the economy to

sudden withdrawals of foreign investor from the financial market, which will affect liquidity

and contribute to financial market volatility. One opinion that could be explored in the face

of capital inflow surge is absorption by the external sector through capital outflows.

Financial markets are thrown open to Foreign Institutional Investors (FII’s) and there is

convertibility of the rupee for FII’s both on current and capital account. Over the years,

Indian capital market has experienced a significant structural transformation. Financial

markets are significantly different from other markets; market failures are likely to be more

pervasive in these markets and there exists Government intervention. Government

interventions in the financial markets that promoted savings and the efficient allocation of

capital are the centralfactor to the efficiency of financial markets (Agarwal, 1997; Bernan

1997).

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CHAPTER 4

CASE STUDY

ARGENTINA COUNTRY

• Argentina, officially the Argentine Republic, is a federal republic located in

southeastern South America.

• Capital : Buenos Aires

• Dialing code : 54

• Currency : Argentine peso

• President : Cristina Fernandez de Kirchner

• Official language : Spanish Language

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• Government : Presidential system, Federal republic, Constitutional republic,

Representative democracy

International capital flows in Argentina

1. Capital flows and economic growth Although there is some discussion as to whether

international capital flows move as freely as they did during the heyday of the gold standard,

there is general agreement that restrictions on capital flows have declined markedly since the

1970s. Although much of this new freedom of movement comes from more permissive

attitudes towards foreign direct investment, it has also included substantially increased

movements in short-term portfolio flows. It also seems to be associated with increased

episodes of financial and banking difficulties. The evidence on foreign direct investment

(FDI) is quite positive. FDI flows tend to be long lived, only slightlyprocyclical, and are

strongly correlated with long-run growth. In addition, FDI tends to provide technological

spillovers, especially in those cases where host country firms are taken on as intermediate

input suppliers. Short-term portfolio investments have been concentrated in a small number

of middle income countries. These flows are highly procyclical and quite volatile. A number

of countries, Chile for example, have had restrictions on short-term inflows.

As a result, they have experienced less capital flow volatility than the regional

average, and sustained growth. Rapid withdrawals of short-run portfolio investment have

been accompanied by financial and banking crises and severe downturns in output. The high

correlation between international capital flows and recent movements in Argentina’s real

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output seems clear in the data (see Graph 1). High real output growth in the early 1990s

accompanied substantial capital inflows. Capital inflows declined substantially during the

Tequila crisis of early 1995 and real output fell accordingly. Both output growth and capital

inflows recovered in 1996 and remained strong until 1999, after which they declined

precipitously through 2002.

SUDDEN STOPS OF CAPITAL INFLOWS

The increase in portfolio financing to emerging market economies in recent

decades has increased vulnerability to sudden reversals of capital flows. There have been

many instances of sudden stops in capital inflows precipitating a financial and/or banking

crisis that, in the majority of cases, has led to a reduction in real output. Except for Korea,

financial crises since 1990 have involved a nominal and real exchange rate depreciation (see

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Graphs 4 and 5). About half of the crises were followed by inflation of between 40% and

200% over two years. All but Brazil saw at least some real output decline shortly after the

crisis, although for five out of nine countries, real output was above its starting level two

years after the crisis. The real recovery has usually required a substantial restructuring of the

debts of both the financial and corporate sectors, and the speed of the recovery has, in part,

depended on the ability of the country to restructure these private debts. Several countries

formed specific government agencies or courts which adjudicated debt restructuring. Many

of these used newly issued government bonds as a form of compensation or for recapitalising

banks (in a few countries, these bonds were exchanged for equity participation).

In Argentina, the sudden stop in the refinancing of maturing government debt

accelerated a run on the banking system that had started around March 2001 and ultimately

resulted in the suspension of convertibility of deposits to cash (the corralito), the default on

most government debt, severe depreciation of the currency, and the compulsory conversion

of the currency denomination (pacification) of dollar bank deposits (at 1.4 pesos per dollar)

and debts (at one to one). Output in the first quarter of 2002 was 16% below that of the

previous year and 28% below the peak of 1998, deposits fell more than 40% in real terms

and credit plummeted from 16% to 8% of GDP. The BCRA initially tried to defend a

moderate 40% increase in the peso/dollar rate but was unable to do so.

The subsequent depreciation was considerably greater, with significant

overshooting (Graph 4). After a few months of adverse expectations, the introduction of

substantial foreign currency and capital controls plus severe monetary stringency was able to

reverse expectations and a gradual appreciation of the peso followed. The process of

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monetary control was tightened when the BCRA began issuing its own short-term (one-

week, initially) zero coupon bonds (LEBACs) in order to mop up excess liquidity. The

LEBAC market later developed into a principal instrument of monetary control and the

LEBAC interest rate has become a reference interest rate. Twenty months after the crisis, the

interest rate on one-month LEBACs was under 1% and that on the one-year bond at 12%.

The volatility of the dollar/peso exchange rate was markedly reduced, and deposits in the

banking system were growing slowly. Most of the restrictions on bank deposits have been

lifted, and the banks are again regularly reporting their condition to the Central Bank. The

real exchange rate remains very competitive in real terms compared to most other countries

who have experienced crises (see Graph 5) and the accumulated change in the price level is

closer to the countries with moderate crises than to those with more severe crises. The path

of output since the default has been very similar to the average of other crisis countries,

except that the initial decline in output was deeper. With respect to the recovery of the

financial system, even though some shock strategies proved to be useful for solving financial

crises in many emerging markets, they were neither necessary nor affordable for solving

Argentina’s recent crises. The explanation lies in the nature of the crises, and the role of

International Financial Institutions (IFIs).

With respect to the first item, Argentina’s crisis was not preceded by a credit

boom. On the contrary, it was the corollary of a deep recession that started in 1998 and

reflected a downsizing of the financial system, with a reduction of 12% in the number of

bank branches between 1998 and 2002. With respect to official money, IFIs were net

recipients of funds. Argentina has made net payments of more than $8 billion to IFIs, while

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Mexico for instance received $50 billion of foreign assistance to deal with its financial crisis

in 1995.Within this context of scarcity of resources and instruments, the Central Bank’s

strategy for the stabilization of the financial system was based on two pillars: (1) providing

institutions with time to absorb the losses caused by the crises and rebuild their capital base

internally, and (2) changing regulations and prudential rules so that banks can expand their

business, aiming for a financial system that is not only sound but flexible and profitable.

After several years of recession and profound multiple crises, the Argentine economy is well

into the expansionary phase of the business cycle. At the time of writing, a number of

problems remain: in particular, the central government has yet to come to an agreement with

its foreign creditors, bank lending has been very slow to pick up, and the sharp relative price

changes brought about by the devaluation have significantly reduced real incomes.

Nevertheless, the economy is now growing briskly and there seems to be a recent broadening

of the growth base, with investment expanding fast, albeit from extremely low levels.

Capacity utilisation has been growing rapidly in manufacturing but is still very low in several

service sectors.

The change in relative prices has had a positive impact on the labour

market. Although aggregate unemployment remains high, employment has been growing

significantly for the first time in years. Tax collection, which had fallen sharply with the

crisis, is rising steadily and the government is running a sizable and increasing primary

surplus. In the last 13 years, sudden stops in international capital flows have been very costly

for countries in Latin America, Asia, and eastern Europe. While some place all the blame for

the sudden stops on international markets, every country that experienced from this event

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suffered weaknesses in its banking system, its macroeconomic policy, or both. Strong

prudential regulations, designed for the type of problems a developing country’s financial

system can encounter, along with sound macroeconomic policies are necessary conditions

for a country to escape sudden stops. However, this might not be enough.

Countries which are completely open to international capital, especially

portfolio flows, seem to be particularly vulnerable. International investors seem to display, at

least partially, herding behavior in their willingness to take on risk. Changes in investor risk

aversion can change international capital flows for even quite sound countries. Historically,

those countries that imposed restrictions on international capital flows, such as Chile and

Taiwan, seem to have been less affected by their experience with sudden stops. Some mild

form of restrictions on portfolio capital flows may well be part of prudent financial policy.

How can countries make the most of international capital flows?

International capital movements can support long term growth but are not

without short term risks. The long term benefits arise from an efficient allocation of saving

and investment between surplus and deficit countries.

However, large capital inflows may challenge the absorptive capacity of host

countries in the short run by making them vulnerable to external shocks, heightening the

risks of economic overheating and abrupt reversals in capital inflows, and facilitating the

emergence of credit and asset price boom and bust cycles. Empirical analysis carried out by

the OECD for a large sample of mature and emerging market economies Shows that the

probability of a banking crisis or sudden stop increases by a factor of 4 after large capital

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inflows. Indeed, the probability of occurrence of a crisis or a sudden stop is particularly high

after large debt capital inflows Moreover, debt driven episodes of large capital inflows tend

to have a stronger impact on domestic credit than when inflows are driven primarily by FDI

or equity portfolio investment.

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CONCLUSIONS

Capital movements offer significant benefits, but also problems:

− The scale of capital movements is not in itself a problem. Rather, the problem lies in the

fact that emerging economies find it difficult to get the capital they need.

− Free trade, capital movements and cross-border ownership all limit the independence of

economic policy somewhat, but their benefits are much more important.

− A solution to the problems of tax competition must be sought in international coordination

and not in restrictions on capital movements.

Exchange rate uncertainty will be a fact as long as national currencies exist:

− The nature of exchange rate uncertainty derives from the exchange rate regime. A degree

of volatility is inevitable with floating rates, as with asset prices in financial markets in

general.

− A system of fixed rates reduces volatility but is susceptible to currency crises.

No universally applicable measure to restrict capital movements will protect economies

against crises:

− This does not exclude the possibility that introducing restrictions in certain situations

during or after a crisis might be justified. Such situations must be judged case by case.

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− The best protection against financial crises and any excessive capital movements that

might accompany them is a sustainable economic policy, a strong financial system with

efficient supervision of bank risk-taking and capital adequacy, and watchfullness to ensure

that the chosen exchange rate regime is compatible with free movements of capital.

− In order to prevent crises, it is important to develop a financial system ensuring that those

who take risks also have to bear their consequences in crisis situations. For this reason it is

particularly important to develop stock markets in emerging economies. This will reduce the

vulnerability of the financial system, because companies could replace loans with equity-

based financing, and thus reduce their dependency on short-term imports of foreign capital.

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BIBLIOGRAPHY

Economics of global trend and finance- P.A.Johnson

Articlas.economics.indiatimes.com>collection>financial system

www.google.com (wikipedia of international capital movement)

www.igidr.ac.in/conf/money/mfc

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