UNIVERSITY OF MUMBAI PROJECT REPORT ON BUSINESS ECONOMICS INTERNATIONAL CAPITAL MOVEMENT

BY

Mr. OJAS NITIN NARSALE

M.COM (Part-I) (SEM-II) (Roll No.40)

ACADEMIC YEAR 2015-2016

PROJECT GUIDE PROF. R.A.JOSHI

PARLE TILAK VIDYALAYA ASSOCIATION’S

M.L. DAHANUKAR COLLEGE OF COMMERCE

DIXIT ROAD, VILE PARLE (E)

MUMBAI- 400057

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DECLERATION

I, Mr. OJAS NITIN NARSALE of PARLE TILAK VIDYALAYA ASSOCIATION’S M.L. DAHANUKAR COLLEGE OF COMMERCE of M.COM (Part-I) (SEM-II) (Roll No.40) hereby declare that I have completed this project on INTERNATIONAL CAPITAL MOVEMENT in the ACADEMIC YEAR 2015-2016. This information submitted is true and original to the best of my knowledge.

(Signature of Student)

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ACKNOWLEDGEMENT

To list who all helped me is difficult because they are so numerous and the depth is so enormous.

I would like to acknowledge the following as being idealistic channels and fresh dimensions in the completion of this project.

I would firstly thank the University of Mumbai for giving me chance to do this project.

I would like to thank my Principal, Dr. Madhavi Pethe for providing the necessary facilities required for completion of this project.

I even will like to thank our co-coordinator, for the moral support that I received.

I would like to thank our College Library, for providing various books and magazines related to my project.

Finally I proudly thank my Parents and Friends for their support throughout the Project.

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Sr. No. Topic Page No.1. Objectives of Study and Research Methodology 5

2. Introduction 6

3. Meaning of Capital Flows 8

4. Types and Sources of International Capital

Movements

9

5. Factors affecting International Capital Movements 13

6. Role of International Capital Movements 15

7. Importance of Capital Movements 17

8. Trends in International Capital Flows 22

9. International Finance 26

10. Exchange Rate and Capital Mobility 27

11. Policies and Institutions 28

12. International Financial Stability 30

13. Migration 31

14. Globalization 33

15. Current Regulations to Manage Capital Flows in

India

36

16. Future of International Capital Movement 37

17. Conclusion 39

18. Bibliography 40

Table of Contents

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Objectives of Study

The objective of this study is to understand the concept of capital movements across

borders and study its impact on the economic and financial stability of both the economies.

Reasons for capital flight have been discussed in detail and also the urgency of controlling

capital movements. Trends in capital movements have been discussed about.

Research Methodology

The data contained in this study has been collected from various sources that have been

duly recognized at the end of the study. The information is secondary information collected from

websites and a magazine.

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Introduction

International capital movements have played an important role in the economic

development of several countries. They provide an outlet for savings for the leading countries

which help to smoothen out business cycles and lead to more stable pattern of economic growth.

On other hand, they help to finance development of under-developed countries. They also help to

ease the balance of payments problems of developing economies. Thus, international capital

movements have an important role to play in the balance of payments mechanism.

As compared to developed countries of the world, the developing countries suffer from

scarcity of capital and poor technology. Therefore, they rely on International capital flows to

finance their investment opportunities and hence, to raise income and employment.

The term International capital movement refers to borrowing and lending between

countries. These capital movements are recorded in the capital account of the balance of

payments. 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 and real GDP by a comparatively modest 26 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 looks very different today than it did a decade ago.

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These developments are often attributed to the increased integration of world financial

markets. Easier access to foreign financial markets, so the story goes, has led to the changing

pattern of asset ownership as investors have sought to realize the benefits from international

diversification. It is much less clear how the growth in the size and volatility of capital flows fits

into this story. If the benefits of diversification were well-known, 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. With this perspective, the prolonged increase in

the size and volatility of capital flows we observe suggests 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.

International capital flows are the financial side of international trade. When someone imports a

good or service, the buyer (the importer) gives the seller (the exporter) a monetary payment, just

as in domestic transactions. If total exports were equal to total imports, these monetary

transactions would balance at net zero: people in the country would receive as much in financial

flows as they paid out in financial flows. But generally the trade balance is not zero. The most

general description of a country’s balance of trade, covering its trade in goods and services,

income receipts, and transfers, is called its current account balance. If the country has a surplus

or deficit on its current account, there is an offsetting net financial flow consisting of currency,

securities, or other real property ownership claims. This net financial flow is called its capital

account balance.

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Meaning of Capital Flows

Capital Flows is the movement of money for the purpose of investment, trade or business

production. 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.  Movement of goods and services in the form of trade is one

form of international integration. Another form of integration is international movements of

factors of production or factor movements. Factor movements can be in the form of:

•Labor migration

•Transfer of capital via international borrowing and lending

•International linkages involved in the formation of multinational corporations (FDI)

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Types and Sources of International Capital Movements

Capital movements can be classified by instrument in to debt or equity and by maturity into

short term and long term. Capital movements can be divided into short term and long term flows,

depending upon the nature of credit instrument involved. A Capital movement is a short term

embodied in a credit instrument of less than a year maturity. If instrument has duration of more

than a year or consist title of ownership, the capital movement is long term.

(a) Short Term Capital Movements: They can take place through changes in claims of

domestic residents on foreign residents or in liabilities of domestic residents owed to

foreign residents. Short term capital movements are demand deposits, bills, overdrafts,

commercial and item in process of collection. They are mostly speculative in nature.

Short term capital movements may take place in form of hot money movement.

(b) Long Term Capital Movements: They are generally for long term investments. They

may further be classified into direct investment, portfolio investment and assistance from

Governments and institutions.

Foreign Direct Investments

A foreign direct investment (FDI) is a controlling ownership in a business enterprise in one

country by an entity based in another country.

Foreign direct investment is distinguished from portfolio foreign investment, a passive

investment in the securities of another country such as public stocks and bonds, by the element

of "control". According to the Financial Times, "Standard definitions of control use the

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internationally agreed 10 percent threshold of voting shares, but this is a grey area as often a

smaller block of shares will give control in widely held companies. Moreover, control of

technology, management, even crucial inputs can confer de facto control."

The origin of the investment does not impact the definition as an FDI: the investment may be

made either "inorganically" by buying a company in the target country or "organically" by

expanding operations of an existing business in that country.

The Foreign Direct Investment (FDI) in any country abroad is the net inflow of

investment (capital or other), in order to acquire management control and profit sharing (10% or

more voting stock) or the whole ownership of an accredited company operating in the country

receiving investment. The foreign direct investment generally encompasses the transfer of

technology and expertise, and participation in the joint venture and management. Highly

productive advantages of foreign direct investment have been constantly being harvested by both

governmental and private companies and organizations of all over the world.

The Foreign Direct Investment is profitable both to the country receiving investment

(foreign capital and funds) and the investor. For the investor company FDI offers an exclusive

opportunity to enter into the international or global business, new markets and marketing

channels, exclusive access to new technology and expertise, expansion of company with new or

more products or services, and cheaper production facilities. While the host country receives

foreign funds for development, transfer of new profitable technology, wealth of expertise and

experience, and increased job opportunities.

Owing to the ever-increasing globalization of businesses of almost all sectors,

liberalization of trade policies, and loosening of foreign investment restrictions, the Foreign

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Direct Investment (FDI) has been quite revolutionary and vital for faster economic growth of

most of the developing and developed countries of all across the world for last few decades.

Official Flows

They are shown as external assistance, i.e. grants and loans from bilateral and

multilateral flows. Long-term capital movements can also take the form of government loans or

grants and loans from International Financial Institutions. Sometimes Governments of advanced

countries may give loans to finance projects in a developing country. These are known as

bilateral loans.

International Financial Institutions like World Bank, Asian Development Bank, etc. also

give financial assistance to developing countries. These loans are called as multilateral loans.

Thus, governments and International Institutions play an important role in international capital

movements.

Foreign Aid

A part of the foreign capital is received on concessional terms and it is called as

assistance or foreign aid. It may be received by way of loans and grants. Grants are in the form

of outright gifts which do not have to be repaid. Loans qualify as aid only to the extent that they

bear a concessional rate of interest and have longer maturity periods than commercial loans.

Foreign aid has mostly been given by Foreign Governments and International Financial

Institutions like IMF, World Bank, Asian Development Bank And so on.

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External Commercial Borrowings

An external commercial borrowing (ECB) is an instrument used in India to facilitate the

access to foreign money by Indian corporations and PSUs (Public Sector Undertakings). ECBs

include commercial bank loans, buyers' credit, suppliers' credit, securitized instruments such as

floating rate notes and fixed rate bonds etc., credit from official export credit agencies and

commercial borrowings from the private sector window of multilateral financial Institutions such

as International Finance Corporation (Washington), etc. ECBs cannot be used for investment in

stock market or speculation in real estate. The DEA (Department of Economic Affairs), Ministry

of Finance, Government of India along with Reserve Bank of India, monitors and regulates ECB

guidelines and policies. For Infrastructure and Greenfield projects, funding up to 50% (through

ECB) is allowed. In Telecom sector too, up to 50% funding through ECBs is allowed. Recently

Government of India has increased limits on RBI to up to $40 billion and allowed borrowings in

Chinese currency Renminbi. Borrowers can use 25 per cent of the ECB to repay rupee debt and

the remaining 75 per cent should be used for new projects. A borrower cannot refinance its

existing rupee loan through ECB. The money raised through ECB is cheaper given near-zero

interest rates in the US and Europe, Indian companies can repay their existing expensive loans

from that.

The ministry has not put any ceiling on individual companies for using Renminbi as

currency for ECB. Even though the overall limit for permitting it under ECB is only $1 billion,

the officials denied possibilities of a single company using the entire amount as it would come

under ‘approval’ route. “The cost of borrowing in Renminbi is far less,” said a Finance Ministry

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Official. “Companies go for it as it is on easier terms. We are getting their (China’s) money

cheap.”

The limit for automatic approval has also been increased from $100 million to $200

million for the services sector (hospitals, tourism) and from $5 million to $10 million for non-

government organizations and microfinance institutions. The decisions will come into effect

through a notification by RBI.

Factors Affecting International Capital Movements

The following factors are affecting international capital movements:

1. Interest Rates:

The most important factor which affects 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 to outflow of capital. On the other hand if there is a possibility of a fall in

domestic interest rates in future, the foreign speculator will invest in securities at a low

price at present. This will lead to inflow of capital in the country.

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3. Expectation of profits:

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

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

capital flows into that country.

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

outflow of capital and vice versa.

5. Production Costs:

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

where labour, 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.

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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:

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; tax relief should

be given to new industries and foreign collaborations, etc.

9. Foreign capital policy:

The government policy relating to foreign capital affects capital movements.

Role of International Capital Movement

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

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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 judgments, 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.

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

equalize 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 equalized.

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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.

The Importance of Capital Movements

International trade and capital movements go together. Merely the financial transactions

involved in foreign trade and managing the risks involved generate a huge volume of capital

movements, accompanied by a large volume of currency trading.

The balance between saving and investment varies in different countries, and this is

reflected in their current account surpluses/deficits. Financing deficits and investing surpluses

always imply international capital movements between countries. If it was not possible to finance

deficits with capital movements, countries would have to adjust to, say, a drop in export demand

or an increase in import prices, by reducing domestic demand.

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Capital movements have had, and will continue to have, an important role in the

development strategy of developing countries. In principle, capital should flow from rich

countries with an ageing population, like the EU states and Japan, to poorer countries with a

younger age structure. The argument for this is that economic growth should be faster in poor

countries than in rich countries: the former can then use investments to adopt existing

technologies and thus increase their productivity and catch up with the living standards of richer

countries.

The growth potential of poor countries is also greater because their labour supply is

expanding as a result of their rising populations. This is in sharp contrast to many rich countries,

where populations are unlikely to rise without an influx of immigrants, and labour supply is

declining as a result of ageing.

Capital should thus flow from rich to poor countries specifically because the latter have

the faster growth potential. In practice, however, this is not always the case. In many developing

countries and transition economies, growth is hampered not only by the low level of domestic

saving but also by the fact that their external financing is largely restricted to development aid

and to loans granted by multilateral international financial institutions.

As they receive no direct investment and the countries find it practically impossible to get

financing on the international capital market, their investments remain small, however

productive they may be, and per capita GDP rises hardly at all. From this point of view, there is

too little capital movement in the world, rather than too much.

Investments find targets in the same way, whether within a single country or globally.

They tend to be directed to targets which promise high expected return with a risk that is

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moderate or at least manageable. The investor's choice is influenced not only by the expected

return and the risk but also by the investment's liquidity, that is, how reliably and cheaply it can

be withdrawn and converted into cash.

The possibility of investing outside the home country provides a better opportunity for

risk diversification, as the number of potential targets is many times greater than the number of

domestic targets. Though investment beyond national borders and international diversification

are becoming more common, both private and institutional investors continue to invest a large

proportion of their portfolio in domestic equities and other domestic assets. This proportion is

still far larger than what might be considered optimal in terms of the expected return and the

related risk. There may be many reasons for favouring domestic investments, such as asymmetric

information. However, as these reasons become less important the significance of capital

movements can be expected to grow still further.

Capital movements are also important in terms of the pricing of capital and international

risks. On a well-functioning market, future expectations affect the price that investors are ready

to pay. This is true of all forms of investment, but is most apparent in securities. In a purely

financial sense, the price paid for a security reflects the cash return that the holder can expect to

enjoy in the future.

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Causes of Capital Movements

The responsiveness of private capital to opportunities in emerging markets started to

improve in the 1990s because of both internal and external factors. Internal factors improved

private risk-return characteristics for foreign investors through three main channels. First,

creditworthiness improved as a result of external debt restructuring in a wide range of countries.

Second, productivity gains were obtained from structural reform and the establishment of

confidence in macroeconomic management in several developing countries that had undertaken

successful stabilization programs. Third, countries adopting fixed exchange rate regimes became

increasingly attractive to investors owing to the transfer of the risk of exchange rate volatility—

at least in the short run—from investors to the government.

In addition, because of both cyclical and structural forces, external influences played a

significant role in the capital inflow surge of the 1990s. Cyclical forces were the dominant

explanation in the early 1990s, when the decline in world real interest rates "pushed" investors to

emerging markets. The persistence of private capital flows after the increase in world interest

rates in 1994 and the Mexican crisis of 1994-95 suggest, however, that structural external forces

were also at work.

The structural external forces started to work when two developments in the financial

structures of capital-exporting countries increased the responsiveness of private capital to cross-

border investment opportunities. First, falling communication costs, strong competition, and

rising costs in domestic markets led firms in industrial countries to produce abroad to increase

their efficiency and profits. Second, institutional investors became more willing and able to

invest in emerging market countries because of their higher long-term expected rates of return,

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wider opportunities for risk diversification owing to their broader and deeper securities markets,

and greater feasibility of investing as their capital accounts were liberalized. Nonetheless,

investments in emerging markets account for only about 2 percent of total mutual fund assets in

the United States, 3-4 percent in the United Kingdom, and almost none in the rest of Europe and

Japan. The importance of structural forces gives rise to optimism about the volume of capital

flows that developing countries can attract in the medium term. With the growing importance of

private capital flows to these economies, however, has come the threat of major reversals.

Understanding reversals of capital flows

Major reversals of capital flows occurred in a number of developing countries even

before the 1990s.

A common reason for the reversals has been a lack of confidence in domestic

macroeconomic policies, leading to speculative attacks on currencies and balance of payments

crises. Balance of payments crisis can also result from financial vulnerabilities or other factors

that make macroeconomic policy less credible. In particular, if a country's banking sector is

weak, its authorities might prefer to devalue rather than to increase interest rates. Moreover, as

shown by the Mexican experience, the maturity and currency composition of the public sector's

liabilities relative to those of its assets are particularly relevant. In fact, even if a country's public

sector is solvent, it might be vulnerable to short-run liquidity crises if creditors prove reluctant to

refinance the government's short-term liabilities. Finally, the role of contagion is particularly

important for understanding the recent volatility of international capital markets.

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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 mid-1990s 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 mid-2007. 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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Objectives

All restrictions on capital movements between Member States as well as between

Member States and third countries should be removed. However, for capital movements between

Member States and third countries, Member States also have:

(1) the option of safeguard measures in exceptional circumstances;

(2) the possibility to apply restrictions that existed before a certain date to third countries and

certain categories of capital movements; and

(3) a basis for the introduction of such restrictions — but under very specific circumstances.

Liberalization should help to establish the Single Market by supplementing other freedoms (in

particular the movement of persons, goods and services).

It should also encourage economic progress by enabling capital to be invested efficiently

and promoting the use of the euro as an international currency, thus contributing to the EU's role

as a global player. It was also indispensable for the development of Economic and Monetary

Union (EMU) and the introduction of the euro.

Benefits of Capital Flows

Economists have long argued that trade in assets (capital flows) provides substantial

economic benefits by enabling residents of different countries to capitalize on their differences.

Fundamentally, capital flows permit nations to trade consumption today for consumption in the

future to engage in intertemporal trade. Because Japan has a population that is aging more

rapidly than that of the United States, it makes sense or Japanese residents to purchase more

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U.S. assets than they sell to us. This allows the Japanese to save for their retirement by building

up claims on future income in the United States while permitting residents of the United States

to borrow at lower interest rates than they could otherwise pay. A closely related concept is that

capital flows permit countries to avoid large falls in national consumption from economic

downturn or natural disaster by selling assets to and/or borrowing from the rest of the world.

Role of Foreign Capital

Foreign capital has played important role in the early stages of industrialization of most of

the advanced countries of today like countries of Europe and North America. This is the general

view that foreign capital, if properly diverted and utilized, can assist economic development of

developing countries. These countries need resource to finance investment in health, education,

infrastructure and so on. It can supplement a country’s domestic saving effort and foreign

exchange earnings. Foreign capital can contribute to economic development of developing

countries in the following ways:

Supplements domestic capital formation:

Economic development depends on, among other things, capital formation. The

domestic capital formation is inadequate in LDCs. The foreign capital can supplement

the domestic resources to achieve the critical minimum investment to break the

vicious circle of low income-low saving-low investment. If more domestic is to be

created by a country’s own effort, resources will have to be diverted from the

production of goods required for current consumption.

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Accelerates economic development:

Foreign capital helps to accelerate the pace of economic development by facilitating

imports of capital goods, technical know-how and other imports which are required

for carrying out development programs.

Improve trade balance:

Foreign capital inflow may help to increase a country’s exports and reduce the import

requirements if such capital flows into export oriented and import competing

industries.

Transfer of technology:

The Foreign capital may facilitate transfer of technology to LCDs. It may help to

modernize the production techniques in industry, agriculture and other sectors.

Income and Employment:

If foreign capital flows into real sectors in the form of direct investment it helps to

increase productivity, income and employment in the economy.

Balance of payments adjustment:

Inflow of foreign capital, especially the short term, may be able to provide a

breathing space to a deficit country to cover the deficit until a complete adjustment is

achieved to correct the balance of payment deficit.

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International Finance

International finance has exploded during the 1990s as countries, particularly in the

developing world, have bowed to the conventional wisdom that they should remove

barriers to these flows.

The flood of capital into countries like Mexico, while fueling economic growth for a

period of time, has done little to improve the lives of the majority of people.

The roots of the crisis may lay in the financial liberalization that encouraged a flood of

short-term private flows into Thailand, the Philippines, and elsewhere in the early 1990s.

Scope

The economics of international finance do not differ in principle from the economics of

international trade but there are significant differences of emphasis. The practice of international

finance tends to involve greater uncertainties and risks because the assets that are traded are

claims to flows of returns that often extend many years into the future. Markets in financial

assets tend to be more volatile than markets in goods and services because decisions are more

often revised and more rapidly put into effect. There is the share presumption that a transaction

that is freely undertaken will benefit both parties, but there is a much greater danger that it will

be harmful to others.

For example, mismanagement of mortgage lending in the United States led in 2008 to

banking failures and credit shortages in other developed countries, and sudden reversals of

international flows of capital have often led to damaging financial crises in developing countries.

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Exchange rates and capital mobility

A major change in the organization of international finance occurred in the latter years of

the twentieth century, and economists are still debating its implications. At the end of the Second

World War the national signatories to the Bretton Woods Agreement had agreed to maintain

their currencies each at a fixed exchange rate with the United States dollar, and the United States

government had undertaken to buy gold on demand at a fixed rate of $35 per ounce. In support

of those commitments, most signatory nations had maintained strict control over their nationals’

use of foreign exchange and upon their dealings in international financial assets.

But in 1971 the United States government announced that it was suspending the

convertibility of the dollar, and there followed a progressive transition to the current regime of

floating exchange rates in which most governments no longer attempt to control their exchange

rates or to impose controls upon access to foreign currencies or upon access to international

financial markets. The behavior of the international financial system was transformed. Exchange

rates became very volatile and there was an extended series of damaging financial crises. One

study estimated that by the end of the twentieth century there had been 112 banking crises in 93

countries, another that there had been 26 banking crises, 86 currency crises and 27 mixed

banking and currency crises - many times more than in the previous post-war years.

The outcome was not what had been expected. In making an influential case for flexible

exchange rates in the 1950s, Milton Friedman had claimed that if there were any resulting

instability, it would mainly be the consequence of macroeconomic instability, but an empirical

analysis in 1999 found no apparent connection Economists began to wonder whether the

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expected advantages of freeing financial markets from government intervention were in fact

being realized.

Neoclassical theory had led them to expect capital to flow from the capital-rich

developed economies to the capital-poor developing countries - because the returns to capital

there would be higher. Flows of financial capital would tend to increase the level of investment

in the developing countries by reducing their costs of capital, and the direct investment of

physical capital would tend to promote specialization and the transfer of skills and technology.

However, theoretical considerations alone cannot determine the balance between those benefits

and the costs of volatility, and the question has had to be tackled by empirical analysis.

A 2006 International Monetary Fund working paper offers a summary of the empirical

evidence. The authors found little evidence either of the benefits of the liberalization of capital

movements, or of claims that it is responsible for the spate of financial crises. They suggest that

net benefits can be achieved by countries that are able to meet threshold conditions of financial

competence but that for others, the benefits are likely to be delayed, and vulnerability to

interruptions of capital flows is likely to be increased.

Policies and institutions

Although the majority of developed countries now have "floating" exchange rates, some

of them – together with many developing countries – maintain exchange rates that are nominally

"fixed", usually with the US dollar or the euro. The adoption of a fixed rate requires intervention

in the foreign exchange market by the country’s central bank, and is usually accompanied by a

degree of control over its citizens’ access to international markets.

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A controversial case in point is the policy of the Chinese governments who had, until

2005, maintained the Renminbi at a fixed rate to the dollar, but have since "pegged" it to a basket

of currencies. It is frequently alleged that in doing so they are deliberately holding its value

lower than if it were allowed to float.

Some governments have abandoned their national currencies in favor of the common

currency of a currency area such as the "Eurozone" and some, such as Denmark, have retained

their national currencies but have pegged them at a fixed rate to an adjacent common currency.

On an international scale, the economic policies promoted by the International Monetary Fund

(IMF) have had a major influence, especially upon the developing countries.

The IMF was set up in 1944 to encourage international cooperation on monetary matters,

to stabilize exchange rates and create an international payments system. Its principal activity is

the payment of loans to help member countries to overcome balance of payments problems,

mainly by restoring their depleted currency reserves. Their loans are, however, conditional upon

the introduction of economic measures by recipient governments that are considered by the

Fund's economists to provide conditions favorable to recovery.

Their recommended economic policies are broadly those that have been adopted in the

United States and the other major developed countries (known as the "Washington Consensus")

and have often included the removal of all restrictions upon incoming investment. The Fund has

been severely criticized by Joseph Stiglitz and others for what they consider to be the

inappropriate enforcement of those policies and for failing to warn recipient countries of the

dangers that can arise from the volatility of capital movements.

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International Financial Stability

From the time of the Great Depression onwards, regulators and their economic advisors

have been aware that economic and financial crises can spread rapidly from country to country,

and that financial crises can have serious economic consequences. For many decades, that

awareness led governments to impose strict controls over the activities and conduct of banks and

other credit agencies, but in the 1980s many governments pursued a policy of deregulation in the

belief that the resulting efficiency gains would outweigh any systemic risks.

One of their effects has been greatly to increase the international inter-connectedness of

the financial markets and to create an international financial system with the characteristics

known in control theory as "complex-interactive". The stability of such a system is difficult to

analyse because there are many possible failure sequences. The internationally systemic crises

that followed included the equity crash of October 1987, the Japanese asset price collapse of the

1990s, the Asian financial crisis of 1997, the Russian government default of 1998 (which

brought down the Long-Term Capital Management hedge fund) and the 2007-08 sub-prime

mortgages crisis. The symptoms have generally included collapses in asset prices, increases in

risk premiums, and general reductions in liquidity.

Measures designed to reduce the vulnerability of the international financial system have

been put forward by several international institutions. The Bank for International Settlements

made two successive recommendations (Basel I and Basel II) concerning the regulation of banks,

and a coordinating group of regulating authorities, and the Financial Stability Forum, that was set

up in 1999 to identify and address the weaknesses in the system, has put forward some proposals

in an interim report.

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Migration

Elementary considerations lead to a presumption that international migration results in a

net gain in economic welfare. Wage differences between developed and developing countries

have been found to be mainly due to productivity differences which may be assumed to arise

mostly from differences in the availability of physical, social and human capital. And economic

theory indicates that the move of a skilled worker from a place where the returns to skill are

relatively low to a place where they are relatively high should produce a net gain (but that it

would tend to depress the wages of skilled workers in the recipient country).

There have been many econometric studies intended to quantify those gains. A

Copenhagen Consensus study suggests that if the share of foreign workers grew to 3% of the

labour force in the rich countries there would be global benefits of $675 billion a year by 2025.

However, a survey of the evidence led a House of Lords committee to conclude that any benefits

of immigration to the United Kingdom are relatively small. Evidence from the United States also

suggests that the economic benefits to the receiving country are relatively small, and that the

presence of immigrants in its labour market results in only a small reduction in local wages.

From the standpoint of a developing country, the emigration of skilled workers represents

a loss of human capital (known as brain drain), leaving the remaining workforce without the

benefit of their support. That effect upon the welfare of the parent country is to some extent

offset by the remittances that are sent home by the emigrants, and by the enhanced technical

know-how with which some of them return. One study introduces a further offsetting factor to

suggest that the opportunity to migrate fosters enrolment in education thus promoting a "brain

gain" that can counteract the lost human capital associated with emigration.

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Whereas some studies suggest that parent countries can benefit from the emigration of

skilled workers, generally it is emigration of unskilled and semi-skilled workers that is of

economic benefit to countries of origin, by reducing pressure for employment creation. Where

skilled emigration is concentrated in specific highly skilled sectors, such as medicine, the

consequences are severe and even catastrophic in cases where 50% or so of trained doctors have

emigrated. The crucial issues, as recently acknowledged by the OECD, is the matter of return

and reinvestment in their countries of origin by the migrants themselves: thus, government

policies in Europe are increasingly focused upon facilitating temporary skilled migration

alongside migrant remittances.

Unlike movement of capital and goods, since 1973 government policies have tried to

restrict migration flows, often without any economic rationale. Such restrictions have had

diversionary effects, channeling the great majority of migration flows into illegal migration and

"false" asylum-seeking. Since such migrants work for lower wages and often zero social

insurance costs, the gain from labour migration flows is actually higher than the minimal gains

calculated for legal flows; accompanying side-effects are significant, however, and include

political damage to the idea of immigration, lower unskilled wages for the host population, and

increased policing costs alongside lower tax receipts.

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Globalization

The term globalization has acquired a variety of meanings, but in economic terms it

refers to the move that is taking place in the direction of complete mobility of capital and labour

and their products, so that the world's economies are on the way to becoming totally integrated.

The driving forces of the process are reductions in politically imposed barriers and in the costs of

transport and communication (although, even if those barriers and costs were eliminated, the

process would be limited by inter-country differences in social capital).

It is a process which has ancient origins which has gathered pace in the last fifty years,

but which is very far from complete. In its concluding stages, interest rates, wage rates and

corporate and income tax rates would become the same everywhere, driven to equality by

competition, as investors, wage earners and corporate and personal taxpayers threatened to

migrate in search of better terms. In fact, there are few signs of international convergence of

interest rates, wage rates or tax rates. Although the world is more integrated in some respects, it

is possible to argue that on the whole it is now less integrated than it was before the first world

war., and that many middle-east countries are less globalized than they were 25 years ago.

Of the moves toward integration that have occurred, the strongest has been in financial

markets, in which globalization is estimated to have tripled since the mid-1970s. Recent research

has shown that it has improved risk-sharing, but only in developed countries, and that in the

developing countries it has increased macroeconomic volatility. It is estimated to have resulted in

net welfare gains worldwide, but with losers as well as gainers. Increased globalization has also

made it easier for recessions to spread from country to country. A reduction in economic activity

in one country can lead to a reduction in activity in its trading partners as a result of its

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consequent reduction in demand for their exports, which is one of the mechanisms by which the

business cycle is transmitted from country to country. Empirical research confirms that the

greater the trade linkage between countries the more coordinated is their business cycles.

Globalization can also have a significant influence upon the conduct of macroeconomic

policy. The Mundell–Fleming model and its extensions are often used to analyse the role of

capital mobility (and it was also used by Paul Krugman to give a simple account of the Asian

financial crisis). Part of the increase in income inequality that has taken place within countries is

attributable - in some cases - to globalization. A recent IMF report demonstrates that the increase

in inequality in the developing countries in the period 1981 to 2004 was due entirely due to

technological change, with globalization making a partially offsetting negative contribution, and

that in the developed countries globalization and technological change were equally responsible.

Capital flows and domestic investment

Economic theory suggests that capital will move from countries where it is abundant to

countries where it is scarce because the returns on new investment opportunities are higher

where capital is limited. Such a reallocation of capital will boost investment in the recipient

country and, as Summers (2000) suggests, bring enormous social benefits. Underlying this

theory is the premise that returns to capital decrease as more machinery is installed and new

structures are built, although, in practice, this is not always, or even generally, true. New

investment is more productive in countries with a skilled workforce and well-developed physical

infrastructure, as Lucas (1990) recognized in explaining why capital does not flow from rich to

poor countries. Thus, a consistent finding is that new capital flows tend to go to countries that

have received large flows in the past and that investors also seek favorable business

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environments. Although economic theory and empirical investigations have much to say about

where international capital may flow, both the theory and the evidence are less definitive about

the impact of such flows. Once in a country, private capital may increase either domestic

consumption or investment, or it may principally increase the country's foreign exchange

reserves. If flows are driven merely by incentives to evade taxes or jump other legal barriers,

money may flow out of a country as quickly as it flows in.

Despite these ambiguities, private capital flows are generally found to have a significant

impact on domestic investment, with the relationship being strongest for Foreign Direct

Investment and international bank lending and weaker for portfolio flows (Bosworth and Collins,

1999). When a country is poor and saves little, additional capital from outside the country can

help it realize investment opportunities. For example, our analysis suggests that a 1 percent

increase in capital inflows to Africa boosts investment by more than 1 percent. However, little

foreign capital is directed to Africa, and that is largely limited to a few countries with significant

natural resources. Moreover, because the productivity of investment in many of these countries is

not high, the long-term impact of foreign capital on growth may be small. Over time, as a

country becomes better integrated with the rest of the world, a dollar of foreign capital raises

investment less than it did in the past.

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Current Regulations to Manage Capital Flows in India

Capital flows contribute in filling the resource gap in a country like India where the

domestic savings are inadequate to finance investment. Today, India requires approximately

500 billion US $ investment in infrastructure sector alone in the next 5 years for sustaining

present growth rate of approximately 8-9 per cent. This amount is around 2.5 times more

than the 10th Plan. Add to this, already, several infrastructure projects have reportedly been

shelved and indefinitely delayed. Such huge mobilization of resources is not possible from

India’s internal resources. Therefore, India needs foreign capital in the form of ECBs and

other foreign loans and aids. Keeping in view the growing requirements of foreign capital in

India, Indian government has come up with many policies and liberalized regulations to

manage foreign capital in India. Some of the important and recent measures taken by Indian

government to manage foreign investments in India are as under:

1. Foreign Direct Investment:

2. Foreign Portfolio Investment:

3. Foreign Venture Capital Investors:

4. External Commercial Borrowings:

5. Investment by NRIs in Immovable Properties: The NRIs are permitted to freely

acquire immoveable property (other than agricultural land, plantations and

farmhouses). NRIs are also permitted to avail of housing loans for acquiring property

in India and repayment of such loans by close relatives is also permitted.

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The Future of International Capital Movement

The experience of the past decade has demonstrated the challenges that international

capital flows can pose for financial stability. Between 2002 and 2007, annual gross international

capital flows rose from 5% to 17% of world GDP, and the network of cross-country financial

linkages became increasingly complex. Net international capital flows also rose sharply over this

period, with global current-account imbalances (the sum of global deficits and surpluses)

doubling from 3% to 6% of world GDP. The build-up of global imbalances was one of the

preconditions for the recent financial crisis. And the increased interconnectedness between

countries’ financial sectors associated with large gross flows created channels through which the

initial shock could spread around the world. As remarkable as the pre-crisis growth in

international capital flows was, the collapse post-Lehman was yet more dramatic. Gross global

cross-border capital flows plummeted to less than 1% of world GDP in 2008, with severe

implications for both advanced economies – especially those with large, open financial sectors –

and many emerging-market economies that had hitherto accessed funding from abroad. In these

respects, the scale and volatility of international capital flows were crucial determinants of the

depth and breadth of the crisis which followed Lehman Brothers’ demise.

These dramatic events bring home just how essential it is for policymakers to develop

strategies to deal with these risks in future. Yet, however great the challenges policymakers may

have faced in the most recent episode because of the size and volatility of capital flows, these are

set to become even greater in the future as large emerging-market economies increasingly

integrate into the global financial system. Whereas the immediate challenge for policymakers

today is to prevent – or to have policies to deal with – the risk of a sharp cross border

deleveraging of gross capital flows, the medium-term risk is the opposite – having policies to

deal with much larger inflows.

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The experience of the past decade has demonstrated the challenges that international

capital flows can pose for financial stability. The build-up of global imbalances (large net capital

flows) was one of the preconditions for the recent financial crisis. Increased interconnectedness

between countries’ financial sectors (large gross capital flows) created channels through which

the initial shock could spread around the world. In these respects, the scale and volatility of

international capital flows were crucial determinants of the depth and breadth of the crisis which

followed Lehman Brothers’ demise. These dramatic events demonstrate that it is incumbent upon

policymakers to develop strategies to deal with these risks in the future. But however great the

challenges policymakers may have faced in the most recent episode, these are set to become even

greater in the future as large emerging market economies (EMEs) increasingly integrate into the

global financial system. This paper elaborates on the simulations of Haldane (2010), with the aim

of constructing some illustrative thought experiments to describe some potential trajectories for

G20 countries’ capital flows and external balance sheets over the next 40 years. Some key results

from our simulations are as follows: The overall size of external balance sheets relative to GDP

across the entire G20 increases from a ratio of around 1.3 to 2.2. The distribution of external

assets shifts to emerging markets. By 2050, more than 40% of all external assets are held by the

BRICs, up from the current 10%. Non-G7 annual capital outflows are simulated to be more than

twice the size of G7 outflows by 2050. Global current account imbalances (the sum of deficits

and surpluses) rise from around 4% of world GDP to around 8% at their peak. These simulations

focus on two fundamental drivers of capital flows — GDP convergence and demographics.

Plainly, other factors which we do not explicitly model — such as financial development,

changes in investor preference, exchange rate policies and the development of social safety nets

— will also be important in the years to come. Notwithstanding these caveats, it seems

reasonable to envisage a future world in which the financial integration of EMEs is accompanied

by a substantial rise in international capital flows relative to world GDP.

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Conclusion

The premature celebration of the boom in capital flows in the first half of the 1990s has

been replaced in recent years by a skepticism that is equally unwarranted. Private capital flows

are not likely to solve all development problems and can impose significant costs. However,

when harnessed effectively, they can boost investment and spur productivity growth. Domestic

policy priorities that foster more efficient investment will also attract productive foreign capital.

Ultimately, domestic strength, including a robust and prudent financial sector, will also protect a

country from the volatility induced by capital flows. However, special safeguards, such as higher

foreign exchange reserves or contingent credit lines, may be advisable in certain situations.

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

recent reversal following the crises around the globe have reignited a heated debate on how to

manage international capital flows. Capital outflows worry policy makers, but so do capital

inflows, as they may trigger bubbles in asset markets and lead to an appreciation of the domestic

currency and a loss of competitiveness. Policy makers also worry that capital inflows are mostly

of the “hot money” type, which is why capital controls have mostly targeted short-term capital

inflows. While capital controls may work, at least in the very short run, the introduction of

restrictions to capital mobility may have undesirable long-run effects. In particular, capital

controls protect inefficient domestic financial institutions and thus may trigger financial

instability.

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Bibliography

www.amazon.com

www.econlib.org

www.investopedia.com

www.bankofengland.co.uk

Ref. Book : Economics of Global Trade & Finance (Manan Prakashan)

Journal of International Money & Finance

http://www.bankofengland.co.uk/financialstability/Documents/fpc/fspapers/fs_paper12.pdf

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