INTERNATIONAL MOVEMENT

INTERNATIONAL
CAPITAL
MOVEMENT

INTERNATIONAL MOVEMENT

CHAPTER 1
INTRODUCTION TO CAPITAL
In economics, capital goods, real capital, or capital assets are alreadyproduced 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
enhance a person's power to perform economically useful worka stone or an arrow is
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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 exchangeit 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 organizations 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.

INTERNATIONAL MOVEMENT

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'sexchange
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.

INTERNATIONAL MOVEMENT

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 capitaldeficit 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.

INTERNATIONAL MOVEMENT

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

20

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
countries during this period.
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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 XIIXV 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 movements vis--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 countrys
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 countrys 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 ows 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 benets and drawbacks of nancial 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 ows triggering
bubbles and nancial crises and magnifying the business cycle. In contrast, the traditional
view asserts that international capital markets enhance growth and productivity by allowing
capital to ow to its most attractive destination.
Even if international capital ows do not trigger excess volatility in domestic
nancial markets, it is still true that large capital inows can spark off ination in the
presence of a xed exchange-rate regime. Moreover, transitory capital inows 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 ows, especially ows of the hot money type.

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INTERNATIONAL FINANCIAL FLOWS ON INDIAS 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 1990s. 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 (FIIs) and there is
convertibility of the rupee for FIIs 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 Argentinas 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.

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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
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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
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.

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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
monetary control was tightened when the BCRA began issuing its own short-term (oneweek, 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
Argentinas recent crises. The explanation lies in the nature of the crises, and the role of
International Financial Institutions (IFIs).

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With respect to the first item, Argentinas 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
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 Banks
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
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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
suffered weaknesses in its banking system, its macroeconomic policy, or both. Strong
prudential regulations, designed for the type of problems a developing countrys 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.

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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
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.
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
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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 equitybased 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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