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13th February 2014


I hereby certify that are the work which is being presented in the M.Com. internal Project Report “INTERNATIONAL CAPITAL MOVEMENT”, in partial fulfilment of the requirement for the award of the Master in Commerce in ECONOMICS and submitted to the Lala Lajpatrai College of Commerce and Economics, Mahalaxmi, Mumbai-4000 34 is an authentic record of my own work carried out under the supervisor of Professor Janki Annanraj. The matter presented in this project Report has not been submitted by me for the award of any other degree elsewhere.

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I would like to place on record my deep sense of gratitude to Prof. Janki Annanraj –Dept of for His generous guidance, help and useful suggestion. I express my sincere gratitude to Prof. Janki Annanraj for his stimulating guidance, continuous encouragement and supervision throughout the course of present work.

I also wish to extend my thanks to Prof. Janki Annanraj and other colleagues’ for attending my seminars and for their insightful comment and constructive suggestion to improve to the quality of this project work. I am extremely thankful to to Prof. Dr. Suryakant lasune coordinator and Principal Mrs. Neelam Arora for providing me infrastructure facilities to work in, without which this work would not have been possible.


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Abstract Introduction What are international capital movements Types of capital Flows Factors Effecting Capital Movements Trends in international capital Flows Persistence in Capital Flows Scale of Capital Movements Price Uncertainty and Crisis Role of Capital Movement In Crisis Controlling Capital Movements Transfer Tax and Short term Capital Movements Review & Results Conclusion Bibliography

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5 . However .investigation of the statistical properties of these flows shows that no regular relationships exist to suggest that the particular composition of capital flows can help to explain the overall stability of the external accounts. We show that while industrialised economies have experienced a trend rise in the volatility of individual components in the capital account.Abstract Conventional wisdom is that some capital flows are inherently more volatile than others. Such offsetting relationships appear less prevalent in emerging economies. this variability is largely offsetting. Instead. capital seems to come and go in different forms with few reliable patterns.

covering its trade in goods and services. during 1996–2001. the international capital and trade data contain a balancing error term called “net errors and omissions. real property. the former was $17. many financial transactions between international 6 . When a country’s imports exceed its exports. or other real property ownership claims. financial. When someone imports a good or service. is just offset by the capital-account balance. which is the total balance of claims that domestic investors and foreign investors have acquired in newly invested financial. Thus. real property.3 trillion. 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. If the country has a surplus or deficit on its current account. it has a current account deficit. While all the above statements are true by definition of the accounting terms. and equity claims. The most general description of a country’s balance of trade. Capital flows move in the opposite direction to the goods and services trade claims that give rise to them. securities. the buyer (the importer) gives the seller (the exporter) a monetary payment. But generally the trade balance is not zero. or they can use the money to buy other financial assets. Therefore. there is an offsetting net financial flow consisting of currency. just as in domestic transactions. one might expect total recorded world trade—exports plus imports summed over all countries—to equal financial flows—payments plus receipts. which is the total balance of internationally traded goods and services.0 trillion.” Because the capital account is the mirror image of the current account. This net financial flow is called its capital account balance. at $5. more than three times the latter. In BALANCE-OF-PAYMENTS accounting terms. Net capital flows comprise the sum of these monetary. If total exports were equal to total imports. and transfers. or equities (stocks) in the trade-deficit country. the data on international trade and financial flows are generally riddled with errors. income receipts. Its foreign trading partners who hold net monetary claims can continue to hold their claims as monetary deposits or currency. real property. and equity assets in each others’ countries. a country with a current account deficit necessarily has a capital account surplus. But in fact.2 There are three explanations for this. First.INTRODUCTION International capital flows are the financial side of INTERNATIONAL TRADE. is called its current account balance. the current-account balance. generally because of undercounting.

Third. In that year the combination of the Russian debt default and ruble devaluation. banks have claims on French banks for $10 million and French banks have claims on U. with the rest. material.S. Turkey. banks for $12 million. Singapore. For example.4 The shares of both industrial nations and the international organizations have been receding from their highs in 1998: 90 percent for industrial nations and 5 percent for the international organizations.4 trillion (84 percent) involved the 24 industrial countries and almost $1. and adding Taiwan.S.4 trillion in gross financial transactions. a huge share of export and import trade is intrafirm transactions. and the lingering uncertainty about financial consequences of the return of Hong Kong to Chinese sovereignty in July 1997 drove the LDC share down to 5 percent of world capital flows. or semi-finished parts (especially automobiles and other no electronic machinery) between parent companies and their subsidiaries. if on a particular day.5 In the more tranquil five years following these crises. flows of goods. since the 1970s. In 2003. less than 1 percent.3 The bulk of capital flows are transactions between the richest nations. accounted for by international organizations. the south Asia financial crisis. intra firm trade for the United States in recent years accounts for 30–40 percent of exports and 35–45 percent of imports. of the more than $6. and Korea brings the share to 53 percent of the developingcountry transactions. Poland. 1999–2003. about $5. and the Czech Republic) and the Western Hemisphere (primarily Mexico. Second. Of the remaining forty-seven percentage points of developing-country transactions. U. the transactions will be cleared through their central banks with a recorded net flow of only $2 million from the United States to France even though $22 million of exports was financed. with the Middle East and Africa combining for the remaining sixteen percentage points. Compensation for such trade is accomplished with accounting debits and credits within the firms’ books and does not require actual financial institutions are cleared by netting daily offsetting transactions.0 trillion (15 percent) involved the 162 less-developed countries (LDCs) or economic territories. 7 . Europe (primarily Russia. there have been sustained and unexplained balance-of-payments discrepancies in both trade and financial flows. Brazil. Although data on such intra firm transactions are not generally available for all industrial countries. LDC financial transactions involving mainland China and Hong Kong averaged 28 percent of the LDC total. part of these balance-of-payments anomalies is almost certainly due to unrecorded capital flows. and Chile) each accounted for about sixteen percentage points. that is.

Hence. the payment will be in dollars. a demand for the dollar is created. when Japanese investors purchase American securities. and through trade with other nations and currencies. an American company would have to buy yen in order to pay its creditors. governments direct capital flows from tax receipts into programs and operations. For instance. trade or business production.” 8 . necessitating an increase in the dollar's exchange rate. Conversely. IN SIMPLE WORDS “The transfer of capital between countries either by the import or export of securities. bonds and mutual funds. This would cause a demand in yen and the price of yen would increase in terms of dollars. dividend payments or interest payments. Capital flows occur within corporations in the form of investment capital and capital spending on operations and research & development.WHAT ARE CAPITAL MOVEMENTS? The movement of money for the purpose of investment. On a larger scale. Individual investors direct savings and investment capital into securities like stocks.

Portfolio investments comprise cross-border investments in equities and other securities. for instance. The foreign receivables and liabilities of banks are mostly short-term claims. Direct investments comprise real investments and corporate acquisitions made by companies in other countries. which are counted as direct investments and the volume of which has grown appreciably in recent years. investments in equities and government bonds are long-term capital movements in principle. bank deposits. The lenders may then be private-sector banks as well as governments in developed countries and multilateral international financial institutions. On the other hand. portfolio investment and other capital movements.Types of capital movement International capital movements refer to investments and financial transactions between one country and another. but being arbitrary this is no longer the practice. The exchange rate regime and 9 . Among portfolio investments. Other capital movements mean cross-border lending and investments in. participation by international organisations is often a precondition for a supply of private-sector financing. foreign direct investments in the form of equity investments are long-term capital movements. Examples of short-term capital movements are financial transactions connected with foreign trade financing and the related risk management. This is because short-term investment flows may suddenly change course. as well as loans between companies belonging to the same group. In the case of developing countries. Portfolio investments in another country's shortterm money market claims are by definition short-term capital movements. this is not always so. prompting great tension on money and currency markets and possibly causing a currency crisis or a more severe financial and banking crisis. are in the statistics considered as short-term movements. so changes in them reflect short-term capital movements. In balance of payments statistics capital movements are divided into foreign direct investment. a distinction was made between short and long-term capital movements. since such investments can be sold off at any time on a liquid market. Earlier. In practice. though. A considerable proportion derives from transactions related to finance for foreign trade. Investment and development loans are likewise usually long-term. Short-term capital movements have been said to play a crucial role in creating instability. By definition. Special mention should be made of loans taken out by governments (sovereign debt). The financing of longterm capital movements also gives rise to short-term capital movements. inter-company loans.

a large proportion of all currency trading comprises the kind of transaction that does not feature at all in the balance of payments statistics as a capital movement. either by buying a company in the target country or by expanding operations of an existing business in that country. If the exchange rate is floating freely. the banks' currency dealers. furthering a trend that has been in evidence for many years (see Chart 1). In sharp contrast. capital movements into or out of the country have a direct impact on the exchange rate. If. in East Asian countries. the central bank has to take steps of its own to neutralize the impact of one-way capital movements. This is a misconception. This resilience could lead many developing countries to favour FDI over other forms of capital flows. on the other hand. we devote some of the present report to currency movements are linked in many ways. or at least viewed as an element in them. In the balance of payments statistics. Though international capital movements usually generate currency transactions at some point. these steps are reflected as changes in the foreign exchange reserves of central banks. Currency trading is often identified with capital movements. other forms of private capital flows—portfolio equity and debt flows. The resilience of FDI during financial crises was also evident during the Mexican crisis of 1994-95 and the Latin American debt crisis of the 1980s. central banks and governments resorting to foreign debt. Foreign direct investment is in contrast to portfolio investment which is a passive investment in the securities of another country such as stocks and bonds. since the large volume of currency trading has been the focus of keen attention in the debate on the Tobin tax. and particularly short-term flows—were subject to large reversals during the same period. multilateral international financial institutions. Is the preference for FDI over other forms of private capital inflows justified? This article sheds some light on this issue by reviewing recent theoretical and empirical work on its impact on developing countries' investment and growth. 10 . Foreign direct investment (FDI) has proved to be resilient during financial crises. FDI Foreign direct investment (FDI) is a direct investment into production or business in a country by an individual or company of another country. However. such investment was remarkably stable during the global financial crises of 1997-98. BELOW ARE THE FOLLOWING TYPES: 1. The most important actors in terms of capital movements are companies engaged in international trade. the departments of banks responsible for corporate and foreign finance. the exchange rate is fixed or other means are used to control it. For instance. institutional investors engaged in international investment. Lack of confidence in the central bank's ability to maintain the target rate may attract speculative capital movements and a capital flight.

The case for free capital flows Economists tend to favour the free flow of capital across national borders because it allows capital to seek out the highest rate of return. countries often choose to forgo some of this revenue when they cut corporate tax rates in an attempt to attract FDI from other locations. international flows of capital reduce the risk faced by owners of capital by allowing them to diversify their lending and investment. Second. FDI should contribute to investment and growth in host countries through these various channels. accounting rules. Profits generated by FDI contribute to corporate tax revenues in the host country. Unrestricted capital flows may also offer several other advantages. which contributes to human capital development in the host country. In principle. 11 . which in principle apply to all kinds of private capital inflows. Third. therefore. Of course. as noted by Feldstein (2000). and legal traditions. In addition to these advantages. note that the gains to host countries from FDI can take several other forms:    FDI allows the transfer of technology—particularly in the form of new varieties of capital inputs—that cannot be achieved through financial investments or trade in goods and services. the global integration of capital markets can contribute to the spread of best practices in corporate governance. First. For instance. the global mobility of capital limits the ability of governments to pursue bad policies. FDI can also promote competition in the domestic input market. Recipients of FDI often gain employee training in the course of operating the new businesses. the sharp decline in corporate tax revenues in some of the member countries of the Organization for Economic Cooperation and Development (OECD) may be the result of such competition.

The purpose of the investment is solely financial gain. in cash or in kind and inter. 12 . Private capital is generally guaranteed by the government or the central bank of the borrowing country. 5. to spread the risk of possible loss due to below-expectations performance of one or a few of them. foreign capital implies investments made by foreigners in the country. On the other hand. It includes investment in an assortment or range of securities. Foreign Aid: It refers to public foreign capital on hard or soft terms. or other types of investment vehicles. Profit motive is the principal factor behind such investment. On the other hand. A portfolio investment is an investment made by an investor who is not particularly interested in involvement in the management of a company.2. loan to finance exports and imports and to finance particular projects 4. Thus home capital refers to the out flow of capital. PORTFOLIO INVESTMENT A portfolio investment is a passive investment in securities. Such capital movements are under the direct control of government in fact government are important international lenders they make stability loan.aid may be tied by project and by commodities untied loan is a general purpose aid and is known as non-project loan. Home and foreign capital: Home capital is concerned with investments made abroad by residents of the country. International portfolio diversification 3. which entails no active management or control of the securities by the investor. Foreign capital is concerned with the inflow of capital. Profitable use of funds B. government capital movements imply lending and borrowing between governments. Foreign aid is tied or untied . Private and Government Capital: Private capital movement means lending or borrowing from abroad by private individuals and institutions. REASONS WHY PORTFOLIO INVESTMENT IS TAKING PLACE? A.government grants. Diversification C.

up to 50% funding through ECBs is allowed. 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). ADB. monitors and regulates ECB guidelines and policies. Indian companies can repay their existing expensive loans from that. tourism) and from $5 million to $10 million for non-government organisations and microfinance institutions.. The money raised through ECB is cheaper given near-zero interest rates in the US and Europe.” said a finance ministry official. The decisions will come into effect through a notification by RBI.6. AFIC. Even though the overall limit for permitting it under ECB is only $1 billion.” The limit for automatic approval has also been increased from $100 million to $200 million for the services sector (hospitals. ECBs include commercial bank loans. funding up to 50% (through ECB) is allowed. Government of India along with Reserve Bank of India. suppliers' credit. the officials denied possibilities of a single company using the entire amount as it would come under ‘approval’ route. etc. 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. buyers' credit. In telecom sector too. securitised 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). A borrower can not refinance its existing rupee loan through ECB. 13 . Ministry of Finance. Recently Government of India has increased limits on RBI to up to $4[1]0 billions and allowed borrowings in Chinese currency yuan. The ministry has not put any ceiling on individual companies for using renminbi as currency for ECB. The DEA (Department of Economic Affairs). ECBs cannot be used for investment in stock market or speculation in real estate. For infrastructure and greenfield projects. We are getting their (China’s) money cheap. “Companies go for it as it is on easier terms. The cost of borrowing in Renminbi is far less. CDC.

This will lead to inflow of capital in the country. 3. 4. 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. Rate of interest shows rate of return over capital. Interest Rates: The most important factor which effect international capital movement is the difference among current interest rates in various countries. they will invest in short. 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. This will lead out flow of capital. On the other hand if possibility of fall of in domestic interest rates in future.term foreign securities to earn profit. Speculation: Speculation related to expecting variations in foreign exchange rates or interest rates affect short capital movements. 2. the foreign speculator investing securities at a low price at present. If bank rate is low. there will be out flow of capital and vice versa 14 . Bank Rate: A stable bank rate of the central bank of the country also influences capital movements because market interest rates depend on it. When speculators feel that the domestic interest rates will increase in future.Factors affecting International capital Movements 1. capital flows into that country. Where the possibility of earning profit is more.

6. efficient labor. Singapore. especially size of the market. Hong Kong. raw materials. 15 . etc. To encourage the inflow of capital. Malaysia and other developing countries by MNCs is low production cost there. encourage the inflow of capital in the country. Taxation Policy: The taxation policy of a country also affects the inflow or outflow of capital. Political Stability: Political stability. 7. etc. power and other resources. etc encourage the inflow of capital there. more private foreign capital flows there. give tax relief to new industries and foreign collaborations.5. Soft taxation policy should be followed. 8. Production Costs: Capital movements depends on production costs in other countries. etc are cheap and easily available. friendly relation with other countries. Economic Condition: The economic condition of a country. The main reasons of huge capital investment in Korea. availability of infrastructure facilities like the means of transportation and communication. security of life and property. In countries where labor.

interest etc to foreign investors will attract foreign capital similarly fiscal and monetary policy of a country also affect capital inflow and outflow 16 .9. Foreign capital policy: The government policy relating to foreign capital affects capital movement’s provision of different facilities relating • to transferring profits • dividend.

Trends in international capital flows International capital flows have increased dramatically over time. driven by a bounce-back in portfolio investment from advanced to emerging-market economies and increasingly among emerging-market economies. and facilitating the emergence of credit and asset price boom-and-bust cycles. The contraction affected mainly international banking flows among advanced economies and subsequently spread to other countries and asset classes. 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. Capital flows have rebounded since the spring of 2009. the dominant components were capital flows among advanced economies and notably cross-border banking flows. 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. large capital inflows may challenge the absorptive capacity of host countries in the short run by making them vulnerable to external shocks. 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. However. Prior to the crisis. or about three times faster than world trade flows (Figure 1). 17 .1 Indeed. Gross cross-border capital flows rose from about 5% of world GDP in the mid-1990s to about 20% in 2007. The crisis resulted in a sharp contraction in international capital flows. despite a temporary contraction during the global crisis. after reaching historical highs in mid-2007. the probability of occurrence of a crisis or a sudden stop is particularly high after large debt capital inflows. The long-term benefits arise from an efficient allocation of saving and investment between surplus and deficit countries. heightening the risks of economic overheating and abrupt reversals in capital inflows. Moreover.

more adaptable labour markets. On the one hand. OECD analysis for a large sample of mature and emerging-market economies shows that countries with more open financial markets. On the other hand. which may heighten short-term risks.Structural policy reforms can maximize the long-term gains from international capital movements in support of stronger.which is more stable and less prone to risk. higher institutional quality and greater capital account openness) are associated with a composition of capital inflows -principally more FDI and less debt -. These are. improved structural policy settings are likely to increase the overall scale of capital flows. Structural policy can also minimize the short-term risks associated with capital flows. more balanced and sustainable growth. The net effect of capital flows on short-term risks will depend on the particular form of structural reforms enacted. and especially during debt inflows episodes. In addition. 18 . better institutional quality and more competitive product and labour markets appear to be more able to attract and absorb foreign and domestic capital flows and on balance these countries have lower net foreign assets. have a large impact on net foreign capital positions. also have an important role to play in reducing vulnerabilities associated with capital inflows. Structural policy. however. countries that typically follow counter-cyclical fiscal policy have on average experienced more moderate credit booms during large inflow episodes. Macroeconomic policies. but also on how they are buttressed by progress in financial reforms to strengthen the prudential and macro-prudential framework in both emerging and advanced economies. Exchange rate flexibility mitigates some of the effect of large capital inflows on domestic credit. general findings and related policy recommendations have to take into account countries‟ individual conditions and institutional settings. particularly exchange rate and fiscal policies. better structural policies (more competition-friendly product market regulation. including financial and product market regulation.

In addition.3 Countries agreed on a framework for cooperation on issues concerning capital movements. First. derivatives and other sensitive operations was approached in a prudent manner. Secondly. the countries may reintroduce measures at any time. They also decided that stand-still should not apply to these operations and that they should therefore be added to the Code under List B (Table 1). acknowledging risks associated with these operations. It was not until 1992 that OECD countries as a group decided that the Code should cover almost all capital movements. Special treatment of short-term capital flows. in particular to deal with the higher volatility of short-term capital flows. They made this decision in view of financial innovations which blurred traditional distinctions between short-term and long-term capital flows and the benefits for private and public actors to access wider sets of financial products. which is a time-bound suspension of the liberalisation commitments made to others.What moved OECD countries to adopt the Code of Capital Movement? In recognition of the benefits of international capital flows and the need to deal with the associated risks in a cooperative manner (Box 1). The extension of obligations to cover short-term flows. The Code provides flexibility in two ways regarding commitments to openness. adherents decided that financial credits by non-residents to individuals as opposed to corporate entities should not be covered by the Code. Adherents agreed to define short-term flows as those having a maturity of one year or less. including short-term capital operations. countries may resort to derogation of obligations. which is reflected in the Code‟s disciplines and understanding How have countries dealt with volatile capital flows and episodes of instability in the context of the Code? While there may be efficiency gains from liberalisation of capital movements. for short-term and other sensitive operations (such as derivatives and foreign exchange transactions). there may also be a role for capital flow measures to reduce attendant risks. 19 . Furthermore. countries will face situations in which extraordinary measures will be required. OECD countries adopted the Code of Liberalisation of Capital Movements in 1961.

Experience of adherents during the 1990s with surges in capital inflows The countries that joined the Code in the 1990s all came under pressure shortly after joining. as the older members had when faced by crisis in the 1970s and 1980s. increased capital mobility and integration to global financial markets. It has also provided a means for countries to experiment with fine tuning of measures or lifting of restrictions. as such. faced with speculative pressures on the zloty. The arrangement becomes all the more valuable at times of crisis. The derogation clause has been used 28 times since 1961 (Table 2). it refrains from a “beggar-thy-neighbour” approach. The crisis-struck countries did not resort to suspension (derogation) of their obligations under the Code. Commitments under the Code serve an adhering country as a means to communicate to its Code partners. and to market participants. however in several countries adjustments in regulations followed. Countries may have shunned the re-introduction of restrictions in view of the potential cost of a further loss of market confidence (including by domestic investors).This approach has provided flexibility in taking steps to deal with potentially destabilising shortterm flows. The dialogue process has also helped support countries‟ efforts to improve policy implementation by learning from the experience of others. All of the new adherents had gone through a period of rapid financial innovation. and may wish to reassure market participants that it does not intend to maintain controls that are broader than necessary and that such controls will be removed when no longer needed. without having to make an irreversible commitment Episodes of instability and the derogation clause The derogation is a time bound suspension of the liberalisation commitments of the country. Poland. On three occasions it was used to request a general dispensation of the obligations on account of the country‟s economic development. The response of recent members was generally to maintain previous commitments to openness. unless there is consensus among adherents to disapprove them (Box 5). that it is a co-operative member of the international community and. postponed the liberalisation measures for short-term operations that it had planned and 20 . which allows it to introduce measures. when authorities may have resort to emergency measures. The Central and Eastern European members came under pressure at the time of the Russian crisis and both Korea and Mexico were prey to banking and currency crises.

For the United States we find that portfolio debt flows are highly persistent. There are. This may reflect the structural ‘hollowing out’ of Japanese manufacturing as Japanese companies undertook direct investment to set up plants in other Asian countries where labour costs were lower.7 The capital account in emerging economies is typically less autocorrelated and only two of the emerging economies examined have autocorrelation coefficients of greater than two-thirds for four or more lags. The evidence is somewhat different for emerging economies. Foreign direct investment is typically not as persistent as might have been expected and can hardly be distinguished from the bank and money market or portfolio flows. Korea issued a new Foreign Exchange Transaction Act in the wake of the crisis which simplified regulations and eliminated restrictions on some short-term flows. Persistence of Capital Flows A complementary measure of the stability of capital flows is their degree of persistence over time. This is not surprising given that the United States is home to the largest debt markets and the US dollar is the world’s main reserve currency. Foreign direct investment flows are relatively 21 . Total capital flows are found to exhibit a high degree of persistence in most industrialised economies.announced to its partners at the time of adherence to the Code. compared to five out of the six industrialised economies. The autocorrelation coefficients for the components of the capital account suggest that these flows generally display little if any persistence for industrialised economies. The data are quarterly ratios of flows to GDP and the correlations are calculated for 16 lags (Figures 3 and 4). however. These changes in legislation led to adjustments in Korea‟s reservations under List. a number of notable exceptions. and gradually decay as the lags increase. while introducing new requirements for qualification for non-bank borrowers to raise short-term funds abroad. there is no evidence among industrialised economies to support the view that some types of capital flow are inherently more persistent than others. positive. which are often thought of as being relatively temporary. ‘Cold’ flows that are perceived to be relatively stable should also display evidence of strong positive correlation with their own past values. To assess persistence we calculate autocorrelation coefficients for each flow in each country over the sample. This suggests that there is a high degree of persistence in the overall capital account for at least one to two years. Other than these exceptions. Japanese foreign direct investment flows are also shown to be highly persistent. The coefficients are small and change sign frequently. The autocorrelation coefficients are typically large.

Merely the financial transactions involved in foreign trade and managing the risks involved generate a huge volume of capital movements. a drop in export demand or an increase in import prices. The growth potential of poor countries is also greater because their labour supply is expanding as a result of their rising populations. countries would have to adjust to. 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. To provide a more comprehensive view of the data and how the flows interact we estimate cross-correlation coefficients for all capital flows. In principle. by reducing domestic demand. but there are no consistent patterns across emerging economies. Financing deficits and investing surpluses always imply international capital movements between countries. and will continue to have. where populations are unlikely to rise without an influx of immigrants. to poorer countries with a younger age structure. Interactions Between Flows The results in the preceding Sections suggest that the co-movement of different types of capital flows seems to be central to understanding the overall variability of the capital account. This can probably be attributed to emerging economies being natural destinations for such investments.persistent for a number of these economies. we distinguish between how different types of flows are correlated ‘within’ each country’s capital account and with the flows of ‘other’ countries. This is in sharp contrast to many rich countries. thereby shifting focus away from high-frequency changes in the flows. Capital movements have had. accompanied by a large volume of currency trading. with inflows typically dominating this category.8 There are also several other examples of persistence for some components of the capital account. and this is reflected in their current account surpluses/deficits. Importantly. capital should flow from rich countries with an ageing population. an important role in the development strategy of developing countries. The balance between saving and investment varies in different countries. like the EU states and Japan. The quarterly data are summed to annual totals (and expressed as a ratio to GDP) for this purpose. If it were not possible to finance deficits with capital movements. say. and labour supply is declining as a result of ageing. Its importances International trade and capital movements go together. 22 .

In other words. as these reasons become less important the significance of capital movements can be expected to grow still further. However. In a purely financial sense. such as asymmetric information. there is too little capital movement in the world. Though investment beyond national borders and international diversification are becoming more common. how reliably and cheaply it can be withdrawn and converted into cash. Investments find targets in the same way. the price paid for the financial instrument depends on investor expectations concerning its return. There may be many reasons for favouring domestic investments. however. This is true of all forms of investment. future expectations affect the price that investors are ready to pay. This proportion is still far larger than what might be considered optimal in terms of the expected return and the related risk. that is. This kind of capital is not reflected in balance of payment statistics. Direct investments and portfolio investments have been shown to have substantial positive spillover effects. 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. whether within a single country or globally. The investor's choice is influenced not only by the expected return and the risk but also by the investment's liquidity.Capital should thus flow from rich to poor countries specifically because the latter have the faster growth potential. They are the vehicles not only for financial and productive capital but also for technological and managerial know-how. The possibility of investing outside the home country provides a better opportunity for risk diversification. 23 . In practice. rather than too much. but is most apparent in securities. but its importance for longer-range economic growth may be crucial. As they receive no direct investment and the countries find it practically impossible to get financing on the international capital market. both private and institutional investors continue to invest a large proportion of their portfolio in domestic equities and other domestic assets. They tend to be directed to targets which promise high expected return with a risk that is moderate or at least manageable. In many developing countries and transition economies. as the number of potential targets is many times greater than the number of domestic targets. and per capita GDP rises hardly at all. From this point of view. Capital movements are also important in terms of the pricing of capital and international risks. this is not always the case. the price paid for a security reflects the cash return that the holder can expect to enjoy in the future. their investments remain small. however productive they may be. On a well-functioning market.

and capital controls should not be excluded entirely as a possible remedy in certain situations. When assessing tax competition. 24 . The impact of capital movements on the efficiency of economic activity and on development as a whole cannot be disputed. this has to be weighed against the benefits gained from free movements of capital. capital movements and cross-border ownership . for instance. exchange rates and other asset prices get transferred from one country to another . this does not mean an absence of problems. It is not unusual that the scant savings of citizens in developing countries are invested in gold and precious stones or is otherwise hoarded. restricting them would not eliminate the problems. A less costly solution to the problems of tax competition.countries fall victim to financial and currency crises. However. Capital movements and their growing volume are claimed to give rise to the following problems: . free capital movements. In many cases though. which may lead to a deterioration in the tax base . That is why a careful analysis of the actual role of capital movements is warranted. while capital movements may aggravate problems in particular circumstances. either. one should compare the effects of closing off the economy against the alternative offered by free trade. and tax competition. Though instability is a genuine cause for concern. If private capital movements are not the cause. capital movements do transmit. thus reducing the need for foreign financing. However. It is in fact difficult to demonstrate that it is specifically capital movements that cause these problems.independence of economic policy declines as countries become increasingly dependent on each other as a result of growing foreign trade. is likely to be found in international coordination rather than in restrictions on capital movements.Capital movements may also spur the growth of domestic financial markets in a way that promotes domestic saving and mobilises these savings to finance domestic productive investment. for instance. and proliferation of such crises from one country to another is facilitated. the arguments outlined above are not necessarily valid.changes in interest rates. and sometimes even aggravate these competition increases in corporate and capital taxation.

Table 1 shows the quantities of capital movements defined in this way. however. most current account transactions also involve capital movements. a change in foreign debt means a net increase. for instance. If we only want to consider how much capital movement (gross/net) there is. or portfolio securities be bought and sold across borders several times. Information is gathered on the trading parties.000 billion. i. futures and currency swaps). 1995 and 1998) by asking the banks for detailed reports on their currency trading during the month of April. This is less than the annual GDP of the USA or the EU.e. the actual volume of capital movements is far larger. For instance. 1992. Compared with the annual gross volume of currency trading. Because various payment periods are granted in foreign trade and this is financed in different ways. Volume of currency trading The Bank for International Settlements (BIS) has been compiling data on the volume of currency trading since 1989. If we add to global trade in goods and services cross-border payments of interest. Viewed gross. it is not in fact necessary to define the gross volume of capital movements. Newer data are also available on the volume of trading in currency derivatives. More recently. the volume of capital movements is small.SCALE OF CAPITAL MOVEMENTS Capital movements proper In 2000. looks small at something over USD 50 billion (1998). which are not connected with current account transactions in any way. No distinction is made between public and private capital movements. the total comes to around USD 8. new debt less amortizations. the official development aid of the OECD countries. because over a year short-term debt may be withdrawn and paid back many times over when credit is renewed. the total value of global trade in goods and services was around USD 7. between countries and how much and what kinds of net capital flow from developed to developing economies. The data are collected at three-year intervals (1989. for instance. the scope of the survey has been extended to include OTC trading in currency and interest rate derivatives. In portfolio and other short-term investments.500 billion. Long-term capital movements are usually defined following the gross/net principle. 25 . we can assume that the sum is many times the volume of current account transactions. the change in outstanding receivables (or liabilities) over a given period – for instance a year is recorded as a capital movement. These transactions are recorded as transactions on the current account. the currencies traded. dividend and income transfers. and the types of currency transaction (spots. Compared with their total sum. There is also a considerable volume of crossborder financial transactions. Though there are no statistics on gross capital movements.

een financial centres in the developed countries. a currency becomes the target of speculative attack. in addition to factors specific to individual companies and sectors. there are unlikely to have been any major changes in the structure of currency trading. The biggest centre is London. In foreign investments. Singapore. In other respects. the most important trading currency is the US dollar. use of the dollar in currency trading will have decreased. Currency trading mainly takes place in and betw. PRICE UNCERTAINTY AND CRISES In speaking of instability of capital movements. i. Frankfurt. a distinction needs to be made between price instability and different types of crisis. Price uncertainty Price uncertainty is an inevitable element in the functioning of financial markets.e. because factors specific to the country concerned affect expectations of the returns. A debt crisis arises when a country's creditworthiness is over-rated and its foreign debts have risen to a level at which its income from abroad is insufficient to service the debt. This situation affects currencies where the exchange rate is regulated or whose value is tied to some other currency. Because market prices are based on future expectations. on the other hand. capital movements. is by definition an exceptional situation.500 billion. the current prices of equities in the target country of a 26 . In a currency crisis. there are more sources of price variation. A banking and financial crisis arises either because the banks have underestimated the credit risk of the loans they have granted or because refinancing of the loans is threatened. however. which is involved in over No precise information is yet available on how introduction of the euro has affected volumes of currency trading because the next BIS survey will not be made until April 2001. because there is less need for it as a vehicle currency. are compiled by the BIS. Tokyo. This is completely irrespective of whether the investments are foreign. which publishes them in its Quarterly According to the most recent BIS calculation. Hong Kong and Paris. A crisis. Gross volumes will probably have declined somewhat. London's standing as the biggest centre has not suffered despite introduction of the euro. for instance. because there is no longer any wholesale currency trading between the countries in the euro area. Both are appealed to when capital controls are proposed.These. or domestic. new information about the return on investments and the related risks is immediately reflected in prices. Price instability may mean either normal price volatility on financial markets or that prices are viewed as diverging too far from the long-run equilibria dictated by the fundamentals (misalignment). too. Zurich. Consequently. the daily volume of conventional currency trading in April 1998 was USD 1. followed by New York. At all these centres. If.

A slower than expected growth rate increases the probability that a country will get into payment difficulties and that its debt instruments will prove. say. These are the exchange rate volatility and simultaneous fluctuations in asset prices across countries.foreign portfolio investment are based on market expectations of an annual economic growth rate of 7 per cent. This does not seem to be the case. the volume of capital movements has risen many times over both in absolute terms and in relation to global GDP. yet the volatility between the main currencies has remained more or less stable. at worst.say. It is a fairly common view that it is the increase in international capital movements that causes exchange rate volatility. a change in growth prospects to a mere 3-4 per cent for a few years would reduce share values by several dozen percent. Naturally. the volatility of individual equity prices can be many times this. however. it is then not necessary to have capital movements or currency transactions at all. exchange rate volatility is only about half that of equity prices. Thereafter. liquid markets allow for very large individual transactions to take place without these having any effect on the exchange rate. Deep. Prices fluctuate at the same time and in the same way in various countries. and between the dollar and the yen. Volatility rose appreciably when the Bretton Woods system based on fixed exchange rates collapsed in the early 1970s. short-term volatility increases. has remained at 2-3 per cent for thirty years now (Table 6). the volume of currency trading may actually decrease because the spread between the bid and the ask rate widens and market liquidity declines. which has an immediate impact on prices. which tends to even out short-term variations in prices. The growing volume of capital movements and currency trading is often linked with exchange rate instability. worthless pieces of paper. To generate price impacts. These latter are a direct consequence of increasingly internationalised nature of investment and business. exchange rate fluctuations largely derive from the constant flow of new information about the economic fundamentals affecting the rates. to do with a large volume of currency trading. largely because the same information . When this probability increases. excessive exchange rate volatility 27 . When uncertainty about the factors influencing exchange rates grows substantially. it is enough for the same information to spread internationally. equity prices in particular. Measured by this standard deviation. the price of a debt instrument falls. The volatility of exchange rates has very little. measured using a broad share index. This is a sign of a highly liquid market. the standard deviation in the monthly percentage change in the exchange rate between the US dollar and the German mark. At the same time. if anything. or that financiers have to write up loan losses. about the changing prospects in a particular sector affects investor decisions in the same way all over the world. In fact. amid floating rates. It is argued that. The expected growth rate that affects the share prices of companies operating in a given country also affects the market prices of debt instruments issued by the government of that country and companies operating there. For instance. Cross-border price impacts may also be the consequence of investors being forced to sell their investments in certain countries because they need liquidity after suffering capital losses as a result of a crisis in another country. Capital movements add two new dimensions to price uncertainty.

though less pronounced. tying the exchange rate to some other currency or currency basket. Even if the attack is not successful. These form expectations of short-term future trends in exchange rates based on recent events. new types of models have been developed in the literature in order to sharpen the tools of the analysis of crises. If the attack succeeds. A fixed exchange rate regime. Examples can be found in the history of floating exchange rates in which the prices of major countries' currencies have over the longer term moved in a direction that cannot readily be explained by fundamentals such as inflation rate differentials or differences in current account deficits. however. however. Though it is not difficult to find examples of the short-sighted speculation just mentioned. but do not take account of the long-term fundamentals affecting the rates. provided that the system remains credible. it should be pointed out that speculation comes in two types: attempts to exploit a perceived price trend irrespective of its cause. there seem to be several different types of reasons for currency crises. The present situation between the dollar and the euro is somewhat similar. the exchange rate in any case has to be supported.e. As a result. it is impossible to present any evidence to show that the longer-term strengthening of the dollar rate could be traced back to short-term speculative capital movements or some kind of herding behaviour. A standard explanation suiting many situations is that the economic fundamentals and the desire to maintain a fixed exchange rate come into conflict. the currency has to be devalued or it weakens sharply as a result of floating. In the light of the experience of the past few decades. especially currency dealers. In both cases. making the currency more vulnerable to future attacks. reduces exchange rate uncertainty. For a number of reasons such a country may become vulnerable to a currency crisis. One advocate of this view is James Tobin. interest rates rise dramatically or the currency reserves shrink rapidly. However. By contrast. there is no clear evidence of this being a dominant feature of the currency market or its significance being greater than the impact of new information on economic fundamentals. Currency crises In a currency crisis. The only kind of speculation that has a destabilising effect is the kind that is indifferent to the cause of the price trend. the latter type of speculation in fact promotes stability because it helps the price to remain somewhere close to its fundamental value. 28 . The bestknown case is the sharp strengthening of the dollar against the German mark and other ERM currencies in 1982/85. If its credibility is threatened. In response to this experience. i. and attempts to exploit the fact that the price (exchange rate) diverges from the value dictated by the fundamentals. From the viewpoint of the currency market. The situation is somewhat different if we look at longer-term fluctuations in exchange rates. price uncertainty appears in the form of higher interest rates and greater interest rate volatility. a country's currency comes under speculative caused by the actions of the parties actually operating on the market.

despite the fact that capital movements were regulated in the countries hit by the crises. inflation rates and current accounts . and expectations of future trends in all these factors. but rather complementary. the situation can only deteriorate.for instance.the most important fundamentals are inflation differentials. portfolio investors or banks granting loans. though in most cases the indicators . Indeed. economic policy plays a key role. A large number of past currency crises can be understood using the above firstgeneration currency crisis explanation. The inflation rate was higher than elsewhere and the government debt was. This is the case even if the macro-economic fundamentals resulting from the country's earlier economic policy .seem at first sight to be in good shape. but in addition the 29 . A similar model explains most of the currency crises in Latin American countries. Once again. and the country often devalues or abandons its fixed exchange rate . the situation is ripe for a speculative attack.its budget and current account deficits and inflation rate . the Italian lira came under attack in 1992. and the action taken to defend it failed. including the government debt. However. If there begin to appear expectations that the high interest rates needed to defend the currency will increase unemployment or raise interest costs on the government debt to a level that the country concerned finds unacceptable. As economic policy affects them all. The reason for these crises was that the monetary policy independence conferred by regulation of capital movements was over-exploited. For some time. an inflation rate faster than in other countries and a consequent current account deficit may eventually lead to a currency crisis. A large current account deficit makes a country susceptible to currency crisis because it is dependent on foreign investors. second-generation explanations of currency crises focus on the fact that expectations of devaluation may be self-fulfilling.were not in themselves alarming. the current account deficit and the amount of foreign debt. This also applies to the occasional crises during the Bretton Woods system. they are not mutually exclusive. This. in turn. during the onset of recession . the ultimate issue is how compatible it is with the exchange rate regime. whether companies making direct investments. Fiscal policy relying on budget deficits. resulting in faster inflation than elsewhere and a current account deficit. For instance. When there begin to be expectations that the reserves will be insufficient to defend the currency. provokes a speculative attack. Though these first and second-generation explanations underline different factors in the emergence of a crisis. If there is a belief that a country is ready to abandon its fixed exchange rate .just as it was expected to do. holding onto a fixed exchange rate creates the temptation to venture a one-way bet on devaluation.this expectation raises its interest rates. many ERM currencies suffered speculative attacks in the early 1990s. not all past currency crises can be explained solely by the weakness of fundamentals. where the ultimate cause was usually government inability or unwillingness to keep the public debt under control. but this is limited if capital imports dry up. a country can finance its deficit out of its foreign exchange reserves. For instance. If the rise comes during the recession itself.such as the budget deficits.

The factors hampering the operation of the price mechanism include any implicit or explicit guarantees given by government that it will come to the rescue of the banks or certain debtor groupings. Typically. a run on deposits or some other problem with refinancing loans can set off a banking and financial crisis. In France's case. In 1992 the attack was rebuffed and the next year France (and other ERM countries) responded to a fresh attack by substantially widening its fluctuation range. so if confidence falters. Investment projects are suspended and even perfectly sound businesses get into difficulties because they cannot get working capital. in turn. If a bank's short-term funding dries up. The value of collateral falls. gives rise to large balance sheet positions representing both high return and high risk. because it was believed that more unemployment as a result of higher interest rates would not be politically acceptable. Government guarantees offer protection that may also encourage excessive risk-taking. Similarly. A run on deposits caused by lack of confidence in a single bank may infect other banks. No lender can be completely sure that a debtor will be able to repay his debt. the new competitive situation and new forms of operation may lead the banks to take distorted lending and investment decisions and tempt them into heavy risk-taking. Sometimes merely a decline in general economic conditions can prompt a lack of confidence that sets off a crisis. Financial and banking crises One basic source of instability stems from the fact that the operation financial markets is fundamentally based on confidence. bank funding is short-term compared with its lending.government debt was short-term. The price mechanism on the credit market . the prices set on risks – does not always work properly because lenders do not know enough about borrowers and about the risk potential of the projects being financed. The French franc came under attack in 1992 and 1993. Defending the currency with very high shortterm interest rates would have weakened the financial standing of the public sector still further and raised doubts about the government's solvency Speculative attacks were made on the Finnish markka in 1991-1992. The importance of these factors grows particularly just after financial market regulation has ended. the exchange rate and interest rates soon returned to normal. showing that the attack could not be explained by fundamentals. Amid fast-changing circumstances. the seriousness of this collapse could be alleviated by 30 . it cannot grant new loans and may have to call in old ones.that is. threatening the whole financial system with collapse. This. because it reduces the losses of depositors and investors if a crisis breaks out. no depositor can be sure that the bank will meet its commitments under all circumstances. A financial and banking crisis may have serious effects on the real economy. partly because of the country's poor competitiveness but possibly also because the defence would have come costly as the banking industry was known to be rather weak and the private sector heavily in debt (second-generation explanation). In a closed economy. aggravating the situation still further.

The ultimate source of financial and banking crises lies in the behaviour of financial institutions. International banks and financial institutions actively offered developing countries credit at the same time as they were recycling the oil-exporting countries' huge surpluses to the world economy. Mechanisms like these were at work particularly clearly in the crisis Finland went through in the early 1990s and in the crises in Southeast Asian countries towards the end of the decade. As the debt of developing countries is usually in foreign currencies and their own currencies are weak as a result of the crisis. It is very difficult to break free from the resulting debt overhang. The main cause of these debt problems is that the availability of credit became very easy in mid-1970s. they naturally experience great difficulties in coping with their foreign debt. and several still are. the country has difficulties to pay the interest on its loans. i. by hindsight. In a small open economy. As a result. Any deficiencies in the supervision of financial institutions often surface when conditions on financial markets change dramatically. because a rise in interest rates may make the level of indebtedness unsustainable.e. Because of their high debt-servicing costs. the liquidity of customers who were originally in perfectly sound financial shape may suffer. this method can also be used if the banks ‘short-term funding is in foreign currencies. setting off a financial and banking crisis. This. faster inflation and loss of price competitiveness result in a currency crisis. When financial markets tightened in the early 1980s. may cause the banks' foreign financing to dry up. the economies have no resources for correcting these problems. This is a risky situation.increasing central bank funding of the banks and by accepting a higher level of inflation. Such debt crisis is often accompanied by numerous defects in the financial system and other structural problems in the economy. Faster inflation and lack of confidence may cut heavily at the exchange rate if it is floating. As a result. many developing countries became heavily over-indebted. in turn. The debt crisis in developing countries Many developing countries found themselves in a debt crisis in the early 1980s. A weaker currency implies that the internal value of loans denominated in foreign currencies rises sharply. 31 . which in turn depends partly on how effectively they are supervised. for instance when regulation is dismantled and controls are partly lifted. by contrast. not to speak about the repayments. If it is fixed. interest rates and the dollar both rose. pushing several heavily indebted countries into an unsustainable position and eventually into debt crisis.

which in turn is the result of the fact that the government or the private-sector is willing to incur debt. The short-term claims of an individual bank on a country may well be small compared with the bank's total assets. A similar possibility may arise because of the credit supply. as well as the financial risk to the banks caused by the maturity discrepancy between the foreign funding and their domestic lending. This does not imply that capital movements are the sole cause of such crises.e. If circumstances turn against them. how the banks and financial institutions behave. Financing the current account deficit then implies that other kinds of capital imports. If the borrower's creditworthiness is already low. such as more shortterm foreign debt. and has to resort to short-term foreign lending. capital exports and speculative behaviour patterns during crises. and why it is short term. In the following. the situation of those offering the credit may come to be a problem for the whole economy. making the risk also small. The 32 . A substantial import of short-term capital makes a country more vulnerable and a crisis more likely in two senses. The exchange rate risk is thus shifted to customers. and during and after them. One must go below the surface and analyse which factors have affected capital movements and sudden changes in them. capital imports are needed to finance the current account deficit. but at the same time the banks risk more loan losses. which in practice usually means the foreign exchange reserves of the central bank. the banks' foreign funding is in foreign currencies and the domestic loans financed using it are also denominated in foreign currencies. it finds it difficult to get long-term financing.The role of capital movements in crises Obviously enough. a low interest loan denominated in a foreign currency may then seem more tempting than a domestic loan. the lower nominal interest rates abroad may make foreign financing to appear attractive. either. i. If a bank's customers do not take the exchange rate risk properly into account. Protection of domestic firms from foreign ownership may signal that direct and portfolio investments by foreigners are considered undesirable. The role of the banks in the OECD countries in granting refinancing should not be forgotten. There is an exchange rate risk attached to this. have to be accepted. Second. however. Competition between the financial institutions may induce them to accept rather large and risky credit positions relying on foreign refinancing. Second. more imports of short-term capital increase the probability of financial and banking crises if the banks have financed their long-term domestic loans to relatively risky projects with short-term foreign debt. Typically. we examine separately capital imports. A decline in short-term foreign financing may then lead to liquidity problems. The reason for higher interest rates at home is typically the economic policy that is not consistent with the exchange rate target. even if the country is not overindebted or insolvent. The customers then misjudge the exchange rate risk and banks their customers' credit risk. First. There is every reason to ask why capital is imported at all. the country's liquidity is endangered when its short-term foreign debt rises relative to its short-term foreign receivables. First. capital movements play a key role in creating currency crises and related financial and banking crises.

A sudden turnabout in the direction of capital movements triggers the crisis. Expectation of such a situation creates good ground for destabilising speculation and speculative attacks. Periods of instability often follow a stage at which capital movements are deregulated but the exchange rates fixed or tied to a fluctuation range. Deregulation of capital movements has often led to excessive capital imports. Around the same time that the banks start to limit their short-term lending. This means that much more capital is imported than would have been the case had the lenders realized what kind of imbalance the economy was heading for. Unlike the cases described earlier. one-way changes in exchange rates. Monetary policy could also have been tightened if necessary.the monetary conditions are eased. as long as the foreign banks have not themselves taken any exchange rate risks. A typical situation is one in which foreign banks refuse to renew their interbank deposits. Faster inflation implies a real appreciation of the currency and loss of competitiveness. a search for profit through expectations of devaluation. which without exception means devaluation or a substantial weakening of the currency after a decision is made to float it. It is entirely a matter of taste whether one calls this hedging or speculation. eventually making a fixed exchange rate unsustainable. as well as capital flows. however. the various actors try to hedge against exchange rate risks by reducing their liabilities in foreign currencies while at the same time increasing their foreign assets. capital exports are nearly always an element in an acute crisis. implying more capital exports. other actors probably start behaving differently. because they have access to the same information. i. Thus merely a change in risk assessment may spark off a crisis. Such misjudgments based on incomplete information are commonplace and also understandable when financial markets are in a state of rapid change. As expectations of devaluation grow. The banks in the OECD countries have also been known to display this kind of herd behavior. While heavy capital imports are seen as a phenomenon connected with crises. speeding domestic inflation and inflating asset prices.vulnerability of the recipient country grows. This is not currency speculation. Most crises are a matter of large. implying a tightening of monetary conditions. As a result of the capital imports . A floating rate would have reacted to the capital imports with a nominal appreciation. This decision is taken because the foreign banks' view of the risks attached to the country or its banking system has changed.e. this is not prompted by a decline in refinancing or a reallocation of portfolios. It also changes the prices and interest rates of securities. A large volume of very short-term capital movements is involved in speculative action in a crisis. 33 .whether short or long term . Hedging leads to capital exports irrespective of whether the action taken affects short or long-term receivables and liabilities. if several banks actively market loans to it at the same time. shutting off the national banks' refinancing.

and the force of the crises suffered by South-East Asian countries at the end of the same decade prompted extensive debate about capital controls.CONTROLLING CAPITAL MOVEMENTS Arguments for capital controls In earlier decades capital movements were extensively regulated by administrative means in most countries. as far as the importance of capital movements and the attendant risks are concerned. even in principle. and the amount of bank lending was often restricted and its allocation controlled. Restrictions have also been defended by more conventional arguments. such as poverty or climate change. Even comprehensive regulation failed to protect countries against balance of payment problems and against occasional currency crises. Regulation of capital flows and domestic financial markets made monetary policy efficient. What kind of controls would best suit each objective? Is it possible. but they prompt many questions. it does not follow that similar restrictive measures should be adopted everywhere. This kind of change can take place even if the country is not sliding into crisis. Generally countries are in very different positions. No one has proposed a return to the comprehensive regulation of earlier decades. For instance. measures taken to prevent excessive capital imports are totally unsuited to a situation in which capital flows change direction. For this reason. in the early 1990s. such as allowing the currency to strengthen or limiting bank risk-taking in the intermediation of loans denominated in foreign 34 . there are other ways to restrain excessive capital imports. In addition. The difficulties encountered by the European Exchange Rate Mechanism. monetary policy often had to be tightened at the same time as monetary conditions were otherwise tightening because of external imbalance. the room for maneuver of monetary policy was not used primarily for counter-cyclical ends or to ensure price stability. The most frequently mentioned justification for capital controls was the need to safeguard the country's external liquidity. What is more. Because price mechanism was not allowed to work. Various objectives are thus offered to justify the restriction of capital movements. at least in principle. restricting capital movements by the introduction of a tax on currency transactions has been proposed as means to generate funds that could be used to finance the solution of global problems. Similarly. However. Simultaneously the domestic financial markets were regulated on a considerable scale. though restraining excessive capital imports might be a justifiable goal in one country. such as monetary policy independence and the need to limit exchange rate volatility. to find ways of regulating capital movements that would promote attainment of all the objectives at the same time? Would the proposed controls be at all effective in achieving the objectives? Could the objectives be attained better other means than by resorting to restrictions on capital movements? It is clear that. one and the same country can be in totally different situations at various times. Interest rates were controlled. The idea put forward was that such crises could be averted by limiting capital movements. however. Very often it had to be adapted to meet the demands of the country's external balance. the liquidity of the domestic economy could be controlled by simultaneously regulating bank lending and net capital imports.

With free movement of capital. on the other hand. Demands for universal capital controls in order to minimize exchange rate volatility are ultimately demands for a new international monetary system. independent national monetary policy is a dead letter. either. monetary policy tends to have to function to quite the opposite effect. credibility is low. Yet others. Restrictions on capital movements would grant only limited independence for monetary policy. If this independence is used in a manner that permits higher inflation than elsewhere and a growing current account deficit.currencies. the UK. as is the case in the euro area. Sweden and several other countries. Anyway. A tighter monetary policy is not necessarily enough to correct the course of the economy. From a single country's viewpoint. the USA. Promoting exchange rate stability as a justification for capital controls relates directly to the exchange rate system. the paradox of such a system lies in the fact that if the exchange rate is credibly fixed. exacerbating the cyclical movements. monetary policy eventually has to be tightened just when conditions are more stringent anyway because of the external imbalance. this does not totally eliminate uncertainty over exchange rates because the rates relative to other currencies will still vary. Ensuring independent national monetary policy cannot be made such a universal goal that would justify insisting that all countries adopt capital controls. in which the exchange rates are fixed for all currencies or tied together with some target-zone arrangements. monetary policy independence can be achieved simply by letting the currency to float. As far as monetary policy independence is concerned. have deliberately chosen an exchange rate regime that excludes active exercise of an independent monetary policy. such as Denmark and Estonia. even if it decides to tie its own currency to some other currency or currency basket. restricting capital movements and maintaining the fixed exchange rates implies that monetary policy must have objectives other than controlling inflation and promoting stable economic development. These countries are not able to influence monetary policy decisions that affect their own monetary conditions. Justifying capital controls by the need to safeguard the room for manouevre of national monetary policy only applies to countries that have chosen a fixed (though adjustable) exchange rate or some other exchange rate regime based on pegging or on a target zone. in which case the country is heading for a currency crisis despite capital controls. however. 35 . If.

These restrictions were only in effect for a short time. The most interesting experiences of capital controls in the 1990s were in Chile and Malaysia. Chilean experience has frequently been cited as an example about the effectiveness of market-based 36 . while Malaysia introduced new measures to restrict capital exports. When direct. it gave others the chance to make money by getting round the controls in completely legal ways. when capital controls were common and comprehensive. Another is the proposal for a currency transfer tax to restrain all short-term capital movements. In many developing countries capital movements are restricted fairly extensively. Ireland. One example is the reserve requirements on capital imports introduced by Chile in early 1990s. the Tobin tax has attracted a lot of attention in the past few years. South Korea. as well as Taiwan. During the ERM crisis in Autumn 1993. India and China. leading ultimately to a regulation of the financing of foreign trade as well. Financial innovations based on changes in information and communication technologies and the internationalization of business and banking have made the idea of a return to comprehensive capital controls of past decades rather unrealistic. Similarly. Examples are the two Asian giants. In India's and China's case. This can be done in several ways. there were practically no remaining restrictions on capital movements left between developed countries. new administrative controls have been introduced rather rarely. One example is the restrictions introduced in 1997 by Malaysia to restrain capital exports. Market based measures do not themselves limit the freedom of capital movements. Maintaining their effectiveness would have called for the introduction of new and new controls in order to cover the holes. Therefore it will be discussed separately below. From 1991 to 1998. These countries were less affected by the crises of the late 1990s. which proposal is better known as Tobin tax. it is likely that both countries have forfeited export opportunities and obtained less direct investments important for their development than would have been the case without such regulation. Chile used controls to restrain short-term capital imports. on the other hand. Although there is no experience of its use. even though the capital movements were regulated. Finland's own experience in the 1970s and 1980s offers plenty of examples of how it gradually became easier and easier to circumvent the controls then in force. Chile imposed restrictions on short-term capital movements for a long time. This was a standard practice in earlier decades. but they do set a price on it. require a permit from the authorities or are allowed only under given conditions. there are no guarantees that these countries will not suffer currency or financial crises in the future. However. Direct restrictions are still employed in many developing countries. Portugal and Spain attempted to restrict the sale of their currencies. even if capital controls are kept in force. certain capital movements are prohibited completely. While the capital controls did restrict the behavior of some actors. found itself in crisis. In the beginning of the last decade.Experiences of the effectiveness of capital controls Capital controls can be direct or market-based. using various forms of administrative controls. The methods employed ranged from reserve requirements (Spain) to direct restrictions on forward transactions (Ireland) or on open foreign exchange positions by the banks (Portugal).

in controls. to make the structure of remaining capital imports more long-term. All in all. this independence meant that it could 37 . For a maturity of less than a year. Chile seemed to survive the turbulence of 1997-98 with less volatility in its exchange rates. it would have fallen to around 1. especially. Consequently. There is evidence that such circumvention did take place in Chile. as well as to loans related to direct investments. and indeed to other Latin American countries. an American investor who could have invested his money in US government debt instruments at 5. the reserve requirements on capital imports proved effective with respect at least some of the objectives set for such regulations. there started to be a shortage of short-term capital.5 per cent and on three years to about 0.a.2 per cent p. On a year's investment. It has been argued that. short-term loans to Chile. and in September it was lifted completely. On a one-month investment. Throughout this time. To prevent evasion. the deposit was required for the whole period of the investment. promoting the country's growth and stability. From a foreign investor's point of view. increased as a home was sought for liquidity fleeing from Asia. hard to say what role was played here by regulation of capital imports. Even so. During autumn 1997. It is. to arrange their assets and liabilities internally in a way that allows them to circumvent controls. When the Chilean economy weakened in spring 1998 and the next wave of the Asian crisis hit Latin America in July 1998. would have had to pay Chile for his one-week investment costs equivalent to 83 per cent interest p. to reduce real strengthening of the currency and to give the central bank a freer hand in pursuing an independent monetary policy.a. the deposit requirement was raised to 30 per cent and the deposit was required for a year irrespective of how long the capital remained in the country. The aim of the Chilean authorities was to slow down the inflow of capital into the country. Initially. a 20 per cent deposit was required for portfolio investments. The effect of Chile's zero-interest deposit requirement can be judged similar to that of a tax on capital imports. It is worth noting that a tax is only effective if it cannot be evaded. the deposit requirement was extended to such credit. Chile's regulation meant that the shorter the investment. the cost would have been equivalent to 19 per cent p. It is easy for big international companies. for instance by defining portfolio investment as trade credit. while on longer investments the deposit was required for the holding period of one year. direct investments were also regulated by setting a minimum period for which they had to remain in the country.5 per cent. thanks the controls. Converted into a tax. For instance. interest rates and share prices than its neighbours. extending the restrictions to prevent further evasion. however. The mechanics of the market-based regulation of capital imports in Chile was as follows: foreign investors who wanted to transfer assets to Chile were required to make zero-interest reserve deposits with the central bank. At the same time. the deposit requirement was reduced in June to 10 per cent. the higher the tax. the capital imports were mainly of long-term nature. In Chile's case. Because the restrictions were widely circumvented.a. the deposit requirement was further extended in 1995 to the shares of Chilean companies traded on the New York Stock Exchange and to international issues of government bonds. the tax percentage is determined by the interest that the investor forfeits on the capital deposited.

Malaysia's action succeeded in practice in blocking foreign access to the ringgit. Even before the crisis. The restrictions did not apply to current account transactions or to transactions connected with direct investments. All receivables denominated in the ringgit had to be repatriated by the end of September 1998. Regulation succeeded in altering the structure of capital imports in the desired manner. However. The Malaysian government decided in September 1998 on regulatory measures to limit capital exports. In reality. Similarly. the restrictions on capital exports were lifted somewhat. and the exchange rate was stabilized. it is difficult to assess their impact as such because the fundamentals of the Malaysian economy before the crisis were quite good and the authorities issued plenty of information about the restrictions in order to make regulation transparent. to be replaced by a new tax on export of profits by foreign companies. On the other hand. net capital exports were successfully limited. In February 1999. Malaysia had deregulated most capital movements related to portfolio investments. Regulation made it possible to keep the interest rates higher than otherwise would have been the case. The foreign exchange reserves had been depleted during a financial and currency crisis the previous year and the currency (the ringgit) had been devalued. and had to be held for at least one year. which was judged to be contributing to a speculative retreat of capital. capital adequacy usually exceeded the recommended level. killing off the offshore market.keep interest rates higher than would otherwise have been the case. as well as for Malaysians to export capital. thus preventing the authorities from lowering the interest rate. Chile also wanted to reduce its susceptibility to turbulence on international financial markets. Effort was also made to strengthen the financial sector. although the regulations probably reduced the volatility of stock prices. In Chile's case. At the end of 1997 a new banking act was passed. it is difficult to assess the costs and benefits of regulation. It is fair to say at least that his restrictions on capital exports certainly do not seem to have had any dramatically negative effects on the economy. Foreign transactions connected with trading and financing in the ringgit had also been deregulated. the ringgit was pegged to the US dollar. As it was made more difficult for foreigners to repatriate their capital investments. At the same time. Bank supervision was tightened. probably played a more important role than regulation in ensuring that the country survived the global crises at the end of the decade with relatively little damage. The main form of controls was an attempt to end the offshore market in the currency. requiring the banks' capital adequacy to comply with the recommendations of the Basle Committee. It is therefore impossible to say whether regulation 38 . The government also did not want to keep interest rates high enough to attract capital imports. Total imports of capital rose up to 1998 while at the same time the proportion of short-term capital fell from 73 per cent to only 3 per cent during the period when the controls were in force. The extensive bank reform carried out in the 1990s. the deposit requirement did not insulate Chilean interest rates from the effects of the Asian crisis. regulation did not prevent the real exchange from strengthening. soon after the major currency crisis in the early years of the decade. and the banks were issued with strict instructions on risk-taking.

even if the nominal interest rate were well below that on a domestic loan. Portugal and Spain during the ERM crisis in 1992. the tax has no systematic effect on price uncertainty. the tax would raise ration of investment the larger the increase in the required return would be. This does not mean that they would be practicable as permanent systems. even at zero interest. On the other hand. Experience indicates that measures aimed at permanently preventing the capital flight are ineffectual because over the long term ways are found to get round them. i. The same also applies to taking a short-term foreign debt. the volatility of share prices. A one percentage point tax would reduce the return on a one-year foreign investment by two percentage points. the tax would make short-term foreign debt unattractive. however. It would not be worth taking out a one-month foreign debt at all. so empirical study of its effects is not possible. there is some experience of similar taxes applied in some other markets. For instance. Appended tables A1 and A2 present hypothetical examples of the effects of the tax on the required return on foreign investment as well as on the cost of a foreign debt for a given domestic rate of interest. which was actually the purpose Tobin's initial proposal. However. an introduction of such a tax would also add a cost on short-term capital movements. Transfer tax and short-term capital movements Levying a fixed proportionate tax on all currency transactions would mean additional costs for currency buyers and sellers.achieved something that would have been impossible otherwise. the result was that most trading in its biggest companies' shares shifted to international financial centres. The experiences of small countries show that levying a transfer tax on share trading pushes a substantial amount of trading outside the country's borders. At a one per cent tax rate the foreign investment should yield a 34 per cent annual return in order for the net return after tax to be equal to 5 per cent as in the home country. Restrictions also have a tendency to encourage corruption. A currency transfer tax has never been tried.e. The examples take account of the fact that the tax is levied twice: once when the investment is made and again when it is repatriated and converted back into the home currency. As capital movements typically lead to currency transactions at some stage. when Sweden adopted first a one and then a two per cent transfer tax (valpskatten) in 1984. Similarly. The examples show that a tax on 39 . Malaysia's and Thailand's experiences of the restrictions indicate that they probably were effective in the short term. A stamp duty has been used widely on stock markets in various countries. Temporary restrictions were also placed on capital exports by Ireland. At a given domestic rate of interest. The appended tables show how the required rate of return on a foreign investment rises as the tax rate increases and the maturity of the investment shortens. Research on such experiments indicate that introducing a tax greatly reduces the volume of trade at the same time as it lowers share prices. as well as by Thailand during its own crisis in 1997-1998. and would increase the costs of a one-year foreign debt correspondingly.

even a small devaluation would make a short-term foreign debt. Such speculative movements do not arise if the exchange rate is expected to either rise or fall with the same degree of probability. and nearly 14. The rate of devaluation used in the hypothetical examples is rather low — lower than is usually the case in actual devaluations with fixed but adjustable exchange rates. penalizing those who have use short term Foreign assets and liabilities for non-speculative purposes. however. It is also lower than the standard deviation in the month-by-month change of the exchange rate for the main floating currencies. At lower tax rates. Devaluation reduces the return on a foreign investment and increases the cost of a foreign debt. this alone would be enough to counterbalance the one per cent tax. These examples are highly misleading. short-term capital movements become grossly expensive. hardly any speculative capital movements based on exchange rate changes take place anyway. However. however. It is precisely this possibility of one-way change that attracts speculative attacks. This is not a significant benefit. The calculations show that a currency transfer tax would effectively limit short term capital movements when the exchange rate is stable and is expected to remain so.currency transactions would. Higher devaluation percentages would. The main thing in the calculations is that they assume a fixed exchange rate or one that only moves in one direction. and with investment horizons of under a year. A currency transfer tax does not provide any real protection against speculative capital movements once confidence in the exchange rate begins to falter. for instance to finance foreign trade. 40 . Even then. in terms of Annual interest a two per cent one-off devaluation would imply a 27 per cent annual return over a one-month horizon. limit short-term capital exports extremely effectively if the rate was high. Over a one-year investment.000 per cent over a one-day horizon. yield much higher figures. 180 per cent over a one-week horizon. because if the exchange rate is believed to be stable. If the currency were to be devalued. This is illustrated in the examples by assuming a two per cent devaluation during the holding period. of course. it would only restrain capital exports at the very shortest maturities. Correspondingly. because they assume that the exchange rate remains unchanged throughout the holding period of the investment or the debt. in principle. At low rates. things would change substantially. capital exports would nearly always be profitable despite the tax if the probability of a devaluation is high.

but is conversely susceptible to currency crises. RESULTS International capital movements play a positive role in the efficiency of economic activity and in economic development. Hence. It appears that capital flows exhibit few regular and systematic relationships and there is little evidence across our sample of countries to suggest that some flows are inherently more conducive to overall stability than others. but on the other hand they are accompanied by significant benefits. On the other hand. capital movements are not the reason for such problems. they reduce the room of maneuver of national economic policy. increase exchange rate variability and make countries susceptible to currency and financial crises. Restricting movements of capital does not offer any guaranteed protection 41 . there will be uncertainty about exchange rates. There is tentative evidence that these countries meet certain preconditions that allow them to integrate into global markets more smoothly. Calls for capital controls derive from these concerns. A degree of volatility is inherent in all floating rates. Interestingly. On one hand. there is no evidence to suggest that the capital account has become more volatile overall.REVIEW Capital has become increasingly mobile as global financial integration has accelerated. The effects of this contagion are less serious in countries with strong economic fundamentals as well as an efficiently supervised banking system. the overall stability of the capital account among industrialised economies does not appear to be due to the inherent properties of different types of capital flows and the mix of capital flows underpinning the capital account of these countries. Globalization may well have promoted the spread of these crises from country to country. Such crises usually occur because economic policy is at odds with the exchange rate target. foreign trade. However. The character of the uncertainty depends on the exchange rate regime. A system of fixed rates reduces exchange rate fluctuation. As long as national currencies continue to exist. capital movements and cross-border ownership all restrict the independence of a country's economic policy. the rising volume of such movements has been found to give rise to numerous problems. as in asset prices in general. while industrialised economies have experienced increased volatility in different types of capital flows as financial globalization progressed.

such as those related to foreign trade financing. This would make the cost of shortterm capital movements high but would not affect the cost of long-term movements. The idea behind the tax is that a low tax should be levied on all currency transactions. currency transactions on the wholesale side – i. the proceeds from the tax would be small. the central bank could not choose its own inflation target. because the transaction costs of currency trading would rise appreciably. and its impact would mainly be felt by those whose transaction costs are highest to start with. i. has been proposed as a solution to all the problems that excessive short-term capital movements are accused of causing. The benefit to be gained from the interest rate policy margin conferred by the tax is questionable.e. the so-called Tobin tax. These objectives are not likely to be achieved with a currency transfer tax. A transaction tax on currency transfers. a solution to the problems of tax competition must be sought in international coordination. Market operators usually learn how to get around restrictions that continue for a long time. The tax might prevent speculative short-term capital movements in a situation where they would be unlikely. very expensive. give domestic interest rate policy room for manoeuvre and reduce exchange rate volatility. though they may have the desired impact in the short run. in cases where the exchange rate target is not credible.against such crises. As a result. Experiences of capital controls in the 1990s offer no support for the view that this is an effective approach in the long term. Though differences between tax systems in fact give rise to capital movements. it would make other short-term financial transactions. Earlier experience of crises suggests that the biggest risks relate to short-term capital movements via the banking system. It is also argued that capital movements increase undesirable tax competition between countries. where there are reliably fixed exchange rates. A currency transfer tax could be expected to reduce the tax base quite considerably. Experience in many countries indicate that deregulating capital movements without strengthening the banking system and intensifying its supervision make a country extremely vulnerable not only to currency crises but also to financial and banking crises. its impact on the real economy can be grave.e. If the exchange rate target forfeits its credibility. The tax would make short-term speculation expensive. At the same time. As a currency crisis may be accompanied by a financial crisis and a banking crisis. However. In addition. Many debtors that were originally perfectly solvent may be driven into insolvency by rises in the domestic value of loans in foreign currencies or because the bank calls in their outstanding loans. as short-term interest rates have little impact on private consumption or investment. would shrink to a fraction of the present level. Specifically. the interest rate policy can only be used to defend the exchange rate by raising the interest rate. 42 . such as consumers and small and medium-sized companies engaged in foreign trade. the tax would not prevent speculative transactions. and not in restrictions on capital movements. The tax has also aroused interest because it is seen as pointing to an untapped tax base that could yield funds to finance the solution of globally important problems.

This does not imply that restrictions might not be justified in certain situations. a strong financial system incorporating efficient supervision of banks’ risk-taking and capital adequacy. the Community and its Member States should make sure that Europe's financial system remains stable amid rapid technological advances and structural change. It is therefore particularly important to develop the stock market in emerging economies. This will reduce the vulnerability of the financial system. 43 . Supervisory bodies should concentrate on monitoring the risks taken by European banks in developing countries. In particular. The best protection against financial crises and any excessive capital movements associated with them is a sustainable economic policy. they should help the new candidate countries to modernise and consolidate their banking systems and financial markets so that enlargement can proceed without endangering the monetary and financial stability of the area. both between Member States and in relations with third countries. Ever since the signing of the Treaty of Rome. European countries have based their development strategy on free movement of capital. It should then be kept in mind that all taxes have to be paid by someone. and that they also have an influence on the behavior of economic actors. The alternative to international taxes is to use domestic taxation to achieve the same goals. during a crisis or in dealing with its consequences. The only way these principles could be abandoned would involve altering the Treaty. The whole issue of capital controls is not relevant for the European Union or its Member States today.The idea of using a currency transfer tax to solve global problems should be scrutinised in a comprehensive manner by comparing it with other forms of taxation. It is also important that the financial system ensures that those who take risks also carry the responsibility for any consequences in a crisis. because companies can use equity-based financing instead of debt and thus reduce their dependency on short-term capital imports. and watchfulness to ensure that the chosen exchange rate regime is compatible with free movement of capital. The Treaty forbids all restrictions on capital movements. Such situations have to be assessed on a case-by-case basis. Rather than contemplating restrictions. It is in the interests of the Union's institutions and Member States to play an active role in processes aimed at strengthening the stability of the international financial system and at preventing crises. No universally applicable measure to control capital movements provides protection against economic crises.

Rather. The best protection against financial crises and any excessive capital movements that might accompany them is a sustainable economic policy. but their benefits are much more important.CONCLUSION Capital movements offer significant benefits. Free trade. it is important to develop a financial system ensuring that those who take risks also have to bear their consequences in crisis situations. In order to prevent crises. A degree of volatility is inevitable with floating rates. the problem lies in the fact that emerging economies find it difficult to get the capital they need. because companies could replace loans with equity-based financing. Such situations must be judged case by case. This will reduce the vulnerability of the financial system. and watch fullness to ensure that the chosen exchange rate regime is compatible with free movements of capital. as with asset prices in financial markets in general. A system of fixed rates reduces volatility but is susceptible to currency crises. 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. and thus reduce their dependency on short-term imports of foreign capital 44 . 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. A solution to the problems of tax competition must be sought in international coordination and not in restrictions on capital movements. capital movements and cross-border ownership all limit the independence of economic policy somewhat. a strong financial system with efficient supervision of bank risktaking and capital adequacy. For this reason it is particularly important to develop stock markets in emerging economies. but also problems: The scale of capital movements is not in itself a problem.