Trade and Capital Flows- The Associated factors

Professor Shah Md Ahsan Habib

Trade flows means export and import payment flows. Several factors affect export and import
flows that may include:

Demand and Elasticity

Demand for particular products or services is an essential component of international trade. For
example, the demand for oil impacts the price and the trade balance of oil-exporting and oil-
importing countries alike. If a small oil importer faces a falling oil price, its overall imports
might fall. The oil exporter, on the other hand, might see its exports fall. Depending on the
relative importance of a particular good for a country, such demand shifts can have an impact on
the overall balance of trade. Elasticities are also associated with trade payment flows that may be
all forms of elasticities: price elasticities, income elasticity, and cross elasticity.

Changes in Factor Availability and Prices

Changes in the quantity of factors of productions and the associated prices affect prices of
exportable and importable and thus export and import flows.

Changes in Technology
Technological changes also affect the terms of trade (ratio of export and import prices) of a
country, and thus demand and supply of exportable and importable.

Changes in Tastes
Changes in tastes of the people of a country also influence its terms of trade with another
country. Suppose England’s tastes shift from Germany’s linen to its own cloth. In this situation,
England would export less cloth to Germany and its demand for Germany’s linen would also fall.

Economic Growth and Productive Capacity

Economic growth is another important factor which affects trade flows. Given the tastes and
technology in a country, an increase in its productive capacity may affect trade flows.

Trade Incentives and Restrictions

Tariff, quota, and trade incentives affect trade volumes and trade flows of a country, and that
depends upon a country’s trade policies and fiscal stance.

Exchange Rate
Exchange rate fluctuation affects a country’s export and import volumes and trade payment
flows. This also depends upon the exchange -1
“;lrate management system of a country.
Capital flows include Foreign Direct Investment, Portfolio investment flows, and external debt
flows. These flows are affected by several factors.

Foreign Direct Investments (FDI) flows are affected by:

Wage rates and Labour Skills

A major incentive for a multinational to invest abroad is to outsource labour-intensive production
to countries with lower wages. This is why many Western firms have invested in clothing
factories in the Indian sub-continent. However, wage rates alone do not determine FDI, countries
with high wage rates can still attract higher tech investment. Some industries require higher
skilled labour, for example pharmaceuticals and electronics. Therefore, multinationals will invest
in those countries with a combination of low wages, but high labour productivity and skills.

Restrictions and Tax rates

Investment and trade restrictions are important determinants to attract FDI. Large multinationals,
such as Apple, Google and Microsoft have sought to invest in countries with lower corporation
tax rates. For example, Ireland has been successful in attracting investment from Google and
Microsoft. In fact, it has been controversial because Google has tried to funnel all profits through
Ireland, despite having operations in all European countries.

Transport and infrastructure

A key factor in the desirability of investment are the transport costs and levels of infrastructure.
A country may have low labour costs, but if there is then high transport costs to get the goods
onto the world market, this is a drawback. Countries with access to the sea are at an advantage to
landlocked countries, who will have higher costs to ship goods.

Size of economy / potential for growth

Foreign direct investment is often targeted to selling goods directly to the country involved in
attracting the investment. Therefore, the size of the population and scope for economic growth
will be important for attracting investment. Small countries may be at a disadvantage because it
is not worth investing for a small population. China and India are targets for foreign investment
as the newly emerging middle classes could have a very strong demand for the goods and
services of multinationals.

Political stability / property rights

Foreign direct investment has an element of risk. Countries with an uncertain political situation,
will be a major disincentive. Also, economic crisis can discourage investment. The EU is seen as
a signal of political and economic stability, which encourages foreign investment. Related to
political stability is the level of corruption and trust in institutions, especially judiciary and the
extent of law and order.

Exchange rate
A weak exchange rate in the host country can attract more FDI because it will be cheaper for the
multinational to purchase assets. However, exchange rate volatility could discourage investment.

Access to free trade areas, trade and economic policy stability are also important factors.

Factors that Influence Foreign Portfolio Investment

Growth Prospects
The economy of a nation is important to foreign investment. Investors like to invest in a
country’s financial assets if its economy is strong and expanding. In contrast, investors tend to
reduce or abandon their investments if there is financial instability or a recession. 

Interest Rates
A high return on investment is what every investor seeks. As a result, investors seek out nations
with high-interest rates. Higher interest rates frequently draw foreign investment, which raises
both demand for and the value of the host nation’s currency. Intertest rate affect price of bonds
and securities and thus expectations and portfolio investment flows.

Tax Rates
Capital gains are subject to taxes, and a higher tax rate might result in a lower overall return on
investment. As a result, investors favour making investments in nations with lower tax rates. The
tax rate in one country may considerably impact an investor’s decision when other criteria, such
as infrastructure, economic stability etc., are more or less equal. 

Exchange Rate Fluctuations and Expectations

Exchange rate fluctuation affect asset values of the foreign portfolio investments. These types of
investments are commonly called as hot capital. Expectations of currency appreciation and
depreciation may cause sudden inflows and outflows of portfolio investment flows.

Moreover, the policy restrictions, monetary policy stance, development level of the securities
market are also crucial factors.
Factors that Influence External Debt Flows

Restrictions and Policy Approaches

Cross-border bank lending is relatively restricted component especially in the context of the
developing countries. Both inflows and outflows are restricted in most of the developing
countries. Crises literature identified ‘high foreign currency borrowing’ as one of the culprits of a
few previous banking crises.

Growth Prospects of the Economy and Performance of the Financial Sector

The economy of a nation is important to cross-border debt flows. Banks would be happy to lend
in an economy if its economy is strong and expanding. NPL culture and other banking sector
challenges may discourage international banks to lend in a country.

Interest Rates
Interest rate regime is important determinants for both domestic and cross-border lending and
borrowing and thus monetary policy stance that affect money supply, exchange rate, interest rate,
and price level.

Exchange Rate Fluctuations

Exchange rate fluctuation affect repayment liabilities of a foreign borrowing. Very high
appreciation and/or depreciation may significantly affect foreign borrowing and lending
activities.

Moreover, political stability, financial strength of the potential borrowers are also important
factors to influence cross-border debt flows.