One of the most important developments in the world economy in the 1990s has been the spectacular surge in international capital flows.

1. IRL 6230 A: INTERNATIONAL
FINANCIAL MECHANISMS
International Capital Flows, current
account, reserve accumulation, and
global imbalances

2. Introduction
One of the most important developments in the world economy in the
1990s has been the spectacular surge in international capital flows.
These flows have emanated from a greater financial liberalisation,
improvement in information technology, emergence and proliferation
of institutional investors such as mutual and pension funds, and the
spectra of financial innovation.
With the increasing capital flows and participation of foreign investors
and institutions in the financial markets of developing countries, the
capital account has been the focus of attention since the late 1980s
and especially so in the 1990s.
The expansion of capital flows has been much larger than that of
international trade flows.
The process has been reinforced by the ongoing abolition of
impediments and capital controls and the widespread liberalisation of
financial markets in the developing countries during the 1990s.

4. Types/Sources of International Capital Movements
Capital movement can be classified by instrument into debt or
equity and by maturity into short-term and long-terms.
Capital movement can be divided in to short-term and long-terms flows.
Depending upon the nature of credit instruments involved.
“A capital movement is short-term if it is embodied in a credit instruments of
less than a year’s maturity. If the instruments has duration of more than a
year or consist of the title to ownership, such as the share of stock or a deed
to property, the capital movement is long-term.”
SHORT-TERM CAPITAL MOVEMENT:-
Short-term capital instruments are demand deposits, bills, overdraft,
commercial and financial papers and acceptances, loan and commercial
banks credits, and items in the process of collection.
They are mostly speculative in nature. Short-terms capital movements may
take the form of hot money movements which refers to capital movements to
take advantages of international difference in interest rate.
LONG-TERM CAPITAL MOVEMENTS:-
They are generally for long-term investments. They may be further classified
in to direct investment, portfolio investment and assistance from
governments and institutions.

6. Foreign Direct Investment [FDI]
Foreign direct investment (FDI) is a direct investment into production or business in a
country by an individual or company in another country, either by buying a company in
the target country or by expanding operations of an existing business in that country.
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.
 Broadly, foreign direct investment includes "mergers and acquisitions, building new
facilities, reinvesting profits earned from overseas operations and intra company
loans".
 In a narrow sense, foreign direct investment refers just to building new facilities.
 The numerical FDI figures based on varied definitions are not easily comparable.
 As a part of the national accounts of a country, and in regard to the GDP equation
Y=C+I+G+(XM)[Consumption + Domestic investment + Government spending
+(eXports - iMports], I is investment plus foreign investment, FDI is defined as the
net inflows of investment (inflow minus outflow) to acquire a lasting management
interest (10 percent or more of voting stock) in an enterprise operating in an
economy other than that of the investor.

7. TYPES OF FDI
Horizontal FDI arises when a firm duplicates its home
country-based activities at the same value chain stage in a
host country through FDI.
Platform FDI Foreign direct investment from a source country
into a destination country for the purpose of exporting to a
third country.
Vertical FDI takes place when a firm through FDI moves
upstream or downstream in different value chains i.e., when
firms perform value-adding activities stage by stage in a
vertical fashion in a host country.
Horizontal FDI decreases international trade as the product of
them is usually aimed at host country; the two other types
generally act as a stimulus for it.

8. METHODS
The foreign direct investor may acquire voting
power of an enterprise in an economy through any
of the following methods:
by incorporating a wholly owned subsidiary or
company anywhere
by acquiring shares in an associated
enterprise
through a merger or an acquisition of an
unrelated enterprise
participating in an equity joint venture with
another investor or enterprise.

10. Portfolio
The term portfolio refers to any collection of financial assets such as stocks,
bonds, and cash.
Portfolios may be held by individual investors and/or managed by financial
professionals, hedge funds, banks and other financial institutions.
It is a generally accepted principle that a portfolio is designed according to the
investor's risk tolerance, time frame and investment objectives.
The monetary value of each asset may influence the risk/reward ratio of the
portfolio and is referred to as the asset allocation of the portfolio.
When determining a proper asset allocation one aims at maximizing the
expected return and minimizing the risk.
This is an example of a multi-objective optimization problem: more "efficient
solutions" are available and the preferred solution must be selected by
considering a tradeoff between risk and return.
In particular, a portfolio A is dominated by another portfolio A' if A' has a
greater expected gain and a lesser risk than A.
If no portfolio dominates A, A is a Pareto-optimal portfolio.
The set of Pareto-optimal returns and risks is called the Pareto Efficient
Frontier for the Markowitz Portfolio selection problem.

12. Official Flows
They are shown as external assistance, i.e. grants and loans from
bilateral and multilateral flows.
Long-term capital movements can also take the form of
government loan grants and loans from international financial
institutions like IBRD, IDA, etc.
Sometimes government of advanced countries may gives loans to
financial project in a developing country. These are known as
bilateral loans.
International financial institution like World Bank, African
Development Bank, etc. also give financial assistance to
developing countries.
These loans are called multilateral loans.
Thus, governments and international institutions play an important
role in international capital movement.

13. Foreign Aid
A part of the foreign capital is received on concessional term and it
is known as external assistance and foreign aids.
It may be received by way of loans and grants. Grants are in a
forms of out right gift which do not have to be repaid.
Loan qualify as aid only to the extent that they bear a concessional
rate of interest and have longer maturity period than commercial
loans.
Foreign aid has mostly been given by foreign governments and
international financial institutions like IMF, World Bank, Africa
Development Bank and so on.
Official flow were about 75-80 percent of capital flow till 1991.
By 1994, this had come down to about 20 percent and has further
fallen to below 5 percent by late 1990s.

14. External Commercial Borrowing
An External Commercial Borrowing (ECB) is an instrument used by
countries to facilitate access to foreign money by their corporations and
PSUs (public sector undertakings).
ECBs include
 commercial loans,
 buyers' credit,
 suppliers' credit,
 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), ADB, etc.
ECBs cannot be used for investment in stock market or speculation in real
estate.

15. Twenty Years of EM Capital Flows
-2
-1
0
1
2
3
4
5
6
7
8
9
-200
0
200
400
600
800
1000
1200
1400
1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015
Direct Equity Investment
Portfolio Equity
Nonbanks
Commercial Banks
Net Private Capital Inflowsto Emerging Markets
$ billion percent of EM GDP
Total, Percent
of EM GDP
Sourc e: IIF.
IIF
Forecast

16. Regional Breakdown of Foreign Inflows
-1.5
0.0
1.5
3.0
4.5
6.0
7.5
9.0
10.5
-200
0
200
400
600
800
1000
1200
1400
1990 1995 2000 2005 2010 2015
EM Europe
Latin Americ a
MENA
EM Asia ex. China
China
Total, Perc ent of EM GDP
IIF
Forec ast
Private Non-Resident Capital Inflowsto Emerging Markets
$ billion perc ent of EM GDP
Sourc e: IIF.

17. Determinants Of International Capital
Flows
• The pace, magnitude, direction and composition of international capital flows
have crucial implication for the recipient countries.
• The surge in private capital inflows to developing economies in the 1990s
coincided with the period of low international interest rate in the advanced
economies and domestic policy reform in the developing world .
• The literature on determinants of cross-countries capital flow has identified
various factors which, inter alia, include:
the overall macroeconomic scenario,
political risk perception,
regulatory regimes,
fiscal concessions and
business strategy of the entity from which the capital flow originates.
• The literature usually distinguishes between two broad sets of factors affecting
capital movements.

18. Country-specific “Pull” Factors
They reflect:
• domestic opportunity and risk.
• improved policies that increase the long run expected returns or reduced the perceived
risk on real domestic investments. These includes:
measures that increase the openness of the domestic financial market to foreign investors;
liberalisation of FDI;
credible structural or macroeconomic policies;
sustainable debt and debt service reduced ensuring timely repayments;
stabilisations policies that affect the aggregate efficiency of resource allocation;
policies that affect the level of domestics absorption relative to income; and
the ability of the economy to absorb shocks from changes in international terms of trade.
• Pull factors like rebuts economic reforms in emerging economies are internal to an
economy.

19. Global or “Push” Factors
• The push or exogenous factors are external to an economy
and include parameters like lower foreign interest rates,
abundant liquidity, slow growth, recession abroad, herd mentality
in international capital markets or lack of investment
opportunities in advanced economies.
• FDI may be attracted by the opportunity to use local raw material
or employ a local labour force that are relatively cheap.
• Push and Pull factors explains international capital flows.
• The Pull factors determine the geographic distribution of the
flows amongst the recipient economies.

20. Rate of Interest
• An important factors which has a bearing on the
international capital movements is differences in the
rate of interest.
• According to L. M. Bhole ,” Like population
migration, capital migration can be and has been
explained in terms of the “PULL” and “PUSH
FACTORS”.
• As far as the recent increase in capital flows is
concerned, greater weight has to be given to the
push factors, particularly the falling interest rates in
the US and some other countries.

21. Integration of Financial and other Markets
• The various forms of foreign capital movements depends upon the degree of openness of
the financial and other markets and the extent of their international integration.
• In the recent years most of the countries have adopted the policy of deregulation,
liberalisation, privatisation and structural adjustments.
• They have also dismantled various control related to trade, foreign exchange, foreign
investment, ownership and capital flows.
• All these changes have contributed to recent increase in capital flows.
• Rapid improvements in technologies for collecting, processing, and disseminating
information, along with the opening of domestic financial markets, the liberalisation of
capital account transactions, and increased private savings for retirements have stimulated
financial innovation and created a larger pool of internationally mobile capital.
• At the same time, consolidation in the global banking industry and competition from non-
bank financial institution [including mutual funds] have lured new players to the
international financial area.
• These trends accelerated in the 1990s, expanding investments opportunities for saver and
offering borrowers a wide array of sources of capital.

22. Growing Pool International Financial Capital
• Over the last two decades, the financial markets of leading industrial countries
have transformed into a global financial system, permitting larger amounts of
capital to be allocated not only to theirs economies, but also to developing
economies.
• Firms in developing and industrial countries a like are raising more funds from
international securities markets.
• Multinational corporations are registering their equity on more than one country’s
stock exchange and raising funds from financial markets in different economies.
• Mutual funds, hedge funds, pension funds, insurance companies and other
investments and asset managers now compete with banks for national savings.
• Even though this phenomenon has been confined so far primarily to developed
economies, it has started to spread to some developing countries too.
• Institutional investors have taken advantages of the easing of restrictions in many
developed countries to diversify their portfolios internationally, enlarging the pool
of financial capital potentially available to developing economies.
• According to world development report of 1999-2000, in 1995 these investors
controlled 20trillion dollars, 1980 of which only 2 percent was invested abroad.
• Thus, there was a tenfold increase in the funds and a fortyfold increase
investments abroad.

23. Liberalisation of Capital Account Transactions
and move towards flexible exchange rate regime
• The 1990s have seen a consistent trend toward more flexible
exchange rate regimes and the liberalisation of capital account
transactions.
• The latter involves changes in policies toward different types of
private capital flows, such as foreign direct investments, foreign
bond and equity investments, and short term borrowing from
abroad.
• Most countries have moved towards capital account
convertibility as part of wide-ranging gradual economic reform
program that includes measuring to strengthen the financial
sector.

24. Stability
•Relative stability of economic factors
especially rates of inflation, external value of
different currencies, etc. also determine
foreign capital flows.
•Along with economic stability, political stability
is an important factors which determines
international capital movements.

25. Government Policies
•Policies of governments with respect to
privatisation, foreign investment, foreign exchange,
liberalisation, taxation, etc. are likely to influence
the capital inflows.
•If the governments adopt a policy of liberalisation,
deregulation and dismantling of control related to
investments as being undertaken in Kenya since
1991 it will encourage foreign capital inflows to the
country.

26. Social and Economic Overheads
• Infrastructural facilities, availability of skilled labour,
advances in computer and telecommunication
technologies, etc. will influence private capital investment
into the country.
• Labour policies will also have a bearing on the foreign
investments.
• The market potential, i.e. the ability of the market to
absorb the whole range of new products, is also likely to
influence the inflow of foreign capital.

27. Credit Rating
The credit rating and credit
standing of nation, which
depend on economic, political
and social stability, also
influence foreign capital flows.

28. Speculation
Short-term capital movement may
be influenced by speculation
relating to expected changes in
interest rates or rate of return or
foreign exchange rates.

29. Profitability
• Foreign capital movements are also influenced by profitability
considerations of investments.
• It is noteworthy that an overwhelming proportion of
international capital flows towards developing countries is
directed towards middle-income countries.
• Notwithstanding fluctuation over the year, this concentration
has increased, especially with regard to FDI and portfolio
flows.
• Inflow of debt-creating capital toward developing countries
declined sharply in the wake of the East Asian crisis

30. Role of Foreign Capital
• Foreign Capital had played an important role in the early stages of industrialisation
of most of the advanced countries of today like countries of Europe and North
America.
• There is a general view that foreign capital, if property diverted and utilised, can
assist economic development of developing countries.
• These countries need resources to finance investment in health, education,
infrastructure and so on.
• It can supplement a country’s domestic saving effort and foreign exchange
earnings.
• A number of studies have confirmed that international capital flows can contribute
significantly to promote growth in developing countries by augmenting domestic
savings, reducing cost of capital, transferring technology, developing domestic
financial sector and fostering human capital formation.
• Foreign capital can contribute to economics development of developing countries in
following ways:

31. Supplements Domestic Capital formation
• Economic development depends on , among other things, capital
formation.
• The domestic capital formation is inadequate in LDCs.
• The foreign capital can supplements the domestic resources to
achieve the critical minimum investment to break the vicious circle
of low-income-low saving-low investment.
• If more domestic capital is to be created by country’s own efforts,
resources will have to be diverted from the production of goods
requirements for current consumption.
• This may lead to a cut in present living standards.
• Thus, foreign capital can help to supplement the domestic capital.

32. Accelerates Economic Development
Foreign capital helps to accelerate the
pace of economies development by
facilitating imports of capital goods,
technical know-how and other imports
which are required for carrying out
development programmes.

33. Improve Trade Balance
Foreign capital inflow may help to
increase a country’s exports and
reduced the imports requirements
if such capital flows into export
oriented and import competing
industries.

34. Transfer of Technology
The foreign capital may
facilitate transfer of technology
to LDCs. It may helps to
modernise the production
techniques in industry,
agriculture and other sector.

35. Realisation of External Economies
If the foreign capital is allowed to flow
into the development of infrastructure it
may lead to realisation of external
economies which may stimulate
domestic investments in the country.

36. Income and Employment
If foreign capital flows into real
sectors in the form of direct
investments it helps to increase
productivity, income and
employment in the economy.

37. Balance of Payments Adjustment
Inflow of foreign capital, especially the
short-term, may be able to provide a
breathing space to a deficit country to
cover the deficit until a complete
adjustments is achieved to correct the
balance of payments deficit,. However,
such capital movement should be seen as a
temporary phenomenon.

49. • https://tradingeconomics.com/kenya/balance-of-trade

51. The Balance of Payments Accounts
U.S. Balance of Payments Accounts for 2000 (billions of dollars)

52. The Balance of Payments Accounts continued

53. • The Statistical Discrepancy
• Data associated with a given transaction may come from
different sources that differ in coverage, accuracy, and timing.
• This makes the balance of payments accounts seldom
balance in practice.
• Account keepers force the two sides to balance by adding to
the accounts a statistical discrepancy.
• It is very difficult to allocate this discrepancy among the
current, capital, and financial accounts.
The Balance of Payments Accounts

54. • Official Reserve Transactions
• Central bank
• The institution responsible for managing the supply of
money
• Official international reserves
• Foreign assets held by central banks as a cushion against
national economic misfortune
• Official foreign exchange intervention
• Central banks often buy or sell international reserves in
private asset markets to affect macroeconomic conditions in
their economies.
The Balance of Payments Accounts

55. • Official settlements balance (balance of payments)
• The book-keeping offset to the balance of official reserve transactions
• It is the sum of the current account balance, the capital account
balance, the non-reserve portion of the financial account balance, and
the statistical discrepancy.
• Example: The U.S. balance of payments in 2000 was -$35.6 billion,
that is, the balance of official reserve transactions with its sign
reversed.
• A country with a negative balance of payments may signal that it is
running down its international reserve assets or incurring debts to
foreign monetary authorities.
The Balance of Payments Accounts

56. The Balance of Payments Accounts
Calculating the U.S. Official Settlements Balance for 2000 (billions of dollars)

61. Global imbalances: past, present, and
future
• Imbalances had many causes and players
• Saving behavior
• Decline in U.S. private saving since 2001 …
• Dramatic increase in the saving rate in China over the past decade.
• Investment behavior …
• U.S. productivity boom and stock market increase in late 1990s …
I
• Investment boom in“peripheral”Europe particularlysince2005 …
I
• Investment boom in peripheral Europe, particularly since 2005.
• Policy choices …
• Accumulation of reserves to strengthen external position …
• Choice by many EM countries to pursue policies of export-led growth …
• US fiscal deterioration 2000-onwards

62. Imbalances had many causes (II)
• Commodity prices
• Gyrations in oil and other commodity prices since the
early2000s
• Attitudes towards risk
• Decline in risk aversion in the 2000s, triggering capital
flows towards fast-growing countries in Southern,
Central, and Eastern Europe …
• Dramatic increase in risk aversion during the crisis, and
increased demand for U.S. Treasury securities.

63. A Timeline for Global imbalances
• 1996-2000 …
• US investment boom, Asian investment bust. …
• US financing through FDI, equity flows …
• Surpluses in emerging Asia, Japan
• 2001-2004
• US fiscal deficits …
Financing through US bonds (incl. foreign central banks) …
• Surpluses in Germany and other Ctr-Nort. Europ. countries, oil exporters
• 2005-2008
• Stable/declining deficits in US, large deficits in peripheral Europe …
Boom in
surplus in China, oil exporters, Central-Northern Europe

64. THANK YOU