Theory of Capital Movements
The international trade and the movements of productive resources such as labour, capital and technology are substitutes for one another. A relatively capital-abundant country like the United States can export either capital-intensive commodities or export capital itself.
The conditions of capital-scarce countries require them to either import capital-intensive goods or procure the desired flow of capital from abroad. The movement or flow of financial resources from one country to another either for the adjustment of BOP disequilibrium or for expanding the production frontier in a country denotes international capital flow or movement.
It is necessary to distinguish the international capital movements from the payments for imports. The capital movements may either be meant for financing the deficits in the BOP or for bringing about a net increase in productive capacity in the economy. In the latter situation, the international capital movements can be treated as a factor of production. If the sufficient inflow of capital fails to take place from abroad, the productive activity is likely to be adversely affected.
In this connection, it must be recognised that only real capital movements are significant from the point of view of the allocation of resources. It means the countries depending on the inflow of foreign capital to maintain and/or to raise the level of economic activity should have capital inflow of the magnitude which is more than the offset of the domestic price movements.
The international capital movements have continued to take place over centuries. Historically, the development of Britain, the U.S.A., Canada, Australia and many other countries took place by virtue of foreign capital. The century preceding World War I was the “golden age” of private investment activity. During that period, Britain, the United States, France and Germany became increasingly industrialised through large scale foreign investments.
Apart from these countries, the recipients of foreign investment during that period included several countries of Europe, Latin America, Canada, Asia and Africa. During the inter-war period, the major development was that the United States got transformed from a net international debtor into a significant net creditor country.
The depression of 1930’s caused a sharp decline in the international trade and capital movements on account of disorganization of international monetary apparatus and intensification of tariff, trade and exchange restrictions.
In the decade of 1930’s, there were extensive defaults on interest and amortization payments due from foreign borrowers, both private and governmental. During the period after Second World War, there has been a substantial increase in the capital flow from the advanced to the LDCs.
These capital movements have taken place on private account through multinational corporations (MNCs), on bilateral government to government basis and on multilateral basis through international monetary and financial institutions such as World Bank, International Monetary Fund, International Finance Corporation and the regional financial institutions like the Asian Development Bank.
Classification of International Capital Movements:
(i) Home and Foreign Capital:
The investments undertaken by the residents of the home country in foreign countries denote the home capital. On the opposite, the investments undertaken by the foreigners in the home country signify the foreign capital. In the first case, there is a movement of capital from home country to abroad and in the latter case, there is a capital movement from abroad to the home country.
In the BOP account, the inflow of capital from abroad is the credit item whereas the outflow of capital to foreign countries is the debit item. The difference between the debits and credits on account of capital movements represents the net foreign investment which may be either positive or negative.
(ii) Government and Private Capital:
The government capital refers to the lending and borrowing from foreign countries by the government of a given country. On the opposite, the lendings made by the private individuals and institutions to the foreigners and borrowing by them from abroad signify the private capital. The private capital transfers from one country to another are many often guaranteed by the government or central bank of the borrowing country.
(iii) Short-Term and Long-Term Capital:
Short- term international capital movements consist of such credit instruments that have a maturity of less than one year. The short term capital movements can take place through currency, demand deposits, bills of exchange, commercial papers and time deposits upto a maturity of one year.
The short-term capital movements bring about some important changes in the money supply of a country. These changes take place in the forms of primary, secondary and tertiary effects-
Firstly, the capital movements can result in the BOP deficit or surplus. If there is a BOP deficit, there is some contraction in domestic money supply. On the contrary, the BOP surplus results in an expansion in money supply. These changes in money supply represent a primary change.
Secondly, the short-term capital movements can cause changes in the reserve position of the commercial banks. As the reserves get affected, there can be changes in the capacity of those banks to expand or reduce deposits and credits. These can be considered as secondary changes in money supply. In this connection, however, an assumption has been made that the commercial banks do not already have excess reserves with them.
Thirdly, the short term capital movements can cause variations in the reserves of a central bank. If the central bank of a country operates on the basis of its reserves and it is ready to expand open market investments in the event of an expansion in its reserves and vice-versa, there can be changes in money supply. Such changes can be treated as the tertiary changes in the supply of money.
Both under gold and inconvertible paper standards, the short-term capital movements resulted from the international differentials in the rates of interest. The interest rate movements induce the speculators to undertake investments or disinvestments in the foreign exchange markets to make speculative gains.
In this connection, it is presumed that the central bank, commercial banks and other institutions in the money market are willing to take risk and speculate on the basis of their expectations concerning the variations in the rates of interest in different countries.
Whether the short-term capital movements induced by the activities of speculators will have a destabilising or stabilising effect depends upon the extent of interest rate and discount rate differences and expectations of the speculators concerning the future changes in the interest and discount rates.
The long-term capital movements take place through credit instruments having a maturity of more than one year. Long-term capital movements occur through the purchase or sale of long term securities or bonds. These sales or purchases may be undertaken by the individuals or corporations in the foreign countries or by foreign individuals or corporations in the home country. The long- term capital movements may also take place in the form of loans procured from the international financial institutions such as IMF and IBRD.
(iv) Direct and Portfolio Capital:
Foreign direct investment (FDI) means the direct investment by foreign capitalists and business institutions in other countries. The essence of foreign direct investment is that the ownership, control and management of business are vested with the foreign investors.
The foreign direct investments can assume different forms:
(a) The formation of a concern in which the foreign investors or foreign companies have a majority share.
(b) The formation of a subsidiary of a concern of the investing country in the capital-importing country.
(c) The organization of a firm in the capital-importing country that is financed fully by some established concern in the investing country.
(d) The creation of fixed assets by the nationals of the investing country in the capital-importing country.
(e) The setting up of an autonomous corporation by the investing country for the specific purpose of operating other concerns.
Such concerns or firms which operate in different countries and are under a centralized management are termed as transnational corporations (TNCs) or multi-national corporations (MNCs).
Portfolio investment or portfolio capital consists mainly of investment in the form of holding of transferable securities, shares or debentures by the foreign investors. In case of this type of investment, the foreign investors have only the ownership of capital. The control and management rests with the capital-importing country. The foreign investors are entitled to dividends or interests on their holdings of equities, bonds or debentures.
The capital-importing countries naturally have a preference for portfolio investments, whereas the investing countries have a preference for the foreign direct investments.
Factors Influencing International Capital Movements:
(i) Rate of Interest:
Changes in capital both in short and long periods are greatly influenced by the changes in the rates of interest (short or long rates). The capital flow takes place from a country where the interest rates are low to those countries where the interest rates are relatively high and vice-versa. Ohlin affirmed that the difference in interest rates between countries is perhaps the most important stimulus to export and import of capital.
(ii) Marginal Efficiency of Investment:
If the expected rate of return over cost related to a given dose of investment in foreign country is higher compared with the rate in home country, there will be outflow of capital to the foreign country. On the opposite, the lower expected rate of return over cost or the marginal efficiency of investment (MEI) than in the home country will result in an inflow of capital from abroad.
(iii) Bank Rate:
The variations in bank rate by the central bank have effect upon the structure of interest rates in the money market. An increase in bank rate in the home country will cause a rise in both short-term and long-term interest rates.
As these rates rise higher than the corresponding rates in the foreign countries, the home country will be able to attract short-term and long-term capital flows from abroad. A reduction in bank rate will lower the short and long term interest rates. As these rates fall below the levels of interest rates abroad, there will be outflow of capital to foreign countries.
The speculative activities of the operators in the exchange market can also result in capital movements. Speculation may be with respect to either interest rates or exchange rates. When speculators anticipate a rise in interest rates in the home country relative to such an expectation abroad, the security prices are expected to fall by a greater extent in the home country than abroad. This will make the speculators transfer funds from home country to abroad.
If the interest rates in home country are expected to fall more than in foreign country, the speculators will transfer funds from the foreign countries to the home country. The speculation in exchange rates too influences capital movements between the countries. If the currency of home country is expected to depreciate, the speculators will move funds from the home country to the foreign country, the currency of which is expected to rule stronger. An anticipated devaluation is likely to induce the flight of capital from the devaluing country.
There is a greater possibility of such capital flight when variation in exchange rates can take place freely rather than within a narrow band. On the opposite, if the speculators anticipate a revaluation (a rise in exchange rate of home currency relative to foreign currency) of the home currency, the inflow of capital may take place from abroad.
(v) Foreign Capital Policy:
The capital movements are affected also by the foreign capital policy of the government of a country. If there is regime of restrictions upon foreign capital, the inflow of foreign capital will remain clogged. On the opposite, a liberal policy in this regard can induce a substantial inflow of capital from the foreign countries.
(vi) Economic and Political Conditions:
If a country has well-developed economic infrastructure, including means of transport and communications, power, market structures and financial institutions, along with political stability, peace, law and order, the foreign investors are induced to undertake investments in the home country in a larger measure.
However, if such economic and political conditions do not exist, there will be little possibility of inflow of foreign capital. There is rather a danger that even the indigenous investors will prefer to invest in foreign countries resulting in a flight of capital.
(vii) Exchange Control Policy:
The existence of stiff exchange control measures tend to prevent the inflow of capital from abroad and also adversely affect the flow of trade. A liberal policy in this respect can be more helpful in the expansion of trade and induce the inflow of capital to the home country.
(viii) Tax Policy:
If the tax rates on personal incomes and corporate profits are high, the foreign investments, both direct and portfolio are likely to be discouraged. The lower tax rates, on the other hand, can have a stimulating effect upon the capital inflow from abroad.