8.3 Capital flows and financial account

Capital flows are the lifeblood of the global economy. They come in various forms, from long-term foreign direct investment to short-term portfolio investments, each with unique impacts on host countries.

Understanding these flows is crucial for grasping international economics. They affect exchange rates, economic growth, and financial stability. Capital flows can bring both opportunities and risks, shaping the economic landscape of nations worldwide.

Types and Impacts of Capital Flows

Types of capital flows

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• Foreign direct investment (FDI) involves long-term investment in physical capital such as factories (manufacturing plants) or real estate (office buildings) which increases the financial account balance and contributes to capital formation in the host country
• Portfolio investment refers to short-term investment in financial assets including stocks (shares of publicly traded companies) and bonds (government or corporate debt securities) which can be more volatile than FDI potentially leading to sudden capital outflows but also increases the financial account balance
• Other investment encompasses loans (bank lending), currency and deposits (bank accounts), and trade credits (short-term financing for international trade) that can be short-term or long-term and may provide more stability compared to portfolio investment while increasing the financial account balance
• Official reserve assets are foreign exchange reserves held by central banks (US dollars, euros, yen) with changes in these reserves affecting the financial account balance as they are used to intervene in foreign exchange markets and manage exchange rates

Factors in international capital flows

• Interest rate differentials play a key role as higher interest rates (5% vs 2%) attract capital inflows seeking better returns while lower rates encourage outflows in search of higher yields abroad
• Economic growth and stability are important considerations since stronger economic performance (higher GDP growth) and political stability (stable government) attract capital inflows from investors seeking opportunities in thriving economies
• Exchange rate expectations influence capital flows as expected currency appreciation (rising value of the yuan) attracts inflows speculating on further gains while depreciation expectations (falling value of the peso) lead to outflows to avoid losses
• Institutional factors such as the quality of institutions including property rights (legal protections for ownership) and contract enforcement (reliable court system) shape the attractiveness of a country for international capital flows
• Global risk sentiment reflects changes in investors' appetite for risk (bullish vs bearish market sentiment) which affects capital flows to emerging markets (Brazil, Indonesia) that are often viewed as riskier than developed markets

Risks vs benefits of capital flows

• Benefits:
  1. Capital inflows can finance investment (construction of new factories) and support economic growth (higher GDP)
  2. Access to international capital markets allows countries to diversify their funding sources beyond domestic savings
  3. Portfolio investment can improve market efficiency (price discovery) and liquidity (ease of buying and selling assets)
• Risks:
  1. Sudden capital outflows can lead to financial instability (stock market crashes) and currency crises (sharp depreciation)
  2. Excessive reliance on short-term capital flows increases vulnerability to external shocks (global financial crisis)
  3. FDI may result in foreign control over domestic assets (foreign ownership of natural resources) and potential political tensions
  4. Capital inflows can contribute to asset price bubbles (housing market booms) and financial imbalances (excessive debt)

Financial account for current account imbalances

• Current account deficit arises when a country's imports of goods (oil), services (tourism), and transfers (remittances) exceed its exports requiring financing through a financial account surplus or net capital inflows (foreign borrowing)
• Current account surplus occurs when a country's exports of goods (cars), services (IT outsourcing), and transfers (foreign aid) exceed its imports leading to a financial account deficit or net capital outflows (overseas investment)
• Balance of payments identity states that the sum of the current account balance, financial account balance, capital account balance, and errors and omissions must equal zero implying that current account imbalances are offset by corresponding financial and capital account imbalances