7.4 Impact of capital flows on host and home countries

International capital flows bring both opportunities and challenges to global economies. They can boost investment, transfer technology, and stimulate growth. However, they also pose risks like currency appreciation, asset bubbles, and financial instability.

For home countries, capital outflows can lead to reduced domestic investment and brain drain. They may also cause balance of payments pressures and tax base erosion. These impacts highlight the complex nature of global financial interconnectedness.

Benefits and Risks of International Capital Flows

Benefits of capital inflows

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• Increased investment through Foreign Direct Investment and portfolio investment expands domestic capital markets
• Technology transfer provides access to advanced production techniques and improved management practices enhancing R&D capabilities
• Job creation generates direct employment in foreign-owned enterprises and indirect employment through supply chain linkages fostering skill development
• Economic growth stimulation boosts productivity increases competition in domestic markets diversifies economic sectors
• Access to global markets integrates international supply chains improves export capabilities

Risks of large capital inflows

• Currency appreciation reduces export competitiveness triggers Dutch disease effect pressures domestic industries
• Asset bubbles lead to overvaluation in real estate markets (Manhattan, Tokyo) inflate stock markets misallocate resources
• Financial instability increases vulnerability to external shocks (Asian Financial Crisis 1997) causes sudden stops or reversals of capital flows amplifies business cycles
• Macroeconomic management challenges create inflationary pressures complicate independent monetary policy affect fiscal policy decisions
• Structural economic distortions result in overreliance on specific sectors (oil in Venezuela) crowd out domestic investment widen income inequality

Impact on Home Countries and Policy Implications

Impact of capital outflows

• Reduced domestic investment decreases available capital for local projects lowers productivity growth potentially slows economic expansion
• Brain drain results in loss of skilled workers (engineers, doctors) reduces innovation capacity negatively impacts long-term competitiveness
• Balance of payments pressures create current account deficits potentially depreciate currency necessitate external borrowing or reserve depletion
• Tax base erosion reduces government revenues challenges funding for public services and infrastructure
• Shift in economic structure leads to deindustrialization in some sectors (US manufacturing) changes comparative advantage
• Political and social implications raise public concerns over job losses increase pressure for protectionist policies potentially cause social unrest due to economic changes