7.1 Types and drivers of international capital flows

International capital flows are the lifeblood of the global economy. They come in various forms, including foreign direct investment, portfolio investments, and bank loans. Each type plays a unique role in fostering economic growth, facilitating trade, and connecting markets worldwide.

These flows are driven by factors like interest rate differences, growth prospects, and risk diversification. International financial markets act as the conduit for these flows, enabling efficient capital allocation, enhancing liquidity, and providing risk management tools. Understanding these dynamics is crucial for navigating the interconnected global financial landscape.

Types of International Capital Flows

Types of international capital flows

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• Foreign Direct Investment (FDI)
  • Long-term investment in foreign countries involves acquiring controlling interest in companies (>10% ownership) or establishing new subsidiaries abroad
  • Provides capital, technology, and management expertise to host countries (Toyota plants in USA)
  • Can stimulate economic growth and job creation in recipient economies
• Portfolio Investment
  • Purchase of foreign financial assets without controlling interest (<10% ownership) enables diversification and higher returns
  • Equity investments like stocks in foreign companies (Apple shares on Tokyo Stock Exchange)
  • Debt securities such as government or corporate bonds from other countries (US Treasury bonds held by Chinese investors)
• Bank Loans
  • Cross-border lending by financial institutions facilitates international trade and investment
  • Syndicated loans pool resources from multiple banks for large projects (financing for infrastructure in developing countries)
  • Interbank lending supports liquidity in global financial system
• Other types of capital flows
  • Official development assistance provides grants or low-interest loans to developing countries (World Bank projects)
  • Remittances transfer money from migrant workers to their home countries (Filipino workers sending money home)
  • Trade credits offer short-term financing for international trade transactions

Drivers of cross-border capital

• Interest rate differentials
  • Higher returns in foreign markets attract capital flows (investors seeking higher yields in emerging markets)
  • Carry trade strategies exploit interest rate differences between countries
• Economic growth prospects
  • Faster-growing economies draw more capital as investors seek growth opportunities (FDI in China's rapidly expanding economy)
  • Emerging markets become attractive investment destinations due to potential for high returns
• Risk diversification
  • Geographic diversification of portfolios spreads risk across different markets and economies
  • Reduction of country-specific risks by investing in multiple countries or regions
• Political and economic stability
  • Investor confidence increases with stable political systems and economic policies
  • Strong regulatory environment and legal protections for investments encourage capital inflows
• Exchange rate expectations
  • Anticipated currency appreciation potential influences investment decisions
  • Impact on returns when converted back to domestic currency affects capital flow directions
• Technological advancements
  • Improved access to global markets through online trading platforms and financial technology
  • Reduced transaction costs for cross-border investments encourage more capital flows
• Global liquidity conditions
  • Central bank policies like quantitative easing affect availability of capital for international investment
  • Low interest rates in developed economies can push investors to seek higher yields abroad

Role of international financial markets

• Facilitation of capital allocation
  • Matching global savings with investment opportunities across borders enhances economic efficiency
  • Improved distribution of resources to areas with highest potential returns
• Enhanced liquidity
  • Deeper and more liquid markets for financial instruments increase trading volumes
  • Greater number of market participants from around the world
• Price discovery mechanism
  • Efficient pricing of assets across borders reflects global supply and demand
  • Asset prices quickly incorporate new information about global economic conditions
• Risk management tools
  • Derivatives and hedging instruments allow investors to manage currency and interest rate risks
  • Cross-border risk transfer through instruments like credit default swaps
• Financial innovation
  • Development of new financial products to meet global investor needs (Exchange-Traded Funds tracking international indices)
  • Structured finance and securitization create new investment opportunities
• Impact on global economic integration
  • Increased interdependence among economies through financial linkages
  • Spillover effects of economic shocks can quickly spread across borders
• Challenges and risks
  • Volatility and contagion effects can amplify market movements globally
  • Regulatory arbitrage may lead to potential for financial instability
• Role in economic development
  • Access to capital for emerging economies supports infrastructure and industrial growth
  • Technology and knowledge transfer through FDI can boost productivity in host countries