[Economic Report of the President (2004)]
[Administration of George W. Bush]
[Online through the Government Printing Office, www.gpo.gov]


 
CHAPTER 13
International Capital Flows

International capital flows are the transfer of financial assets,
such as cash, stocks, or bonds, across international borders. They
have become an increasingly significant part of the world economy
over the past decade and an important source of funds to support
investment in the United States. In 2002, around $700 billion flowed
into the United States. Inflows of international capital help to
finance U.S. factories, support U.S. medical research, and fund
U.S. companies. At the same time, U.S. investors provided nearly
$200 billion in capital to other countries for a wide range of
purposes.
Around $2 trillion flowed into countries around the world in 2002,
equivalent to roughly 6 percent of global GDP (Chart 13-1). Although
these world capital flows have dropped from a peak of over 13 percent
of GDP in 2000, largely reflecting a global economic slowdown, they
remain above the level of the early 1990s.



This chapter describes the various types of international capital
flows and discusses their benefits, as well as their risks. The
key points in this chapter are:

 Capital flows have significant potential benefits
for economies around the world.
 Countries with sound macroeconomic policies and
well-functioning institutions are in the best position
to reap the benefits of capital flows and minimize
the risks.
 Countries that permit free capital flows must choose
between the stability provided by fixed exchange rates
and the flexibility afforded by an independent monetary
policy.


Types of International Capital Flows

Not all capital flows are alike, and there is evidence that the
motivation for capital flows and their impact vary by the type of
investment. Capital flows can be grouped into three broad categories:
foreign direct investment, portfolio investment, and bank and other
investment (Chart 13-2).



Foreign Direct Investment

Foreign direct investment occurs when an investor, in many cases a
firm rather than an individual, gains some control over the
functioning of an enterprise in another country. This typically
takes place through a direct purchase of a business enterprise or
when the purchaser acquires more than 10 percent of the shares of
the target asset.
A number of factors affect the flow of foreign direct investment.
Trade links between investor and recipient countries tend to increase
foreign direct investment, as demonstrated by the establishment of
Japanese auto plants in the United States starting in the 1980s.
Proximity to foreign markets also plays a role, as shown by the
investment of U.S. companies in China to service Chinese consumers
and firms. The political, economic, and legal stability of the
recipient country also matters. Investors are reluctant to establish
ownership of foreign companies or set up businesses abroad if
corruption or political or social instability are likely to
jeopardize operations.
In 2002, foreign direct investment made up roughly one quarter of
world capital inflows. About 40 percent of these flows went to the
major industrial countries--the United States, Canada, the United
Kingdom, Japan, and countries in the euro zone. During much of the
1990s, the United States was the largest single recipient of foreign
direct investment. Foreign direct investment flows to industrialized
countries are driven largely by the desire for better distribution
networks and market access. Another 30 percent of total foreign
direct investment went to emerging markets. Relative to flows to
industrial countries, these investments were driven more by the
low production costs and growing markets of Asia, as well as the
privatization of state-owned enterprises in many countries in
Latin America and Eastern Europe.


Portfolio Investment

Portfolio investment occurs when investors purchase noncontrolling
interests in foreign companies or buy foreign corporate or
government bonds, short-term securities, or notes. This type of
investment accounted for almost half of world capital inflows in
2002.
Economic and financial conditions in the recipient and investor
countries are important influences on portfolio investment flows.
The market for these assets is typically more liquid than that for
direct investments; it is usually easier to sell a stock or bond
than a factory. As a result, investors can quickly reshuffle
portfolio investments if they lose confidence in their purchases.
Not surprisingly, portfolio investment is far more volatile than
foreign direct investment. Countries that receive large capital
inflows in one year can see a quick reversal of these inflows if
economic or political developments cause investors to reevaluate
the expected return on their assets.
Sudden and destabilizing reversals of portfolio investment took
place in countries such as Korea, Mexico, Russia, Brazil, and
Argentina during the second half of the 1990s and early 2000s.
These reversals partly reflected the concern that private-sector
and government borrowers in emerging market economies might be
unable to meet their financial obligations.
In the United States, portfolio investment in U.S. government
securities has played an increasingly important role since 2001.
Foreign purchases of U.S. government securities rose from 3 percent
of total capital inflows in 2001 to 33 percent in the first three
quarters of 2003. One of the most important factors explaining
this change is a shift in the share of U.S. security purchases
by foreign investors from equities into lower-risk assets, such
as U.S. government obligations. Another important factor is
increased purchases of U.S. government securities by foreign
central banks. A decline in the number of mergers and acquisitions
in the United States has also led to lower foreign purchases of
private assets.


Bank Investment

Bank investment is the third major type of capital flow. Bank-related
international investment includes deposit holdings by foreigners and
loans to foreign individuals, businesses, and governments. These
investments, grouped with a few other miscellaneous types of
investments, accounted for over one quarter of total international
capital inflows in 2002. For emerging markets, the importance of
these bank-related and other investment flows has declined
dramatically in the past decade. While these flows represented an
average of 28 percent of capital inflows to emerging economies from
1992 to 1996, they represented an average of only 3 percent of
inflows from 1997 to 2002. Economic crises in a number of Asian
and Latin American countries since the mid-1990s have contributed
to reduced bank lending to these regions since 1997, notably from
banks in Japan and Europe.


Benefits of International Capital Flows

Capital flows can have a number of important benefits:
 International capital allows countries to finance more
investment than can be supported by domestic saving,
thereby increasing output and employment.
 Greater access to foreign markets can provide new
opportunities for foreign and domestic investors to
increase the return and reduce the risk of their
portfolios.
 Foreign direct investment can facilitate the transfer
of technology and managerial expertise to developing
countries, thus improving productivity.
 Better risk management and other management techniques
associated with foreign direct investment can help
recipients modify their production processes to lower
costs and raise productivity
 Exposure to international capital markets and the
resulting increased competition may induce governments
and firms issuing assets to improve macroeconomic
policy, management, and profitability. These
improvements may, in turn, encourage additional
foreign investment.
 Improved international access to investment
opportunities in the country receiving capital inflows
expands the number of potential investors in any
domestic project. This will tend to reduce the cost of
raising capital.
 Increased capital inflows can spur the development of
domestic financial sectors. A well-developed financial
sector can lead to greater investment and reduced
financial-sector vulnerability.

Empirical evidence suggests that countries that are open to capital
flows can enjoy many of these benefits. In the case of foreign direct
investment, studies indicate that industries and some developing
countries with more foreign direct investment grow faster than those
with less foreign direct investment. In addition, extensive research
has found that foreign-owned firms tend to have higher productivity
and wages than do their domestic counterparts. Finally, for some
developing countries, foreign direct investment can help catalyze
the adoption of more-advanced technologies and management practices.
Foreign portfolio investment has played a key role in furthering the
development of domestic equity and bond markets. In the case of
equity markets, one report estimates that opening up to foreign
shareholders leads to an almost 40 percent increase in the real
dollar value of the stock market. This lowers the cost of equity
capital for domestic firms, as a higher stock price means that a
smaller portion of a company needs to be sold to raise a given
amount of capital. Developing equity markets can help restrain the
ability of corporate managers to pursue their own goals and can
help align managerial incentives with earnings growth. In the case
of debt markets, evidence indicates that foreign investment can
widen the investor base and help businesses raise capital. Moreover,
developing countries that lack debt markets may rely excessively
on bank lending. Studies suggest that this may leave economies more
vulnerable to financial crises because banks are less likely to
hold well-diversified portfolios than are participants in developed
bond markets.
For all of these reasons, financial market liberalization has been
linked to greater investment and higher output growth. One study
found that equity market liberalization raised annual economic
growth by about 1 percentage point per year in the five years
following liberalization. In a related study, the same researchers
showed that 17 out of a set of 21 countries that opened their
equity markets to foreign participation experienced faster
average-growth rates than before liberalization.
A foreign banking presence can also have substantial benefits for
the host economy. Foreign-owned financial institutions have been
shown to improve the standards and efficiency of the domestic
banking sector. This can raise the net yield on saving and enhance
capital accumulation and growth. In Latin America, studies have
shown that foreign banks in the latter half of the 1990s had
higher and less-volatile loan growth than the average domestic
bank. Foreign banks may also be a stabilizing force during periods
of financial stress. This is partly because foreign banks are
often better capitalized and have access to financing through their
parent companies at times when domestic banks might be unable to
raise capital. Because foreign banks are often better managed and
less exposed to domestic downturns, they can also provide citizens
some insurance against a collapse of the domestic banking sector.
Drawing on the experiences of the Asian crises, academic work
suggests that the greater the foreign bank presence in a developing
country, the less likely the country was to experience a banking
crisis. The ability to hold bank accounts in other countries and
borrow from overseas financial institutions can also facilitate
trade.


Risks of International Capital Flows

Many countries that reduced barriers to capital flows in the 1990s
experienced large capital inflows, increased investment, and strong
growth. Several of these countries, however, subsequently experienced
economic crises. In the majority of these crises, capital outflows
were associated with currency depreciations. The governments, firms,
and citizens of many of these emerging markets had significant
amounts of debt denominated in foreign currency but received income
denominated in domestic currency. The currency depreciations
therefore greatly impaired the capacity of these borrowers to
service their debts. The resulting increase in bankruptcies and,
in some cases, government defaults, weakened the banking sectors
and other financial institutions in these countries. All of these
factors contributed to sharp contractions in output and high
unemployment rates. Such ``currency crises'' occurred in Mexico,
Thailand, Korea, Russia, and Argentina from the mid-1990s through
2001. These experiences have led to a more guarded view of the
advantages of capital flows.
One lesson learned from these crises is that a strong institutional
framework is important if a country is to benefit fully from openness
to capital flows. In other words, capital flows are more likely to
yield substantial benefits and carry fewer risks in countries where
the financial system is strong and well developed; laws and
regulations are clear, reasonable, and enforced by the courts and
public institutions; and the reporting of financial information is
timely and accurate so that investors have a clear understanding of
the conditions and strength of the assets in which they are
investing. Corruption is also associated with lower foreign
investment and weaker growth.
In countries with weak institutions or high levels of corruption,
capital inflows may not be channeled to their most-productive uses,
dissipating their potential benefits. In these cases, improved
access to capital can allow firms and sovereigns to accumulate high
levels of debt through purchases of unproductive assets. This can
ultimately leave firms and countries vulnerable to changes in
investor sentiment, possibly contributing to economic crises.
One approach to limiting these risks when legal and financial
institutions are poorly developed is to restrict foreign capital
flows. Experience, however, suggests that capital controls impose
substantial costs. Controls on the movement of capital can distort
firms' investment decisions, increase opportunities for corruption,
and discourage foreign direct investment. All of these effects can
depress growth (Box 13-1).

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Box 13-1:  Capital Controls in Emerging Markets

Recent economic crises in several emerging economies that opened their
markets to capital flows have renewed debate on the desirability of
capital controls. Any benefits of restrictions on capital flows,
however, must be weighed against the costs and distortions they
impose.
Capital controls can take various forms and can target either capital
inflows or capital outflows. Countries may adopt controls on capital
inflows in an attempt to prevent an appreciation of their currency
or to direct foreign investments to longer-term ventures.  Experience
shows that these controls, regardless of whether they achieve their
objective, can create problems, including economic distortions and
large administrative fees.  For example, in the 1990s, the Chilean
government required that a portion of capital inflows be temporarily
deposited in a non-interest-bearing central bank account. These
restrictions lowered the risk of rapid capital flight, and some
analyses show that they lengthened the average period of time that
capital inflows remained in Chile. These restrictions, however, also
increased administrative costs, especially because the government
had to modify them frequently to close numerous loopholes. Research
also shows that these controls on capital inflows caused smaller,
public firms to face greater financing constraints than they did
before the restrictions.  These higher financing costs may have
stifled an important source of growth and innovation in Chile.
Countries' experiences with controls on capital outflows reinforce
the view that controls are difficult to implement and often carry
unexpected costs.  Controls on capital outflows also take a variety
of forms, such as limitations on the amount of domestic holdings
of foreign currency and restrictions on the ability of foreign
investors to repatriate their earnings. The potential to avert
financial crises triggered by capital outflows can make controls
appealing in theory. In practice, however, any such benefits tend
to be eroded over time as firms and individuals find ways to
circumvent the restrictions.  Such evasive activity can create
additional problems, such as reduced financial transparency and
tax compliance, distortions from the unequal impact of the controls
(as not all sectors have equal access to the evasive measures), and
a general reduction in respect for the law.  For example, studies
indicate that controls on capital outflows in Russia in the
mid-1990s were evaded by exporters, particularly in the energy
sector, through the underreporting of earnings.
Finally, capital controls can also distort the behavior of foreign
investors.  For example, research indicates that American
multinational firms invest less in their local affiliates in
countries with capital controls.  In addition, multinationals tend
to alter their investment and payment structure in order to minimize
the effect of the restrictions.  This distortion is yet another way
capital controls can reduce the productivity of the world's stock
of capital.
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Another approach for developing countries to minimize the risks from
opening up to capital movements involves the careful timing, or
sequencing, of policies designed to ``liberalize'' financial markets.
One variant of this approach suggests that countries should first
achieve macroeconomic stability, in part by implementing sound
fiscal and monetary policies. Countries should next strengthen
financial market institutions, and only then allow for free capital
flows. While this approach may work for some countries under
specific economic conditions, the pace and timing of reforms appear
to be less important than the consistency of the reforms and the
government's commitment to them.
Policy makers increasingly realize that there is no simple rule to
best achieve free capital flows, and that country characteristics
should be considered. There is some consensus, however, that the
benefits of international capital mobility can be substantial and
that to best achieve these benefits, countries should implement
reforms of domestic financial and legal institutions.


Constraints Imposed by Free Capital Flows

One consequence of allowing capital to flow freely in and out of a
country is that this constrains a nation's choice of monetary policy
and exchange-rate regime. For important but subtle reasons related
to the tendency for capital to flow to where returns are the highest,
countries can maintain only two of the following three policies--free
capital flows, a fixed exchange rate, and an independent monetary
policy. Economists refer to this restriction as the impossible
trinity. As illustrated by Chart 13-3, countries must choose to be
on one side of the triangle, adopting the policies at each end,
but forgoing the policy on the opposite corner.



The easiest way to understand this restriction is through specific
examples. The United States allows free capital flows and has an
independent monetary policy, but it has a flexible exchange rate.
(The U.S. government does not attempt to fix, or ``peg,'' the exchange
value of the dollar at any particular level against other
currencies.) As a simplified example, if the Federal Reserve Board
raised its target interest rate relative to foreign interest rates,
capital would flow into the United States. By increasing the demand
for U.S. dollars relative to other currencies, these capital
inflows would increase the price of the dollar against other
currencies. This would cause the exchange rate to adjust and the
U.S. dollar to appreciate. In the opposite case, if the Federal
Reserve Board lowered its target interest rate, net capital outflows
would reduce the demand for dollars, thereby causing the dollar to
depreciate against foreign currencies.
In contrast, Hong Kong essentially pegs the value of its currency
to the U.S. dollar and allows free capital flows. (Hong Kong is a
Special Administrative Region of China, but maintains its own
currency.) The trade-off is that Hong Kong loses the ability to use
monetary policy to influence domestic interest rates. Unlike the
United States, Hong Kong cannot cut interest rates to stimulate a
weak economy. If Hong Kong's interest rates were to deviate from
world rates, capital would flow in or out of the Hong Kong economy,
just as in the U.S. case above. Under a flexible exchange rate,
these flows would cause the price of the Hong Kong dollar to change
relative to that of other currencies. Under a fixed exchange rate,
however, the monetary authority must offset these flows by
purchasing domestic or foreign currency in order to keep the supply
and demand for its currency fixed, and therefore the exchange rate
unchanged. The capacity of the government to sustain large purchases
and sales of its currency is ultimately limited by several factors,
including the amount of foreign exchange reserves held by the
government and its willingness to accumulate stocks of relatively
low-return foreign currency assets.
Just as in the case of Hong Kong, China pegs its exchange rate to the
U.S. dollar. China can operate an independent monetary policy,
however, as it maintains restrictions on capital flows. In China's
case, world and domestic interest rates can differ, because
controls on the transfer of funds in and out of the country limit
the resulting changes in the money supply and the corresponding
pressures on the exchange rate.
As these three examples show, if a country chooses to allow capital
to flow freely, it must also decide between having an independent
monetary policy or a fixed exchange rate. Many factors affect how
a country makes this crucial decision (Box 13-2).

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Box 13-2: Choosing Among a Fixed Exchange Rate, Independent Monetary
Policy, and Free Capital Movements

How does a country choose whether to give up a fixed exchange rate,
independent monetary policy, or free capital movements? While
country-specific factors play a role, experience has shown that
these decisions also reflect global trends.
In the late 1920s, many countries, including the United States,
adopted an exchange-rate system in which they pegged their currencies
to a fixed quantity of gold. This system, which was used previously
but was abandoned during World War I, was known as the gold
standard. It effectively fixed the exchange rates of the currencies
for all participating countries. Countries generally coupled this
fixed exchange rate with the free movement of capital, relinquishing
the ability to influence economic activity at home through the use
of independent monetary policy.
This system proved sustainable until the Great Depression of the
1930s, when many governments abandoned exchange-rate stability in
order to expand domestic demand by increasing the money supply and
lowering interest rates. Following the economic recoveries under
this regime, the choice of free capital flows and independent
monetary policy remained popular through the end of World War II.
The postwar era, however, saw substantial international integration
of markets and increasing cross-border trade. Countries such as the
United States wanted to facilitate this increase in trade by
eliminating the risks of exchange-rate fluctuations. At a summit
held in Bretton Woods, New Hampshire, in 1944, representatives from
the major industrial economies designed and implemented a plan that
encouraged exchange-rate stability while maintaining autonomous
monetary policies. The Bretton Woods system, as it became known,
offered countries greater monetary independence while fixing the
value of the dollar, yen, deutsche mark, and other currencies. Just
as with the previous systems, however, something had to be
sacrificed--the Bretton Woods arrangement required capital controls.
Capital controls included caps on the interest rates that banks
could offer to depositors and limitations on the types of assets in
which banks could invest.  Further, governments frequently intervened
in financial markets to direct capital toward strategic domestic
sectors. Though none of these controls alone prevented international
capital flows, in combination they allowed governments to restrain
the amount of cross-border capital transactions.
In the early 1970s, the Bretton Woods system gave way to a
more-diverse set of regimes. Ultimately, as growth in other countries
outstripped growth in the United States, demand shifted from the
U.S. dollar to foreign currencies, putting downward pressure on the
dollar's value. After several negotiated devaluations of the dollar,
governments agreed to abandon the system rather than continue to be
forced to change domestic interest and inflation rates to keep the
dollar's value constant. Furthermore, greater financial sophistication
and increasing capital mobility made it more difficult and costly
to sustain capital controls in the advanced economies.
Since the end of the Bretton Woods system, countries have chosen a
variety of exchange-rate regimes. Countries in the euro zone, for
instance, have adopted the euro as a common currency. This is
equivalent to fixing the exchange rates among the participating
countries. The euro, however, is allowed to move freely against
other currencies such as the dollar. Each of the countries within
the euro zone has had to give up its own independent monetary
policy. The value of the U.S. dollar, on the other hand, floats
freely against other currencies. The free movement of capital has
been uniformly embraced by the advanced industrial economies and
is increasingly being adopted by developing economies.
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Encouraging Free Capital Flows

The Administration supports the free flow of capital between the
United States and other countries and encourages countries to take
steps to open their markets to international investment. Such efforts
include the negotiation of Bilateral Investment Treaties, as well as
Trade and Investment Framework Agreements. Under these agreements,
foreign countries commit to treating U.S. investors fairly and to
allowing U.S. corporations to operate in foreign countries in
closer accordance with standard U.S. practices and procedures.
This protection reduces the risks associated with investing abroad
and encourages U.S. multinational companies to expand through foreign
direct investment.
Investment measures and protections have also played a central role
in free trade agreements negotiated by the United States (these are
discussed in Chapter 12, International Trade and Cooperation).
Recent trade agreements, such as that with Chile, have included
investment provisions that protect American investors and ensure
their access to foreign investment opportunities.
The United States also encourages countries to undertake the reforms
that will help them best reap the benefits of greater investment
and capital flows. These reforms include improvements in corporate
governance and the distribution of accurate, timely, and complete
information on economic conditions, government regulations, and
corporate performance. The Administration has focused on reducing
the risks of destabilizing capital flows in a number of ways.
One important development in this regard has been the increased
inclusion of ``collective action clauses'' in international bonds
issued by emerging market countries--a practice that has been
supported and encouraged by the United States. These clauses allow
a majority of creditors to bind a minority to key financial terms
in the event of a debt restructuring. They also help facilitate
ongoing discussions and negotiations between a sovereign and its
creditors. By making it easier for issuers and bondholders to agree
to changes in bond terms in the event of a default or restructuring,
collective action clauses provide a contractual method for improving
the resolution of situations where sovereign debt levels are
unsustainable. Such improvements to the debt-resolution process
should reduce the unnecessary loss of value to creditors and
thereby lessen the risk of lending to emerging market countries.
The United States has also endorsed the efforts of the International
Monetary Fund and the World Bank to increase the availability,
frequency, scope, and quality of the reported data of their member
countries. Better and more timely information can assist policy
makers and investors to make appropriate decisions. Some of these
efforts include:

 The Financial Sector Assessment Program, which
involves a rigorous and in-depth analysis of a
country's financial system.
 The Special Data Dissemination Standard, which sets
certain standards of timeliness and quality for economic
and financial statistics to guide countries that have
(or desire) access to foreign capital markets.
 The implementation of agreed-upon norms, such as the
Code of Good Practices and Fiscal Transparency, which
emphasize adherence to certain standards of good
practice and promote quality accounting procedures and
fiscal transparency.

These programs help investors, public-sector lenders, and governments
identify weaknesses and vulnerabilities in firms, sectors, and the
economy in general. They also target areas for reform in a country's
macroeconomic policy, financial sector, and supervisory systems.
This combination of policies should help developed and developing
countries take advantage of greater capital market integration,
while minimizing the risks.
Finally, the Millennium Challenge Account, a Presidential initiative
enacted in January 2004, provides incentives for developing countries
to adopt policies that spur economic growth and reduce poverty.
First-year funding for the Millennium Challenge Account is $1 billion.
The Administration has requested that this amount rise to $5 billion
per year by fiscal year 2006. The Millennium Challenge Corporation,
which administers the Millennium Challenge Account, will direct
development grants to poor countries that have appropriate economic,
political, and structural conditions to benefit from foreign
assistance. The Millennium Challenge Corporation will partner with
countries that demonstrate a strong commitment to ruling justly,
investing in their people, and encouraging economic freedom in order
to develop their own strategies for catalyzing economic growth and
reducing poverty. The Millennium Challenge Account is designed to
provide funding for programs that have clear objectives, a sound
financial plan, and measured benchmarks for demonstrating progress
in overcoming major obstacles to sustained economic growth. The
Millennium Challenge Account will not only improve the ability of
recipient countries to fight poverty and to grow more quickly, but
will also encourage the international investment that helps to
strengthen growth.


Conclusion

Underlying each of the policies promoted by the Administration is the
goal of helping countries reap the substantial benefits of the free
flow of international capital. Foreign direct investment can
facilitate the transfer of technology, allow for the development of
markets and products, and improve a country's infrastructure.
Portfolio flows can reduce the cost of capital, improve
competitiveness, and increase investment opportunities. Bank flows
can strengthen domestic financial institutions, improve financial
intermediation, and reduce vulnerability to crises. These flows
are not without their risks, but such risks can be reduced if
countries adopt prudent fiscal and monetary policies, strengthen
financial and corporate institutions, and develop the regulations
and agencies that supervise such institutions. Such steps allow
countries to fully gain from free capital flows.