Capital flows refer to the movement of money for the purpose of investment, trade or business production, including the flow of capital within corporations in the form of investment capital, capital spending on operations and research and development (R&D).On a larger scale, a government directs capital flows from tax receipts into programs and operations and through trade with other nations and currencies. Individual investors direct savings and investment capital into securities, such as stocks, bonds, and mutual funds.
Categories of capital flow
Asset-class movements are measured as capital flows between:
- bonds, and other financial instruments, while venture capital shifts in regards to investments being placed in startup businesses. Mutual fund flows track the net cash additions or withdrawals from broad classes of funds. Capital-spending budgets are examined at the corporate level to monitor growth plans, while federal budgets follow government spending plans (Gelos, 2011).
Factors that influence on capital flow
Capital flows respond differently to global factors depending on whether a country's monetary authorities intervene in foreign exchange markets to influence the local currency exchange rate, or whether a capital flow pressures result in changes un the exchange rate or interest rate sufficient to disclosure capital flow pressures from being realized in actual flows. In fully floating exchange rate regimes, capital flow pressures would materialize in exchange rate adjustments while in fixed exchange rate regimes, the price adjustment is prevented, and a capital flow is fully realized in response to the same pressure. Recent event studies of international monetary spillovers underscore the importance of this point, with full international capital flow pressures reflected in actual flows, as well as in exchange rate or interest rate changes (Goldberg, 2018).
Exchange market pressure index
Exchange Market Pressure Index (EMP) measures capital flow pressures in units of exchange rate depreciation equivalents, with an increase denoting a capital outflow pressure. For analytical purposes, it is like a “super exchange rate” index that directly accounts for central bank interventions in the foreign exchange market by converting the intervention to a hypothetical exchange rate response calibrated to country-specific asset market conditions. EMO can be used to show the period by global factor over time, also testing for differences between so-called safe haven currencies and emerging markets. The importance of the common global factor changes significantly over time (Goldberg, 2018).
Global Risk Response
Global Risk Response (GRR) index, to empirically categorize the link between global risk factors and changes in international capital flow pressures by country. The index is constructed as the correlation between monthly observations of a measure of global risk sentiment and monthly observations of the GRR. The GRR shows that the status of currencies evolves over time. While currency status has some persistence, the label of “safe haven” for currencies and for countries clearly is not stagnant (Goldberg, 2018).
Examples of Capital flow
- Foreign Direct Investment (FDI): FDI occurs when an individual or company from one country invests in a company or venture in another country in order to gain a controlling interest in the business. FDI can take the form of a purchase of equity, bonds, or other securities, as well as the purchase of real estate, the opening of a branch office, the acquisition of a local business, or other investments.
- Portfolio Investment: Portfolio investment involves the purchase of securities, such as stocks and bonds, with the intention of earning a return on the capital invested. These investments may be bought and sold on the open market, or they may be held as a long-term investment, such as in a retirement fund.
- Financial Derivatives: Financial derivatives are financial instruments, such as options and futures contracts, that derive their value from the underlying asset. These derivatives are used to manage risk and to speculate on the direction of the market.
- International Aid: International aid is money or resources provided by one country to another in order to promote economic growth and development. These funds can be used to build infrastructure, provide humanitarian aid, or support economic development projects.
- Currency Exchange: Currency exchange is the process of exchanging one currency for another. This is often done to take advantage of currency fluctuations in order to make a profit. It can also be used to hedge against currency risk, or to purchase goods and services abroad.
Advantages of Capital flow
Capital flows can bring a variety of benefits to countries and economies, including:
- Increased investment: Capital flows can increase investment in a country's economy, bringing in additional capital and resources that can be used to create jobs, stimulate economic growth, and help fund infrastructure projects.
- Increased economic development: Capital flows can provide resources for economic development and help create a more efficient and competitive economy.
- Improved economic stability: Capital flows can help stabilize a country's economy by providing a source of liquidity and reducing the risk of financial crises.
- Increased trade: Capital flows can facilitate increased trade between countries, allowing them to buy and sell goods and services more efficiently.
- Increased efficiency: Capital flows can increase the efficiency of an economy by providing an additional source of capital and resources to businesses and corporations.
- Increased competition: Capital flows can help create a more competitive environment, as businesses and corporations compete for resources. This can lead to lower prices and better services for consumers.
Limitations of Capital flow
Capital flows are limited by a variety of factors, including:
- Exchange Rate Risk: Exchange rate risk is the risk of losses due to currency exchange rate fluctuations. It is possible for a capital flow to be adversely affected by changes in the exchange rate as the currency from the country of origin may become more expensive in the destination country.
- Regulatory Risk: Regulatory risk is the risk of losses due to changes in government regulations. Depending on the regulations, it may be more difficult for investors to access capital flows and make investments in certain countries or regions.
- Political Risk: Political risk is the risk of losses due to political instability or changes in government. Political risk can make it difficult for capital flows to enter or remain in certain countries.
- Credit Risk: Credit risk is the risk of losses due to a borrower's inability to pay. It can be difficult for capital flows to be invested in companies with high credit risk, as lenders may be unwilling to take on the additional risk.
- Liquidity Risk: Liquidity risk is the risk of losses due to a lack of liquidity in the market. Capital flows may be limited if there is not enough liquidity in the market to support their flow.
- Reputational Risk: Reputational risk is the risk of losses due to a company or country's reputation. Reputational risk can make it difficult for capital flows to enter markets if investors are wary of the country or company's reputation.
Capital flows are a major factor in international economics and can be divided into two categories: direct investment and portfolio investment.
- Direct investment includes foreign direct investment (FDI), foreign venture capital investments, and other forms of direct investment. FDI occurs when a company invests in a foreign company or establishes a business presence in a foreign country. Foreign venture capital investments involve investments in start-up companies in foreign countries. Other forms of direct investment include the purchase of foreign assets such as land, factories, and mines.
- Portfolio investment includes investments in stocks, bonds, and other financial instruments. This type of investment involves the purchase of securities on the open market, such as on the New York Stock Exchange or the London Stock Exchange. Portfolio investments are made by individual investors, mutual funds, and institutional investors.
In summary, capital flows can be divided into two categories, direct investment and portfolio investment. Direct investment involves foreign direct investment, foreign venture capital investments, and other forms of direct investment. Portfolio investment includes investments in stocks, bonds, and other financial instruments.
- Árvai Z. (2005), Account Liberalization, Capital Flow Patterns, and Policy Responses in the EU's New Member States, International Monetary Fund, Washington,
- Gelos G. (2011), International Mutual Funds, Capital Flow Volatility, and Contagion-A Survey, International Monetary Fund, Washington,
- Giordani P. (2014), Capital Flow Deflection, International Monetary Fund
- Goldberg L. (2018), Capital Flow Pressures, International Monetary Fund, Washington
- Rowley C. (2013), Trade and Capital Flow among Asian Economies, Routledge, Oxon.
Author: Katarzyna Adamczyk