economics project mcom i 670

8/13/2019 Economics Project Mcom i 670

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INTERNATIONAL CAPITAL MOVEMENT

A PROJECT REPORT

SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIRMENTS FOR THE AWARD OF

M.COM. DEGREE OF

MASTER IN COMMERCE

(MANAGEMENT)

SUBMITTED TO

UNIVERSITY OF MUMBAI,

LALA LAJPATRAI COLLEGE, MAHALAXMI, MUMBAI

SUBMITTED BY

ZISHAN SIDDIQUI 670

SUPERVISED BY

PROF. JANKI ANNANRAJ

DR.SARIKA MAHAJAN

13thFebruary 2014


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CERTIFICATE

I hereby certify that are the work which is being presented in the M.Com. internal Project Report

INTERNATIONAL CAPITAL MOVEMENT,in partial fulfilment of the requirement for the

award of the Master in Commerce in ECONOMICSand submitted to the Lala Lajpatrai College oCommerce and Economics, Mahalaxmi, Mumbai-4000 34 is an authentic record of my own work

carried out under the supervisor ofProfessor Janki Annanraj.The matter presented in this projec

Report has not been submitted by me for the award of any other degree elsewhere.

Signature of Student :

Signature of Supervisors :

Internal Examiner :

External Examiner :

College Stamp Principal


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ACKNOWLEDGEMENT

I would like to place on record my deep sense of gratitude toProf. Janki AnnanrajDept of for

His generous guidance, help and useful suggestion.

I express my sincere gratitude to Prof. Janki Annanrajfor his stimulating guidance, continuous

encouragement and supervision throughout the course of present work.

I also wish to extend my thanks to Prof. Janki Annanraj and other colleagues for attending my

seminars and for their insightful comment and constructive suggestion to improve to the quality of

this project work.

I am extremely thankful to toProf. Dr. Suryakant lasunecoordinator and Principal Mrs. NeelamArorafor providing me infrastructure facilities to work in, without which this work would not have

been possible.

INDEX


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Sr

No.

Title Page no.

1. Abstract 5

2. Introduction 6

3. What are international capital movements 8

4. Types of capital Flows 9

5. Factors Effecting Capital Movements 14

6. Trends in international capital Flows 17

7. Persistence in Capital Flows 21

8. Scale of Capital Movements 25

9. Price Uncertainty and Crisis 26

10. Role of Capital Movement In Crisis 32

11. Controlling Capital Movements 34

12. Transfer Tax and Short term CapitalMovements

38

13. Review & Results 41

14. Conclusion 44

15. Bibliography 45


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Abstract

Conventional wisdom is that some capital flows are inherently more volatile than others. However

,investigation of the statistical properties of these flows shows that no regular relationships exist to

suggest that the particular composition of capital flows can help to explain the overall stability of

the external accounts. Instead, capital seems to come and go in different forms with few reliable

patterns. We show that while industrialised economies have experienced a trend rise in the

volatility of individual components in the capital account, this variability is largely offsetting. Such

offsetting relationships appear less prevalent in emerging economies.


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INTRODUCTION

International capital flows are the financial side ofINTERNATIONAL TRADE.When someone

imports a good or service, the buyer (the importer) gives the seller (the exporter) a monetary

payment, just as in domestic transactions. If total exports were equal to total imports, these

monetary transactions would balance at net zero: people in the country would receive as much in

financial flows as they paid out in financial flows. But generally the trade balance is not zero.

The most general description of a countrys balance of trade, covering its trade in goods and

services, income receipts, and transfers, is called its current account balance. If the country has a

surplus or deficit on its current account, there is an offsetting net financial flow consisting of

currency, securities, or other real property ownership claims. This net financial flow is called its

capital account balance.

When a countrys imports exceed its exports, it has a current account deficit. Its foreign trading partners wh

hold net monetary claims can continue to hold their claims as monetary deposits or currency, or they can use

the money to buy other financial assets, real property, or equities (stocks) in the trade-deficit country. Net

capital flows comprise the sum of these monetary, financial, real property, and equity claims. Capital flows

move in the oppositedirection to the goods and services trade claims that give rise to them. Thus, a country

with a current account deficit necessarily has a capital account surplus. InBALANCE-OF-PAYMENTS

accounting terms, the current-account balance, which is the total balance of internationally traded goods and

services, is just offset by the capital-account balance, which is the total balance of claims that domestic

investors and foreign investors have acquired in newly invested financial, real property, and equity assets in

each others countries. While all the above statements are true by definition of the accounting terms, the dat

on international trade and financial flows are generally riddled with errors, generally because of

undercounting. Therefore, the international capital and trade data contain a balancing error term called net

errors and omissions.

Because the capital account is the mirror image of the current account, one might expect total recorded worl

tradeexports plus imports summed over all countriesto equal financial flowspayments plus receipts.

But in fact, during 19962001, the former was $17.3 trillion, more than three times the latter, at $5.0

trillion.2There are three explanations for this. First, many financial transactions between international
http://www.econlib.org/library/Enc/InternationalTrade.htmlhttp://www.econlib.org/library/Enc/InternationalTrade.htmlhttp://www.econlib.org/library/Enc/InternationalTrade.htmlhttp://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt282http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt282http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt282http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt282http://www.econlib.org/library/Enc/BalanceofPayments.htmlhttp://www.econlib.org/library/Enc/InternationalTrade.html


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financial institutions are cleared by netting daily offsetting transactions. For example, if on a particular day,

U.S. banks have claims on French banks for $10 million and French banks have claims on U.S. banks for

$12 million, the transactions will be cleared through their central banks with a recorded net flow of only $2

million from the United States to France even though $22 million of exports was financed. Second, since the

1970s, there have been sustained and unexplained balance-of-payments discrepancies in both trade andfinancial flows; part of these balance-of-payments anomalies is almost certainly due to unrecorded capital

flows. Third, a huge share of export and import trade is intrafirm transactions; that is, flows of goods,

material, or semi-finished parts (especially automobiles and other no electronic machinery) between parent

companies and their subsidiaries. Compensation for such trade is accomplished with accounting debits and

credits within the firms books and does not require actual financial flows. Although data on such intrafirm

transactions are not generally available for all industrial countries, intra firm trade for the United States in

recent years accounts for 3040 percent of exports and 3545 percent of imports.3

The bulk of capital flows are transactions between the richest nations. In 2003, of the more than $6.4 trillion

in gross financial transactions, about $5.4 trillion (84 percent) involved the 24 industrial countries and

almost $1.0 trillion (15 percent) involved the 162 less-developed countries (LDCs) or economic territories,

with the rest, less than 1 percent, accounted for by international organizations.4The shares of both industrial

nations and the international organizations have been receding from their highs in 1998: 90 percent for

industrial nations and 5 percent for the international organizations. In that year the combination of the

Russian debt default and ruble devaluation, the south Asia financial crisis, and the lingering uncertainty

about financial consequences of the return of Hong Kong to Chinese sovereignty in July 1997 drove the

LDC share down to 5 percent of world capital flows.5In the more tranquil five years following these crises,

19992003, LDC financial transactions involving mainland China and Hong Kong averaged 28 percent of

the LDC total, and adding Taiwan, Singapore, and Korea brings the share to 53 percent of the developing-

country transactions. Of the remaining forty-seven percentage points of developing-country transactions,

Europe (primarily Russia, Turkey, Poland, and the Czech Republic) and the Western Hemisphere (primarily

Mexico, Brazil, and Chile) each accounted for about sixteen percentage points, with the Middle East and

Africa combining for the remaining sixteen percentage points.
http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt283http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt283http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt283http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt284http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt284http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt284http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt285http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt285http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt285http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt285http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt284http://www.econlib.org/library/Enc/InternationalCapitalFlows.html#lfHendersonCEE2-093_footnote_nt283


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WHAT ARE CAPITAL MOVEMENTS?

The movement of money for the purpose of investment, trade or business

production. Capital flows occur within corporations in the form of investment

capital and capital spending on operations and research & development. On a

larger scale, governments direct 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 like stocks, bonds

and mutual funds.

IN SIMPLE WORDS

Thetransferofcapitalbetween countries either by

theimportorexportofsecurities,dividendpaymentsorinterestpayments. For instance, when

JapaneseinvestorspurchaseAmerican securities, the payment will be in dollars. Hence,

ademandfor the dollar is created, necessitating anincreasein thedollar'sexchange rate.

Conversely, an Americancompanywould have to buy yen in order to pay itscreditors.This

would cause a demand in yen and thepriceof yen would increase intermsof dollars.
http://www.investorwords.com/5048/transfer.htmlhttp://www.investorwords.com/5048/transfer.htmlhttp://www.investorwords.com/5048/transfer.htmlhttp://www.investorwords.com/694/capital.htmlhttp://www.investorwords.com/694/capital.htmlhttp://www.investorwords.com/694/capital.htmlhttp://www.investorwords.com/2383/import.htmlhttp://www.investorwords.com/2383/import.htmlhttp://www.investorwords.com/2383/import.htmlhttp://www.investorwords.com/1852/export.htmlhttp://www.investorwords.com/1852/export.htmlhttp://www.investorwords.com/1852/export.htmlhttp://www.investorwords.com/5954/securities.htmlhttp://www.investorwords.com/5954/securities.htmlhttp://www.investorwords.com/5954/securities.htmlhttp://www.investorwords.com/1509/dividend.htmlhttp://www.investorwords.com/1509/dividend.htmlhttp://www.investorwords.com/3634/payment.htmlhttp://www.investorwords.com/3634/payment.htmlhttp://www.investorwords.com/3634/payment.htmlhttp://www.investorwords.com/2531/interest.htmlhttp://www.investorwords.com/2531/interest.htmlhttp://www.investorwords.com/2531/interest.htmlhttp://www.investorwords.com/2630/investor.htmlhttp://www.investorwords.com/2630/investor.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/1396/demand.htmlhttp://www.investorwords.com/1396/demand.htmlhttp://www.investorwords.com/1396/demand.htmlhttp://www.investorwords.com/10007/increase.htmlhttp://www.investorwords.com/10007/increase.htmlhttp://www.investorwords.com/10007/increase.htmlhttp://www.investorwords.com/7129/dollar.htmlhttp://www.investorwords.com/7129/dollar.htmlhttp://www.investorwords.com/1806/exchange_rate.htmlhttp://www.investorwords.com/1806/exchange_rate.htmlhttp://www.investorwords.com/1806/exchange_rate.htmlhttp://www.investorwords.com/992/company.htmlhttp://www.investorwords.com/992/company.htmlhttp://www.investorwords.com/992/company.htmlhttp://www.investorwords.com/1207/creditor.htmlhttp://www.investorwords.com/1207/creditor.htmlhttp://www.investorwords.com/1207/creditor.htmlhttp://www.investorwords.com/3807/price.htmlhttp://www.investorwords.com/3807/price.htmlhttp://www.investorwords.com/3807/price.htmlhttp://www.investorwords.com/4950/terms.htmlhttp://www.investorwords.com/4950/terms.htmlhttp://www.investorwords.com/4950/terms.htmlhttp://www.investorwords.com/4950/terms.htmlhttp://www.investorwords.com/3807/price.htmlhttp://www.investorwords.com/1207/creditor.htmlhttp://www.investorwords.com/992/company.htmlhttp://www.investorwords.com/1806/exchange_rate.htmlhttp://www.investorwords.com/7129/dollar.htmlhttp://www.investorwords.com/10007/increase.htmlhttp://www.investorwords.com/1396/demand.htmlhttp://www.investorwords.com/3952/purchase.htmlhttp://www.investorwords.com/2630/investor.htmlhttp://www.investorwords.com/2531/interest.htmlhttp://www.investorwords.com/3634/payment.htmlhttp://www.investorwords.com/1509/dividend.htmlhttp://www.investorwords.com/5954/securities.htmlhttp://www.investorwords.com/1852/export.htmlhttp://www.investorwords.com/2383/import.htmlhttp://www.investorwords.com/694/capital.htmlhttp://www.investorwords.com/5048/transfer.html


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Types of capital movement

International capital movements refer to investments and financial transactions between one

country and another. In balance of payments statistics capital movements are divided into foreign

direct investment, portfolio investment and other capital movements. Earlier, a distinction was

made between short and long-term capital movements, but being arbitrary this is no longer the

practice. Direct investments comprise real investments and corporate acquisitions made by

companies in other countries, as well as loans between companies belonging to the same group.

Portfolio investments comprise cross-border investments in equities and other securities. Other

capital movements mean cross-border lending and investments in, for instance, bank deposits. A

considerable proportion derives from transactions related to finance for foreign trade. Special

mention should be made of loans taken out by governments (sovereign debt). The lenders may then

be private-sector banks as well as governments in developed countries and multilateral internationa

financial institutions. In the case of developing countries, participation by international

organisations is often a precondition for a supply of private-sector financing. By definition, foreign

direct investments in the form of equity investments are long-term capital movements. On the other

hand, inter-company loans, which are counted as direct investments and the volume of which has

grown appreciably in recent years, are in the statistics considered as short-term movements.

Investment and development loans are likewise usually long-term. Among portfolio investments,

investments in equities and government bonds are long-term capital movements in principle. In

practice, though, this is not always so, since such investments can be sold off at any time on a liqui

market. Short-term capital movements have been said to play a crucial role in creating instability.

This is because short-term investment flows may suddenly change course, prompting great tension on

money and currency markets and possiblycausing a currency crisis or a more severe financial and banking

crisis. Examplesof short-term capital movements are financial transactions connected withforeign trade

financing and the related risk management. The financing of longterm capital movements also gives rise to

short-term capital movements. The foreign receivables and liabilities of banks are mostly short-term claims,

sochanges in them reflect short-term capital movements. Portfolio investments inanother country's short-

term money market claims are by definition short-termcapital movements.The exchange rate regime and


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capital movements are linked in many ways. Ifthe exchange rate is floating freely, capital movements into

or out of the countryhave a direct impact on the exchange rate.

If, on the other hand, the exchangerate is fixed or other means are used to control it, the central bank has to

take steps of its own to neutralize the impact of one-way capital movements. In the balance of paymentsstatistics, these steps are reflected as changes in the foreign exchange reserves of central banks. Lack of

confidence in the central bank's ability to maintain the target rate may attract speculative capital movements

and a capital flight. Currency trading is often identified with capital movements, or at least viewed as an

element in them. This is a misconception. Though international capital movements usually generate currenc

transactions at some point, a largeproportion of all currency trading comprises the kind of transaction that

does not feature at all in the balance of payments statistics as a capital movement. However, since the large

volume of currency trading has been the focus of keen attention in the debate on the Tobin tax, we devote

some of the present report tocurrency trading. The most important actors in terms of capital movements are

companies engagedin international trade, institutional investors engaged in international investment, the

departments of banks responsible for corporate and foreign finance, the banks' currency dealers, multilateral

international financial institutions, central banks and governments resorting to foreign debt.

BELOW ARE THE FOLLOWING TYPES:

1.FDIForeign direct investment(FDI) is a direct investment into production or business in a country byan individual or company of another country, either by buying a company in the target country or

by expanding operations of an existing business in that country. Foreign direct investment is incontrast toportfolio investmentwhich is a passive investment in the securities of another countrysuch asstocksandbonds.

Foreign direct investment (FDI) has proved to be resilient during financial crises. For instance, inEast Asian countries, such investment was remarkably stable during the global financial crises of1997-98. In sharp contrast, other forms of private capital flowsportfolio equity and debt flows,and particularly short-term flowswere subject to large reversals during the same period. Theresilience of FDI during financial crises was also evident during the Mexican crisis of 1994-95 and

the Latin American debt crisis of the 1980s.

This resilience could lead many developing countries to favour FDI over other forms of capitalflows, furthering a trend that has been in evidence for many years (see Chart 1). Is the preferencefor FDI over other forms of private capital inflows justified? This article sheds some light on thisissue by reviewing recent theoretical and empirical work on its impact on developing countries'investment and growth.
http://en.wikipedia.org/wiki/Portfolio_investmenthttp://en.wikipedia.org/wiki/Portfolio_investmenthttp://en.wikipedia.org/wiki/Portfolio_investmenthttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Bond_(finance)http://en.wikipedia.org/wiki/Stockhttp://en.wikipedia.org/wiki/Portfolio_investment


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The case for free capital flows

Economists tend to favour the free flow of capital across national borders because it allows capitalto seek out the highest rate of return. Unrestricted capital flows may also offer several other

advantages, as noted by Feldstein (2000). First, international flows of capital reduce the risk facedby owners of capital by allowing them to diversify their lending and investment. Second, the globaintegration of capital markets can contribute to the spread of best practices in corporate governanceaccounting rules, and legal traditions. Third, the global mobility of capital limits the ability ofgovernments to pursue bad policies.

In addition to these advantages, which in principle apply to all kinds of private capital inflows, notethat the gains to host countries from FDI can take several other forms:

FDI allows the transfer of technologyparticularly in the form of new varieties of capitalinputsthat cannot be achieved through financial investments or trade in goods and services.

FDI can also promote competition in the domestic input market. Recipients of FDI often gain employee training in the course of operating the new

businesses, which contributes to human capital development in the host country. Profits generated by FDI contribute to corporate tax revenues in the host country.Of course, countries often choose to forgo some of this revenue when they cut corporate tax rates inan attempt to attract FDI from other locations. For instance, the sharp decline in corporate taxrevenues in some of the member countries of the Organization for Economic Cooperation andDevelopment (OECD) may be the result of such competition. In principle, therefore, FDI shouldcontribute to investment and growth in host countries through these various channels.


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2.PORTFOLIO INVESTMENTA portfolio investmentis apassive investmentinsecurities,which entails no active management

or control of the securities by theinvestor.A portfolio investment is an investment made by an

investor who is not particularly interested in involvement in themanagementof a company. The

purpose of the investment is solely financial gain.

It includes investment in an assortment or range of securities, or other types of investment vehicles,

to spread the risk of possible loss due to below-expectations performance of one or a few of them.

REASONS WHY PORTFOLIO INVESTMENT IS TAKING PLACE?

A. Profitable use of fundsB. DiversificationC. International portfolio diversification

3.Private and Government Capital:

Private capital movement means lending or borrowing from abroad by private individuals and

institutions. Private capital is generally guaranteed by the government or the central bank of the

borrowing country. Profit motive is the principal factor behind such investment.

On the other hand, government capital movements imply lending and borrowing between

governments. Such capital movements are under the direct control of government in fact

government are important international lenders they make stability loan, loan to finance exports

and imports and to finance particular projects

4. Home and foreign capital:Home capital is concerned with investments made abroad by residents of the country. Thus home

capital refers to the out flow of capital,

On the other hand, foreign capital implies investments made by foreigners in the country.Foreign capital is concerned with the inflow of capital.

5.Foreign Aid:It refers to public foreign capital on hard or soft terms, in cash or in kind and inter- governmentgrants. Foreign aid is tied or untied .aid may be tied by project and by commodities untied loan is a

general purpose aid and is known as non-project loan.
http://en.wikipedia.org/wiki/Passive_investmenthttp://en.wikipedia.org/wiki/Passive_investmenthttp://en.wikipedia.org/wiki/Passive_investmenthttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Corporate_managementhttp://en.wikipedia.org/wiki/Corporate_managementhttp://en.wikipedia.org/wiki/Corporate_managementhttp://en.wikipedia.org/wiki/Corporate_managementhttp://en.wikipedia.org/wiki/Investorhttp://en.wikipedia.org/wiki/Securitieshttp://en.wikipedia.org/wiki/Passive_investment


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6.EXTERNAL COMMERCIAL BORROWINGSAn external commercial borrowing(ECB) is an instrument used in India to facilitate the

access to foreign money by Indian corporations and PSUs (public sectorundertakings). ECBs

includecommercial bankloans, buyers' credit, suppliers' credit, securitised instruments such

asfloating ratenotes and fixed rate bonds etc., credit from officialexport credit agenciesand

commercial borrowings from the private sector window of multilateral financial

Institutionssuch asInternational Finance Corporation(Washington), ADB, AFIC, CDC, etc.

ECBs cannot be used for investment instock marketor speculation inreal estate.The DEA

(Department of Economic Affairs), Ministry of Finance,Government of Indiaalong

withReserve Bank of India,monitors and regulates ECB guidelines and policies. For

infrastructure and greenfield projects, funding up to 50% (through ECB) is allowed. In telecom

sector too, up to 50% funding through ECBs is allowed. Recently Government of India has

increased limits on RBI to up to $4[1]0 billions and allowed borrowings in Chinese currency

yuan.

Borrowers can use 25 per cent of the ECB to repay rupee debt and the remaining 75 per cent

should be used for new projects. A borrower can not refinance its existing rupee loan throughECB. The money raised through ECB is cheaper given near-zero interest rates in the US and

Europe, Indian companies can repay their existing expensive loans from that.

The ministry has not put any ceiling on individual companies for using renminbi as currency fo

ECB. Even though the overall limit for permitting it under ECB is only $1 billion, the officials

denied possibilities of a single company using the entire amount as it would come under

approval route.

The cost of borrowing in Renminbi is far less, said a finance ministry official. Companies go

for it as it is on easier terms. We are getting their (Chinas) money cheap.

The limit for automatic approval has also been increased from $100 million to $200 million for

the services sector (hospitals, tourism) and from $5 million to $10 million for non-governmentorganisations and microfinance institutions. The decisions will come into effect through a

notification by RBI.
http://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Export_Credit_Agencieshttp://en.wikipedia.org/wiki/Export_Credit_Agencieshttp://en.wikipedia.org/wiki/Export_Credit_Agencieshttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/International_Finance_Corporationhttp://en.wikipedia.org/wiki/International_Finance_Corporationhttp://en.wikipedia.org/wiki/International_Finance_Corporationhttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/Real_estatehttp://en.wikipedia.org/wiki/Real_estatehttp://en.wikipedia.org/wiki/Real_estatehttp://en.wikipedia.org/wiki/Government_of_Indiahttp://en.wikipedia.org/wiki/Government_of_Indiahttp://en.wikipedia.org/wiki/Government_of_Indiahttp://en.wikipedia.org/wiki/Reserve_Bank_of_Indiahttp://en.wikipedia.org/wiki/Reserve_Bank_of_Indiahttp://en.wikipedia.org/wiki/Reserve_Bank_of_Indiahttp://en.wikipedia.org/wiki/External_commercial_borrowing_(India)#cite_note-1http://en.wikipedia.org/wiki/External_commercial_borrowing_(India)#cite_note-1http://en.wikipedia.org/wiki/Reserve_Bank_of_Indiahttp://en.wikipedia.org/wiki/Government_of_Indiahttp://en.wikipedia.org/wiki/Real_estatehttp://en.wikipedia.org/wiki/Stock_markethttp://en.wikipedia.org/wiki/International_Finance_Corporationhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Financial_institutionhttp://en.wikipedia.org/wiki/Export_Credit_Agencieshttp://en.wikipedia.org/wiki/Floating_exchange_ratehttp://en.wikipedia.org/wiki/Commercial_bankhttp://en.wikipedia.org/wiki/Public_sector


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Factors affecting International capital Movements

1.Interest Rates:The most important factor which effect international capital

movement is the difference among current interest rates in variouscountries. Rate of interest shows rate of return over capital.

Capital flows from that country in which the interest rates are low tothose where interest rates are high because capital yields high returnthere.

2.

Speculation:

Speculation related to expecting variations in foreign exchange

rates or interest rates affect short capital movements. When

speculators feel that the domestic interest rates will increase in

future, they will invest in short- term foreign securities to earn

profit. This will lead out flow of capital.

On the other hand if possibility of fall of in domestic interest rates infuture, the foreign speculator investing securities at a low price at

present. This will lead to inflow of capital in the country.

3. Expectation of profits:A foreign investor always has the profit motives in his mind at the

time of making capital investment in the other country. Where the

possibility of earning profit is more, capital flows into that country.

4. Bank Rate:A stable bank rate of the central bank of the country also influences

capital movements because market interest rates depend on it.

If bank rate is low, there will be out flow of capital and vice versa


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5.Production Costs:Capital movements depends on production costs in other

countries. In countries where labor, raw materials, etc are cheap

and easily available, more private foreign capital flows there.The main reasons of huge capital investment in Korea, Singapore,

Hong Kong, Malaysia and other developing countries by MNCs is

low production cost there.

6.Economic Condition:The economic condition of a country, especially size of the market,

availability of infrastructure facilities like the means oftransportation and communication, power and other resources,

efficient labor, etc encourage the inflow of capital there.

7. Political Stability:Political stability, security of life and property, friendly relation with

other countries, etc. encourage the inflow of capital in the country.

8.Taxation Policy:The taxation policy of a country also affects the inflow or outflow of

capital. To encourage the inflow of capital, Soft taxation policy

should be followed, give tax relief to new industries and foreign

collaborations, etc.


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9.Foreign capital policy:The government policy relating to foreign capital affects capital

movementsprovision of different facilities relating

to transferring profits dividend, interest etc to foreign investors will attract foreign capita

similarly fiscal and monetary policy of a country also affect capital

inflow and outflow


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Structural policy reforms can maximize the long-term gains from international capital movements

in support of stronger, more balanced and sustainable growth. Structural policy, including financial

and product market regulation, have a large impact on net foreign capital positions. OECD analysis

for a large sample of mature and emerging-market economies shows that countries with more open

financial markets, better institutional quality and more competitive product and labour markets

appear to be more able to attract and absorb foreign and domestic capital flows and on balance

these countries have lower net foreign assets.

Structural policy can also minimize the short-term risks associated with capital flows. On the one

hand, improved structural policy settings are likely to increase the overall scale of capital flows,

which may heighten short-term risks. On the other hand, better structural policies (more

competition-friendly product market regulation, more adaptable labour markets, higher institutiona

quality and greater capital account openness) are associated with a composition of capital inflows -

principally more FDI and less debt -- which is more stable and less prone to risk. The net effect of

capital flows on short-term risks will depend on the particular form of structural reforms enacted,

but also on how they are buttressed by progress in financial reforms to strengthen the prudential an

macro-prudential framework in both emerging and advanced economies.

Macroeconomic policies, particularly exchange rate and fiscal policies, also have an important role

to play in reducing vulnerabilities associated with capital inflows. Exchange rate flexibilitymitigates some of the effect of large capital inflows on domestic credit. In addition, countries that

typically follow counter-cyclical fiscal policy have on average experienced more moderate credit

booms during large inflow episodes, and especially during debt inflows episodes. These are,

however, general findings and related policy recommendations have to take into account countries

individual conditions and institutional settings.


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What moved OECD countries to adopt the Code of

Capital Movement?In recognition of the benefits of international capital flows and the need to deal with the associated

risks in a cooperative manner (Box 1), OECD countries adopted the Code of Liberalisation of

Capital Movements in 1961.3 Countries agreed on a framework for cooperation on issues

concerning capital movements, which is reflected in the Codes disciplines and understanding

How have countries dealt with volatile capital flows

and episodes of instability in the context of the Code?While there may be efficiency gains from liberalisation of capital movements, there may also be a

role for capital flow measures to reduce attendant risks, in particular to deal with the higher

volatility of short-term capital flows. Furthermore, countries will face situations in which

extraordinary measures will be required.

The Code provides flexibility in two ways regarding commitments to openness. First, for short-term

and other sensitive operations (such as derivatives and foreign exchange transactions), the countrie

may reintroduce measures at any time. Secondly, countries may resort to derogation of obligations,

which is a time-bound suspension of the liberalisation commitments made to others.

Special treatment of shor t-term capital fl ows.

It was not until 1992 that OECD countries as a group decided that the Code should cover almost all

capital movements, including short-term capital operations. They made this decision in view of

financial innovations which blurred traditional distinctions between short-term and long-term

capital flows and the benefits for private and public actors to access wider sets of financial

products. The extension of obligations to cover short-term flows, derivatives and other sensitive

operations was approached in a prudent manner, acknowledging risks associated with these

operations. Adherents agreed to define short-term flows as those having a maturity of one year or

less. They also decided that stand-still should not apply to these operations and that they should

therefore be added to the Code under List B (Table 1). In addition, adherents decided that financial

credits by non-residents to individuals as opposed to corporate entities should not be covered by th

Code.


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This approach has provided flexibility in taking steps to deal with potentially destabilising short-

term flows. It has also provided a means for countries to experiment with fine tuning of measures o

lifting of restrictions, without having to make an irreversible commitment

Episodes of instabil ity and the derogation clause

The derogation is a time bound suspension of the liberalisation commitments of the country, which

allows it to introduce measures, unless there is consensus among adherents to disapprove them

(Box 5). The derogation clause has been used 28 times since 1961 (Table 2). On three occasions it

was used to request a general dispensation of the obligations on account of the countrys economic

development. Commitments under the Code serve an adhering country as a means to communicate

to its Code partners, and to market participants, that it is a co-operative member of the internationa

community and, as such, it refrains from a beggar-thy-neighbour approach. The arrangement

becomes all the more valuable at times of crisis, when authorities may have resort to emergency

measures, and may wish to reassure market participants that it does not intend to maintain controls

that are broader than necessary and that such controls will be removed when no longer needed. The

dialogue process has also helped support countries efforts to improve policy implementation by

learning from the experience of others.

Exper ience of adherents dur ing the 1990s with surges in capital in fl ows

The countries that joined the Code in the 1990s all came under pressure shortly after joining. The

Central and Eastern European members came under pressure at the time of the Russian crisis and

both Korea and Mexico were prey to banking and currency crises. All of the new adherents had

gone through a period of rapid financial innovation, increased capital mobility and integration to

global financial markets. The crisis-struck countries did not resort to suspension (derogation) of

their obligations under the Code, as the older members had when faced by crisis in the 1970s and

1980s. Countries may have shunned the re-introduction of restrictions in view of the potential cost

of a further loss of market confidence (including by domestic investors). The response of recent

members was generally to maintain previous commitments to openness, however in several

countries adjustments in regulations followed. Poland, faced with speculative pressures on the

zloty, postponed the liberalisation measures for short-term operations that it had planned and


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announced to its partners at the time of adherence to the Code. Korea issued a new Foreign

Exchange Transaction Act in the wake of the crisis which simplified regulations and eliminated

restrictions on some short-term flows, while introducing new requirements for qualification for

non-bank borrowers to raise short-term funds abroad. These changes in legislation led to

adjustments in Koreas reservations under List.

Persistence of Capital FlowsA complementary measure of the stability of capital flows is their degree of persistence over time.

Cold flows that are perceived to be relatively stable shouldalso display evidence of strong

positive correlation with their own past values. To assess persistence we calculate autocorrelation

coefficients for each flow in each country over the sample. The data are quarterly ratios of flows to

GDP and the correlations are calculated for 16 lags (Figures 3 and 4). Total capital flows are found

to exhibit a high degree of persistence in most industrialised economies. The autocorrelation

coefficients are typically large, positive, and gradually decay as the lags increase. This suggests tha

there is a high degree of persistence in the overall capital account for at least one to two years.7

The capital account in emerging economies is typically less autocorrelated and only two of the

emerging economies examined have autocorrelation coefficients of greater than two-thirds for four

or more lags, compared to five out of the six industrialised economies. The autocorrelation

coefficients for the components of the capital account suggest that these flows generally displaylittle if any persistence for industrialised economies. The coefficients are small and change sign

frequently. There are, however, a number of notable exceptions. For the United States we find that

portfolio debt flows are highly persistent. This is not surprising given that the United States is hom

to the largest debt markets and the US dollar is the worldsmain reserve currency. Japanese foreign

direct investment flows are also shown to be highly persistent. This may reflect the structural

hollowing out of Japanesemanufacturing as Japanese companies undertook direct investment to

set up plants in other Asian countries where labour costs were lower. Other than these exceptions,

there is no evidence among industrialised economies to support the view that some types of capital

flow are inherently more persistent than others. Foreign direct investment is typically not as

persistent as might have been expected and can hardly be distinguished from the bank and money

market or portfolio flows, which are often thought of as being relatively temporary. The evidence i

somewhat different for emerging economies. Foreign direct investment flows are relatively


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persistent for a number of these economies. This can probably be attributed to emerging economies

being natural destinations for such investments, with inflows typically dominating this category.8

There are also several other examples of persistence for some components of the capital account,

but there are no consistent patterns across emerging economies.

Interactions Between Flows

The results in the preceding Sections suggest that the co-movement of different types of capital

flows seems to be central to understanding the overall variability of the capital account. To provide

a more comprehensive view of the data and how the flows interact we estimate cross-correlation

coefficients for all capital flows. Importantly, we distinguish between how different types of flows

are correlated within eachcountrys capital account and with the flows of other countries. The

quarterly data are summed to annual totals (and expressed as a ratio to GDP) for this purpose,

thereby shifting focus away from high-frequency changes in the flows.

Its importances

International trade and capital movements go together. Merely the financial transactions involved i

foreign trade and managing the risks involved generate a huge volume of capital movements,

accompanied by a large volume of currency trading. The balance between saving and investment

varies in different countries, and this is reflected in their current account surpluses/deficits.

Financing deficits and investing surpluses always imply international capital movements between

countries. If it were not possible to finance deficits with capital movements, countries would have

to adjust to, say, a drop in export demand or an increase in import prices, by reducing domestic

demand. Capital movements have had, and will continue to have, an important role in the

development strategy of developing countries. In principle, capital should flow from rich countries

with an ageing population, like the EU states and Japan, to poorer countries with a younger age

structure. The argument for this is that economic growth should be faster in poor countries than in

rich countries: the former can then use investments to adopt existing technologies and thus increase

their productivity and catch up with the living standards of richer countries. The growth potential o

poor countries is also greater because their labour supply is expanding as a result of their rising

populations. This is in sharp contrast to many rich countries, where populations are unlikely to rise

without an influx of immigrants, and labour supply is declining as a result of ageing.


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Capital should thus flow from rich to poor countries specifically because the latter have the faster

growth potential. In practice, however, this is not always the case. In many developing countries

and transition economies, growth is hampered not only by the low level of domestic saving but also

by the fact that their external financing is largely restricted to development aid and to loans granted

by multilateral international financial institutions. As they receive no direct investment and the

countries find it practically impossible to get financing on the international capital market, their

investments remain small, however productive they may be, and per capita GDP rises hardly at all.

From this point of view, there is too little capital movement in the world, rather than too much.

Investments find targets in the same way, whether within a single country or globally. They tend to

be directed to targets which promise high expected return with a risk that is moderate or at least

manageable. The investor's choice is influenced not only by the expected return and the risk but

also by the investment's liquidity, that is, how reliably and cheaply it can be withdrawn and

converted into cash.

The possibility of investing outside the home country provides a better opportunity for risk

diversification, as the number of potential targets is many times greater than the number of

domestic targets. Though investment beyond national borders and international diversification are

becoming more common, both private and institutional investors continue to invest a large

proportion of their portfolio in domestic equities and other domestic assets. This proportion is still

far larger than what might be considered optimal in terms of the expected return and the related

risk. There may be many reasons for favouring domestic investments, such as asymmetric

information. However, as these reasons become less important the significance of capital

movements can be expected to grow still further. Capital movements are also important in terms of

the pricing of capital and international risks. On a well-functioning market, future expectations

affect the price that investors are ready to pay. This is true of all forms of investment, but

is most apparent in securities. In a purely financial sense, the price paid for a security reflects the

cash return that the holder can expect to enjoy in the future. In other words, the price paid for the

financial instrument depends on investor expectations concerning its return. Direct investments and

portfolio investments have been shown to have substantial positive spillover effects. They are the

vehicles not only for financial and productive capital but also for technological and managerial

know-how. This kind of capital is not reflected in balance of payment statistics, but its importance

for longer-range economic growth may be crucial.


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Capital movements may also spur the growth of domestic financial markets in a way that promotes

domestic saving and mobilises these savings to finance domestic productive investment, thus

reducing the need for foreign financing. It is not unusual that the scant savings of citizens in

developing countries are invested in gold and precious stones or is otherwise hoarded. The impact

of capital movements on the efficiency of economic activity and on development as a whole cannot

be disputed. However, this does not mean an absence of problems. Capital movements and their

growing volume are claimed to give rise to the following problems:

- independence of economic policy declines as countries become increasingly dependent on each

other as a result of growing foreign trade, capital movements and cross-border ownership

- tax competition increases in corporate and capital taxation, which may lead to a deterioration in

the tax base

- changes in interest rates, exchange rates and other asset prices get transferred from one country t

another

- countries fall victim to financial and currency crises, and proliferation of such crises from one

country to another is facilitated.

Though instability is a genuine cause for concern, the arguments outlined above are not necessarily

valid. It is in fact difficult to demonstrate that it is specifically capital movements that cause these

problems. If private capital movements are not the cause, restricting them would not eliminate the

problems, either. In many cases though, capital movements do transmit, and sometimes even

aggravate these problems. That is why a careful analysis of the actual role of capital movements is

warranted, and capital controls should not be excluded entirely as a possible remedy in certain

situations. However, while capital movements may aggravate problems in particular circumstances

this has to be weighed against the benefits gained from free movements of capital. When assessing

tax competition, for instance, one should compare the effects of closing off the economy against th

alternative offered by free trade, free capital movements, and tax competition. A less costly solutio

to the problems of tax competition, for instance, is likely to be found in international coordination

rather than in restrictions on capital movements.


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SCALE OF CAPITAL MOVEMENTSCapital movements proper

In 2000, the total value of global trade in goods and services was around USD 7,500 billion. This is less than

the annual GDP of the USA or the EU. If we add to global trade in goods and services cross-border

payments of interest, dividend and income transfers, the total comes to around USD 8,000 billion. These

transactions are recorded as transactions on the current account. Compared with their total sum, the official

development aid of the OECD countries, for instance, looks small at something over USD 50 billion (1998)

Because various payment periods are granted in foreign trade and this is financed in different ways, most

current account transactions also involve capital movements. There is also a considerable volume of cross-

border financial transactions, which are not connected with current account transactions in any way.

Long-term capital movements are usually defined following the gross/net principle. For instance, a change i

foreign debt means a net increase, i.e. new debt less amortizations. In portfolio and other short-term

investments, the change in outstanding receivables (or liabilities) over a given periodfor instance a year -

is recorded as a capital movement. Viewed gross, the actual volume of capital movements is far larger,

because over a year short-term debt may be withdrawn and paid back many times over when credit is

renewed, or portfolio securities be bought and sold across borders several times. Though there are no

statistics on gross capital movements, we can assume that the sum is many times the volume of current

account transactions. Compared with the annual gross volume of currency trading, however, the volume of

capital movements is small.

If we only want to consider how much capital movement (gross/net) there is, for instance, between countrie

and how much and what kinds of net capital flow from developed to developing economies, it is not in fact

necessary to define the gross volume of capital movements. Table 1 shows the quantities of capital

movements defined in this way. No distinction is made between public and private capital movements.

Volume of currency trading

The Bank for International Settlements (BIS) has been compiling data on the volume of currency trading

since 1989. The data are collected at three-year intervals (1989, 1992, 1995 and 1998) by asking the banks

for detailed reports on their currency trading during the month of April. Information is gathered on the

trading parties, the currencies traded, and the types of currency transaction (spots, futures and currency

swaps). More recently, the scope of the survey has been extended to include OTC trading in currency and

interest rate derivatives. Newer data are also available on the volume of trading in currency derivatives.


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These, too, are compiled by the BIS, which publishes them in its Quarterly According to the most recent BI

calculation, the daily volume of conventional currency trading in April 1998 was USD 1,500 billion.

Currency trading mainly takes place in and betw.een financial centres in the developed countries. The

biggest centre is London, followed by New York, Tokyo, Singapore, Frankfurt, Zurich, Hong Kong and

Paris. At all these centres, the most important trading currency is the US dollar, which is involved in over Nprecise information is yet available on how introduction of the euro has affected volumes of currency tradin

because the next BIS survey will not be made until April 2001. Gross volumes will probably have declined

somewhat, because there is no longer any wholesale currency trading between the countries in the euro area

Consequently, use of the dollar in currency trading will have decreased, because there is less need for it as a

vehicle currency. In other respects, however, there are unlikely to have been any major changes in the

structure of currency trading. London's standing as the biggest centre has not suffered despite introduction o

the euro.

PRICE UNCERTAINTY AND CRISES

In speaking of instability of capital movements, a distinction needs to be made between price instability and

different types of crisis. Both are appealed to when capital controls are proposed. Price instability may mean

either normal price volatility on financial markets or that prices are viewed as diverging too far from the

long-run equilibria dictated by the fundamentals (misalignment). A crisis, on the other hand, is by definition

an exceptional situation. In a currency crisis, a currency becomes the target of speculative attack. This

situation affects currencies where the exchange rate is regulated or whose value is tied to some other

currency. A banking and financial crisis arises either because the banks have underestimated the credit risk

of the loans they have granted or because refinancing of the loans is threatened. A debt crisis arises when a

country's creditworthiness is over-rated and its foreign debts have risen to a level at which its income from

abroad is insufficient to service the debt.

Price uncertaintyPrice uncertainty is an inevitable element in the functioning of financial markets. Because market prices are

based on future expectations, new information about the return on investments and the related risks is

immediately reflected in prices. This is completely irrespective of whether the investments are foreign, i.e.

capital movements, or domestic. In foreign investments, there are more sources of price variation, because

factors specific to the country concerned affect expectations of the returns, in addition to factors specific to

individual companies and sectors. If, for instance, the current prices of equities in the target country of a


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foreign portfolio investment are based on market expectations of an annual economic growth rate of 7 per

cent, a change in growth prospects to a mere 3-4 per cent for a few years would reduce share values by

several dozen percent. The expected growth rate that affects the share prices of companies operating in a

given country also affects the market prices of debt instruments issued by the government of that country

and companies operating there. A slower than expected growth rate increases the probability that a countrywill get into payment difficulties and that its debt instruments will prove, at worst, worthless pieces of paper

or that financiers have to write up loan losses. When this probability increases, the price of a debt instrumen

falls. Capital movements add two new dimensions to price uncertainty. These are the exchange rate volatilit

and simultaneous fluctuations in asset prices across countries, equity prices in particular. These latter are a

direct consequence of increasingly internationalised nature of investment and business. Prices fluctuate at th

same time and in the same way in various countries, largely because the same information - say, about the

changing prospects in a particular sector affects investor decisions in the same way all over the world. To

generate price impacts, it is then not necessary to have capital movements or currency transactions at all; it i

enough for the same information to spread internationally. Cross-border price impacts may also be the

consequence of investors being forced to sell their investments in certain countries because they need

liquidity after suffering capital losses as a result of a crisis in another country.

The growing volume of capital movements and currency trading is often linked with exchange rate

instability. It is a fairly common view that it is the increase in international capital movements that causes

exchange rate volatility. This does not seem to be the case, however. Volatility rose appreciably when the

Bretton Woods system based on fixed exchange rates collapsed in the early 1970s. Thereafter, the volume o

capital movements has risen many times over both in absolute terms and in relation to global GDP, yet the

volatility between the main currencies has remained more or less stable. For instance, the standard deviation

in the monthly percentage change in the exchange rate between the US dollar and the German mark, say, an

between the dollar and the yen, has remained at 2-3 per cent for thirty years now (Table 6). Measured by thi

standard deviation, exchange rate volatility is only about half that of equity prices, measured using a

broad share index. Naturally, the volatility of individual equity prices can be many times this. The volatility

of exchange rates has very little, if anything, to do with a large volume of currency trading. This is a sign of

a highly liquid market, which tends to even out short-term variations in prices. Deep, liquid markets allow

for very large individual transactions to take place without these having any effect on the exchange rate. In

fact, exchange rate fluctuations largely derive from the constant flow of new information about the economi

fundamentals affecting the rates, which has an immediate impact on prices. When uncertainty about the

factors influencing exchange rates grows substantially, short-term volatility increases. At the same time, the

volume of currency trading may actually decrease because the spread between the bid and the ask rate

widens and market liquidity declines. It is argued that, amid floating rates, excessive exchange rate volatility


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is caused by the actions of the parties actually operating on the market, especially currency dealers. These

form expectations of short-term future trends in exchange rates based on recent events, but do not take

account of the long-term fundamentals affecting the rates. One advocate of this view is James Tobin.

However, it should be pointed out that speculation comes in two types: attempts to exploit a perceived price

trend irrespective of its cause, and attempts to exploit the fact that the price (exchange rate) diverges fromthe value dictated by the fundamentals. The only kind of speculation that has a destabilising effect is the

kind that is indifferent to the cause of the price trend. By contrast, the latter type of speculation in fact

promotes stability because it helps the price to remain somewhere close to its fundamental value. Though it

is not difficult to find examples of the short-sighted speculation just mentioned, there is no clear evidence o

this being a dominant feature of the currency market or its significance being greater than the impact of new

information on economic fundamentals.

The situation is somewhat different if we look at longer-term fluctuations in exchange rates. Examples can

be found in the history of floating exchange rates in which the prices of major countries' currencies have

over the longer term moved in a direction that cannot readily be explained by fundamentals such as

inflation rate differentials or differences in current account deficits. The bestknown case is the sharp

strengthening of the dollar against the German mark and other ERM currencies in 1982/85. The present

situation between the dollar and the euro is somewhat similar, though less pronounced. In both cases,

however, it is impossible to present any evidence to show that the longer-term strengthening

of the dollar rate could be traced back to short-term speculative capital movements or some kind of herding

behaviour. A fixed exchange rate regime, i.e. tying the exchange rate to some other currency or currency

basket, reduces exchange rate uncertainty, provided that the system remains credible. If its credibility is

threatened, however, price uncertainty appears in the form of higher interest rates and greater interest rate

volatility. For a number of reasons such a country may become vulnerable to a currency crisis.

Currency crisesIn a currency crisis, a country's currency comes under speculative attack. If the attack succeeds, the currency

has to be devalued or it weakens sharply as a result of floating. Even if the attack is not successful, the

exchange rate in any case has to be supported. As a result, interest rates rise dramatically or the currency

reserves shrink rapidly, making the currency more vulnerable to future attacks. In the light of the experience

of the past few decades, there seem to be several different types of reasons for currency crises. In response t

this experience, new types of models have been developed in the literature in order to sharpen the tools of

the analysis of crises. A standard explanation suiting many situations is that the economic fundamentals and

the desire to maintain a fixed exchange rate come into conflict. From the viewpoint of the currency market,


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the most important fundamentals are inflation differentials, the current account deficit and the amount of

foreign debt, including the government debt, and expectations of future trends in all these factors. As

economic policy affects them all, the ultimate issue is how compatible it is with the exchange rate regime.

Fiscal policy relying on budget deficits, an inflation rate faster than in other countries and a consequent

current account deficit may eventually lead to a currency crisis.

A large current account deficit makes a country susceptible to currency crisis because it is dependent on

foreign investors, whether companies making direct investments, portfolio investors or banks granting loans

For some time, a country can finance its deficit out of its foreign exchange reserves, but this is

limited if capital imports dry up. When there begin to be expectations that the reserves will be insufficient to

defend the currency, holding onto a fixed exchange rate creates the temptation to venture a one-way bet on

devaluation. This, in turn, provokes a speculative attack. A large number of past currency crises can be

understood using the above firstgeneration currency crisis explanation. This also applies to the occasional

crises during the Bretton Woods system, despite the fact that capital movements were regulated in the

countries hit by the crises. The reason for these crises was that the monetary policy independence conferred

by regulation of capital movements was over-exploited, resulting in faster inflation than elsewhere and a

current account deficit. A similar model explains most of the currency crises in Latin American countries,

where the ultimate cause was usually government inability or unwillingness to keep the public debt under

control. However, not all past currency crises can be explained solely by the weakness of fundamentals. For

instance, many ERM currencies suffered speculative attacks in the early 1990s, though in most cases the

indicators - such as the budget deficits, inflation rates and current accounts - were not in themselves

alarming. Indeed, second-generation explanations of currency crises focus on the fact that expectations of

devaluation may be self-fulfilling. If there is a belief that a country is ready to abandon its fixed exchange

rate - for instance, during the onset of recession - this expectation raises its interest rates. If the rise comes

during the recession itself, the situation can only deteriorate, and the country often devalues or abandons its

fixed exchange rate - just as it was expected to do. Once again, economic policy plays a key role. If there

begin to appear expectations that the high interest rates needed to defend the currency will increase

unemployment or raise interest costs on the government debt to a level that the country concerned finds

unacceptable, the situation is ripe for a speculative attack. This is the case even if the macro-economic

fundamentals resulting from the country's earlier economic policy - its budget and current account deficits

and inflation rate - seem at first sight to be in good shape. Though these first and second-generation

explanations underline different factors in the emergence of a crisis, they are not mutually exclusive, but

rather complementary. For instance, the Italian lira came under attack in 1992, and the action taken to defen

it failed. The inflation rate was higher than elsewhere and the government debt was, but in addition the


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government debt was short-term. Defending the currency with very high shortterm interest rates would have

weakened the financial standing of the public sector still further and raised doubts about the government's

solvency Speculative attacks were made on the Finnish markka in 1991-1992, partly because of the country

poor competitiveness but possibly also because the defence would have come costly as the banking industr

was known to be rather weak and the private sector heavily in debt (second-generation explanation). TheFrench franc came under attack in 1992 and 1993, because it was believed that more unemployment

as a result of higher interest rates would not be politically acceptable. In 1992 the attack was rebuffed and

the next year France (and other ERM countries) responded to a fresh attack by substantially widening its

fluctuation range. In France's case, the exchange rate and interest rates soon returned to normal, showing tha

the attack could not be explained by fundamentals.

Financial and banking crises

One basic source of instability stems from the fact that the operation financial markets is fundamentallybased on confidence. No lender can be completely sure that a debtor will be able to repay his debt. Similarly

no depositor can be sure that the bank will meet its commitments under all circumstances. Typically, bank

funding is short-term compared with its lending, so if confidence falters, a run on deposits or some other

problem with refinancing loans can set off a banking and financial crisis. The price mechanism on the credit

market - that is, the prices set on risksdoes not always work properly because lenders do not know enough

about borrowers and about the risk potential of the projects being financed. The factors hampering the

operation of the price mechanism include any implicit or explicit guarantees given by government that it wi

come to the rescue of the banks or certain debtor groupings.

The importance of these factors grows particularly just after financial market regulation has ended. Amid

fast-changing circumstances, the new competitive situation and new forms of operation may lead the banks

to take distorted lending and investment decisions and tempt them into heavy risk-taking. This, in turn, give

rise to large balance sheet positions representing both high return and high risk. Government guarantees

offer protection that may also encourage excessive risk-taking, because it reduces the losses of depositors

and investors if a crisis breaks out. Sometimes merely a decline in general economic conditions can prompt

lack of confidence that sets off a crisis. A financial and banking crisis may have serious effects on the real

economy. If a bank's short-term funding dries up, it cannot grant new loans and may have to call in old ones

Investment projects are suspended and even perfectly sound businesses get into difficulties because they

cannot get working capital. The value of collateral falls, aggravating the situation still further. A run on

deposits caused by lack of confidence in a single bank may infect other banks, threatening the whole

financial system with collapse. In a closed economy, the seriousness of this collapse could be alleviated by


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increasing central bank funding of the banks and by accepting a higher level of inflation. In a small open

economy, this method can also be used if thebanks short-term funding is in foreign currencies. Faster

inflation and lack of confidence may cut heavily at the exchange rate if it is floating. If it is fixed, by

contrast, faster inflation and loss of price competitiveness result in a currency crisis. This, in turn, may cause

the banks' foreign financing to dry up, setting off a financial and banking crisis. A weaker currency impliesthat the internal value of loans denominated in foreign currencies rises sharply. As a result, the liquidity of

customers who were originally in perfectly sound financial shape may suffer. Mechanisms like these were a

work particularly clearly in the crisis Finland went through in the early 1990s and in the crises in Southeast

Asian countries towards the end of the decade. The ultimate source of financial and banking crises lies in th

behaviour of financial institutions, which in turn depends partly on how effectively they are supervised. Any

deficiencies in the supervision of financial institutions often surface when conditions on financial markets

change dramatically, for instance when regulation is dismantled and controls are partly lifted.

The debt crisis in developing countriesMany developing countries found themselves in a debt crisis in the early 1980s, and several still are. The

main cause of these debt problems is that the availability of credit became very easy in mid-1970s.

International banks and financial institutions actively offered developing countries credit at the same

time as they were recycling the oil-exporting countries' huge surpluses to the world economy. As a result, by

hindsight, many developing countries became heavily over-indebted. This is a risky situation, because a rise

in interest rates may make the level of indebtedness unsustainable, i.e. the country has difficulties to pay the

interest on its loans, not to speak about the repayments. When financial markets tightened in the early 1980s

interest rates and the dollar both rose, pushing several heavily indebted countries into an unsustainable

position and eventually into debt crisis. As the debt of developing countries is usually in foreign currencies

and their own currencies are weak as a result of the crisis, they naturally experience great difficulties in

coping with their foreign debt. Such debt crisis is often accompanied by numerous defects in the financial

system and other structural problems in the economy. Because of their high debt-servicing costs, the

economies have no resources for correcting these problems. It is very difficult to break free from the

resulting debt overhang.


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The role of capital movements in crises

Obviously enough, capital movements play a key role in creating currency crises and related financial and

banking crises, and during and after them. This does not imply that capital movements are the sole cause of

such crises, however. One must go below the surface and analyse which factors have affected capital

movements and sudden changes in them. In the following, we examine separately capital imports, capital

exports and speculative behaviour patterns during crises. A substantial import of short-term capital makes a

country more vulnerable and a crisis more likely in two senses. First, the country's liquidity is endangered

when its short-term foreign debt rises relative to its short-term foreign receivables, which in practice usually

means the foreign exchange reserves of the central bank. A decline in short-term foreign financing may then

lead to liquidity problems, even if the country is not overindebted or insolvent. Second, more imports of

short-term capital increase the probability of financial and banking crises if the banks have financed their

long-term domestic loans to relatively risky projects with short-term foreign debt. There is an exchange rate

risk attached to this, as well as the financial risk to the banks caused by the maturity discrepancy between th

foreign funding and their domestic lending. Typically, the banks' foreign funding is in foreign currencies an

the domestic loans financed using it are also denominated in foreign currencies. The exchange rate risk is

thus shifted to customers, but at the same time the banks risk more loan losses. There is every reason to ask

why capital is imported at all, and why it is short term. First, capital imports are needed to finance the

current account deficit, which in turn is the result of the fact that the government or the private-sector is

willing to incur debt. If the borrower's creditworthiness is already low, it finds it difficult to get long-term

financing, and has to resort to short-term foreign lending. Protection of domestic firms from foreignownership may signal that direct and portfolio investments by foreigners are considered undesirable.

Financing the current account deficit then implies that other kinds of capital imports, such as more short-

term foreign debt, have to be accepted. Second, the lower nominal interest rates abroad may make foreign

financing to appear attractive. The reason for higher interest rates at home is typically the economic policy

that is not consistent with the exchange rate target. If a bank's customers do not take the exchange rate risk

properly into account, a low interest loan denominated in a foreign currency may then seem more tempting

than a domestic loan. The customers then misjudge the exchange rate risk and banks their customers' credit

risk. A similar possibility may arise because of the credit supply, i.e. how the banks and financial institution

behave. Competition between the financial institutions may induce them to accept rather large and risky

credit positions relying on foreign refinancing. If circumstances turn against them, the situation of those

offering the credit may come to be a problem for the whole economy. The role of the banks in the OECD

countries in granting refinancing should not be forgotten, either. The short-term claims of an individual ban

on a country may well be small compared with the bank's total assets, making the risk also small. The


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vulnerability of the recipient country grows, however, if several banks actively market loans to it at the sam

time. The banks in the OECD countries have also been known to display this kind of herd behavior.

Such misjudgments based on incomplete information are commonplace and also understandable when

financial markets are in a state of rapid change. Periods of instability often follow a stage at which capital

movements are deregulated but the exchange rates fixed or tied to a fluctuation range. Deregulation ofcapital movements has often led to excessive capital imports. This means that much more capital is imported

than would have been the case had the lenders realized what kind of imbalance the economy was heading

for. As a result of the capital imports - whether short or long term - the monetary conditions are eased,

speeding domestic inflation and inflating asset prices. Faster inflation implies a real appreciation of the

currency and loss of competitiveness, eventually making a fixed exchange rate unsustainable. A floating rat

would have reacted to the capital imports with a nominal appreciation, implying a tightening of monetary

conditions. Monetary policy could also have been tightened if necessary. While heavy capital imports are

seen as a phenomenon connected with crises, capital exports are nearly always an element in an acute crisis

A sudden turnabout in the direction of capital movements triggers the crisis. A typical situation is one in

which foreign banks refuse to renew their interbank deposits, shutting off the national banks' refinancing.

This decision is taken because the foreign banks' view of the risks attached to the country or its banking

system has changed. This is not currency speculation, i.e. a search for profit through expectations of

devaluation, as long as the foreign banks have not themselves taken any exchange rate risks. Thus merely a

change in risk assessment may spark off a crisis. Around the same time that the banks start to limit their

short-term lending, other actors probably start behaving differently, because they have access to the same

information. As expectations of devaluation grow, the various actors try to hedge against exchange rate risk

by reducing their liabilities in foreign currencies while at the same time increasing their foreign assets,

implying more capital exports. It is entirely a matter of taste whether one calls this hedging or speculation.

Hedging leads to capital exports irrespective of whether the action taken affects short or long-term

receivables and liabilities. It also changes the prices and interest rates of securities, as well as capital flows.

Most crises are a matter of large, one-way changes in exchange rates, which without exception means

devaluation or a substantial weakening of the currency after a decision is made to float it. Expectation of

such a situation creates good ground for destabilising speculation and speculative attacks. A large volume o

very short-term capital movements is involved in speculative action in a crisis. Unlike the cases described

earlier, this is not prompted by a decline in refinancing or a reallocation of portfolios.


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CONTROLLING CAPITAL MOVEMENTSArguments for capital controls

In earlier decades capital movements were extensively regulated by administrative means in most countries

The most frequently mentioned justification for capital controls was the need to safeguard the country's

external liquidity. Simultaneously the domestic financial markets were regulated on a considerable scale.

Interest rates were controlled, and the amount of bank lending was often restricted and its allocation

controlled. Regulation of capital flows and domestic financial markets made monetary policy efficient, at

least in principle. Because price mechanism was not allowed to work, the liquidity of the domestic economy

could be controlled by simultaneously regulating bank lending and net capital imports. However, the room

for maneuver of monetary policy was not used primarily for counter-cyclical ends or to ensure price

stability. Very often it had to be adapted to meet the demands of the country's external balance. For this

reason, monetary policy often had to be tightened at the same time as monetary conditions were otherwise

tightening because of external imbalance. Even comprehensive regulation failed to protect countries against

balance of payment problems and against occasional currency crises. The difficulties encountered by the

European Exchange Rate Mechanism, in the early 1990s, and the force of the crises suffered by South-East

Asian countries at the end of the same decade prompted extensive debate about capital controls. The idea pu

forward was that such crises could be averted by limiting capital movements. Restrictions have also been

defended by more conventional arguments, such as monetary policy independence and the need to limit

exchange rate volatility. In addition, restricting capital movements by the introduction of a tax on currency

transactions has been proposed as means to generate funds that could be used to finance the solution of

global problems, such as poverty or climate change. No one has proposed a return to the comprehensiveregulation of earlier decades, however. Various objectives are thus offered to justify the restriction of capita

movements, but they prompt many questions. What kind of controls would best suit each objective? Is it

possible, even in principle, to find ways of regulating capital movements that would promote attainment of

all the objectives at the same time? Would the proposed controls be at all effective in achieving the

objectives? Could the objectives be attained better other means than by resorting to restrictions on capital

movements? It is clear that, as far as the importance of capital movements and the attendant risks are

concerned, one and the same country can be in totally different situations at various times. Generally

countries are in very different positions. For instance, measures taken to prevent excessive capital imports

are totally unsuited to a situation in which capital flows change direction. This kind of change can take plac

even if the country is not sliding into crisis. Similarly, though restraining excessive capital imports might be

a justifiable goal in one country, it does not follow that similar restrictive measures should be adopted

everywhere. What is more, there are other ways to restrain excessive capital imports, such as allowing the

currency to strengthen or limiting bank risk-taking in the intermediation of loans denominated in foreign


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currencies. Justifying capital controls by the need to safeguard the room for manouevre of national monetary

policy only applies to countries that have chosen a fixed (though adjustable) exchange rate or some other

exchange rate regime based on pegging or on a target zone. With free movement of capital, the paradox of

such a system lies in the fact that if the exchange rate is credibly fixed, independent national monetary polic

is a dead letter. If, on the other hand, credibility is low, monetary policy tends to have to funct

economics project mcom i 670

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