This document is a project report submitted by a student to the University of Mumbai on international capital movement. It includes a declaration by the student, acknowledgements, a table of contents, and sections covering objectives, research methodology, and various topics related to international capital movement such as meaning, types, factors affecting, role, importance, trends, and policies. The report provides an overview of concepts and issues related to the flow of capital across international borders.

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UNIVERSITY OF MUMBAI
PROJECT REPORT ON
BUSINESS ECONOMICS
INTERNATIONAL CAPITAL MOVEMENT
BY
Mr. OJAS NITIN NARSALE
M.COM (Part-I) (SEM-II) (Roll No.40)
ACADEMIC YEAR 2015-2016
PROJECT GUIDE
PROF. R.A.JOSHI
PARLE TILAK VIDYALAYA ASSOCIATION’S
M.L. DAHANUKAR COLLEGE OF COMMERCE
DIXIT ROAD, VILE PARLE (E)
MUMBAI- 400057

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DECLERATION
I, Mr. OJAS NITIN NARSALE of PARLE TILAK VIDYALAYA
ASSOCIATION’S M.L. DAHANUKAR COLLEGE OF COMMERCE
of M.COM (Part-I) (SEM-II) (Roll No.40) hereby declare that I have
completed this project on INTERNATIONAL CAPITAL MOVEMENT
in the ACADEMIC YEAR 2015-2016. This information submitted is
true and original to the best of my knowledge.
(Signature of Student)

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ACKNOWLEDGEMENT
To list who all helped me is difficult because they are so numerous and
the depth is so enormous.
I would like to acknowledge the following as being idealistic channels
and fresh dimensions in the completion of this project.
I would firstly thank the University of Mumbai for giving me chance to
do this project.
I would like to thank my Principal, Dr. Madhavi Pethe for providing
the necessary facilities required for completion of this project.
I even will like to thank our co-coordinator, for the moral support that I
received.
I would like to thank our College Library, for providing various books
and magazines related to my project.
Finally I proudly thank my Parents and Friends for their support
throughout the Project.

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Table of Contents
Sr. No. Topic Page No.
1. Objectives of Study and Research Methodology 5
2. Introduction 6
3. Meaning of Capital Flows 8
4. Types and Sources of International Capital
Movements
9
5. Factors affecting International Capital Movements 13
6. Role of International Capital Movements 15
7. Importance of Capital Movements 17
8. Trends in International Capital Flows 22
9. International Finance 26
10. Exchange Rate and Capital Mobility 27
11. Policies and Institutions 28
12. International Financial Stability 30
13. Migration 31
14. Globalization 33
15. Current Regulations to Manage Capital Flows in
India
36
16. Future of International Capital Movement 37
17. Conclusion 39
18. Bibliography 40

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Objectives of Study
The objective of this study is to understand the concept of capital movements across
borders and study its impact on the economic and financial stability of both the economies.
Reasons for capital flight have been discussed in detail and also the urgency of controlling
capital movements. Trends in capital movements have been discussed about.
Research Methodology
The data contained in this study has been collected from various sources that have been
duly recognized at the end of the study. The information is secondary information collected from
websites and a magazine.

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Introduction
International capital movements have played an important role in the economic
development of several countries. They provide an outlet for savings for the leading countries
which help to smoothen out business cycles and lead to more stable pattern of economic growth.
On other hand, they help to finance development of under-developed countries. They also help to
ease the balance of payments problems of developing economies. Thus, international capital
movements have an important role to play in the balance of payments mechanism.
As compared to developed countries of the world, the developing countries suffer from
scarcity of capital and poor technology. Therefore, they rely on International capital flows to
finance their investment opportunities and hence, to raise income and employment.
The term International capital movement refers to borrowing and lending between
countries. These capital movements are recorded in the capital account of the balance of
payments. International capital flows have increased dramatically since the 1980s. During the
1990s gross capital flows between industrial countries rose by 300 per cent, while trade flows
increased by 63 percent and real GDP by a comparatively modest 26 percent. Much of the
increase in capital flows is due to trade in equity and debt markets, with the result that the
international pattern of asset ownership looks very different today than it did a decade ago.

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These developments are often attributed to the increased integration of world financial
markets. Easier access to foreign financial markets, so the story goes, has led to the changing
pattern of asset ownership as investors have sought to realize the benefits from international
diversification. It is much less clear how the growth in the size and volatility of capital flows fits
into this story. If the benefits of diversification were well-known, the integration of debt and
equity markets should have been accompanied by a short period of large capital flows as
investors re-allocated their portfolios towards foreign debt and equity.
After this adjustment period is over, there seems little reason to suspect that international
portfolio flows will be either large or volatile. With this perspective, the prolonged increase in
the size and volatility of capital flows we observe suggests that the adjustment to greater
financial integration is taking a very long time, or that integration has little to do with the recent
behavior of capital flows.
International capital flows are the financial side of international 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 country’s 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.

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Meaning of Capital Flows
Capital Flows is 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. Movement of goods and services in the form of trade is one
form of international integration. Another form of integration is international movements of
factors of production or factor movements. Factor movements can be in the form of:
•Labor migration
•Transfer of capital via international borrowing and lending
•International linkages involved in the formation of multinational corporations (FDI)

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Types and Sources of International Capital Movements
Capital movements can be classified by instrument in to debt or equity and by maturity into
short term and long term. Capital movements can be divided into short term and long term flows,
depending upon the nature of credit instrument involved. A Capital movement is a short term
embodied in a credit instrument of less than a year maturity. If instrument has duration of more
than a year or consist title of ownership, the capital movement is long term.
(a) Short Term Capital Movements: They can take place through changes in claims of
domestic residents on foreign residents or in liabilities of domestic residents owed to
foreign residents. Short term capital movements are demand deposits, bills, overdrafts,
commercial and item in process of collection. They are mostly speculative in nature.
Short term capital movements may take place in form of hot money movement.
(b) Long Term Capital Movements: They are generally for long term investments. They
may further be classified into direct investment, portfolio investment and assistance from
Governments and institutions.
Foreign Direct Investments
A foreign direct investment (FDI) is a controlling ownership in a business enterprise in one
country by an entity based in another country.
Foreign direct investment is distinguished from portfolio foreign investment, a passive
investment in the securities of another country such as public stocks and bonds, by the element
of "control". According to the Financial Times, "Standard definitions of control use the

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internationally agreed 10 percent threshold of voting shares, but this is a grey area as often a
smaller block of shares will give control in widely held companies. Moreover, control of
technology, management, even crucial inputs can confer de facto control."
The origin of the investment does not impact the definition as an FDI: the investment may be
made either "inorganically" by buying a company in the target country or "organically" by
expanding operations of an existing business in that country.
The Foreign Direct Investment (FDI) in any country abroad is the net inflow of
investment (capital or other), in order to acquire management control and profit sharing (10% or
more voting stock) or the whole ownership of an accredited company operating in the country
receiving investment. The foreign direct investment generally encompasses the transfer of
technology and expertise, and participation in the joint venture and management. Highly
productive advantages of foreign direct investment have been constantly being harvested by both
governmental and private companies and organizations of all over the world.
The Foreign Direct Investment is profitable both to the country receiving investment
(foreign capital and funds) and the investor. For the investor company FDI offers an exclusive
opportunity to enter into the international or global business, new markets and marketing
channels, exclusive access to new technology and expertise, expansion of company with new or
more products or services, and cheaper production facilities. While the host country receives
foreign funds for development, transfer of new profitable technology, wealth of expertise and
experience, and increased job opportunities.
Owing to the ever-increasing globalization of businesses of almost all sectors,
liberalization of trade policies, and loosening of foreign investment restrictions, the Foreign

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Direct Investment (FDI) has been quite revolutionary and vital for faster economic growth of
most of the developing and developed countries of all across the world for last few decades.
Official Flows
They are shown as external assistance, i.e. grants and loans from bilateral and
multilateral flows. Long-term capital movements can also take the form of government loans or
grants and loans from International Financial Institutions. Sometimes Governments of advanced
countries may give loans to finance projects in a developing country. These are known as
bilateral loans.
International Financial Institutions like World Bank, Asian Development Bank, etc. also
give financial assistance to developing countries. These loans are called as multilateral loans.
Thus, governments and International Institutions play an important role in international capital
movements.
Foreign Aid
A part of the foreign capital is received on concessional terms and it is called as
assistance or foreign aid. It may be received by way of loans and grants. Grants are in the form
of outright gifts which do not have to be repaid. Loans qualify as aid only to the extent that they
bear a concessional rate of interest and have longer maturity periods than commercial loans.
Foreign aid has mostly been given by Foreign Governments and International Financial
Institutions like IMF, World Bank, Asian Development Bank And so on.

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External Commercial Borrowings
An external commercial borrowing (ECB) is an instrument used in India to facilitate the
access to foreign money by Indian corporations and PSUs (Public Sector Undertakings). ECBs
include commercial bank loans, buyers' credit, suppliers' credit, securitized instruments such as
floating rate notes and fixed rate bonds etc., credit from official export credit agencies and
commercial borrowings from the private sector window of multilateral financial Institutions such
as International Finance Corporation (Washington), etc. ECBs cannot be used for investment in
stock market or speculation in real estate. The DEA (Department of Economic Affairs), Ministry
of Finance, Government of India along with Reserve 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 $40 billion and allowed borrowings in
Chinese currency Renminbi. 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 cannot refinance its
existing rupee loan through ECB. 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 for 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

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Official. “Companies go for it as it is on easier terms. We are getting their (China’s) 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-
government organizations and microfinance institutions. The decisions will come into effect
through a notification by RBI.
Factors Affecting International Capital Movements
The following factors are affecting international capital movements:
1. Interest Rates:
The most important factor which affects international capital movement is the
difference among current interest rates in various countries. Rate of interest shows rate of
return over capital. Capital flows from that country in which the interest rates are low to
those where interest rates are high because capital yields high return there.
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 to outflow of capital. On the other hand if there is a possibility of a fall in
domestic interest rates in future, the foreign speculator will invest in securities at a low
price at present. This will lead to inflow of capital in the country.

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3. Expectation of profits:
A foreign investor always has the profit motives in his mind at the time of making
capital investment in 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
outflow of capital and vice versa.
5. Production Costs:
Capital movements depend on production costs in other countries. In countries
where labour, 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 of transportation and communication, power and
other resources, efficient labor, etc. encourage the inflow of capital there.

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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; tax relief should
be given to new industries and foreign collaborations, etc.
9. Foreign capital policy:
The government policy relating to foreign capital affects capital movements.
Role of International Capital Movement
In traditional economics, capital movements were treated merely as international
balancing items in a country's balance of trade. It was held that, a creditor country having a
surplus in its current account in order to balance out its total payments account will invest or lend
capital to deficit or debtor countries.
Apparently, debtor countries with deficit in current account will borrow from the surplus
countries in order to even out their balance of payments. Consequent upon foreign capital
movements, thus, a credit in current account of a surplus country, there will be a corresponding
lender position or its capital account, while to a deficit country there will be a corresponding
borrower position on its capital account. Modern economists, however, are of the view that

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capital movements are much more than merely balancing items. In reality, all international
capital movements are not dependent upon the balance of payments deficit and surpluses.
A significant portion of capital flow may also be independent of the balance of trade
position which, in fact, is based on the judgments, financial decisions and discretions of lenders
and borrowers in the international money markets.
Where a country has a surplus in its current account, there will be an outflow of capital
funds to deficit countries, hence, its holdings of short-term capital and its foreign and banking
reserves will be depleted, while a deficit country will find an improvement in these holdings on
account of the inflow of capital.
Again, if a country has invested its capital abroad, it receives income in the form of
interest, dividends, etc., which can be profitably used to finance its current deficits, which thus,
help in balancing its balance of payments account.
It has also been maintained that unrestricted international capital movements tend to
equalize the rates of interest and profits between countries. As a matter of fact, discrepancies in
the rate of interest induce international flow of capital. When there are no checks on the
movements, capital tends to flow from a capital-surplus nation to capital- deficit nation on
account of high yields in the latter. Eventually, interest rates in the capital-exporting country will
be enhanced, while in the capital-importing country it will decline. A condition of equilibrium in
the international flow of capital exists when interest rates and profit yields in different countries
are equalized.

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In practice, however, there are always some restrictions on an impediment to the free
movement of capital which prevent such complete equilibrium to emerge. Moreover, apart from
the rate of return on investment, many other factors such as risks involved, industrial and general
economic policy of the foreign government, political relations between countries, international
treaties and agreements on trade and commerce, etc., influence the investment decisions on
foreign capital.
Indeed, capital movement, especially direct investment and foreign aid, plays an
important role in the economic development of backward countries. External assistance is an
important source of capital formation and finance resource for planning of project in a capital-
deficit poor country.
The Importance of Capital Movements
International trade and capital movements go together. Merely the financial transactions
involved in 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 was 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.

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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 of 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.
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

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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.

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Causes of Capital Movements
The responsiveness of private capital to opportunities in emerging markets started to
improve in the 1990s because of both internal and external factors. Internal factors improved
private risk-return characteristics for foreign investors through three main channels. First,
creditworthiness improved as a result of external debt restructuring in a wide range of countries.
Second, productivity gains were obtained from structural reform and the establishment of
confidence in macroeconomic management in several developing countries that had undertaken
successful stabilization programs. Third, countries adopting fixed exchange rate regimes became
increasingly attractive to investors owing to the transfer of the risk of exchange rate volatility—
at least in the short run—from investors to the government.
In addition, because of both cyclical and structural forces, external influences played a
significant role in the capital inflow surge of the 1990s. Cyclical forces were the dominant
explanation in the early 1990s, when the decline in world real interest rates "pushed" investors to
emerging markets. The persistence of private capital flows after the increase in world interest
rates in 1994 and the Mexican crisis of 1994-95 suggest, however, that structural external forces
were also at work.
The structural external forces started to work when two developments in the financial
structures of capital-exporting countries increased the responsiveness of private capital to cross-
border investment opportunities. First, falling communication costs, strong competition, and
rising costs in domestic markets led firms in industrial countries to produce abroad to increase
their efficiency and profits. Second, institutional investors became more willing and able to
invest in emerging market countries because of their higher long-term expected rates of return,

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wider opportunities for risk diversification owing to their broader and deeper securities markets,
and greater feasibility of investing as their capital accounts were liberalized. Nonetheless,
investments in emerging markets account for only about 2 percent of total mutual fund assets in
the United States, 3-4 percent in the United Kingdom, and almost none in the rest of Europe and
Japan. The importance of structural forces gives rise to optimism about the volume of capital
flows that developing countries can attract in the medium term. With the growing importance of
private capital flows to these economies, however, has come the threat of major reversals.
Understanding reversals of capital flows
Major reversals of capital flows occurred in a number of developing countries even
before the 1990s.
A common reason for the reversals has been a lack of confidence in domestic
macroeconomic policies, leading to speculative attacks on currencies and balance of payments
crises. Balance of payments crisis can also result from financial vulnerabilities or other factors
that make macroeconomic policy less credible. In particular, if a country's banking sector is
weak, its authorities might prefer to devalue rather than to increase interest rates. Moreover, as
shown by the Mexican experience, the maturity and currency composition of the public sector's
liabilities relative to those of its assets are particularly relevant. In fact, even if a country's public
sector is solvent, it might be vulnerable to short-run liquidity crises if creditors prove reluctant to
refinance the government's short-term liabilities. Finally, the role of contagion is particularly
important for understanding the recent volatility of international capital markets.

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Trends in international capital flows
International capital flows have increased dramatically over time, despite a temporary
contraction during the global crisis. Gross cross-border capital flows rose from about 5% of
world GDP in the mid-1990s to about 20% in 2007, or about three times faster than world trade
flows Prior to the crisis, the dominant components were capital flows among advanced
economies and notably cross-border banking flows.
The crisis resulted in a sharp contraction in international capital flows, after reaching
historical highs in mid-2007. The contraction affected mainly international banking flows among
advanced economies and subsequently spread to other countries and asset classes. Capital flows
have rebounded since the spring of 2009, driven by a bounce-back in portfolio investment from
advanced to emerging-market economies and increasingly among emerging-market economies.

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Objectives
All restrictions on capital movements between Member States as well as between
Member States and third countries should be removed. However, for capital movements between
Member States and third countries, Member States also have:
(1) the option of safeguard measures in exceptional circumstances;
(2) the possibility to apply restrictions that existed before a certain date to third countries and
certain categories of capital movements; and
(3) a basis for the introduction of such restrictions — but under very specific circumstances.
Liberalization should help to establish the Single Market by supplementing other freedoms (in
particular the movement of persons, goods and services).
It should also encourage economic progress by enabling capital to be invested efficiently
and promoting the use of the euro as an international currency, thus contributing to the EU's role
as a global player. It was also indispensable for the development of Economic and Monetary
Union (EMU) and the introduction of the euro.
Benefits of Capital Flows
Economists have long argued that trade in assets (capital flows) provides substantial
economic benefits by enabling residents of different countries to capitalize on their differences.
Fundamentally, capital flows permit nations to trade consumption today for consumption in the
future to engage in intertemporal trade. Because Japan has a population that is aging more
rapidly than that of the United States, it makes sense or Japanese residents to purchase more

24. 24
U.S. assets than they sell to us. This allows the Japanese to save for their retirement by building
up claims on future income in the United States while permitting residents of the United States
to borrow at lower interest rates than they could otherwise pay. A closely related concept is that
capital flows permit countries to avoid large falls in national consumption from economic
downturn or natural disaster by selling assets to and/or borrowing from the rest of the world.
Role of Foreign Capital
Foreign capital has played important role in the early stages of industrialization of most of
the advanced countries of today like countries of Europe and North America. This is the general
view that foreign capital, if properly diverted and utilized, can assist economic development of
developing countries. These countries need resource to finance investment in health, education,
infrastructure and so on. It can supplement a country’s domestic saving effort and foreign
exchange earnings. Foreign capital can contribute to economic development of developing
countries in the following ways:
 Supplements domestic capital formation:
Economic development depends on, among other things, capital formation. The
domestic capital formation is inadequate in LDCs. The foreign capital can supplement
the domestic resources to achieve the critical minimum investment to break the
vicious circle of low income-low saving-low investment. If more domestic is to be
created by a country’s own effort, resources will have to be diverted from the
production of goods required for current consumption.

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 Accelerates economic development:
Foreign capital helps to accelerate the pace of economic development by facilitating
imports of capital goods, technical know-how and other imports which are required
for carrying out development programs.
 Improve trade balance:
Foreign capital inflow may help to increase a country’s exports and reduce the import
requirements if such capital flows into export oriented and import competing
industries.
 Transfer of technology:
The Foreign capital may facilitate transfer of technology to LCDs. It may help to
modernize the production techniques in industry, agriculture and other sectors.
 Income and Employment:
If foreign capital flows into real sectors in the form of direct investment it helps to
increase productivity, income and employment in the economy.
 Balance of payments adjustment:
Inflow of foreign capital, especially the short term, may be able to provide a
breathing space to a deficit country to cover the deficit until a complete adjustment is
achieved to correct the balance of payment deficit.

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International Finance
 International finance has exploded during the 1990s as countries, particularly in the
developing world, have bowed to the conventional wisdom that they should remove
barriers to these flows.
 The flood of capital into countries like Mexico, while fueling economic growth for a
period of time, has done little to improve the lives of the majority of people.
 The roots of the crisis may lay in the financial liberalization that encouraged a flood of
short-term private flows into Thailand, the Philippines, and elsewhere in the early 1990s.
Scope
The economics of international finance do not differ in principle from the economics of
international trade but there are significant differences of emphasis. The practice of international
finance tends to involve greater uncertainties and risks because the assets that are traded are
claims to flows of returns that often extend many years into the future. Markets in financial
assets tend to be more volatile than markets in goods and services because decisions are more
often revised and more rapidly put into effect. There is the share presumption that a transaction
that is freely undertaken will benefit both parties, but there is a much greater danger that it will
be harmful to others.
For example, mismanagement of mortgage lending in the United States led in 2008 to
banking failures and credit shortages in other developed countries, and sudden reversals of
international flows of capital have often led to damaging financial crises in developing countries.

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Exchange rates and capital mobility
A major change in the organization of international finance occurred in the latter years of
the twentieth century, and economists are still debating its implications. At the end of the Second
World War the national signatories to the Bretton Woods Agreement had agreed to maintain
their currencies each at a fixed exchange rate with the United States dollar, and the United States
government had undertaken to buy gold on demand at a fixed rate of $35 per ounce. In support
of those commitments, most signatory nations had maintained strict control over their nationals’
use of foreign exchange and upon their dealings in international financial assets.
But in 1971 the United States government announced that it was suspending the
convertibility of the dollar, and there followed a progressive transition to the current regime of
floating exchange rates in which most governments no longer attempt to control their exchange
rates or to impose controls upon access to foreign currencies or upon access to international
financial markets. The behavior of the international financial system was transformed. Exchange
rates became very volatile and there was an extended series of damaging financial crises. One
study estimated that by the end of the twentieth century there had been 112 banking crises in 93
countries, another that there had been 26 banking crises, 86 currency crises and 27 mixed
banking and currency crises - many times more than in the previous post-war years.
The outcome was not what had been expected. In making an influential case for flexible
exchange rates in the 1950s, Milton Friedman had claimed that if there were any resulting
instability, it would mainly be the consequence of macroeconomic instability, but an empirical
analysis in 1999 found no apparent connection Economists began to wonder whether the

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expected advantages of freeing financial markets from government intervention were in fact
being realized.
Neoclassical theory had led them to expect capital to flow from the capital-rich
developed economies to the capital-poor developing countries - because the returns to capital
there would be higher. Flows of financial capital would tend to increase the level of investment
in the developing countries by reducing their costs of capital, and the direct investment of
physical capital would tend to promote specialization and the transfer of skills and technology.
However, theoretical considerations alone cannot determine the balance between those benefits
and the costs of volatility, and the question has had to be tackled by empirical analysis.
A 2006 International Monetary Fund working paper offers a summary of the empirical
evidence. The authors found little evidence either of the benefits of the liberalization of capital
movements, or of claims that it is responsible for the spate of financial crises. They suggest that
net benefits can be achieved by countries that are able to meet threshold conditions of financial
competence but that for others, the benefits are likely to be delayed, and vulnerability to
interruptions of capital flows is likely to be increased.
Policies and institutions
Although the majority of developed countries now have "floating" exchange rates, some
of them – together with many developing countries – maintain exchange rates that are nominally
"fixed", usually with the US dollar or the euro. The adoption of a fixed rate requires intervention
in the foreign exchange market by the country’s central bank, and is usually accompanied by a
degree of control over its citizens’ access to international markets.

29. 29
A controversial case in point is the policy of the Chinese governments who had, until
2005, maintained the Renminbi at a fixed rate to the dollar, but have since "pegged" it to a basket
of currencies. It is frequently alleged that in doing so they are deliberately holding its value
lower than if it were allowed to float.
Some governments have abandoned their national currencies in favor of the common
currency of a currency area such as the "Eurozone" and some, such as Denmark, have retained
their national currencies but have pegged them at a fixed rate to an adjacent common currency.
On an international scale, the economic policies promoted by the International Monetary Fund
(IMF) have had a major influence, especially upon the developing countries.
The IMF was set up in 1944 to encourage international cooperation on monetary matters,
to stabilize exchange rates and create an international payments system. Its principal activity is
the payment of loans to help member countries to overcome balance of payments problems,
mainly by restoring their depleted currency reserves. Their loans are, however, conditional upon
the introduction of economic measures by recipient governments that are considered by the
Fund's economists to provide conditions favorable to recovery.
Their recommended economic policies are broadly those that have been adopted in the
United States and the other major developed countries (known as the "Washington Consensus")
and have often included the removal of all restrictions upon incoming investment. The Fund has
been severely criticized by Joseph Stiglitz and others for what they consider to be the
inappropriate enforcement of those policies and for failing to warn recipient countries of the
dangers that can arise from the volatility of capital movements.

30. 30
International Financial Stability
From the time of the Great Depression onwards, regulators and their economic advisors
have been aware that economic and financial crises can spread rapidly from country to country,
and that financial crises can have serious economic consequences. For many decades, that
awareness led governments to impose strict controls over the activities and conduct of banks and
other credit agencies, but in the 1980s many governments pursued a policy of deregulation in the
belief that the resulting efficiency gains would outweigh any systemic risks.
One of their effects has been greatly to increase the international inter-connectedness of
the financial markets and to create an international financial system with the characteristics
known in control theory as "complex-interactive". The stability of such a system is difficult to
analyse because there are many possible failure sequences. The internationally systemic crises
that followed included the equity crash of October 1987, the Japanese asset price collapse of the
1990s, the Asian financial crisis of 1997, the Russian government default of 1998 (which
brought down the Long-Term Capital Management hedge fund) and the 2007-08 sub-prime
mortgages crisis. The symptoms have generally included collapses in asset prices, increases in
risk premiums, and general reductions in liquidity.
Measures designed to reduce the vulnerability of the international financial system have
been put forward by several international institutions. The Bank for International Settlements
made two successive recommendations (Basel I and Basel II) concerning the regulation of banks,
and a coordinating group of regulating authorities, and the Financial Stability Forum, that was set
up in 1999 to identify and address the weaknesses in the system, has put forward some proposals
in an interim report.

31. 31
Migration
Elementary considerations lead to a presumption that international migration results in a
net gain in economic welfare. Wage differences between developed and developing countries
have been found to be mainly due to productivity differences which may be assumed to arise
mostly from differences in the availability of physical, social and human capital. And economic
theory indicates that the move of a skilled worker from a place where the returns to skill are
relatively low to a place where they are relatively high should produce a net gain (but that it
would tend to depress the wages of skilled workers in the recipient country).
There have been many econometric studies intended to quantify those gains. A
Copenhagen Consensus study suggests that if the share of foreign workers grew to 3% of the
labour force in the rich countries there would be global benefits of $675 billion a year by 2025.
However, a survey of the evidence led a House of Lords committee to conclude that any benefits
of immigration to the United Kingdom are relatively small. Evidence from the United States also
suggests that the economic benefits to the receiving country are relatively small, and that the
presence of immigrants in its labour market results in only a small reduction in local wages.
From the standpoint of a developing country, the emigration of skilled workers represents
a loss of human capital (known as brain drain), leaving the remaining workforce without the
benefit of their support. That effect upon the welfare of the parent country is to some extent
offset by the remittances that are sent home by the emigrants, and by the enhanced technical
know-how with which some of them return. One study introduces a further offsetting factor to
suggest that the opportunity to migrate fosters enrolment in education thus promoting a "brain
gain" that can counteract the lost human capital associated with emigration.

32. 32
Whereas some studies suggest that parent countries can benefit from the emigration of
skilled workers, generally it is emigration of unskilled and semi-skilled workers that is of
economic benefit to countries of origin, by reducing pressure for employment creation. Where
skilled emigration is concentrated in specific highly skilled sectors, such as medicine, the
consequences are severe and even catastrophic in cases where 50% or so of trained doctors have
emigrated. The crucial issues, as recently acknowledged by the OECD, is the matter of return
and reinvestment in their countries of origin by the migrants themselves: thus, government
policies in Europe are increasingly focused upon facilitating temporary skilled migration
alongside migrant remittances.
Unlike movement of capital and goods, since 1973 government policies have tried to
restrict migration flows, often without any economic rationale. Such restrictions have had
diversionary effects, channeling the great majority of migration flows into illegal migration and
"false" asylum-seeking. Since such migrants work for lower wages and often zero social
insurance costs, the gain from labour migration flows is actually higher than the minimal gains
calculated for legal flows; accompanying side-effects are significant, however, and include
political damage to the idea of immigration, lower unskilled wages for the host population, and
increased policing costs alongside lower tax receipts.

33. 33
Globalization
The term globalization has acquired a variety of meanings, but in economic terms it
refers to the move that is taking place in the direction of complete mobility of capital and labour
and their products, so that the world's economies are on the way to becoming totally integrated.
The driving forces of the process are reductions in politically imposed barriers and in the costs of
transport and communication (although, even if those barriers and costs were eliminated, the
process would be limited by inter-country differences in social capital).
It is a process which has ancient origins which has gathered pace in the last fifty years,
but which is very far from complete. In its concluding stages, interest rates, wage rates and
corporate and income tax rates would become the same everywhere, driven to equality by
competition, as investors, wage earners and corporate and personal taxpayers threatened to
migrate in search of better terms. In fact, there are few signs of international convergence of
interest rates, wage rates or tax rates. Although the world is more integrated in some respects, it
is possible to argue that on the whole it is now less integrated than it was before the first world
war., and that many middle-east countries are less globalized than they were 25 years ago.
Of the moves toward integration that have occurred, the strongest has been in financial
markets, in which globalization is estimated to have tripled since the mid-1970s. Recent research
has shown that it has improved risk-sharing, but only in developed countries, and that in the
developing countries it has increased macroeconomic volatility. It is estimated to have resulted in
net welfare gains worldwide, but with losers as well as gainers. Increased globalization has also
made it easier for recessions to spread from country to country. A reduction in economic activity
in one country can lead to a reduction in activity in its trading partners as a result of its

34. 34
consequent reduction in demand for their exports, which is one of the mechanisms by which the
business cycle is transmitted from country to country. Empirical research confirms that the
greater the trade linkage between countries the more coordinated is their business cycles.
Globalization can also have a significant influence upon the conduct of macroeconomic
policy. The Mundell–Fleming model and its extensions are often used to analyse the role of
capital mobility (and it was also used by Paul Krugman to give a simple account of the Asian
financial crisis). Part of the increase in income inequality that has taken place within countries is
attributable - in some cases - to globalization. A recent IMF report demonstrates that the increase
in inequality in the developing countries in the period 1981 to 2004 was due entirely due to
technological change, with globalization making a partially offsetting negative contribution, and
that in the developed countries globalization and technological change were equally responsible.
Capital flows and domestic investment
Economic theory suggests that capital will move from countries where it is abundant to
countries where it is scarce because the returns on new investment opportunities are higher
where capital is limited. Such a reallocation of capital will boost investment in the recipient
country and, as Summers (2000) suggests, bring enormous social benefits. Underlying this
theory is the premise that returns to capital decrease as more machinery is installed and new
structures are built, although, in practice, this is not always, or even generally, true. New
investment is more productive in countries with a skilled workforce and well-developed physical
infrastructure, as Lucas (1990) recognized in explaining why capital does not flow from rich to
poor countries. Thus, a consistent finding is that new capital flows tend to go to countries that
have received large flows in the past and that investors also seek favorable business

35. 35
environments. Although economic theory and empirical investigations have much to say about
where international capital may flow, both the theory and the evidence are less definitive about
the impact of such flows. Once in a country, private capital may increase either domestic
consumption or investment, or it may principally increase the country's foreign exchange
reserves. If flows are driven merely by incentives to evade taxes or jump other legal barriers,
money may flow out of a country as quickly as it flows in.
Despite these ambiguities, private capital flows are generally found to have a significant
impact on domestic investment, with the relationship being strongest for Foreign Direct
Investment and international bank lending and weaker for portfolio flows (Bosworth and Collins,
1999). When a country is poor and saves little, additional capital from outside the country can
help it realize investment opportunities. For example, our analysis suggests that a 1 percent
increase in capital inflows to Africa boosts investment by more than 1 percent. However, little
foreign capital is directed to Africa, and that is largely limited to a few countries with significant
natural resources. Moreover, because the productivity of investment in many of these countries is
not high, the long-term impact of foreign capital on growth may be small. Over time, as a
country becomes better integrated with the rest of the world, a dollar of foreign capital raises
investment less than it did in the past.

36. 36
Current Regulations to Manage Capital Flows in India
Capital flows contribute in filling the resource gap in a country like India where the
domestic savings are inadequate to finance investment. Today, India requires approximately
500 billion US $ investment in infrastructure sector alone in the next 5 years for sustaining
present growth rate of approximately 8-9 per cent. This amount is around 2.5 times more
than the 10th Plan. Add to this, already, several infrastructure projects have reportedly been
shelved and indefinitely delayed. Such huge mobilization of resources is not possible from
India’s internal resources. Therefore, India needs foreign capital in the form of ECBs and
other foreign loans and aids. Keeping in view the growing requirements of foreign capital in
India, Indian government has come up with many policies and liberalized regulations to
manage foreign capital in India. Some of the important and recent measures taken by Indian
government to manage foreign investments in India are as under:
1. Foreign Direct Investment:
2. Foreign Portfolio Investment:
3. Foreign Venture Capital Investors:
4. External Commercial Borrowings:
5. Investment by NRIs in Immovable Properties: The NRIs are permitted to freely
acquire immoveable property (other than agricultural land, plantations and
farmhouses). NRIs are also permitted to avail of housing loans for acquiring property
in India and repayment of such loans by close relatives is also permitted.

37. 37
The Future of International Capital Movement
The experience of the past decade has demonstrated the challenges that international
capital flows can pose for financial stability. Between 2002 and 2007, annual gross international
capital flows rose from 5% to 17% of world GDP, and the network of cross-country financial
linkages became increasingly complex. Net international capital flows also rose sharply over this
period, with global current-account imbalances (the sum of global deficits and surpluses)
doubling from 3% to 6% of world GDP. The build-up of global imbalances was one of the
preconditions for the recent financial crisis. And the increased interconnectedness between
countries’ financial sectors associated with large gross flows created channels through which the
initial shock could spread around the world. As remarkable as the pre-crisis growth in
international capital flows was, the collapse post-Lehman was yet more dramatic. Gross global
cross-border capital flows plummeted to less than 1% of world GDP in 2008, with severe
implications for both advanced economies – especially those with large, open financial sectors –
and many emerging-market economies that had hitherto accessed funding from abroad. In these
respects, the scale and volatility of international capital flows were crucial determinants of the
depth and breadth of the crisis which followed Lehman Brothers’ demise.
These dramatic events bring home just how essential it is for policymakers to develop
strategies to deal with these risks in future. Yet, however great the challenges policymakers may
have faced in the most recent episode because of the size and volatility of capital flows, these are
set to become even greater in the future as large emerging-market economies increasingly
integrate into the global financial system. Whereas the immediate challenge for policymakers
today is to prevent – or to have policies to deal with – the risk of a sharp cross border
deleveraging of gross capital flows, the medium-term risk is the opposite – having policies to
deal with much larger inflows.

38. 38
The experience of the past decade has demonstrated the challenges that international
capital flows can pose for financial stability. The build-up of global imbalances (large net capital
flows) was one of the preconditions for the recent financial crisis. Increased interconnectedness
between countries’ financial sectors (large gross capital flows) created channels through which
the initial shock could spread around the world. In these respects, the scale and volatility of
international capital flows were crucial determinants of the depth and breadth of the crisis which
followed Lehman Brothers’ demise. These dramatic events demonstrate that it is incumbent upon
policymakers to develop strategies to deal with these risks in the future. But however great the
challenges policymakers may have faced in the most recent episode, these are set to become even
greater in the future as large emerging market economies (EMEs) increasingly integrate into the
global financial system. This paper elaborates on the simulations of Haldane (2010), with the aim
of constructing some illustrative thought experiments to describe some potential trajectories for
G20 countries’ capital flows and external balance sheets over the next 40 years. Some key results
from our simulations are as follows: The overall size of external balance sheets relative to GDP
across the entire G20 increases from a ratio of around 1.3 to 2.2. The distribution of external
assets shifts to emerging markets. By 2050, more than 40% of all external assets are held by the
BRICs, up from the current 10%. Non-G7 annual capital outflows are simulated to be more than
twice the size of G7 outflows by 2050. Global current account imbalances (the sum of deficits
and surpluses) rise from around 4% of world GDP to around 8% at their peak. These simulations
focus on two fundamental drivers of capital flows — GDP convergence and demographics.
Plainly, other factors which we do not explicitly model — such as financial development,
changes in investor preference, exchange rate policies and the development of social safety nets
— will also be important in the years to come. Notwithstanding these caveats, it seems
reasonable to envisage a future world in which the financial integration of EMEs is accompanied
by a substantial rise in international capital flows relative to world GDP.

39. 39
Conclusion
The premature celebration of the boom in capital flows in the first half of the 1990s has
been replaced in recent years by a skepticism that is equally unwarranted. Private capital flows
are not likely to solve all development problems and can impose significant costs. However,
when harnessed effectively, they can boost investment and spur productivity growth. Domestic
policy priorities that foster more efficient investment will also attract productive foreign capital.
Ultimately, domestic strength, including a robust and prudent financial sector, will also protect a
country from the volatility induced by capital flows. However, special safeguards, such as higher
foreign exchange reserves or contingent credit lines, may be advisable in certain situations.
The explosion of capital flows to emerging markets in the early and mid-1990s and the
recent reversal following the crises around the globe have reignited a heated debate on how to
manage international capital flows. Capital outflows worry policy makers, but so do capital
inflows, as they may trigger bubbles in asset markets and lead to an appreciation of the domestic
currency and a loss of competitiveness. Policy makers also worry that capital inflows are mostly
of the “hot money” type, which is why capital controls have mostly targeted short-term capital
inflows. While capital controls may work, at least in the very short run, the introduction of
restrictions to capital mobility may have undesirable long-run effects. In particular, capital
controls protect inefficient domestic financial institutions and thus may trigger financial
instability.

40. 40
Bibliography
 www.amazon.com
 www.econlib.org
 www.investopedia.com
 www.bankofengland.co.uk
 Ref. Book : Economics of Global Trade & Finance (Manan Prakashan)
 Journal of International Money & Finance
 http://www.bankofengland.co.uk/financialstability/Documents/fpc/fspapers/fs_paper12.p
df