Steve Bain

Capital Mobility Definition & Capital Flows

The term capital mobility is used in reference to the ease and freedom with which money can be transferred from one country to another. By this I mean very large sums of money - it has less to do with people obtaining foreign currency for their annual vacation, it's more about the vast amounts of money that flow from one country to another in search of the best interest rates and lowest risk levels on various financial assets.

Over the last few decades there has been a great deal of international financial integration that has increased the level of cooperation among countries as part of the globalization process. Capital flows around the world more freely now than at any other time in world history, and there is a well developed set of guidelines that most countries adhere to in order to allow the smooth movement of funds without undue negative impacts on each other's economy's.

Nevertheless, these capital flows can be extremely volatile, and they have had a destabilizing effect on some countries in the past. This has been particularly true of developing countries, where the capital movements have been all the more influential given their relatively large size compared to the modest GDP of the typical developing country.

Why is Capital Mobility Important?

Capital mobility is generally believed to be a desirable thing because it allows international funds to flow freely to the most productive investment projects.

It's a common fallacy that this necessarily leads to unemployment in the developed world due to positive net capital flows being diverted to countries with lower labor costs. This has indeed happened in reality, with offshoring of developed world manufacturing industries wiping out millions of jobs and widening the gap between rich and poor. However, this has only occurred because our western governments have borrowed so heavily in the international capital market and thereby offset the outflow of manufacturing investment with an inflow of capital for government spending.

The consequences of replacing free market investments with government borrowing are clear to see, with a permanent and growing trade deficit matched only by the ever increasing level of national debt. In essence, we've allowed the government to continually expand at the expense of the free market, with inevitable costs in terms of lost productivity.

Had the government simply stayed out of the equation and run balanced budgets, the national debt would not have grown, and exchange rates would have adjusted to prevent excessive capital outflows. It would also have ensured that capital inflows into the economy for investments in projects for which the developed world has a competitive advantage would have matched the outflows. I'm referring to capital intensive projects and projects that require highly skilled employees, the developed world has a competitive advantage in these projects.

Of course, the flip-side of having capital mobility is that it requires us to give up on either stable exchange rates or an independent monetary policy - we can't have all three. This is explained in my article about the:

International Capital Flows

According to the OECD (see link below) global capital flows across international borders rose from about 5% of world GDP in the mid 1990s, to about 20% of world GDP (just prior to the global financial crisis). To put this into context, it amounts to about three times the growth in world trade of goods and services.

Global Capital Inflows & Outflows

The global financial crisis temporarily put the brakes on the magnitude of international capital flows, but it has rebounded back to strong growth since 2009. That growth has typically been characterized by huge outflows of capital from the developed world, and huge capital inflows to the emerging markets (especially China) due to the economic development opportunities there.

As mentioned in the opener, capital movements around the world can be extremely volatile; that's because of the unstable nature of market sentiments when it comes to identifying the best investment returns for any associated level of risk.

Market sentiment, even over the short-term, is virtually impossible to predict because it is driven by all manner of unpredictable real-world variables e.g., political instability, wars, natural disasters, negative/positive press, trade relations and so on.

Latin America in particular has had previous experience of huge capital inflows followed by outflows, and the destabilizing effects that it causes. Left unchecked, capital inflows can easily lead to very loose monetary policy in a recipient country, with a resulting economic boom. According to OECD research, there is strong evidence that such booms are strongly associated with a much higher risk of a banking crisis emerging once the boom turns to bust, and this can easily progress into a sovereign debt crisis if the indebted country owes money denominated in foreign currency rather than its own domestic country.

There have been many examples of this in Latin America in previous decades, but in recent years it appears that the hard lessons have been learned, and that money supply growth has been more restrained with the high capital inflows in the run up to the 2008 global financial crisis.

Research by Fuentes, Raddatz & Reinhart (see link below), shows that capital inflows had been channeled into the accumulation of foreign reserves prior to the crisis, with the effect that Latin America had low levels of external debt when the crisis hit, allowing them to cope with it comparatively well.

Economic Push Factors and Pull Factors

The research by Fuentes, Raddatz & Reinhart goes on to consider the economic push and pull factors behind the mobility of capital i.e., is it that recipient countries make desirable economic policy changes that attract foreign capital, or is it that other countries experience capital flight when circumstances take a turn for the worse, meaning that recipient countries attract capital by default?

In the context of the global financial crisis it was the latter, with a huge flow of money from the developed world into the emerging markets. Monetary policy in the west had set interest rates at near zero rates, and risk levels skyrocketed after the crash, giving a huge incentive to switch into assets in the emerging markets.

There were significant pull factors though. As mentioned already, previous episodes in Latin America with the boom-bust cycle had made developing countries wary of the volatility that comes with massive capital inflows, and they had adopted a policy framework that could provide more economic stability in such circumstances. Financial regulations, and institutional developments to allow greater capital mobility, along with lower national debt levels all helped to attract foreign investment.

International Financial Integration and Globalization

International policy development in the area of financial integration and stability has been prioritized by the big global institutions like the International Monetary Fund (IMF), the World Bank and the World Economic Forum (WEF) since the financial crisis. These institutions appear to be committed to ever increasing globalization, even if the supply-chain problems in the post-pandemic world have made it quite clear that offshoring our entire manufacturing base might not be such a good idea.

The understanding that greater capital mobility comes with potentially destabilizing effects for an economy far predates the 2008 meltdown, with plenty of existing policy and protocols being formed since the 1960s. The 'Code of Liberalization of Capital Movements (1961)' sets out a series of guidelines about international cooperation aimed at preventing the growing flows of capital across national borders from having any undue destabilizing effects.

After the 2008 crisis, policy proposals to prevent any recurrence of another crisis became much more urgent. This culminated in the third Basel Accord, which introduced a package of new Banking regulations which aim to prevent liquidity problems from reoccurring. Time will tell how that works out, but in 2022 the omens are not good. 

International Capital Mobility and Exchange Rates

A final note regarding international capital mobility needs to be made with respect to exchange rate policy. In previous decades fixed exchange rate systems were much more popular, but these have proven very difficult for central banks to maintain against speculative capital attacks. The ever increasing flow of funds in the global markets has only increased this difficulty, and for this reason managed floating exchange rates have become much more popular.

As explained in my article about the Mundell-Fleming Trilemma, a policy combination of capital mobility and floating exchange rates does maintain an independent monetary policy. If, however, a country finds floating exchange rates to be too destabilizing, then either capital mobility or an independent monetary policy must be abandoned. The former option would promote greater stability, but capital controls would be necessary and might hinder the economic growth rate.

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