International capital mobility, International Economics

International Capital Mobility is explained below:

The case for the international capital mobility was most evidently articulated by MacDougal in 1960. He presented a framework including two countries, one abundant in the financial capital and the one scarce in financial capital. As it has been discussed prior, the abundance of the money within an economy leads to the low interest rates, whereas its scarcity causes interest rates to become high. Therefore, the capital-rich country has low interest rates, while the capital-scarce country has the high interest rates. As a result of which there is over-investment in the former, and under-investment in the latter country.

If both the countries could jointly liberalize their capital accounts, some of the capital would move from the capital-rich countries to the capital-scarce countries to take benefit of the higher interest rates prevailing there. This would equalize supply of capital in both the countries causing their interest rates to equalize. Hence, desirably, interest rates in the formerly capital- rich country increase which causes over-investment to disappear, while interest rates in the formerly capital-scarce country decrease causing under-investment to disappear. Another way to state this is that the capital would flow to its most productive uses.

Benefits of International Capital Mobility are stated below:

People have suggested other benefits of the international capital mobility:

i. Consumption smoothing: the ability to borrow from international capital market allows the country to sustain a higher level of expenditures in times of the recession or current account difficulties, than it would be possible if the economy were not integrated into international financial market.

ii. Risk diversification: given international investors’ ability to invest in the other assets

(bonds, property, stocks,  etc.) of the countries other than their home countries permits them to diversify the investment risks. Similar benefits might also accrue to the issuers of debt (or borrowers of the capital) who now enjoy a much more diversified creditor pool. This enables them to bargain down their borrowing rates at the same time cushions them in the face of any one of funding sources drying up.

iii. Fiscal policy becomes more effective in this case: Given permanent exchange rates, expansionary fiscal policy would not contain any crowding out effects if the capital account is open. This is because as the interest rates start to rise due to higher government borrowing (to finance higher spending), capital flows in through the capital account, to which given a fixed exchange rate, expands the foreign exchange reserves and thus the money supply. This is the tantamount to the LM curve shifting to the right. As such, given excess capacity in the particular economy, income and output rises by much more than would have been made possible without an open capital account. Through similar logic, the effects of a fiscal contraction on the income become more evident given the predetermined exchange rate and open capital account. 

Disadvantages of International Capital Mobility are given below:

As with everything else in economics, there is one more side to story as well; that is there are disadvantages of the free capital mobility as well, and it is essential to understand them so as to form an informed view on the particular issue.

i. Monetary policy becomes ineffective when the conditions stated occurs: Given the fixed exchange rates, imagine what would happen if central bank tried to increase the money supply. LM would shift downward putting downward pressure on the interest rates.  Though, as soon as domestic the interest rate falls below the world interest rate, the capital account starts experiencing the deficit (outflows). This outflow is mirrored by the decrease in the foreign exchange reserves which causes the money supply contraction. Therefore the effects of the initial expansion are totally undone. The inability of a country to retain monetary policy autonomy, at the same time as a set exchange rate and an open capital account is known as unholy trinity principle. The unholy trinity belief simply says that the three things above stated cannot coexist; one should be sacrificed. It can be monetary autonomy or fixed exchange rates capital account openness.

ii. Capital flows are pro-cyclical and thus exacerbate boom-bust cycles: The criticisms of the global capital is that it moves in the synchronization with countries’ business cycles, thus magnifying economic fluctuations (instead of smoothing them out); such as more foreign money would flow to a country when it is experiencing a capital inflow boom (that is exactly the time when it does not require more money, per se) often leading to credit booms, inflationary pressures, property bubbles,  loss of competitiveness and BOPs problems.  Conversely, when the conditions are tight, and  countries  require  foreign capital, the latter is not accessible, as all foreign investors “want out.”

iii. Global capital is highly volatile, making countries targets of the speculation: Some types of the capital flows are much more volatile than others. For instance, foreign direct investment, official concessional aid etc.  is  more  stable  then the commercial bank  lending, and  foreign  portfolio investment which  are  right away reversible. The recent increase in capital flows reflects an asymmetric rise in this highly reversible and short-term type also called as hot money. Capital follows short term rates of the return 1-6 month interest rates in the world, and as soon as this rate decreases in one country, it exits that country and enters another with the higher rate, with no regard for the effects on economy left behind (recession, financial crisis stock market crash,). Also, due to this inherent volatility, timing and volume of these flows is frequently determined by the financial speculators, increasing the likelihood with any BOPs difficulties and financial or currency crises will be attributable more to the reversal in such investors’ preferences and  attitudes  than  to  the  weakening of  the  affected  country’s  macroeconomic and financial sector of the fundamentals (healthy financial system, stable real exchange rate, low inflation, absence of unholy trinity etc.). There is agreement with the recent spate of financial crises in the Latin America, East Asia and Russia was at least partly because to such speculation activity (and subsequent herding behavior of the investors).

Suggestions to Cure the Problems of Global capital Mobility are given below: 

Given these problems with the global capital mobility, there are three basic cures suggested. The first focuses on the recipient countries and the importance of these countries to further strengthen their financial and the macroeconomic fundamentals. The second cure focuses  on  reforming  the international  financial  architecture  in  a  way  which the  speculators  and  irresponsible  herding behaviour can be discouraged (through a threat of penalty). Also this approach argues for the setting up of an international lender of last resort which could lend to countries in dire requirement of foreign exchange, so that full-blown crises can be avoided. The third cure stresses the use of tax-like controls on capital movements, structured so as to penalize round-trippers much more heavily. This approach recognizes that major culprit in modern day financial crises is often foreign investors, and hence host countries themselves should find ways to control them. Supporters of this policy route also point out difficulties, or the3 lack of international willingness to, reforming the international financial architecture.

Posted Date: 7/19/2012 4:23:08 AM | Location : United States

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