International Capital Flows

What would happen to the interest rate in the U.S. if British people decided to invest their savings in U.S. assets? What is the impact of capital flow on the economy? Why do countries that have higher growth rates experience more capital flows?

You will be able to answer all these questions once you read our explanation on International Capital Flows.

International Capital Flows Overview

The term "capital flows" is used to describe the movement of monetary resources for investment, the running of a corporation, or commercial trade. Individual investors channel their savings and investing resources into many assets, including stocks, bonds, and mutual funds, among others. Cash movement inside a company can include investment capital, spending on operations, and research and development expenditures (R&D).

On a grander scale, a government manages the flow of money by channeling the revenue it receives from taxes into various programs and activities and via the exchange of goods and services with other countries and their respective currencies. International capital flows refer to the financial side of international trade. When a product is imported, a physical good flows into the importing country, while money flows into the exporting country. Capital can flow back into the importing country if foreign investors decide to buy assets in the importing country.

International Capital Flow Concept

The international capital flow concept revolves around the idea of financial capital movements across countries. There are movements of capital taking place almost everywhere you look, from people to businesses to national governments. Analysts often focus on subsets of capital flows, such as asset-class movements, venture capital flows, mutual fund flows, capital outlay budgets, and the government budget. The federal government and organizations at the state level in the United States collect data on capital flows to conduct research, regulatory activities, and legislative work.

In financial markets, asset-class movements are assessed by the capital flows that occur between cash, equities, bonds, and other financial instruments. Changes in venture capital refer to the investments flowing into new enterprises. The inflows and outflows of net cash from various kinds of funds are referred to as mutual fund flows. At the corporate level, budgets for capital investment are assessed as a part of the monitoring process for growth goals. Meanwhile, federal budgets follow government spending plans.

Companies often consider purchasing commercial real estate as part of their routine company operations to provide a location for manufacturing activities. In addition, the acquisition of real estate is often seen as an investment that may generate revenue via rental services by many people. Depending on the study, they might be categorized as business capital flows or investment capital flows.

Effects of International Capital Flow on the Economy

To understand the effects international capital flows have on the economy, we would have to start by using the market for loanable funds. One of the main impacts of international capital flows on the economy is its impact on the interest rate. In the presence of international capital flows, the interest rate of a country changes.

Let's consider what happens in the United States when the real interest rate is 7% while the real interest rate in the United Kingdom is 3%. As the real interest rates are higher in the U.S., British people could get a higher return on their investment from investing their money in the United States. This then provides the incentive for the British people to move their funds from the United Kingdom to the United States. What does this mean for the interest rate in both countries?

We'd have to look at the loanable funds market to answer that.

Fig 1. - Capital flows and Real Interest Rate

Figure 1 shows the relationship between capital flows and real interest rates between two countries. Initially, the equilibrium interest rate is 7% in the U.S. and 3% in the U.K. In the presence of capital flows, British people will want to invest in U.S. assets. As funds flow from the U.K. to the U.S., there are fewer loanable funds in the U.K. and more loanable funds available in the U.S. As fewer loanable funds are available for the U.K., the supply of loanable funds has decreased, moving the real interest rate up to 5%. On the other hand, due to international capital flows, the U.S. has experienced an increase in the supply of loanable funds, which then drives the interest rate in the U.S. down. Notice at a 5% interest rate, there is a shortage of loanable funds in the U.S., which is covered by capital inflows. On the other hand, at a 5% interest rate, there is a surplus of loanable funds in the U.K. and this surplus then leads to capital outflows (money going into U.S. assets).

Notice that the real interest rate plays an important role in terms of the amount of capital inflow a country will experience. Remember that the Fed can influence the real interest rate in the short term. By changing the interest rate, the Fed also affects the number of net capital inflows in the United States. If the Fed were to decrease the interest rate in the U.S., it would cause the amount of net capital inflows to decline.

The loanable funds model that accounts for an open economy provides insight into international capital flows by analyzing these movements in terms of supply and demand for funds. However, what accounts for the disparities that may be seen from country to country in the supply and demand for funds?

Differences in the demand for money among nations reflect the underlying differences in the investment options available. When all other factors are taken into account, a country that has an economy that is expanding at a quick rate often provides more chances for investment than a nation whose economy is growing at a slower pace. Therefore, an economy growing quickly will often, though not always, have more robust demand for capital and will provide better returns to investors than an economy that is expanding slowly if capital flows are not there. As a direct consequence of this, money tends to flow from countries expanding slowly to those growing quickly.

Examples of International Capital Flows

The movement of money from Britain to the United States and other nations between 1870 and 1914 serves as a typical example of international capital flows and their impact on the economy. During that period, the economy of the United States was expanding at a high rate due to the country's rising industrialization and population, which was shifting westward. Because of this, there was a surge in demand for investment expenditure on things like railways and factories, among other things. Meanwhile, Britain had a population expanding at a considerably slower rate, was already an industrialized nation, and already had a railroad network that covered the whole country. This resulted in Britain having surplus funds, which were then loaned to the United States of America and other economies in the New World.

Differences in national savings rates among countries are reflected in the international variations in the money supply. They may be the consequence of disparities in private savings rates, which may be seen across nations in significantly varying proportions. For example, personal savings made up 25.52 percent of Japan's GDP in 2020, but in the United States, they made up 18.27% percent of GDP, according to Trading Economics.¹ Such differences in savings rates can impact international capital flows, with money flowing from high-saving countries to low-saving countries.

Another example of international capital flows is the case of India. Starting in the 1990s, the government of India undertook some serious reforms in terms of providing a friendly legislative environment for allowing capital flows into the country. The barriers that prevented equity flows were removed, and as a result, many foreigners were able to participate in the Indian equities market and buy shares in Indian companies. This allowed India to experience massive growth in its capital flows, according to the Bank for International Settlements.²

Advantages of International Capital Flows

One of the advantages of international capital flows is increasing aggregate demand. An inflow of capital would cause the interest rate to decrease as more loanable funds are available in the economy. This would make borrowing cheaper, allowing investors to borrow money and invest in new projects. Boosting aggregate demand increases the potential output in the economy and lowers unemployment.

Another important advantage of international capital flows is that it provides technological improvements. It's not just the money that comes with foreign investors inducing cash in domestic companies. They also bring with them new expertise and new methods of conducting business, which may improve productivity, allowing for more output to be generated.