International economics: theory and practice

International Capital Flow: Why is it important for the Global Economy?

This brief paper will consider the role that the international flow of capital has on global economic development. It will provide a basic definition of international capital flow and a description of how it impacts the global economy, as well as a discussion of some recent and historical developments regarding the international flow of capital and potential problems and benefits associated with them.

International capital flow constitutes the financial side of international trade (Ott, 2008). It takes place when investors in a country of origin engage in direct foreign investment in a host country, which then uses that investment to settle financial accounts due to trade imbalances or buy technology to drive further investment or the like. Generally, this flow of capital is seen as a means to achieve growth and development levels that domestic savings and investment alone cannot achieve. When it works beneficially, therefore, it serves to increase the development of economies and the transfer of technology that facilitates economic development, as well as to integrate developing nations into the global trading community (World Bank, 2001; Taskin and Muradoglu, 2003; Feldstein, 1997).

Impact on Global Economic Growth. The international flow of capital has a number of both positive and negative impacts on global economic development. Among the more positive impacts are the following:

1. It supplements the supply of domestic investment savings for host nations.

2. It brings resources such as technology and managerial competence to developing nations.

3. It opens access to markets at lower costs for investor nations.

4. It affords risk diversification for investors with potential for higher returns. (Feldstein, 1997)

There are risks and disadvantages associated with the international flow of capital as well, largely revolving around volatility concerns associated with such factors as interest rates, currency fluctuations, commodity prices, and the like. In those countries where political corruption or instability exists, this financial volatility has been especially pronounced. Therefore, as the Worldbank (2001) reports,

Taken altogether, the evidence suggests that capital flows reinforce a positive growth dynamic. They tend to go more to countries with strong investment climates, and their long-run benefits are most pronounced in such environments. As many of the countries with strong investment climates are middle- rather than low-income economies, international capital flows in recent decades may have contributed to a widening of income differentials between the developing countries…" (59-60).

Historical Trends and Developments. Eichengreen (2004) argues that there have been several major historical "regimes" that have had differentiated approaches to international capital flows. Prior to WWI, the free flow of capital across borders reached heights never seen before of since. This was followed by effort in the 1920s to establish international controls for the international flow of capital. The financial disaster of the 1930s began a period of tight regulation of international transactions. In the 1970s another period of free-flowing capital was begun, culminating in the boom of international capital flows of the 1990s (4).