Initially, the world was operated under autarky. There was no trade between nations. Capital and technology development was confined to particular countries. There were no interactions, and, therefore, a country obtained little benefit from other nations, if any. Each country relied on what it could produce in its local market using the resources and technology that were available. However, that did not last for long as there came the need for opening the markets to allow a free trade of goods and services between nations regionally and globally.
Different countries had varying production capacity, which enhances the need for integration between different nations of the world for their economic survival. Some countries have had an absolute control in the production of particular products over other nations that, in turn, possess an absolute advantage in the production of products. An economy must be in a position to produce a particular product more efficiently than the other for it to trade fairly. There is no nation that has an absolute advantage in production of all goods, and there are nations that have no advantage over production of any. Specialization among the economies has called for the producers’ co-operation to enhance economic benefit among them. Each nation will produce the product that it has specialized and trade it other nation. This transaction could be made possible only through international trade (Kose et al, 2009).
This may not always be the case as one nation may be efficient in production of a specific product while another nation may be inefficient in all products. This may be the case of developed nations and underdeveloped nations. To make trade possible and to create mutual benefits between countries, each country needs to produce the product that it has greatest comparative advantage. By so doing, all nations benefit from international trade. It is through this multilateral trade that the world has experienced international capital flow. Without international trade, there is no international capital flow. Therefore, capital flow and international trade goes hand in hand.
International capital flow is the movement of money, equity claims, financials and real properties. The capital flow is enhanced through trade, that is, exportation and importation at international level. When a country imports products, there is an outflow of capital from the country and an inflow of capital to the exporting nation. The net capital flow is the difference between capital outflow movement and capital inward movement. All nations fight to have a balanced capital account. A country should get finances equal to its payment for imports to have a balance capital account. However, this is not always the case, as a nation receives inflow according to its capacity produce and trade. This means that one nation has a deficit when it is importing more than it is exporting. When a country exports more than it is importing it will have good terms of trade and hence surplus production in capital account. There is a continuous movement of raw materials, semi finished products, manufactured goods and services throughout the world in the form of exports and imports. This implies that international trade is real, so is the international capital flow. The capital flow may also be in the form of foreign direct investments. Private companies owned by foreign investors will inject capital in other nations in the form of investment, and, therefore, these nations earn profits (Bhagwati, 1998).
International capital flow may take different forms. They include: capital investment; international reserve changes; direct investment by foreign firms (FDI); debt clearing; and portfolio investment among others. Foreign direct investment involves direct investing in a foreign nation by a private company or a government. This may be by developing a subsidiary company in the foreign country or by buying a company in another country. Nations encourage FDI through tax exemption and other terms of trade. This tax exemption is considered because there are a lot of benefits that come with these investments. Almost all nations of the world have debts, which may be with international agencies such as World Bank and IMF or with other countries. The settling of this debt is in the form of capital flow. Gold reserves may be used to settle the obligations or even the use of foreign exchange reserves. Another form of international capital flow is through portfolio investment. Foreign companies and individuals may invest in another country’s securities such as bonds and stock (Crotty, 2008).
International capital flow liberalization was championed by the international monetary fund due to its advantages to the growth of the world economy. This was applied especially to the third world nations. In the twentieth century, the international capital flow and financial transactions are the most developed. This capital flow is from both developing and developed nations. Between 1995 and 1997, net flow of capital by private individuals to developing nations tripled. This rapid growth was attributed to the trend of developing countries and industrialized countries towards globalization of trade and economic liberalization. Communication technologies have also played a critical role in transforming financial services through out the world. With increased technologies in computing services, investors are able to get asset information about cost and location at lower cost and within a short period. This has turned the world into a global village. These technologies have also made it difficult for the government to control inflow and outflow of capital.
Advantages of Liberalization of International Capital Flow
Liberalization of international capital flow is now irreversible. It has contributed significantly towards the economic growth and development of developing economies. According to the classical economic theory, international capital movement allows the nations with limited savings to attract funding for their projects from the most developed countries. The third world countries have got high propensity to consume, thus saving very little to be invested. Therefore, through the capital mobility, they are able to finance their projects through portfolio investment.
Globally, nations have got different economic potentials and have different endowment of resources. As a result of this, some countries experience deficit production while others have surplus production. This has led to great inequalities between developed and developing nations. International capital mobility has played a significant role in rechanneling capital from surplus countries to deficit ones. Most of developing nations export raw products that earn them very little. They, in turn, import machineries and other high valued products giving them uncompetitive terms of trade. Because of this, they always have a deficit balance of payment account. It is, therefore, aided by capital inflow to finance its deficit.
Different economies experience trade cycles. They experience economic boom sometimes while, at the other times, there is an economic downturn. They may also experience economic depression because of other forces such as drought, political instabilities or other natural calamities. When there is a boom, which causes inflation, the government may allow outflow of capital thus reduce domestic investment. Therefore, international capital outflow help to control inflation to considerable levels. In case of economic depression, the government borrows from international agencies such as World Bank and IMF to allow a smooth consumption habit. This is by boosting income levels in households and firms, domestic investment accelerates. Firms and households lending money to other foreign countries protect them against losses that might arise in their mother countries. They are assured of their money and assets in those countries that experience peace and economic stability. Their moral to save and invest capital is boosted and makes possible the liberalization of international capital flows. Through borrowing when there is deficit, people’s welfare improves (Edwards, 2001).
The low level of income in a developing nations have been the greatest obstacle to their growth. This is because a level of savings depends on the level of income. Both government and the private sector have experienced low levels of income, thus affecting their capacity to invest. Through international capital flow, the government can get grants from international and regional banks. This can also be from international agencies and organizations such as OPEC. This funding significantly speed up the country’s economic growth. The grants and loans are used in finance infrastructural projects such as energy, communication networks and, transport facilities. This in return will boost investment capacity of the country. Foreign direct investors inject a large amount of money in those countries that have lower capacity to invest. They invest in manufacturing industries adding value to products for export. This benefits the country by improving its terms of trade. Its BOP account is also positively affected. FDI creates job opportunities in the countries where it operates. In addition, as it was emphasized by Bertheley and Demurge, FDI may have long-term effects on economic development, especially in the areas of managerial diffusion. They carry their experts in particular fields. There are trickle down effects of management in the countries of operations. They also transfer technologies that are of great importance to the countries they are operating. The technology development may start in the manufacturing sector. They also fund research in those countries where they operate, bringing innovations and inventions in such countries.
International Monetary Fund being the championing agency of the liberalization of international capital flow has come up with policies that greatly enhance discipline among the nations. Macroeconomic stability of all nations is a key target of the IMF. It has formulated policies that will help gaining macroeconomic discipline among the nations. Poor economic policies of a nation in regard to the international flow of capital attract penalties while those that are in line with IMF policies are awarded by better rates. These policies have contributed to the current world macroeconomic stability. In this regard, liberalization of international capital movement has led to an efficient resource allocation and economic stability. This, in return, has led to a faster growth of the economy (Kose et.al 2009).
In addition to that, international capital movement has led to flow the technological development from industrialized countries to the developing countries in the areas of agriculture, building and construction, and manufacturing among others. This has made some of less developed nations able to produce enough food for their citizens. For instance, a country like Malawi in Africa that was a chief importer of food is now its exporter. It becomes possible through the importation of technologies knowledge and implementation of positive policies. In security matters, technology is widespread to all countries to fight cases of terrorism (Reinhart and Rogoff, 2008).
International capital flow has also led to increased domestic financial stability and banking efficiency. Due to the market liberalization and international capital movement, the growth of financial market in the country has developed significantly. Since banks are profit oriented, they have improved the quality of their services to remain relevant in the banking industry. They have become more efficient to enhance competition with other banks of the world. According to Levine (1996), penetration of foreign banks has improved the quality of available financial services. Banks are able to share their techniques such as management, and, therefore, unify banking services Chang et al, 2004).
A well-developed capital market is an essential tool for economic development. The government is able to sell its capital securities in the international market to finance its projects. It will also enhance political integration between nations. Countries must be in good terms to enhance this kind of transaction. Therefore, it is a good strategy to ensure harmony between nations as they seek market. On the same note, corporates may be operating in a country with poor lending arrangements. In such a case, the best option would be to turn to regional markets for funding (Edwards, 2000).
As the sum-total of the benefits that have resulted from international liberalization, countries are able to concentrate on production of goods and services for which they possess comparative advantage. This is attainable only where resources, particularly labor and capital, are allowed to flow uninterrupted, specifically, in a market liberalization setup. Specialization reduces the costs of production and enables consumers to acquire goods and services at much fair prices. Entities become stronger as they continue improving on what they do best, and the economy avoids wasted capacity that would result from producing for the local market alone.
On the other hand, international market liberalization has not come without its pros. Critics have attached the recent economic distress that have hit various regions of the world to its adverse effects. They argue that the economic system could not bear any meaningful results in a capitalistic world where the aim of all market players is profit maximization. It is extremely difficult for a wealth maximizing investor to act in the best interest of other players in the market and society in general. In a capitalist world, such a behavior cannot be expected (Edwards, 2000).
With specific reference to Asian Financial crisis of 1997-1998, the historic downturn was attributed to mismanaged international behavior Chang et al, 2004). This was done through uncalculated lending practices, more so in immature capital markets and inflated trade deficits. The central banks of these nations have lost control of major regional markets, and, within no time, the adverse effects of ailing equities market and massive currency market fluctuations have become evident. This has just demonstrated what would happen if the international capital markets were left to operate with liberty. It is true that market forces are capable of allocating various resources to their most effective use, but the presence of unscrupulous players in the market makes risky to eliminate all controls (Mishkin, 2009).
Another significant demerit of international market liberalization can be seen in the behavior of powerful nations towards their weaker counterparts. The trend is that there arises a massive damping to the developing economies. The practice leaves the local industries at deplorable states as they look for alternative markets for their products. The local producers, due to their inability to enjoy benefits such as economies of scale and effects of long-term production, are unable to offer competitive prices. Such entities face eminent death. This practice kills the very rationale of promoting technological transfer through international market liberalization.
Uncontrolled capital flows support inflation. This arises where resources move from a country facing inflationary tendencies. The importing country suffers imported inflation. Such a scenario was witnessed in the Asian financial crisis leading to massive currency fluctuations. The affected country finds it extremely difficult to export as its commodities appear artificially expensive in the international markets. In contrast, its imports appear very cheap and hence residents tend to import more. This leaves a serious problem in the country’s balance of payment (Edwards, 2000).
In the event when a country that acts as a harbor in facilitating the connectivity between nations suffers a calamity such as political instability, the effect would be catastrophic. It has been observed over the years of the strong correlation that subsists between a county’s political stability and the health of its economic systems. If capital flows were liberalized in a certain region, then an unfortunate political challenge in one country would spill over to the whole trading block. As a result, the entire population of all the nations that depend directly or indirectly on the interaction would feel that impact. It would then be an uphill task for governments or even international bodies such as the International Monetary Fund to fix the problem due to its high magnitude. This tends to discourage liberalization of international capital movement for the sake of domestic stability and brings the idea of individualism rather than integration of different countries (Crotty, 2008).
FDI are very powerful and with huge capital margins. They tend to be very influential in the process of policy making in those countries they operate. Their operations and interferences with country’s policies negatively affect the working of this economy. They import labor from their mother countries thus reducing job opportunities for the citizens of the country where they operate. They are in favor of policies that directly benefit them without consideration of how it would affect the economic performance of the country. They make abnormal profits after oppressing their workers. They will then transfer these profits to their mother countries leaving their country of operation in the same or even poorer economic condition. Therefore, they may be of insignificant importance to this country’s economic development (Mishkin, 2009).
International capital flow may be an avenue for corruption. Those in charge may use their power over national resources to commit fraud and transfer the money to other nations. Private investors and banks may carry out these illegal transactions. For liberalization to be beneficial to the world and to every nation, appropriate measures need to be put in place. This will allow transparency and accountability for all private investors. Otherwise, liberalization of the international capital market will benefit the minority at the expense of the majority (Chang et al, 2004).
Liberalization of international capital flow has played a significant role in the development of the economy of many developing countries. They have managed to import technologies that would not have been possible without market liberalization. Through FDI, many jobs opportunities have been created in their area of operation. This helped in improving the living standards of the citizens of those nations. Resources have also been distributed from the areas of plenty (surplus) to areas of deficit. This enables maximum utilization of the available resources giving maximum outcomes. Liberalization has also tried to reduce inequality between developed and developing nations. This has been made possible by the ability to transfer capital and technology to where it is mostly required. However, if not well controlled, it may bring problems to the developing nations. There might be damping and importation inflation. The capital may also have some strings attached to it, thus a disadvantage to the importing nation. But despite all these, IMF should be supported in it attempt to liberalize the international capital flow (Mishkin, 2009).