Intro: International Capital Flows
International capital flows are the financial side of international trade. When someone imports a good or a service, the buyer (the importer) gives the seller (the exporter) a monetary payment. Basically, ICF are the transfer of assets across international borders and represent a major source of financing economic activity indeveloping countries. International capital flows have the potential to bring a wide range of benefits to both the host nation and the country of origin, increasing global output, employment, and wealth.
Three groups of investments are the components of ICF: (p143) Portfolio Investments (45%), Bank and other investment (30%) and FDI (25%). Each category has strong benefits and risks for the countryconcerned.
A. Portfolio Investment
Portfolio investment is the category of international investment that covers investment in equity and debt securities. It is a collection of investments all owned by the same individual or organization. These investments often include stocks, which are investments in individual businesses; bonds, which are investments in debt that are designed to earninterest; and mutual funds, which are essentially pools of money from many investors. It does not create a lasting interest or effective management control over an enterprise.
By investing in foreign securities, investors can participate in the growth of other countries, hedge their consumption basket against ex-change rate risk, realize diversification effects and take advantage of marketsegmentation on a global scale. Even though these advantages might appear attractive, the risks for international portfolio investment must not be overlooked. In an international context, financial investments are not only subject to currency and political risk, but there are many institutional barriers. The most obvious way to invest internationally consists in the purchase of foreign securities directly,either abroad as a foreign direct share; or at home in case shares of foreign companies are traded in the domestic market. There are still significant barriers and complexities to this strategy such as transactions costs and lack of information.
B. Banks investment and foreign aid
Aside from the startup capital and additional cash that the bank must keep on hand, banks must have a sourceof funds they can use to invest. This capital flow includes deposit holdings by foreigners and loan to individuals, businesses and governments. Commercial bank loans refer to lending by foreign private banks (For example: Citibank making a loan to a firm in India). This form of international capital flow has faced relative decline. In the 1990s, bank loans accounted for 28% of the capital inflowsfrom the major industrialized countries, compared to less than 3% in 2002.
Foreign aid can be either multilateral (e.g. through the World Bank) or bilateral (e.g. from the United States to Rwanda through US AID). It is most easily thought of as a grant from the donor nation or institution, although it is often a loan on concessional terms. Foreign aid has also declined in relative importance asit has been overtaken by private capital flows. While the United States was the second largest provider of foreign assistance in 1997, the total value of that aid accounted for only 0.08% of U.S. GNP.
C. Foreign Direct Investment
Foreign direct investment refers to long term participation by country A into country B. It usually involves participation in management, transfer oftechnology and expertise. FDI is generally divided into two categories: Greenfield Investment and Mergers & Acquisitions. Greenfield investments are those that create new enterprises and develop or expand production facilities. Mergers and Acquisitions involve the purchase of an existing enterprise. FDI plays an important role in the U.S. economy. In the short run, foreign capital invested in the...