Capital Flows

What are Capital Flows?

Capital flows are transactions involving financial assets between international entities. Financial assets to be included can be bank deposits, loans, equity securities, debt securities, etc. Capital outflow generally results from economic uncertainty in a country, whereas large amounts of capital inflow indicate a growing economy.

Two Major Types of Capital Flow Transactions

1. Official capital flows

Official capital flows include changes in the United States’ monetary reserve, foreign currency exchange, and special withdrawal agreements with the International Monetary Fund. Generally, changes in the country’s foreign official assets are caused by transactions related to U.S. Treasury bonds, federal government obligations, and even U.S. stocks and bonds held by the Federal Reserve.

2. Private capital flows

Private capital flows include direct and portfolio investments made by Americans living abroad and foreigners living in the United States. Direct investment involves the ownership or control of more than 10% of voting securities for a publicly-traded business or the equivalent stake in a private business. Portfolio investment refers to the ownership of financial securities.

How Countries Restrict Capital Flow Transactions

Many countries impose restrictions on the flow of financial capital across borders. Such restrictions are referred to as capital controls. For example, a restriction can be sanctions put in place that prohibit all investment in a foreign entity. Other examples include taxes, tariffs, and volume restrictions.

The capital restrictions can be put in place to prevent foreign investment domestically or to prevent domestic investors from investing in certain countries. Economically, the restrictions reduce economic welfare. However, in the short term, such restrictions prevent large foreign capital inflows during times of expansion and lighten the impact of foreign capital outflows during periods of a market correction.

The Objective of Capital Restrictions

The four primary objectives that a government considers when imposing capital restrictions include:

1. Maintain fixed exchange rates

If a country sets a fixed exchange rate target, the country can control capital flows of foreign capital to achieve the target exchange rate. Fixed exchange rates can help a government maintain low inflation, which ultimately can help keep interest rates low and encourage consumer spending.

2. Keep domestic interest rates low

Restriction of capital outflow allows countries to maintain their low domestic interest rates, and therefore allows the country to manage the economy through macroeconomic monetary policy. Furthermore, restrictions on being able to invest in countries with higher interest rates can be imposed to further control the flow of capital.

3. Protect strategic industries

The government will restrict capital flows if they view it to be a matter of national security. Commonly, the government will prohibit investment by foreign entities into industries related to national security, like the telecommunications industry.

4. Reduce the volatility of domestic asset prices

If a country is experiencing macroeconomic distress, capital will flow out of the country, ultimately reducing asset prices. The assets that are more extensively impacted are liquid investments – such as stocks and bonds. Markets without restriction on inflow or outflow of investment capital are generally more volatile.

Do Capital Restrictions Work?

Restrictions on capital flow often lead to temporary success; however, in the long term, restrictions on the flow of capital can cause many economic problems. The only regulations necessary for optimal allocation of resources in a free-market economy include property rights, the rule of law, and contract law.

Regulating capital flows creates excess friction and ultimately reduces market efficiency. Ultimately, it implies that the regulatory measures will lead to a surplus or shortage of capital in the market.

Many governments that regulate capital flows indirectly indicate to investors that the economy is not functioning efficiently. Additionally, countries with strict restrictions on capital outflows experience major difficulty procuring capital inflows because lenders know that they will be unable to recover their investment.

It is important to note that large capital outflows on their own are not necessarily problematic; however, large capital outflows can be indicative of a larger problem at hand.

Additional Resources

CFI is the official provider of the Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to transform anyone into a world-class financial analyst.

In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:

• Capital Markets
• Market Efficiency
• Capital Markets Education
• Monetary Policy
• See all economics resources