Capital Flows

• Author: Prakash Loungani
• Pages: 5-6

Prakash Loungani¹

Page 5

For both developing and industrial countries, international gross capital flows grew markedly during the 1990s. In the industrial countries, gross capital flows as a percent of GDP are presently about 15 percent of GDP, as compared with an average of about 10 percent in the 1980s; the rise in cross-border capital flows among the members of the European Union is a significant factor behind this rise. For the developing countries as a whole, gross capital flows-after a drop in the 1980s- are now about 5 percent of GDP, roughly the same level as in the late 1970s. ²

In addition to changes in the level of overall capital flows, the 1990s have accelerated an ongoing change in the composition of capital flows: the share of bank loans has declined and that of foreign direct investment (FDI) and portfolio investment has increased. According to Mody and Murshid (2002), in the period 1995-98, FDI accounted for 55 percent of private long-term capital flows to developing countries and bank loans for 15 percent. The remaining 30 percent was accounted for by portfolio flows; while higher than it was two decades ago, this figure reflects a scaling back from a share of nearly 40 percent of total flows in the first-half of the 1990s. ³

Supplementing the data on capital flows, recent IMF work has developed new measures of capital market openness (or restrictions). Lane and Milesi-Ferretti (2001) construct estimates of gross stocks of foreign assets and liabilities as a percentage of GDP, and show that these stocks increased rapidly in both developing and industrialized countries over the 1990s. These stocks can be used as a measure of financial openness, analogous to measuring financial sector depth, using the stock of credit to the private sector, as a percent of GDP. As it is based on the accumulation of stocks , this new measure provides a more gradual and backward-looking view of changes in openness and is less influenced by the reversals of flows that often occur in the course of financial crises. ⁴

In contrast, Edison and Warnock (2001) propose a measure that is available at a high frequency, monthly, but is narrower in coverage-it measures only stock market liberalizations. Their proposed measure of openness is the proportion of a country's total stock market capitalization that is available to foreign investors. This measure, available for 29 emerging market countries, this measure shows substantial opening up in many Asian countries during the 1990s; Latin American countries opened up to foreign equity investment earlier and more extensively than the Asian countries. ⁵

What drives cross-border capital flows? ⁶ Much of the literature on North- South flows has found it useful to dichotomize the driving forces into push and pull factors. The former are factors such as low interest rates (or asset returns) in industrialized countries, which serve to push capital out of these countries in search of higher returns elsewhere. The pull factors are the ones that serve to attract capital into particular host countries-low wages, tax incentives, level of financial market development, protection of property rights, and the like. Mody and Murshid suggest that the "flush of capital inflows in the 1990s was more a push into developing countries rather than a pull based on unmet demand for...