Should Rigorous Controls Be Imposed On Transnational Capital Flows?

I. INTRODUCTION

Transnational capital flow is a term coined to describe the movement of capital across national

boundaries. International financial and capital flows have experienced a phenomenal upsurge during the

late twentieth century. According to the latest estimates, foreign exchange to the tune of one to two

trillion US dollars is transacted internationally every day. Significantly, exchanges in trade and services

constitute only a tiny fraction of these transactions, while the majority is composed of movement of shortterm

capital and foreign investment. While the benefits of such flows are manifold, there are negative

side-effects too. Unfettered movement of capital in developing countries has triggered off several

economic crises in recent history and there is a compelling case for tempering such flows through

imposition of adequate controls.

I.i Types of Global Capital Flows

Transnational capital flows can be broadly classified into the following categories:

1) Foreign Direct Investment (FDI): Acquisition of companies, physical investment in plants and

equipment.

2) Foreign Portfolio Investment: Investments in capital markets.

3) Loans and credit issued by International Banks to local lenders.

4) Currency transactions, primarily as part of currency hedging strategies.

5) Global insurance.

I.ii Benefits of Free Capital Flows

Free Capital Flows lead to greater flexibility in international financial markets and financial transactions

across national boundaries, contributing to overall development of the economy and a rise in living

standards, because of increased foreign investment and financing. In such an environment, investors also

enjoy higher returns and better portfolio diversification. This translates into deepening efficiency and

sophistication of domestic financial markets, by letting the most efficient investors earn profit and

ensuring removal of inefficient investors, leading to efficient resource allocation.

II. TRANSNATIONAL FLOWS Ð'- CONCERNS AND APPREHENSIONS

Developing countries face a much greater risk of financial instability due to free capital flows and

unregulated transnational flows.

1. Developing-country financial markets are smaller, so entry or exit of even medium-sized investors

from industrial countries is capable of causing considerable price fluctuations, even though their

placements in these markets account for a small percentage of their total portfolios.

2. The domestic financial system is more vulnerable because external debt is typically owed by the

private sector rather than by sovereign governments and also a higher share is denominated in foreign

currencies.

3. Differences in environmental standards causes investment flow to developing countries having less

stringent environmental standards to reduce production costs, which adversely affects the

environment.

II.i Problems Associated with Free Capital Flows

International capital flows are highly sensitive to domestic macro-economic policies, the soundness of

banking systems, and other economic and political developments.

1. Short-term capital flows are often volatile and subject to surges and sudden withdrawals, adversely

affecting developing countries.

2. They might also result in loss of autonomy in fiscal policy decision-making national governments

II.ii Pointers to Impending Financial Crisis

Pointers Examples

1) Liberalization of the economy with very weak regulation.

2) Crony Capitalism i.e. the nexus between politics and investors, as well as hiding

or misrepresentation of facts.

3) Lack of regulatory institutions allowing external short-term borrowings for

speculative purposes and long term domestic financing

4) High interest rates and robust economic growth attract foreign banks and hedge

funds

5) Foreign fund inflows, rather than FDI, being encouraged

East Asian

Crisis

1) A period of high overvaluation followed by sudden devaluation of the national

currency.

2) Episodes of currency instability due to a sharp increase in capital inflows

followed by an equally sharp reversal. Such swings due to internal or external

policy changes that produce divergences in domestic financial conditions relative

to those of the rest of the world, often initially reflected in interest-rate

differentials and prospects of capital gains.

Mexican

Crisis

1) Sudden decline in commodity prices on economies heavily dependent on export

of raw materials.

2) Reversals of capital flows associated with deterioration in the macroeconomic

conditions