Chapter 16
International Capital Flows—Increasingly Critical
The digital transmission of communication across borders has given investors much greater confidence to invest out of their home markets and allowed companies to use global value supply chains with greater confidence. International capital flows have often been from investors chasing returns but increasingly have been driven by the globalization of business operations and international supply chains.
When balancing the decisions to invest in your home market or in international markets following capital flows can be critical when monitoring the health of a country, you can often see the interdependence of various countries’ economies and get a sense of what is driving a country’s economy. The ability of a country to attract foreign capital as well as retain its own capital for investment is a considerable strength. The ability to attract foreign capital can lead to dependence on foreign capital which is a classic economic double-edged sword. Many types of foreign investment can be quite fickle.
Foreign capital flight is an issue for concern but so is flight of domestic capital. For example, if it becomes obvious a country is moving to devalue its currency agents in the economy that can shift to foreign currencies will move out of a country as quickly as foreign capital might, assuming there are limited or no capital constraints. If a country’s capital is leaving to go invest in foreign markets, you must ask why it is leaving too.
Traditionally international capital flows fall into three categories; foreign direct investment (FDI), foreign portfolio investment (FPI), and debt. A fourth form of increasingly common capital is foreign bank or liquidity deposits related to supply chains.
FDI is generally considered the stickiest of the forms of investment. It is usually defined as a foreign entity (usually a company) taking a meaningful, relatively illiquid, ownership stake in an asset overseas. For example, this might be a large ownership stake in a gold mine or a fish farm company. Some papers have defined this stake as having to be over a 10% ownership stake up to 100%.
FPI is when a foreign entity takes a smaller ownership stake in an asset. This usually is in the stock of a company. It frequently is in publicly traded stock markets and therefore is liquid and tradable. It may be for a trade in the security or a long-term investment, but it is usually below a 10% stake in a company and liquid.
Debt investments are exactly as they sound, a contractual loan of some kind. Note, that debt can be in the lender’s currency or the borrower’s currency or even a third nation’s currency. It can also take the form of bank loans or bonds or some other form of securitized or unsecured instrument. As bonds are often more tradable than loans, some people differentiate between the two and refer to the more liquid bond debt investments as foreign portfolio debt.
With the increase in global supply chains, many companies have opened bank accounts in foreign countries and store cash there, or invest locally in other short-term instruments. Some might include this in FDI, but it has separate dynamics as the companies are not always making any form of equity investment but simply putting liquid working capital into the market. If this money sits in banks or elsewhere it can then be recirculated as capital through bank loans, it increases available capital in that country. Additionally, some of the supply chain relationships are creating capital sources. A company’s local supply chain partner may be able to access capital because it has a contract from a large foreign business. Companies may also extend trade credit to their international supply chain partners.
Some of the theories behind the drivers of foreign capital investments focus on push attraction and pull attraction. Push factors are generally driven by the environment in the country where the capital is coming from, usually wealthier countries. These push factors are typically driven by central bank actions or other actions that are causing a domestic environment of low returns or increased risks that push investors to look elsewhere for returns or safety. This leads them to invest in foreign markets. Pull factors are specific to the country that is attracting the capital. These might be levels of economic stability, the quality of the rule of law and its institutions. Of course, a major attractor of capital is growth potential and opportunity for asset value appreciation that is greater than in the investors’ home market.
Investors tend to be cautious about making cross-border investments. Reasons for this can include variations in rules and laws, capital flow restrictions, as well as concerns about currency fluctuations. There are also major concerns about asymmetrical information, meaning that local investors and operators will have more access to better information than foreign investors, sort of a home field information advantage. This will allow home market investors to trade or invest better than the foreigner. Real-time communications and news have helped reduce this concern, but not completely. Because of this you will often see greater capital flows between countries with similar cultures, rules of law, proximity, and/or language.
As international capital flows have increased the interaction and interdependence between nations has increased. This leads to greater linkages, when things go bad the can spread across numerous markets quickly, this is called contagion. Because of these increased linkages capital outflows or large international capital losses can more easily end up not just being an isolated regional problem but a global one. Capital outflows can be triggered by a problem in the country that is being invested in and/or from the country that is doing the investing. Diversification by region and the types of economies can help minimize the impact of such events. For example, if your international exposure is all coming from commodity dependent countries or tech service-oriented countries you are more exposed to a specific global industry rout. It is also important to keep in mind that every time there are issues in a country, or even a region, it does not trigger contagion; an infected toenail does not always spread all the way up your leg.
When looking at a country’s risks you want to see if there is a high concentration of international credit. If one country is heavily invested in another or a country is heavily dependent on the capital of another, risks are high of contagion between the two nations. Similarly, if foreign capital is heavily concentrated in one industry it presents risks for that sector and the investors. This has occurred in the past as there was too much foreign capital supporting the Korean banking industry at one point and the Indonesian natural resources businesses.
In trying to monitor that accessibility of capital and the types of capital being utilized there is data, but it is often far from complete and seems to have significant gaps in measuring the new sources of capital rising. There are data sources on public capital raises and there is data on international capital flows, these include balance of payments reports and the U.S. Treasury’s Treasury International Capital (TIC) report.
Data on international capital flows can be found in the databases of several organizations, some of the most accessible are the International Monetary Fund (IMF), the Bank of International Settlements (BIS), the Organization for Economic Cooperation and Development (OECD). Numerous government reports and agencies also have data on these flows. Much of the information is dated by the time it becomes available. The development of softer, faster data in this arena has not really evolved as much as other areas of economic reporting.
Much of the research in this area is focused on flows from developed countries to lesser developed countries. In many cases foreign capital is more important to these advancing countries and it is a larger portion of their overall capital. However, monitoring international capital flows factors can highlight important signals for developed countries as well and can impact growth, currencies, inflation, and other key data.
The greater use of global supply chains has caused a somewhat surreptitious increase in foreign capital investments. At times this “investment” is simply not coming from a company’s balance sheet, but from its expense line, simply by buying products overseas it is sending capital to that country and that industry even if it is not an investment. This growth has been driven by technology improving logistics and information flow. Local capital commitments to infrastructure in exporting countries, especially in Asia, have also fueled this expansion. Supply chains have increased capital in many countries with large exports of intermediate goods. This increase in global supply chains is also distorting current capital flow data from historical information.
When decision making about international investments, foreign capital flows and data on a nation’s balance of payments is an important part of analyzing a country’s political and economic stability, infrastructure and growth. However, recognize the data tend to have a long lag, especially compared to the increase in the speed at which capital can move today. It is also quite likely that globalization and supply chains have distorted some of this current data relative to historical statistics. Foreign capital flows do not happen in isolation. When capital flows out of a country and into another, something is triggering an investor to make that decision, even if it is as benign as a wish to diversify.