Cross-Border Financial Flows

The third pillar of globalization is the flow of financial capital across national borders. The main types of financial flows between nations include foreign direct investment (FDI), portfolio investments, and bank borrowing. The common thread that underlies each type of financial flow is that assets from one country are acquired by someone from another country. FDI flows represent long-term cross-border investments by investors such as TNCs. Portfolio investments, on the other hand, are typically short-term purchases of bonds, stocks, other securities, or other assets. National currencies are even bought and sold for profit. Bank borrowing involves cross-border transfers of money from creditors to borrowers.[1]

Economists have coined the term “financial globalization” to describe the integration of global financial markets. Financial globalization is encouraged by many of the same forces that stimulate international trade, such as sophisticated information and communications technologies (ICTs), supportive financial regulatory regimes, and market-oriented liberalization of trade and investment. Combined, these forces create a global financial system that is larger, more integrated, more complex, and often more efficient. But there are also risks embedded in this largely unregulated global financial system, including the rapid and unpredictable cross-border inflows or outflows of financial capital. In recent years some countries have devised policies, called capital flow management measures (CFMs) to restrict or better regulate the flow of financial capital between nations.[2]

The traditional benefits of cross-border financial flows center on the efficient and profitable allocation of funds in the global economy. Ideally, cross-border financial flows channel investments and loans from countries with excess money to cash-starved countries. By linking investment money with promising business or investment options in another country, both parties stand to win. That is, lenders and investors earn a healthy return on their money, while recipients grow their businesses and, indirectly, grow their economies. Most cross-border flows originate in the advanced economies.[3] During the early 2000s these financial flows mushroomed from less than 10 percent of global gross domestic product (GDP) to 20 percent of global GDP. The global financial crisis of 2008–2009 resulted in a free-fall in global financial flows, however. By 2010–2012 global financial flows were on the mend but still had not recovered to precrisis levels.[4]

Changes in the exchange rate system during the early 1970s also expanded another type of cross-border investment option in the global economy—foreign exchange trading. Foreign exchange trading, also called forex or fx trading, is the buying and selling of currencies by currency dealers for profit. The transition from a fixed exchange rate system to a flexible exchange rate system opened the door to forex trading. Today a highly integrated foreign exchange market provides a mechanism for forex trading. The main participants in forex trading are banks, brokerage firms, and securities dealers. In 2010 over one-half of global turnover in foreign exchange took place in just two countries, the United Kingdom (36.7 percent of foreign exchange turnover) and the United States (18 percent). The Bank for International Settlements (BIS) reported that daily foreign exchange and derivative trading hit $4 trillion in 2010.[5]

Forex and derivative trading is short term, highly speculative, and potentially destabilizing to the global financial system. Sophisticated communications technologies, deregulated financial markets, and the absence of globally recognized investment rules enable speculators to quickly alter money inflows and outflows between countries. Coupled with the volatility of traditional capital flows, the largely unregulated trading of currency and derivatives raises the danger of financial crises, including financial contagion, as occurred during the East Asian financial crisis of the late 1990s.[6]

  • [1] IMF, “IMF Adopts Institutional View on Capital Flows,” IMF Survey Magazine: Policy, December 3, 2012
  • [2] IMF, “The Liberalization and Management of Capital Flows: An Institutional View” (Executive Summary), November 14, 2012, 1–2, 6–10.
  • [3] Committee on International Economic Policy and Reform, “Banks and Cross-Border Capital Flows: Policy Challenges and Regulatory Responses,” Brookings, September 2012
  • [4] Organization for Economic Cooperation and Development (OECD), OECD Economic Outlook. Vol. 2011/1 (2011): 288–292.
  • [5] Bank for International Settlements (BIS), “Table 1: Global Foreign Exchange Turnover by Instrument,” Triennial Central Bank Survey: Foreign Exchange and Derivatives Market Activity in 2010, November 2012 (Annex Tables); BIS, Triennial
  • [6] The Federal Reserve Bank of San Francisco, “What Caused East Asia’s Financial Crisis?” FRBSF Economic Letter, August 7, 1998
 
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