What are international capital flows?
Some countries save more than they need. Others need more money than they have, for roads, factories or schools. Capital flows are the movements of money across borders that connect the two. Money moves to where it can earn more, or where it is needed most.
Money coming in is an inflow; money going out is an outflow. Both are recorded in the financial account of the balance of payments (see Balance of payments).
Forms: credit and investment
Credit (lending)
A loan or credit must be paid back with interest. The lender can be a bank, a government, an international institution, or people who buy a bond. Whether the project succeeds or not, the borrower still owes the money.
Investment (owning)
The investor buys a share of a business or property.
- Foreign direct investment (FDI): a lasting interest and real say in the business, for example building a factory or buying at least about 10% of a company's shares (a common rule of thumb used in statistics).
- Portfolio investment: buying small amounts of shares or bonds to earn money. It is easy to sell quickly, so it can leave fast ("hot money").
The investor earns profit (dividends) that rises or falls with the business. Nothing is promised.
Good and bad sides
Benefits: jobs, new machines, new skills and faster growth. Risks: too much debt, sudden outflows that shake the exchange rate, and profits that leave the country.
IMF, World Bank, EBRD, EIB
- IMF (International Monetary Fund): formed after the Second World War to keep the world money system steady. It watches economies, gives advice and gives short-term loans to countries that cannot pay their foreign bills (balance-of-payments trouble), usually with conditions for reforms.
- World Bank: gives long-term loans and grants for development: roads, power, schools, health, clean water. Its goal is to reduce poverty.
- EBRD (European Bank for Reconstruction and Development): started in 1991 to help former planned economies move to market economies. It mostly invests in private companies and reforms.
- EIB (European Investment Bank): the bank of the European Union. It lends for EU projects such as transport, energy, climate and small businesses.
There are also regional banks, for example the Asian Development Bank and the Asian Infrastructure Investment Bank.
Scientific and technical cooperation
Countries also share knowledge: joint research projects, student and scientist exchange, training, and sharing of technology (technology transfer). Examples: scientists from many countries work together at the CERN laboratory, space agencies like ISRO and NASA build satellites together, and the European Union funds joint research programmes.
This helps the poorer partner learn modern methods faster and helps everyone solve big problems like climate change or diseases. Foreign direct investment is also a channel for it, because the foreign company brings its machines and know-how.
Try it: follow the money
Pick any big project in your town (a bridge, a metro, a factory). Find out who paid for it: a bank loan, a company's own share, or a government? Write if it is credit or investment, and who gets paid back or gets profit.
Key formulas and definitions
- Simple interest = P × r × t
- Amount to repay = P + interest = P(1 + r t)
- Compound amount = P(1 + r)^t
- FDI rule of thumb: ownership share of 10% or more with real say in the business
- Rate of return on a share = profit share ÷ money invested × 100
Worked examples
1. A firm borrows 500 (thousand) from a foreign bank at 8% a year for 1 year. How much does it repay?
Interest = 500 × 0.08 × 1 = 40. Repay 500 + 40 = 540 (thousand).
2. A government takes a loan of 2000 at 5% simple interest for 3 years. Find the total interest.
Interest = 2000 × 0.05 × 3 = 300. It will repay 2300 in total.
3. A foreign company buys 15% of the shares of an Indian car maker and also sits on the board. Is this FDI or portfolio investment?
15% is above the 10% rule of thumb and the investor has a say in running the firm, so it is FDI. If it had bought 1% only to sell later, it would be portfolio investment.
4. A loan of 1000 at 10% a year is compounded for 2 years. How much is owed?
Amount = 1000 × (1.10)² = 1000 × 1.21 = 1210.
5. A country owes 200 million at 6% a year. Its yearly exports earn 300 million. What share of export earnings goes to interest?
Yearly interest = 200 × 0.06 = 12 million. Share = 12 ÷ 300 × 100 = 4%.
Common mistakes
- Mixing up credit and investment: a loan must be repaid, a share is not repaid, it earns profit or loss.
- Thinking the IMF and the World Bank do the same job. IMF = short-term money trouble; World Bank = long-term development.
- Calling every foreign purchase of shares FDI. Small, quick-to-sell purchases are portfolio investment.
- Saying capital flows are only good. Heavy borrowing and sudden outflows can cause crises.