Long Term Capital Flows

Long Term Capital Flows 

While explaining the book-keeping of the balance of payments a reference has been made to capital flows. You will now learn that the long-term capital flows are caused by the development needs of the various countries. Presently the world can be broadly divided into the capital surplus countries and the capital deficit countries. Most developed countries are the capital surplus countries, while almost all developing countries are the capital deficit countries. Since the countries falling in the latter category have not been able to save adequately for their investment requirements they import foreign capital from the capital surplus countries. 

Foreign capital usually takes two main forms :

 i) private foreign investment, and

ii) foreign aid. 

Before World War II, private foreign investment was used by the colonial powers to exploit the market

of the colonies. Since these colonies have become independent, the penetration of private foreign investment in its earlier form has stopped. 

Currently private foreign investment assumes two forms : i) direct foreign investment, and ii) indirect foreign investment. The bulk of the direct foreign investment is now made by the multi-national corporations (MNCs), These MNCs provide substantial amount of financial resources to the countries where they set up branches and subsidiaries. The capital recipient countries thus get substantial help in meeting their needs of capital for growth. But these countries subsequently face problems when repatriation of profits by MNCs starts or the production plans of these companies start causing distortions in their industrial structure,

Indirect foreign investment takes place when nationals of a country make investments in the shares and debentures of the foreign companies. At present most of the private foreign investment is'made in the direct rather than indirect form. Foreign aid, refers to official loans and grants given in currency or in kind from developed countries and international financial institutions to less developed countries.

These loans and grants are provided for development purposes. In international finance only those loans and grants are relevant which are provided in currency. The chief characteristic of such aid is that it is made available on concessional terms implying that the rate of interest is lower and the maturity period is longer. Foreign aid rarely involves any foreign exchange problems when it is provided. Since aid is given by the developed countries in their own currencies and by the international financial institutions in the currencies of the developed countries,it can be used easily to buy capital equipment and technology in the international markets. However, the problem arises when debt servicing obligations are to be met.

For this purpose aid recipient ,countries would need foreign exchange which they can acquire only by having surpluses in their balance of payments. This in most cases is quite difficult to accomplish. As a result most countries inviting foreign capital are now in tight corner. They have either already fallen in the debt trap or are facing the risk of falling into it. 

International Financial System

International financial system refers to the system for the flow of funds between nations. The need for the flow of funds on account of two reasons. First, trade between the nations often requires international transfer of funds. Since trade rarely assumes the form of barter, there is either a surplus or a deficit in the balance of trade of a country. This will transfer of funds between the countries. A second category of transfer of funds from one country to another involves long-term capital flows. These may be at both the government and the private levels.

The need for international finance of two kinds: 1)Long term  and 2) Short term

The balance of payments of almost all countries are invariably in disequilibrium. This implies that there is either a surplus or a deficit in the balance of payments. This would require flow of short-term funds from a surplus to a deficit country. 

On the other hand, flow of long-term capital between the countries is guided by two factors: 

1) the foreign capital needs of developing countries and

 2) the investment opportunities available abroad, Now let us detail about short-term requirements and requirements separately.

Short  Term Flow of Funds:

As discussed earlier, the need for short flow of funds at their level arises from the disequilibrium in the balance of payments of the various countries. 

But what does this disequilibrium mean? The balance of payments of a country refers to the net claims of a country against the rest of the world arising from the transactions over a certain period. these claims are positive, the balance of payments is said to be while if these claims are negative the balance of payments is termed as In order to follow this statement, it is necessary to understand the book-keeping of the balance of payments. In Table 14.1 given below, accounts of a country's balance of have presented in a summary form.

The balance of payments of a country involves double entry book keeping and is, thus, always in balance. This implies that total receipts are equal to total payments. If you  look at Table 14.1 carefully, you will observe that both credit and debit sides have the same total, that is $2,000. Still the balance of payments of this country may not be in equilibrium and may require flow of short-term funds between this country and the rest of the world. This is really a paradoxical situation and it deserves careful attention. Since this is a somewhat complex situation, it is necessary for us to consider each item of the balance of payments account separately.