International Capital Flows

International capital flows include all transactions by residents of one country that involve financial claims on and liabilities to residents of another country. International capital flows are divided into various categories, including foreign direct investment (FDI), foreign portfolio investment (FPI), reserve asset flows, and other flows such as bank loans and export and import credits. International capital flows were vigorous before World War I, resumed in the 1920s, came to a virtual stop after the Great Depression, and were restricted under the Bretton Woods system that defined the international economy between World War II and 1973. Since the collapse of the Bretton Woods system, international capital flows have been a catalyst of increasing integration in the world economy.

International capital flows began to play a major role in the world economy during the second half of the 19th century. Britain, France, and Germany were major sources of financial funds to the rest of the world during this period. The majority of international capital flows were in the form of portfolio investment; debt and equity securities financed governments in the periphery as well as large-scale infrastructure projects such as railroad construction. The volume of international capital flows relative to gross domestic product (GDP) was substantial. World War I disrupted this pattern of high capital mobility. International bank lending and portfolio investment resumed in the 1920s under the leadership of the United States. However, the Great Depression put an end to this wave of rising international capital flows. As autarky became the norm in the [Page 900]1930s, the volume of international capital flows stood at depressed levels.

The international economic system established after World War II (named after the Bretton Woods conference) was hostile to the free flow of capital across borders; industrialized as well as developing countries restricted international capital flows by adopting binding capital controls. Private capital flows resumed only in the 1960s, with the emergence of the Eurodollar markets. As the Bretton Woods system collapsed in 1973, the abolition of capital controls and of restrictions on domestic financial intermediation began in the early 1970s. The United States took the leading role in abandoning capital controls and was followed by other major industrialized countries in the late 1970s and the 1980s.

The growth of international capital flows since the late 1970s has been remarkable. According to the recent studies conducted by the IMF, gross international capital flows stood at approximately 5 percent of world GDP in 1980. While international capital flows have occasionally decreased during times of major financial crises (such as the developing country debt crisis in the early 1980s and the 1994 Mexican crisis), the overall trend has been upward. In 2005 gross international capital inflows were $6.4 trillion, which was close to 15 percent of world GDP.

Due to growing capital flows, international financial integration has risen significantly over the last three decades. As Philip Lane and Gian Maria Milesi-Fer-retti showed, the sum of foreign assets and liabilities as a percentage of GDP increased from approximately 50 percent in the early 1970s to more than 300 percent in 2004 in industrial countries. Furthermore, the rate of the increase itself has been rising, with major acceleration of global financial integration in the 1990s and 2000s (despite a brief slowdown after the Asian financial crisis). Financial integration in emerging and developing market economies has also been strong, although it did not reach the level observed in industrial countries. In emerging economies, the sum of foreign assets and liabilities as a percentage of GDP was approximately 150 percent in 2004.

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