Capital flows in a Globalized World

Countries need foreign currency to pay their import bills.   

They can obtain these from:

- foreign bank loans,

- foreign purchases of stocks or bonds of their countries, or,

- direct foreign investment in local factories.

These flows all are recorded in the capital account of the balance of payments.

Analysts and newspaper headlines tend to focus only on foreign purchases of stocks and bonds.  These are often called "hot money" because foreigners looking for a quick profit can dump stocks and bonds like hot potatoes when crises begin.

Bank loans:  the real hot money 

In recent decades, the most volatile capital flows have actually been bank loans, which are now the real hot money.

China and other emerging markets began opening their doors to foreign capital.  Capital flows rose from 2% of global GDP in 1980 to 16% (a whopping $19 trillion) by early 2007.

Then came the 2008 crisis and optimism about emerging nations vanished. 

By 2014, capital flows had fallen back to $1.2 trillion - once again about 2% of current global GDP.  , Bank lending, the largest portion of capital flows, turned negative during the crisis, indicating that banks were liquidating loans to bring money home.

When capital flows slowed

With capital flows slowing, those countries with persistent current account deficits may run into trouble financing these deficits much sooner.

In the pre-2008 era, the tipping point came when the deficit had been increasing by 5% of GDP for five years in a row.  

In the post-crisis era, the tipping point may come faster and at a lower deficit levels; the 5 percent rule may become a 3% rule.

How to read Money Flows: Study the Balance of Payments, especially the Current Account

Money flows

If the currency feels cheap and the economy is healthy, bargain hunters will pour money in it.

If the currency feels cheap but money is still fleeing, something is wrong.#

Study the balance of payments, particularly the current account

All the legal channels for money flows can be found in the balance of payments, particularly the current account.  

Current account = net trade (mainly) + other foreign income.

The current account captures how much a nation is producing compared to how much it is consuming and it reveals how much a nation has to borrow from abroad to finance its consumption habits.  

If a country runs a sizable deficit in the current account for too long, it is going to amass obligations it cannot pay.  The trick is to identify the tipping point.

Persistently high current account deficit leads to economic slowdown

Testing for various sizes of deficits, over various time periods, confirmed that when the current account deficit runs persistently high, the normal outcome is an economic slowdown.  

If the deficit averages between 2% and 4% of GDP each year over a five-year period, the slow-down is relatively mild.  

If the deficit averages 5% or more, the slowdown is sharper, shaving an average of 2.5% points off the GDP growth rate over the following five years.  

The growth slowdown hit countries rich and poor.  

This is the danger zone

If a country runs a current account deficit as high as 5% of GDP each year for five years, it is consuming more than it is producing and more than it can afford.

Running sustained current account deficits of more than 3% or 4% of GDP can also signal coming economic and financial trouble - just less urgently.

In fact, some emerging-world officials have come to believe that when the current account deficit hits 3% of GDP, it is time to restrain consumer spending and prevent the country from living beyond its means.

Below the 3% threshold, a persistent current account deficit may not be a bad thing.  

• If money is flowing out of the country to import luxury goods, which do not fuel future growth, it will be harder for the country to pay the import bills.  
• If it is going to buy imports of factory machinery, the loans financing those purchases are supporting productive investment in future growth.

One quick way to determine whether the rising deficit is a bad sign is to check whether investment is rising as a share of GDP.   Such a rise at least suggests that money is not flowing out for frivolous consumption.

Appendix:

# In late 2014, the Russian ruble collapsed because of the falling price of oil.  Russians were still pulling tens of billions of dollars out of the c0untry every month, fearing that the situation would get worse.  Cheap was not yet a good sign, because the ruble was not yet cheap and stable.

Summary

The article's key points:

To understand money flows, focus on studying the balance of payments, especially the current account.

The current account reflects a nation's production versus consumption and reveals how much it borrows from abroad.

Persistent high current account deficits lead to economic slowdowns.

Deficits between 2% and 4% of GDP cause milder slowdowns; deficits of 5% or more cause sharper slowdowns.

Running deficits above 3% or 4% of GDP can signal economic trouble.

When a country has a 5% GDP deficit for five years, it is living beyond its means.

For deficits below 3%, it depends on whether the money is invested productively or wasted on non-essential imports.

Appendix: In 2014, the Russian ruble collapsed due to falling oil prices, and money continued to leave the country, showing that cheapness of currency wasn't a positive sign until it stabilized.