Cross-Border Capital Flow

Cross-border capital flow refers to the flow of funds (money) between at least two or more countries (or borders). It is a part of international trade where there is a natural flow or movement of capital across nations. It provides a source of finance for the economy to prosper. 

These free flows can occur in various forms, such as foreign direct investment (FDI), portfolio investment, equity, and debt investment, constituting the financial account or from institutional investors. In short, they create a smooth linkage between nations and domestic financial systems. As a result, there is also an easy transfer of capital between economies. 

Cross-border capital flow is an economic term used to describe the cash flow transfers occurring between two or more nations. It acts as a connective tissue among different borders and facilitates economic prosperity among them. Also, there is equivalent financial support witnessed by the economies of such nations. Thus, an increase in international trade also contributes to such cash flows. However, improper management of cross-border capital flows and financial contagion also lead to instability across nations. 

The occurrence of the cross-border capital flows originated after World War II. Until then, there was limited scope for countries to expand their finances. But, later on, with liberalization, capital started flowing across various nations. It can take the shape of any investment type. One of the popular types includes FDI and portfolio investment. When countries make long-term investments in other nations, it often results in foreign direct investment. Likewise, foreign and institutional investors may also invest in nations with stocks, bonds, and other instruments. 

In addition, the economy may also rely on bank lending as well for capital purposes. Bank lending refers to the debt or loan a domestic country provides to other nations. Plus, remittances and transfers from individuals residing overseas also contribute to these cash flows. It enables a stream of funds to the latter. However, some standardized banks tend not to increase the credit limit. Hence, there are higher cross-border capital flows and bank risk-taking.  

Every nation has its own set of rules and regulations when considering capital flows across borders. There must be stringent control over the funds and the capital running throughout the nations and respective economies. Here are some of the methods listed below:

• Capital controls - At times, there can be frequent cash-related transactions in and out of the country. And if the outflows are more than inflows, it can indicate a serious underlying economic issue. Hence, governments may decide to implement a capital control system to manage cross-border capital flows. These controls can be in the form of limited exchange or currency conversion, taxes, or requirements over the approval of foreign transactions. 
• Macroprudential policies and trade policies - In most countries, macroprudential policies are implemented by the monetary unions or central banks. It ensures enough stability in the financial system and attempts to protect it. Akin to financial policies, they aim to control credit growth or asset bubbles. For instance, in 2020, the cross-border assets rose to $130 trillion, with an almost 60% hike. In such times, these policies help in reducing excessive leverage and liquidity evolving in the market. 
• Foreign exchange intervention - Governments have the upper hand in currency prices with floating exchange rate systems. They have the right to intervene in and try to influence the foreign exchange markets. For instance, they may bulk buy or sell their reserves to create the required balance. 
• Bilateral and multilateral agreements - Likewise, nations may negotiate trade (bilateral or multilateral) agreements with allies and neighboring countries in trade organizations like the WTO (World Trade Organization) or similar ones. 

Let us look at some examples of cross-border capital flows to understand the concept in a better way:

Example #1

Suppose Iseland is a country in the western part of the world. In the later stages, they saw a booming stage for the economy. Also, they wanted to expand their relations with other nations. Therefore, they decided to come into a treaty or a trade deal with the powerful allies as well. One more benefitting factor was that the Iseland saw a huge number of migrants residing in their country for job opportunities. As a result, the economy had a surge in the net national income (NNI). 

However, in the later stages, there was an excess cash outflow from the country. As a result, the government decided to impose transaction taxes and import duties to stabilize the situation again. 

Example #2

According to the recent news update as of January 2024, China is planning to restabilize the cross-border capital flows and bank risk-taking suspects this year. The central bank has predicted a current account's surplus and capital inflows from foreign activities. Likewise, as compared to last year, the surplus is supposed to reach $280 billion, and the trade surplus may surpass $600 billion. 

There are various implications of cross-border capital flows and bank risk-taking on the economies of different nations. Let us understand them in brief:

• Stimulates the nation's economic growth - With the help of capital controls, capital flows try to fill the domestic capital gaps within the economy. It stabilizes the financing activities and provides capital for infrastructure, business, and other productive activities. 
• Exchange rate stability - Another major benefit of the cross-border capital flows is visible in the exchange rates. The intervention of the government creates an equilibrium balance in the currency prices. As a result of this, there are large capital inflows, further benefiting the imports. However, it does impact the balance of payments as well. 
• Combines financial markets - As capital flows from FDI to companies, it has a subsequent effect on the financial markets. It creates a linkage between institutional investors and domestic equity markets to achieve capital for operations. 
• Diversification of risk - Due to the immense diversification of portfolios, there is a similar effect visible on risk as well. As the concentration is not just on domestic countries, the impact of global turndowns and crises is borne by all. However, the impact is quite low and stabilized. 

In contrast to the above benefits, let us look at some challenges of cross-border capital flows and financial contagion:

• One of the major challenges faced by economies and policymakers is the management of cross-border capital flows. They find it tough to implement and monitor the entire process and analyze the same. 
• In the attempt to manage them, the country may witness a negative impact on the cost of credit available to them as well as the residents of the nation. 
• At times, in response to the above situation, the citizens (public) may themselves pull back capital from the economy. 
• Furthermore, it also impacts the country's bank lending capacity. When FDI injects financial resources (capital), it potentially lowers the economy's lending standards.