Uneven Impact of Global Crisis on Capital Movements

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Table of Contents

Introduction
Factors leading to the uneven recovery
The Eclectic Theory (OLI Paradigm)
Porter’s Diamond Model
Country Competitiveness
Political Climate of a country
Level of Financial Integration
Conclusion
Reference List

Introduction

International capital flows have been on an unprecedented growth pattern over the last few years. After the levels went extremely high before the financial crisis of 2007 – 2008, they dropped drastically after the crisis but have been recovering steadily for the last few years (Demyanyk and Hemert, 2011). The fluctuations of capital flows were however much sharper for emerging economies than for developed countries.

This is due to various reasons which have been studied by researchers and economists from different countries. Some researchers have posited that the uneven recovery is due to the different levels of economic activities in various countries, political factors, country specific advantages and other factors such as the level of integration in the international financial markets (Baker, 2008).

After the financial crisis, developed countries have been faced with reduced output in their economies, as well as a sharp increase in deflation risk and reduced policy rates. This has been happening in the context of expanding balance sheets of their central banks. Developing countries have also been faced with various challenges as a result of the financial crisis since they were also affected due to the global economic integration and the integration of financial markets (Colander, 2009).

In the case of emerging economies, the initial effect of the crisis was a sudden drastic drop of international capital flows, the depreciation of their currencies, liquidity problems, and a negative growth of their economies (Neary, 2007).

The situation has however been changing in the last few years as there are recorded cases of increases in capital inflows to the developing countries coupled with growth in credit and appreciation of currencies (Blanchard, Dell’ariccia and Mauro, 2010). Developed countries on the other hand dealt with the post crisis situation by adopting various monetary and fiscal policy measures reinforced by some macro-prudential instruments. The crisis has clearly revealed the need for the use of a mix of instruments and macro-economic policies to ensure financial stability of countries (Hellwig, 2009).

Recovery of the global capital flows has been very uneven and different economies are recovering at different paces. It is important to note that the crisis caused more damage to developed countries and countries in South – East Europe. The recovery in these countries has been very slow and the volume of capital flows has not even reached the levels recorded before the crisis. In contrast however, developing countries have recorded faster recovery rates in terms of capital inflows (Caballero, Farhi and Gourinchas, 2008).

By the year 2011, global capital inflows in developing countries had exceeded the amounts recorded before the financial crisis. Countries that have been leading in recovery are countries in East Asia and China. These countries have also seen tremendous recovery in terms of the imports and exports in most of their trading items (Brunnermeier, 2009).

Factors leading to the uneven recovery

Academicians have evaluated various reasons as to why different regions and countries are recovering at different rates from the effects of the financial crisis on the capital inflows. It is however important to note that these factors are not universal and researchers and economists have also differed on some of the factors. Evaluating these factors is important in that it could help prevent the occurrence of another financial crisis in future as well as it could help other countries in putting up measures to speed up the recovery process (Allen and Carletti, 2008).

The Eclectic Theory (OLI Paradigm)

This is an economic theory which was developed following the internalisation theory. The theory explains the framework of foreign direct investments and can therefore be used to explain the process of global capital flows. OLI refers to Ownership, Location and Internalisation advantages (Gray, 2003). The theory attempts to explain the reasons why multinational companies engage in foreign direct investments through investing in foreign countries (Helpman, 1984).

Ownership advantages relate to the specific advantages that a particular company possesses which enable it to carry out investments in foreign countries. These advantages determine whether the company will be able to overcome the costs of setting up and operating in a foreign country. Location advantages relate to the suitability of a country in terms of the investment climate and the ease of doing business (Plantin, Sapra and Shin, 2008).

Internalisation advantages on the other hand determine how a potential Multi National company chooses to operate in a foreign country. The company can either chose to operate as a fully owned subsidiary, a joint venture, through exporting or even through licensing. In this case, the company chooses the mode that has minimum costs and maximum returns (Markusen, 2002).

The Eclectic theory can be used to explain the post crisis uneven recovery of country economies in terms of capital flows. Some countries are more attractive than others in terms of the investment climate. Companies will consider location advantages to a large extent before they can make their investments in foreign countries. As is seen from the diagram in the figure below, developed countries have been slow to recover in terms of capital inflows unlike developing countries.

Cross-border capital flows have declined significantly in most regions since 2007.

This is due to the fact that developing countries still have a lot of untapped potential which Multi-National companies seek to take advantage of through foreign direct investments. The fact that developed countries have little or no potential for increased growth in production means that most companies seeking to expand globally do not choose them as investment locations due to the limitations on growth (Fried, 2012).

African countries, China, other Asian countries and Latin American countries for example have been quick to recover in terms of capital inflows as they are favourites for foreign direct investments by Multi National companies. This is due to the fact that raw materials in most of these countries are cheap and there is also availability of cheap labour (Jonung, 2008). These two factors are very critical for the success of Multi National corporations since a reduction of costs leads to greater profit margins and thus accelerated rates of growth.

This is one of the reasons why these countries have had faster recovery rates than their counterparts in the developed world (Harsch, 2009). The fact that Multi National corporations are profit making in nature means that they prefer to invest in developing countries due to these advantages and due to the potential for growth and development than investing in developed countries where labour and raw materials are very expensive (Bicksler, 2008).

Most manufacturing companies in the developed world have been seen to relocate their manufacturing units to developing countries in Africa as well as in Asia. China, for example, has attracted a lot of companies from developed countries due to the cheap labour available as a result of the large population. Such investments lead to the transfer of international capital to these countries thereby helping in the recovery process. It is therefore clear that the location of the country is a major factor that has had an effect on the rate of recovery from the global financial crisis of 2007-2008. This theory clearly explains why the capital flows to some countries have been higher than in other countries (Zumer, Egert and Backe, 2009).

Increased foreign direct investment in a country means increased capital inflows leading to the stimulation of the national economic growth. The fact that most Multi-National corporations are from developed countries means that capital flows are transferred from developed countries to developing (emerging) countries. The net effect is therefore negative flow of capital from the developed countries. With such a situation, it is expected that the rate of recovery of these countries in terms of global capital inflows is slower than that of developing countries which are in most cases on the receiving side of the capital inflows (Reinhart and Rogoff, 2008).

Porter’s Diamond Model

This is a classical theory of economics and posits that the factor endowments available in a country lead to competitive advantage in terms of productivity and level of economic activity. According to the classical economists, factor endowments include land, labour, other natural resources like water and mineral deposits and size of the local economy. According to this theory by Michael Porter, it is possible for a country to create other artificial and more effective factor endowments which will lead to improved competitive advantage for the country.

Some of the artificial factor endowments mentioned include highly skilled labour, business supportive culture, government support in terms of supporting rules and regulations, and a strong knowledge and technology base. These artificial factor endowments are becoming increasingly important in today’s highly globalised knowledge economy Porter, 1980).

Using this theory in explaining the artificial factor endowments, it is possible to understand why some countries have recovered faster than others after the global crisis. Countries which have been able to create these artificial endowments and use them to create competitive advantage are generally experiencing higher rates of economic growth than already developed countries (Garnaut, 2009). Most emerging countries are making use of technology and knowledge to come up with highly skilled labour tailored to meet the needs of the local economies. This is helping in that such a labour force is very creative and comes up with various initiatives to drive the growth of the economy (Posner, 2009).

Countries that are experiencing higher rates of economic growth tend to attract investments from Multi National companies in the form of foreign direct investments. Increased FDI activity will lead to increased capital inflows to the country thus improved growth and development of the economy (Shiller, 2008). Developed countries have been having almost stagnant rates of growth of their economies thus minimising the potential for firms to grow and increase the wealth of their shareholders.

For this reason, most companies are increasingly seeking investment opportunities in foreign countries such as in Asia, Africa and in Latin America. This is the reason why these countries have higher rates of capital inflows and thus record faster recovery from the global crisis than developed countries such as the United Kingdom and the USA (Reinhart and Rogoff, 2009).

It is also important to mention that the size of the population of a country greatly influences the level of economic activity. Most of the countries experiencing higher rates of recovery have large populations which are able to provide cheap labour to Multi National companies. A country like China has a large population which has been very instrumental in determining the number of Multi National companies willing to invest in the country.

Large Multi National companies such as automobile companies, computer manufacturing companies and even mobile phone manufacturing companies are increasingly setting up manufacturing units in China and other countries providing cheap labour. When such companies invest in a country, it means that there is increased flow of capital in terms of investment funds thus boosting the level of economic activity in the country. This reason has therefore seen developing countries recover from the effects of the global financial crisis much faster than developed countries in terms of international capital flows (Gupta et al., 2009).

Most developing countries are also putting various efforts to attract foreign investors to their countries. Governments are increasingly involved in providing an investment climate that is attractive to investors in order to promote growth and development in their economies. Governments of developing countries are setting up rules and regulations meant to improve the investment climate of their countries thus attracting major Multi National corporations.

This strategy has been working for most countries as the level of foreign direct investment has been increasing translating into more capital inflows. The fact that foreign investments had slowed down as a result of the financial crisis means that the increasing activities of FDI nature are very welcome to developing countries as they try to rebuild their economies. This is therefore a major factor for the uneven recovery of the economies in terms of global capital inflows (McCulloch and Sumner, 2009).

Country Competitiveness

The competitiveness of a country is also another major factor that has influenced the rate of recovery of the country’s economy from the financial crisis. Some countries have gained a competitive advantage in some areas which are very instrumental in attracting investment activities from foreign companies. Such advantages may include the culture of the local labour force which may be geared towards encouraging hard work from individuals.

Asian countries are known to have a very hardworking population which is a major competitive advantage. The young and middle aged population of most of the developing countries means that there is a large workforce available to be utilised by Multi National corporations. This leads to countries flocking into such countries to take advantage of such labour. The availability of a lot labour means that the Multi National companies can afford to pay them smaller wages than they pay employees in their home countries. This increases the profitability of these companies leading to increased investments in search of growth and development (Yeaple, 2003).

Political Climate of a country

The political climate of a country is also another reason why there is uneven recovery of the economy after the global financial crisis. Countries in the developing world may not have very stable political environments but the instability also fuels foreign direct investment in its own ways. Political climate is a major factor for economic development and this means that most of these countries have been left behind in development as a result of the political climate.

This means that such countries have great potential to grow and therefore Multi National Corporations willing to take the risk are increasingly investing in these countries so as to exploit the untapped potential. It is clear that such increased foreign direct investment activities lead to increased flow of capital into the country (Kang and Sawada, 2008).

Another dimension of looking at the way the political climate can affect the level of economic activity in a country is that a stable political climate provides investors with the relative peace needed to carry out long term investments in the country. A country like China has a very stable political environment and this therefore means that it is an attractive country to invest in. Multi National companies have therefore been flocking into the country and setting up manufacturing units there since the climate is favourable for long term investments.

Coupled with the availability of cheap skilled labour, such a climate provides Multi National companies with the much needed ingredients for foreign direct investments. This in turn means that capital inflows to the country keep growing thus faster recovery from the effects of the global financial crisis (Davies and McGregor, 2009).

Level of Financial Integration

The level of integration of the financial market of a country is also a factor that may have influenced faster rates of recovery from the effects of the financial crisis. Countries with highly integrated financial systems suffered more damage from the crisis. This means that the recovery process is difficult due to the sheer magnitude of the effects themselves.

Most countries in the developing world are yet to become fully integrated in the global financial systems therefore the effects of the crisis were a bit mild. Such countries therefore were able to put up policy measures that would lead to faster recovery of the little effects that were felt. This is therefore another reason that can be used to explain the uneven recovery of country economies in terms of capital flows (Stiglitz, 2010).

Conclusion

The discussion above has concentrated on the economic factors that may have led to the uneven recovery of countries after the global financial crisis of 2007 – 2008. It is clear that developed countries were affected more by the crisis than their counterparts in emerging markets and therefore more work was needed to ensure their economies were on the recovery track.

The fact that developed countries have little potential for growth and development of the economy is also another reason why recovery has been slow since the economies of most of these countries are either stagnant or growing at very small rates. Another issue is the large population of some countries such as China since such a population provides a large workforce which can be used by Multi National corporations at very low levels of wages and other remunerations (Stiglitz, 2010).

Other factors that have led to the uneven recovery are related to the OLI paradigm and have been evaluated clearly using this economic model. It is evident that there are countries that are more competitive than others and this has therefore led to them recovering faster than the rest. Country specific factors have also been very instrumental in the recovery process due to the level of economic activity involved in every country.

Multi National companies are the major drivers of global capital movements and from the discussion; it is evident that these companies are increasingly focusing on developing countries due to the availability of cheap labour (Crotty, 2009). This therefore explains why developing countries have been able to recover faster than their counterparts in the developed world. It is therefore evident that developed countries, which were hit hardest by the crisis, are recovering at a slower rate than developing countries due to the various reasons discussed above as well as others not discussed in this paper.

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