Capital flows in the 1980s: a survey of major trends

Introduction

The 1980s were marked by the emergence of persistent current account imbalances on a scale not seen since before the First World War. Up to 1982, the sum of larger industrial countries' imbalances - calculated simply by adding all surpluses and deficits together, ignoring the sign - never went above $100 billion a year and was normally below $50 billion. Thereafter this aggregate climbed steeply, exceeding $300 billion (more than 2% of aggregate GNP) by the second half of the decade. A comparable calculation for gross capital outflows reveals a still steeper progression (Graph 1). Indeed, gross capital flows continued to expand strongly even after current-account imbalances reached a plateau. By the end of the decade, gross capital flows had risen to about $600 billion, almost double the size of aggregate current-account imbalances. Although preliminary and incomplete estimates for 1990 suggest a sharp reversal from the previous year, gross capital flows remain large. Another indication of the greater quantitative importance of international capital transactions is the rapid growth in foreign exchange trading - which more than doubled between 1986 and 1989, a rate of expansion much faster than that of international trade in goods and services. By 1989, global foreign exchange trading is estimated to have amounted to $650 billion daily, almost forty times the average daily value of world trade. This suggests that most foreign exchange transactions must have been driven by international capital flows in the wake of liberalisation.

Up to the 1970s, there were extensive controls on capital movements in most major industrial countries. Indeed, the Bretton Woods Agreement, which enjoined signatories to avoid restrictions on current external payments, specifically allowed controls on international capital movements under Article VI. Although the 1950s saw opinion shift in favour of greater freedom of capital transactions (as witnessed, for example, by the OECP's adoption of a Code of Liberalisation of Capital Movements in 1981), balance-of payments imbalances in the 1960s led to a retightening of a number of restrictions. Among the most important were US measures to control capital exports and measures taken by current-account surplus countries to limit capital inflows.

Moreover, the private capital movements that could occur tended to be driven to an important extent by expectations of exchange rate realignments. Because such expectations were in turn driven by current-account developments, deficit countries were usually confronted with capital outflows, and surplus countries with inflows, that compounded the initial external disequilibrium.

As some controls were gradually eased during the 1970s, private capital continued to flow from deficit to surplus countries. Even with the advent of floating exchange rates in 1973, private flows still tended to compound, rather than offset, current-account imbalances: surplus countries typically faced sizable ex ante private capital inflows that led to currency appreciation far greater than most observers would have expected before the onset of floating. Likewise, downward exchange rate pressure was exacerbated by capital outflows in deficit countries.

Violent swings in exchange rates intensified inflationary pressures in some countries and put an intolerable burden on the traded goods sector in others. It is not surprising that such external pressures often triggered changes in domestic policies that were not always desirable on domestic grounds - especially, perhaps, in surplus countries. During this decade, then, private capital flows tended to magnify current-account disequilibria, and so intensify the external pressures on economic policy.

The gradual erosion of controls on international capital movements in the 1970s gave way to virtually outright abolition in the 1980s (1979 in the United Kingdom) in those major countries that had not already abolished restrictions. By the end of the decade, private residents of all major and most smaller industrial countries enjoyed almost complete freedom lo acquire foreign asset. At the same time, far-reaching technological innovations dramatically reduced the costs, while increasing the speed, of international communications and financial transactions. These developments paved the way for a growing range of innovative financial instruments. To paraphrase one observer, the world monetary system underwent three revolutions all at once - deregulation, internationalisation and innovation.

With the explosion of flows that resulted, capital movements came more and more to have a life of their own. Certain powerful trends proved capable of sustaining net capital movements in the same direction for many years. Quite unlike the experience of the 1960s and 1970s, countries with large current-account deficits could continue to attract foreign capital, thus weakening external pressures for policy adjustment. This new situation is rather reminiscent of the pre-1914 period when large net capital movements, and thus current- account imbalances, persisted for many years. In the eyes of some observers, the 1980s have seen this "classical" position restored -with capital movements determining current-account imbalances. The analogy with the pre-1914 period is telling, not least because it helps to bring some key characteristics of the last decade into sharper focus.

After exploring the historical parallels with the gold standard period (Section I), the present survey provides an overview of the major characteristics of capital flows during the 1980s (Section II). Subsequent sections look in greater detail at the main components: foreign direct investment, portfolio investment, short-term bank flows and official intervention. A penultimate section asks some simple questions: which categories of capital flows are more volatile? Are some capital flows more autonomous than others? Not surprisingly, these questions have no unambiguous answers. Some tentative implications for the future are drawn in the final section.