Unit V: International Capital Movements | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


4.115 
 
INTERNATIONAL CAPITAL MOVEMENTS 
LEARNING OUTCOMES 
UNIT V: INTERNATIONAL CAPITAL 
MOVEMENTS 
At the end of this unit, you will be able to: 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in 
India 
 
 
UNIT OVERVIEW 
International Trade
International Capital Movements 
FDI FPI
Page 2


4.115 
 
INTERNATIONAL CAPITAL MOVEMENTS 
LEARNING OUTCOMES 
UNIT V: INTERNATIONAL CAPITAL 
MOVEMENTS 
At the end of this unit, you will be able to: 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in 
India 
 
 
UNIT OVERVIEW 
International Trade
International Capital Movements 
FDI FPI
4.116 ECONOMICS FOR FINANCE 
 5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we 
have observed enormous increase in international movement of capital. This 
phenomenon has received a great deal of attention not only from economists and 
policy-makers, but also from people in different walks of life- including workers’ 
organisations and members of the civil society. In this unit, we shall look into 
international capital movements; more precisely, why do capital move across 
national boundaries and what are the consequences of such capital movements.  
We shall also briefly touch upon the FDI situation in India.  
 5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of 
capital into the home country from abroad and therefore, we need to be clear 
about the distinction between movement of capital and foreign investment. 
Foreign capital may flow into an economy in different ways.  Some of the 
important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with 
international organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid 
where there are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by 
governments, institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
Page 3


4.115 
 
INTERNATIONAL CAPITAL MOVEMENTS 
LEARNING OUTCOMES 
UNIT V: INTERNATIONAL CAPITAL 
MOVEMENTS 
At the end of this unit, you will be able to: 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in 
India 
 
 
UNIT OVERVIEW 
International Trade
International Capital Movements 
FDI FPI
4.116 ECONOMICS FOR FINANCE 
 5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we 
have observed enormous increase in international movement of capital. This 
phenomenon has received a great deal of attention not only from economists and 
policy-makers, but also from people in different walks of life- including workers’ 
organisations and members of the civil society. In this unit, we shall look into 
international capital movements; more precisely, why do capital move across 
national boundaries and what are the consequences of such capital movements.  
We shall also briefly touch upon the FDI situation in India.  
 5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of 
capital into the home country from abroad and therefore, we need to be clear 
about the distinction between movement of capital and foreign investment. 
Foreign capital may flow into an economy in different ways.  Some of the 
important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with 
international organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid 
where there are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by 
governments, institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
4.117 
 
INTERNATIONAL CAPITAL MOVEMENTS 
4. Investments in the form of : 
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and  
(ii) Foreign direct investment (FDI) in industrial, commercial and similar 
other enterprises 
A detailed discussion about all types of capital movements is beyond the scope of 
this unit and therefore, we shall concentrate only on foreign investments.  
 5.3 FOREIGN DIRECT INVESTMENT (FDI ) 
International investments are of two types namely, Foreign Direct Investment 
(FDI) and Foreign Portfolio Investment (FPI). Foreign direct investment (FDI) refers 
to the act of  acquisition or construction of physical capital by a firm from one 
(source) country in another (host) country. The term sometimes refers to the flow 
per unit time, and sometimes to the accumulated stock of capital.It is defined as a 
process whereby the resident of one country (i.e. home/source country) acquires 
ownership of an asset in another country (i.e. the host country) and such 
movement of capital involves ownership, control as well as management of the 
asset in the host country.  
Foreign direct investment (FDI), according to IMF manual on 'Balance of 
payments' is "all investments involving a long-term relationship and reflecting a 
lasting interest and control of a resident entity in one economy in an enterprise 
resident in an economy other than that of the direct investor”. This typically occurs 
through acquisition of more than 10 percent of the shares of the target asset. 
Direct investment comprises not only the initial transaction establishing the 
relationship between the investor and the enterprise, but also all subsequent 
transactions between them and among affiliated enterprises, both incorporated 
and unincorporated. 
According to the IMF and OECD definitions, the acquisition of at least ten percent 
of the ordinary shares or voting power in a public or private enterprise by non-
resident investors makes it eligible to be categorized as foreign direct investment 
(FDI). India also follows the same pattern of classification. FDI has three 
components, viz., equity capital, reinvested earnings and other direct capital in 
the form of intra-company loans between direct investors (parent enterprises) 
and affiliate enterprises. 
Foreign direct investors may be individuals, incorporated or unincorporated 
private or public enterprises, associated groups of individuals or enterprises, 
Page 4


4.115 
 
INTERNATIONAL CAPITAL MOVEMENTS 
LEARNING OUTCOMES 
UNIT V: INTERNATIONAL CAPITAL 
MOVEMENTS 
At the end of this unit, you will be able to: 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in 
India 
 
 
UNIT OVERVIEW 
International Trade
International Capital Movements 
FDI FPI
4.116 ECONOMICS FOR FINANCE 
 5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we 
have observed enormous increase in international movement of capital. This 
phenomenon has received a great deal of attention not only from economists and 
policy-makers, but also from people in different walks of life- including workers’ 
organisations and members of the civil society. In this unit, we shall look into 
international capital movements; more precisely, why do capital move across 
national boundaries and what are the consequences of such capital movements.  
We shall also briefly touch upon the FDI situation in India.  
 5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of 
capital into the home country from abroad and therefore, we need to be clear 
about the distinction between movement of capital and foreign investment. 
Foreign capital may flow into an economy in different ways.  Some of the 
important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with 
international organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid 
where there are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by 
governments, institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
4.117 
 
INTERNATIONAL CAPITAL MOVEMENTS 
4. Investments in the form of : 
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and  
(ii) Foreign direct investment (FDI) in industrial, commercial and similar 
other enterprises 
A detailed discussion about all types of capital movements is beyond the scope of 
this unit and therefore, we shall concentrate only on foreign investments.  
 5.3 FOREIGN DIRECT INVESTMENT (FDI ) 
International investments are of two types namely, Foreign Direct Investment 
(FDI) and Foreign Portfolio Investment (FPI). Foreign direct investment (FDI) refers 
to the act of  acquisition or construction of physical capital by a firm from one 
(source) country in another (host) country. The term sometimes refers to the flow 
per unit time, and sometimes to the accumulated stock of capital.It is defined as a 
process whereby the resident of one country (i.e. home/source country) acquires 
ownership of an asset in another country (i.e. the host country) and such 
movement of capital involves ownership, control as well as management of the 
asset in the host country.  
Foreign direct investment (FDI), according to IMF manual on 'Balance of 
payments' is "all investments involving a long-term relationship and reflecting a 
lasting interest and control of a resident entity in one economy in an enterprise 
resident in an economy other than that of the direct investor”. This typically occurs 
through acquisition of more than 10 percent of the shares of the target asset. 
Direct investment comprises not only the initial transaction establishing the 
relationship between the investor and the enterprise, but also all subsequent 
transactions between them and among affiliated enterprises, both incorporated 
and unincorporated. 
According to the IMF and OECD definitions, the acquisition of at least ten percent 
of the ordinary shares or voting power in a public or private enterprise by non-
resident investors makes it eligible to be categorized as foreign direct investment 
(FDI). India also follows the same pattern of classification. FDI has three 
components, viz., equity capital, reinvested earnings and other direct capital in 
the form of intra-company loans between direct investors (parent enterprises) 
and affiliate enterprises. 
Foreign direct investors may be individuals, incorporated or unincorporated 
private or public enterprises, associated groups of individuals or enterprises, 
  
 
4.118 ECONOMICS FOR FINANCE 
governments or government agencies, estates, trusts, or other organizations or 
any combination of the above-mentioned entities. The main forms of direct 
investments are: the opening of overseas companies, including the establishment 
of subsidiaries or branches, creation of joint ventures on a contract basis, joint 
development of natural resources and purchase or annexation of companies in 
the country receiving foreign capital.  
Direct investments are real investments in factories, assets, land, inventories etc. 
and involve foreign ownership of production facilities. The investor retains control 
over the use of the invested capital and also seeks the power to exercise control 
over decision making to the extent of its equity participation. The lasting interest 
implies the existence of a long-term relationship between the direct investor and 
the enterprise and a significant degree of influence by the investor on the 
management of the enterprise.    
Based on the nature of foreign investments, FDI may be categorized as horizontal, 
vertical or conglomerate.  
i) A horizontal direct investment is said to take place when the investor 
establishes the same type of business operation in a foreign country as it 
operates in its home country, for example, a cell phone service provider 
based in the United States moving to India to provide the same service. 
ii) A vertical investment is one under which the investor establishes or acquires 
a  business activity in a foreign country which is different from the investor’s 
main business activity yet in some way supplements its major activity.  For 
example; an automobile manufacturing company may acquire an interest in 
a foreign company that supplies parts or raw materials required for the 
company. 
iii) A conglomerate type of foreign direct investment is one where an investor 
makes a foreign investment in a business that is unrelated to its existing 
business in its home country. This is often in the form of a joint venture with 
a foreign firm already operating in the industry, as the investor has no 
previous experience.  
 Yet another category of investment is ‘two- way direct foreign investments’ 
which are reciprocal investments between countries. These investments 
occur when some industries are more advanced in one nation (for example, 
the computer industry in the United States), while other industries are more 
efficient in other nations (such as the automobile industry in Japan).  
Page 5


4.115 
 
INTERNATIONAL CAPITAL MOVEMENTS 
LEARNING OUTCOMES 
UNIT V: INTERNATIONAL CAPITAL 
MOVEMENTS 
At the end of this unit, you will be able to: 
? Describe the nature and types of foreign capital  
? Distinguish between foreign direct investment and foreign 
institutional investment 
? Outline the factors influencing foreign investments  
? Elucidate the potential costs and benefits of foreign direct 
investment 
? Explain the state-of-affairs of foreign direct investment in 
India 
 
 
UNIT OVERVIEW 
International Trade
International Capital Movements 
FDI FPI
4.116 ECONOMICS FOR FINANCE 
 5.1 INTRODUCTION 
In unit one, our focus was on international trade in goods and services. Lately, we 
have observed enormous increase in international movement of capital. This 
phenomenon has received a great deal of attention not only from economists and 
policy-makers, but also from people in different walks of life- including workers’ 
organisations and members of the civil society. In this unit, we shall look into 
international capital movements; more precisely, why do capital move across 
national boundaries and what are the consequences of such capital movements.  
We shall also briefly touch upon the FDI situation in India.  
 5.2 TYPES OF FOREIGN CAPITAL  
The term 'foreign capital' is a comprehensive one and includes any inflow of 
capital into the home country from abroad and therefore, we need to be clear 
about the distinction between movement of capital and foreign investment. 
Foreign capital may flow into an economy in different ways.  Some of the 
important components of foreign capital flows are: 
1. Foreign aid or assistance which may be:  
(a) Bilateral or direct inter government grants. 
(b) Multilateral aid from many governments who pool funds with 
international organizations like the World Bank. 
(c) Tied aid with strict mandates regarding the use of money or untied aid 
where there are no such stipulations 
(d) Foreign grants which are voluntary transfer of resources by 
governments, institutions, agencies or organizations. 
2. Borrowings which may take different forms such as: 
(a) Direct inter government loans  
(b) Loans from international institutions (e.g. world bank, IMF, ADB) 
(c) Soft loans for e.g. from affiliates of World Bank such as IDA 
(d) External commercial borrowing, and  
(e) Trade credit facilities 
3. Deposits from non-resident Indians (NRI)  
4.117 
 
INTERNATIONAL CAPITAL MOVEMENTS 
4. Investments in the form of : 
(i) Foreign portfolio investment (FPI) in bonds, stocks and securities, and  
(ii) Foreign direct investment (FDI) in industrial, commercial and similar 
other enterprises 
A detailed discussion about all types of capital movements is beyond the scope of 
this unit and therefore, we shall concentrate only on foreign investments.  
 5.3 FOREIGN DIRECT INVESTMENT (FDI ) 
International investments are of two types namely, Foreign Direct Investment 
(FDI) and Foreign Portfolio Investment (FPI). Foreign direct investment (FDI) refers 
to the act of  acquisition or construction of physical capital by a firm from one 
(source) country in another (host) country. The term sometimes refers to the flow 
per unit time, and sometimes to the accumulated stock of capital.It is defined as a 
process whereby the resident of one country (i.e. home/source country) acquires 
ownership of an asset in another country (i.e. the host country) and such 
movement of capital involves ownership, control as well as management of the 
asset in the host country.  
Foreign direct investment (FDI), according to IMF manual on 'Balance of 
payments' is "all investments involving a long-term relationship and reflecting a 
lasting interest and control of a resident entity in one economy in an enterprise 
resident in an economy other than that of the direct investor”. This typically occurs 
through acquisition of more than 10 percent of the shares of the target asset. 
Direct investment comprises not only the initial transaction establishing the 
relationship between the investor and the enterprise, but also all subsequent 
transactions between them and among affiliated enterprises, both incorporated 
and unincorporated. 
According to the IMF and OECD definitions, the acquisition of at least ten percent 
of the ordinary shares or voting power in a public or private enterprise by non-
resident investors makes it eligible to be categorized as foreign direct investment 
(FDI). India also follows the same pattern of classification. FDI has three 
components, viz., equity capital, reinvested earnings and other direct capital in 
the form of intra-company loans between direct investors (parent enterprises) 
and affiliate enterprises. 
Foreign direct investors may be individuals, incorporated or unincorporated 
private or public enterprises, associated groups of individuals or enterprises, 
  
 
4.118 ECONOMICS FOR FINANCE 
governments or government agencies, estates, trusts, or other organizations or 
any combination of the above-mentioned entities. The main forms of direct 
investments are: the opening of overseas companies, including the establishment 
of subsidiaries or branches, creation of joint ventures on a contract basis, joint 
development of natural resources and purchase or annexation of companies in 
the country receiving foreign capital.  
Direct investments are real investments in factories, assets, land, inventories etc. 
and involve foreign ownership of production facilities. The investor retains control 
over the use of the invested capital and also seeks the power to exercise control 
over decision making to the extent of its equity participation. The lasting interest 
implies the existence of a long-term relationship between the direct investor and 
the enterprise and a significant degree of influence by the investor on the 
management of the enterprise.    
Based on the nature of foreign investments, FDI may be categorized as horizontal, 
vertical or conglomerate.  
i) A horizontal direct investment is said to take place when the investor 
establishes the same type of business operation in a foreign country as it 
operates in its home country, for example, a cell phone service provider 
based in the United States moving to India to provide the same service. 
ii) A vertical investment is one under which the investor establishes or acquires 
a  business activity in a foreign country which is different from the investor’s 
main business activity yet in some way supplements its major activity.  For 
example; an automobile manufacturing company may acquire an interest in 
a foreign company that supplies parts or raw materials required for the 
company. 
iii) A conglomerate type of foreign direct investment is one where an investor 
makes a foreign investment in a business that is unrelated to its existing 
business in its home country. This is often in the form of a joint venture with 
a foreign firm already operating in the industry, as the investor has no 
previous experience.  
 Yet another category of investment is ‘two- way direct foreign investments’ 
which are reciprocal investments between countries. These investments 
occur when some industries are more advanced in one nation (for example, 
the computer industry in the United States), while other industries are more 
efficient in other nations (such as the automobile industry in Japan).  
4.119 
 
INTERNATIONAL CAPITAL MOVEMENTS 
 5.4 FOREIGN PORTFOLIO INVESTMENT (FPI) 
Foreign portfolio investment is the flow of what economists call ‘financial capital’ 
rather than ‘real capital’ and does not involve ownership or control on the part of 
the investor. Examples of foreign portfolio investment are the deposit of funds in 
an Indian or a British bank by an Italian company, the purchase of a bond (a 
certificate of indebtedness) of a Swiss company or the Swiss government by a 
citizen or company based in France. Unlike FDI, portfolio capital, in general, 
moves to investment in financial stocks, bonds and other financial instruments 
and is effected largely by individuals and institutions through the mechanism of 
capital market. These flows of financial capital have their immediate effects on 
balance of payments or exchange rates rather than on production or income 
generation.  
Foreign portfolio investment (FPI) is not concerned with either manufacture of 
goods or with provision of services. Such investors also do not have any intention 
of exercising voting power or controlling or managing the affairs of the company 
in whose securities they invest. The sole intention of a foreign portfolio investor is 
to earn a remunerative return through investment in foreign securities and is 
primarily concerned about the safety of their capital, the likelihood of 
appreciation in its value, and the return generated.  Logically, portfolio capital 
moves to a recipient country which has revealed its potential for higher returns 
and profitability. 
Following international standards, portfolio investments are characterised by 
lower stake in companies with their total stake in a firm at below 10 percent. It is 
also noteworthy that unlike the FDIs, these investments are typically of short term 
nature, and therefore, are not intended to enhance the productive capacity of an 
economy by the creation of capital assets. 
Portfolio investors will evaluate, on a separate basis, the prospects of each 
independent unit in which they might invest and may often shift their capital with 
changes in these prospects. Therefore, portfolio investments are, to a large 
extent, expected to be speculative.  Once investor confidence is shaken, such 
capital has a tendency to speedily shift from one country to another, occasionally 
creating financial crisis for the host country.