What’s it: Perfect capital mobility describes a hypothetical scenario where capital, such as money and investments, can move freely across borders without restrictions. In this ideal world, there are no barriers to entry or exit for capital flows. Investors can move their money wherever they see the best opportunities for higher returns, and businesses can easily access capital from a global pool of funds.
Here’s a breakdown of key features of perfect capital mobility:
- Free movement of capital: No government regulations or taxes hinder capital inflows or outflows, so investors can easily transfer money into and out of a country.
- No exchange rate risk: Exchange rates are fixed and don’t fluctuate. This eliminates the risk of losing money due to currency depreciation when converting investments back to the home currency.
- Level playing field: All investors have equal access to investment opportunities globally, regardless of their home country.
Why is capital mobility important?
Access to cheap funds. In global financial markets, mobility of capital provides access to a global pool of savings at lower interest rates. Companies or governments can raise funds cheaper on international financial markets by issuing global debt securities.
If the international interest rate is higher than the domestic interest rate, it will encourage capital inflows. Overseas investors are looking for higher returns. It increases demand and liquidity in the domestic financial market. Ultimately, that leads to lower interest rates and the cost of funds.
Higher returns. Capital owners can get high returns, which increases their income and welfare. They can invest anywhere without having to face risks such as exchange rates or capital flow constraints.
Productive use. If capital flows freely, it will likely move towards its best use. As a result, capital investment has become more efficient. Companies can raise capital at the lowest cost, encouraging them to increase their investment in capital goods and production capacity.
Perfect capital mobility & fixed exchange rates
Without political and macroeconomic risks, perfect mobility of capital is more likely under a fixed exchange rate regime. Because it doesn’t change, there is no exchange rate risk. As a result, the primary consideration for investing is the spread between interest rates (domestic vs. international).
Assume that interest rates on international financial markets are unchanged and at the same level as the domestic market. If the interest rate is domestic, it attracts foreign capital inflows. Foreign investors find the domestic market more attractive because it offers a higher rate of return. Because it is still, the exchange rate is not a problem.
Conversely, if domestic interest rates fall, it will cause investment to exit the domestic market. Investors are pursuing higher returns in overseas markets.
Central Bank intervention to maintain fixed exchange rate
Under fixed exchange rates and perfect capital mobility, the international capital flow determines the domestic money supply. To understand this, let’s assume the previous assumptions hold. And, say, the central bank raises policy rates to cushion the high pressure of domestic inflation.
The increase in interest rates pushed foreign capital inflows, which increased demand for domestic currency and contributed to exchange rate appreciation.
Because the domestic economy adopts a fixed exchange rate system, appreciation requires the government (through the central bank) to intervene. To offset the high demand, the government increased the supply of domestic currency, increasing the money supply.
An increase in the money supply promotes abundant liquidity in the economy. People are increasingly finding loans, and the bank has a lot of money to lend. This situation ultimately lowers interest rates on the domestic financial market.
If the spread is still positive (domestic interest rates minus international interest rates), foreign capital will still flow in, which means the money supply still has to go up.
This situation continues until the interest rate is returned to its original level. In other words, domestic interest rates must be equivalent to international interest rates.
Money supply adjustments and limitations on monetary policy
Domestic monetary policy is not effective in influencing the domestic economy under fixed exchange rates and perfect capital flows. In the above example, external factors (foreign capital flows) produce the opposite effect against monetary policy’s initial objective.
Let’s summarize the effects of capital flows when central banks run monetary policies. Assume the central bank uses the policy rate to carry out monetary policy.
Under the expansionary policy, the central bank lowers the policy rate to increase the money supply. Meanwhile, under a contractionary policy, the central bank raises the policy rate to reduce the money supply.
Now, assume that international interest rates do not change. Thus, spreads are only affected by changes in domestic interest rates. Monetary policy becomes ineffective because:
- If the central bank cuts interest rates, the investment will exit the domestic market, and the domestic exchange rate will depreciate. To keep the exchange rate unchanged, the central bank must step in by selling foreign currency to buy domestic currency. The supply of domestic currency in the economy is shrinking (now held mostly by central banks), which causes interest rates to rise.
- If the interest rate increases, foreign capital will flow in, causing the domestic currency to appreciate. The central bank maintains the exchange rate unchanged by increasing the domestic currency supply to offset foreign investment demand. Increasing the money supply will push domestic interest rates down.
Imperfections of capital mobility in the real world
Perfect capital mobility is only a theoretical foundation and is challenging to achieve in the real world. Several reasons explain why that is.
Floating exchange rates and exchange rate risk
Unlike the theoretical environment of perfect capital mobility with fixed exchange rates, most countries today operate under floating or managed floating exchange rates. These rates fluctuate based on market forces like supply and demand for currencies, which introduces exchange rate risk for investors in imperfect capital mobility. Fluctuations in the exchange rate can erode investment returns when converting them back to the home currency.
Imagine an American investor earning a 10% return on a Chinese investment. However, if the Chinese yuan depreciates by 8% against the US dollar during that time, the investor’s actual return in US dollars would be significantly lower. Investors must consider both interest rate differentials and exchange rate risk when making investment decisions. Unpredictable exchange rate movements add uncertainty and make achieving perfect capital mobility difficult.
Capital controls and government intervention
Several countries have implemented capital flow controls to avoid the undesirable effects of capital inflows and outflows. They consider foreign investment flows, such as foreign portfolio investment, harmful to the economy. They only take short-term gains. They enter when the economy is prosperous and suddenly exit when the economy shows signs of weakness.
These inflows and outflows have a significant impact on the economy when they involve massive amounts. Exchange rates change drastically, increasing uncertainty and jeopardizing economic stability. And it can lead to an exchange rate crisis.
Imperfect information about foreign investment opportunities
Investing in foreign markets carries additional risks due to limited information compared to domestic markets. Investors may lack in-depth knowledge about foreign companies, regulations, and economic conditions. Imagine an American investor interested in a promising new startup in India.
Obtaining reliable financial statements, understanding local business practices, and navigating currency exchange controls can be more challenging compared to investing in a US company. This information gap makes thorough investment analysis more challenging and discourages some investors from participating in international markets. The absence of perfect information creates a friction point that hinders perfect capital mobility.
Limited effectiveness of monetary policy under perfect capital mobility
While perfect capital mobility with fixed exchange rates theoretically eliminates exchange rate risk, it also restricts the central bank’s ability to conduct monetary policy effectively. If a central bank raises interest rates to stimulate the economy by encouraging borrowing and spending, capital inflows can occur as investors seek higher returns in the country.
The central bank would then need to counteract by selling foreign currency reserves to maintain the fixed exchange rate. This action effectively tightens the money supply, negating the initial attempt to stimulate the economy.
Similarly, attempts to curb inflation through higher interest rates can be undermined by capital inflows. The central bank’s limited control over the money supply under perfect capital mobility with fixed exchange rates makes this scenario impractical in the real world. Most countries prioritize maintaining some degree of control over their monetary policy, leading them to adopt floating exchange rates even if it introduces exchange rate risk.
