Capital Mobility

Capital mobility is the degree to which financial capital, meaning money for investment, lending and saving, can move freely between countries. Under perfect capital mobility, investors can buy foreign bonds, shares, property or companies and move the proceeds home again without legal barriers or significant cost, so returns on similar assets tend to equalise across borders. Under low mobility, rules, costs or risks keep savings largely inside the country where they were earned.

Capital mobility is a property of the whole financial system, while a single cross-border investment is a capital account transaction. It is related to, but not the same as, capital account liberalization, which is the policy of removing legal restrictions. A country can liberalise on paper yet still see little movement because its markets are shallow, its currency is little traded or investors distrust its institutions.

Think of water in a set of connected tanks. If the pipes between them are wide open, water flows from the fuller tank to the emptier one until the levels match. If the valves are closed, each tank keeps its own level no matter how different it is from its neighbours. Money behaves in a similar way, flowing towards the places that pay the best return for the risk.

With high capital mobility, the pipes are wide: savers in one country can easily put their money to work in another, and interest rates across countries stay close together. With low mobility, the valves are partly shut, by government rules or simply by the effort and risk of moving money, so each country's interest rates and asset prices can drift far apart.

There are two broad approaches. Legal, or de jure, measures look at the rules. The most widely used is the Chinn-Ito index, published by Menzie Chinn and Hiro Ito in 2006 and updated regularly, which condenses the restrictions recorded in the IMF's Annual Report on Exchange Arrangements and Exchange Restrictions into a single score of financial openness.

Outcome, or de facto, measures look at what actually happens. They include the size of gross foreign assets and liabilities relative to GDP and the tightness of interest-rate links. The best-known test comes from Martin Feldstein and Charles Horioka, who showed in 1980 that national saving and investment rates moved closely together across rich countries. With perfect mobility, a country's investment should not depend on its own saving, so the strong correlation suggested capital was far less mobile than its legal freedom implied, a result later known as the Feldstein-Horioka puzzle.

With high mobility, the expected return on similar assets should be the same in any currency once expected exchange-rate changes are included. This condition, uncovered interest rate parity, is written approximately as:

• $i_d$ is the domestic interest rate.
• $i_f$ is the foreign interest rate on a comparable asset.
• $S_t$ is today's exchange rate, in domestic currency per unit of foreign currency.
• $E(S_{t+1})$ is the exchange rate expected in one period.

If US one-year rates are 4% and markets expect the domestic currency to weaken from 20.00 to 21.00 per dollar, an expected change of $(21.00 - 20.00) \div 20.00 = 0.05$, domestic one-year rates would need to be about $4\% + 5\% = 9\%$ to stop money leaving. Persistent gaps are a sign of limited mobility, risk premiums or capital controls, and they are what carry trade investors try to exploit.

Capital mobility is one corner of the impossible trinity, the result associated with the Mundell-Fleming model that a country cannot at once have a fixed exchange rate, free capital movement and monetary policy independence. Under the Bretton Woods system, most countries chose fixed rates and independent policy and kept capital controls. Since the 1970s, many advanced economies have chosen free movement and a floating exchange rate; the EU's directive 88/361/EEC freed capital movements among most member states by July 1990. Hong Kong's Linked Exchange Rate System combines open capital markets with a fixed rate and gives up independent rates.

Mobile capital can channel savings to where they earn most, lower the cost of funding for growing economies and let households and firms diversify. It also brings risks:

• Sudden stops. Inflows can reverse abruptly, turning into capital flight that drains reserves and forces sharp currency falls.
• Currency mismatch. Easy foreign borrowing can leave firms and banks with debts in dollars and income in local currency, a currency mismatch that turns devaluation into widespread losses.
• Credit booms. Large inflows can inflate asset prices and lending, which is why authorities pair openness with macroprudential policy.

The International Monetary Fund long favoured full liberalisation, but its 2012 Institutional View, reviewed in 2022, accepts that capital flow management measures can be appropriate in some circumstances, such as a surge of inflows, provided they are temporary and not a substitute for needed economic adjustment.

• The Chinn-Ito Index (Portland State University)