Capital Flows: Explanation and Examples of Fund Movement

What Are Capital Flows?

Capital flows refer to the movement of money for the purpose of investment, trade, or business operations. Inside of a firm, these include the flow of funds in the form of investment capital, capital spending on operations, and research and development (R&D).

On a larger scale, a government directs capital flows from tax receipts into programs and operations and through trade with other nations and currencies. Individual investors direct savings and investment capital into securities, such as stocks, bonds, and mutual funds.

Key Takeaways

  • Capital flows follow the movement of funds that are put to use for productive economic purposes.
  • For a firm capital flows entail money allocated to operations, R&D, and investment; for an individual money spend to consumption, investment, and savings.
  • Capital flows also occur at the national level, with governments collecting revenues in the form of taxes or issuing bonds, and spending proceeds on various public projects or investments.

Capital Flows

Capital Flows Explained

Capital flows occur at nearly every scale, from individuals to firms to national governments. Different sub-sets of capital flows are often scrutinized by analysts such as asset-class movements, venture capital flows, mutual fund flows, capital spending budgets, and the federal budget.Within the United States, the federal government and state-level organizations aggregate capital flows for the purpose of analysis, regulation, and legislative efforts.

In the financial markets, asset-class movements are measured as capital flows between cash, stocks, bonds, and other financial instruments, while venture capital shifts in regards to investments being placed in startup businesses. Mutual fund flows track the net cash additions or withdrawals from broad classes of funds. Capital-spending budgets are examined at the corporate level to monitor growth plans, while federal budgets follow government spending plans. The relative strength or weakness of capital markets can be shown through analyzing such capital flows, especially in contained environments like the stock market or the federal budget. Investors also look at the growth rate of certain capital flows, such as venture capital and capital spending, to find any trends that might indicate future investment opportunities or risks.

As part of standard business operations, companies may look to purchase commercial real estate to house production activities. Additionally, many individuals see the purchase of real estate as an investment that produces rental income. These may classified as investment or business capital flows depending on the analysis.

Volatile Capital Flows in Emerging Economies

In emerging economies, capital flows can be particularly volatile as the economy may experience periods of rapid growth followed by subsequent contraction. Increased capital inflows can lead to credit booms and the inflation of asset prices, which may be offset by losses due to depreciation of the currency based on exchange rates and declines in equity pricing.

Emerging economies also are quite sensitive to flows of foreign direct investment (FDI), which takes place when an investor, corporation, or foreign government invests directly in, or establishes foreign business operations or acquires foreign business assets abroad. Often, FDI is a large source of capital flows to a country and greatly supports the economy.

Example of Capital Flows

In India, for instance, periods of fluctuation have been noted beginning in the 1990s. Capital flows during the earlier period, from the 1990s into the early 2000s, was marked by steady growth, transitioning to a rapid influx of funds between the early 2000s and 2007. This rapid growth eventually shifted, partially due to the implications of the financial crisis in 2008, leading to a high level of volatility regarding capital flows.

One of the biggest investing trends of the past several years involves the massive amounts of capital flow from active management into passive strategies such as exchange-traded funds (ETFs). For January 2018, $41.2 billion of investor capital flowed into U.S. equity passive funds, surpassing the $22.5 billion of inflows in December. Meanwhile, $24.1 billion in capital flowed out of active funds, compared to $16.3 billion in December. The path of capital flows also moved to other asset classes. For example, the taxable bond category proved the most popular in January, seeing $47.0 billion in inflows, with active and passive drawing almost equal capital. 

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