Increasing Global Capital Flows and their Monetary Implications for Monetary Policy: A Case Study of the UK Financial Institutions
EXECUTIVE SUMMARY
The existence of the different types of capital flows has different effects in terms of the stability and growth of the financial sectors and the economy at large. Capital flows, cross-border trade, and other forms of international capital flow result in economic growth either directly or indirectly through human capital improvement and technology spillover. Financial development for a nation constitutes a potentially vital mechanism for long-term growth. Several surveys have demonstrated that the opening of the domestic economy to foreign competition and the establishment of appropriate economic systems and institutions is critical. This study focuses on analysing the impact of capital flows on the domestic monetary policy, more particularly in UK.
This principle purpose of this project is to gather information on increasing global capital flows and their monetary implications for monetary policy. The research will involve 24 participants (managers of 4 UK banks). Questionnaire method will be used to collect information. The research philosophy that drives this research is defined by the interest to build a bridge between the fields of monetary policy and the area of global capital flows. It expected that the findings of this project will be helpful to both students wishing to study this topic further as well as to policy makers.
Table of Contents
Structure of the Dissertation. 12
Effect of Capital Flow on Monetary Policy. 17
Potential Determinants of the Capital Flows. 19
Capital Flow Liberalization. 19
Pro-Cyclical Capital Flows. 20
Pro-Cyclical Fiscal Policy. 21
Pro-Cyclical Monetary Policy. 22
Justification of the Epistemological Approach. 25
Limitations, Bias, and Ethical Issues. 28
Human Participants and Ethics Precautions. 28
Findings, Analysis, and Synthesis. 30
Conclusion and Implication. 45
CHAPTER 1
Introduction
Closer global integration and interactions in recent decades have comprised of increased trade across countries. As a result, global capital flows have increased substantially in recent years and have become a key aspect of the monetary system. Capital flows offer several benefits to countries although they could also be a source of risks in terms of policy due to their size and volatility (Fee, 2009, 2362). Capital flows have been found to have significant benefits including promoting financial sector competitiveness, facilitating greater productive consumption smoothing and productive investment, and enhancing efficiency (Sharpe and Watts, 2013, 42). On the other hand, capital flows also present certain risks that can be inflated by gaps in the country’s institutional infrastructure. Largely, capital flow liberalization has formed an integral part of the development strategy and framework of many countries in the recent times especially in recognition of the many benefits that they stand to gain from such capital flows (Atoyan et al., 2012, 1). Liberalization of capital flow is more beneficial in situations where a country has reached certain thresholds of their institutional and financial development. Indeed, it can spur institutional and financial development.
Consequently, capital flow liberalization needs to be appropriately planned, timed, and sequenced to ensure that its respective benefits outweigh the costs. Moreover, countries that have developed an extensive and long-standing frameworks to limit capital flows will likely benefit from further liberalization (Sharpe and Watts, 2013, 43). As Bracke and Schmitz, (2011, 45) notes, disruptive outflows and rapid capital inflow surges are likely to cause policy challenges for countries. Appropriate policy responses include an array of measures and comprise of countries from which the capital flows originate as well as the recipients (Medina and Roldos, 2014, n.p). A crucial role in addressing this situation is of essence by countries in terms of policies to effectively manage the financial and macroeconomic stability risks associated with disruptive outflows or inflow surges including fiscal, exchange rate, and monetary management as well as through sound financial regulatory and supervision and strong institutions (Jones, 2009, 1501). Policymakers should take into account ways in which their policies may affect the global financial and economic stability. Moreover, cross-border coordination of policies can assist in mitigating the risks of capital flow.
Private sector financial capital in the present times has become mobile across the developed nations. Since the 1990s, capital flow liberalization has enabled international investors to realize opportunities in the emerging economies (Sharpe and Watts, 2013, 44). Capital flow from the private sector to the emerging markets as Milesi-Ferretti and Tille (2011, 220) postulate has also increased and has been shared across all geographic regions. In this regard, policy makers have increased their focus on the impact of these flows on a number of variables affecting the economy; domestic saving, total domestic investment, inflation and asset prices, the current account balance, and employment and the output growth. Financial capital flows can be associated with both decreases and increases in these variables (Ohanian and Wright, 2010, 71). However, the effects of these flows upon the real economy is greatly dependent on the reasons for entry into these economies as well as on how they are used once they have found their way into these economies. The main challenge for policymakers concerning capital flows is on how much they accept or resist them.
Study Background
Increasing capital flow has greatly influenced domestic policies across all countries of the world. Growing global markets have made a substantial contribution to improved frameworks and discipline in the area of fiscal and monetary policies (Rangarajan and Prasad, 2008, 134). Moreover, the need for more disciplined monetary policies among nations has fostered a higher level of independence of the central banks and in turn contributed to global disinflation. In addition to improving monetary policy, as Fry et al. (2012, n.p) note, the increased independence of central banks has triggered an evolution in terms of the monetary transmission mechanism. In this regard, monetary policy greatly affects the economy more through exchange rates and inflation expectations. As such, the credibility of these policies has since become a very valuable asset.
On the other hand, growing capital flows have, however, increased market volatilities and also amplified the transmission of shocks. Opaqueness in the financial markets has a limiting effect on the ability of policymakers to assess risks properly (Fry et al., 2012, n.p). According to Host-Madsen, (2003, 167) the theoretical trilemma in international capital mobility; fixed exchange rate or monetary independence has become a key constraint in determining domestic monetary policies as well as the level of international financial integration (Rangarajan and Prasad, 2008, 135). Higher capital mobility has decreased the monetary independence and presented central banks with corner choices in the implementation of financial policy (Campello, 2012, 2777). Indeed, in practice it has become clear that it is more difficult for economies to maintain a fixed exchange rate strategy in a world with increasing financial mobility than it is to conduct independent financial policy. In this context, policy makers are now charged with the task of establishing the optimal mix of interest rates, fiscal policy, exchange rate, and financial rate in the new equilibrium.
Research Background
In addressing the issue of the type of fiscal and monetary policies in use in the UK an analysis done using two econometric tools; Vector Autoregression (VAR) estimation which examines dynamics in macroeconomic time series and the generalized methods of moments (GMM) reveals a number of issues: In terms of the fiscal perspective, both GMM and VAR estimations indicate counter-cyclical policy in UK. Evidence points out to the good state of the economy and support for pro-cyclical influence in the estimations of VAR (Rangarajan and Prasad, 2008, 135). Further analysis of the monetary policies and framework reveals that UK follows a counter-cyclical monetary policy (Country Reports, 2014, 2). Most of the available research in the past has focused on the implication of monetary policy on capital flow. Several studies have demonstrated on the factors that contribute to capital flow and the impact on the economy. There is hardly any study that has focused on the impact of monetary flows on the domestic monetary policy. The researcher identified the gap in the literature concerning what the increasing global capital flows implies for the domestic markets, institutions, and frameworks. This study is, therefore, guided by the need to bridge the identified gap in the literature concerning the implication of international financial flows on the domestic monetary policy with special interest on UK.
Rationale for the Topic
Purpose for the Study
The paper seeks to develop insights into the policy implication of the increasing global financial integration, cooperation, and exchanges to domestic monetary policy. It emphasizes on creating an understanding of the various prospects of capital flow liberalization through globalization and what it means for individual economies. It is widely acknowledged across the economic field that the transmission mechanism of the monetary policy evolves as domestic financial markets mature and develops. This development in turn affects the relative effectiveness of the different monetary frameworks (Blundell-Wignall and Roulet, 2013, 4). The interest rate channel financially will tend to be weak especially when the domestic bond markets are not well developed and banks dominate intermediation of the short-term domestic credit and foreign currency dominated funds (Chowla et al., 2014, 167). In this context, the financial policy will mainly affect the country’s economy through changes in the domestic monetary supply and exchange rate management. The approach is a crucial one for policy makers. Additionally, the direct measures like politically decided discreet changes in the exchange rate and the quantitative instruments will form the bulk of the monetary policy (Zechner, 2014, 1523). There is a big debate regarding the degree to which and the conditions under which the external liberalization of the domestic financial systems are likely to further promote the development of the financial system. However, there is consensus that countries benefit through deeper and more liquid markets, economies of scale, and increased competition.
Problem Statement
Many countries have operated their monetary policy regime that is based on fixed exchange rate. However, the smooth changeover to a floating exchange rate regime is a complicated phenomenon in many dimensions (Artis and Hoffmann, 2011, 501). Other countries have tried to conduct a combination of some elements of the inflation targeting coupled with strict interventions in foreign exchange markets in an attempt to manage the exchange rate (Canterbery, 2009, 426). Increasing capital flows can, however, undermine such an approach. In fact, the probability of a fixed exchange rate regime to last eight years has been found to be below 0.3 (Avnimelech et al., 2010, 102). Another category of countries has attempted to limit financial flows through the use of capital flows (Díaz-Roldán and Monteagudo-Cuerva, C 2013, 2). However, these measures have also proven insufficient and ineffective in most cases have been found to create ways to circumvent the restrictions and to distort the normal functions of the financial markets and systems. In this regard, it imperative that an appropriate policy response to large capital flows should focus on pursuing price stability as well as anchoring inflation expectations. This research is mainly focused on investigating the impact of the current increase in capital flow across countries on domestic economies. Special emphasis during the analysis will be placed on the financial policy in UK as a case study to provide insights into strategies that countries have initiated in addressing the issue.
Research Questions
The research questions that guided this study were:
Research Question 1: What are the current trends and nature of the capital flows within the UK financial market?
Research Question 2: How does the global capital flow impact on the domestic monetary policy making?
Research Question 2: What are the impacts of the international capital flows on the national financial market in UK?
Aim:
The aim of the study is to examine the impact of international capital flows on UK’s monetary policy.
Research Objectives:
- To examine the trends and prospects of capital inflows within the UK financial market
- To evaluate how global capital flows impact on the local financial policy making
- To ascertain the impact of international capital flows on the domestic financial market
Significance of the Study
The paper provides insights into the policy implication of the increasing global financial integration, cooperation, and exchanges to domestic monetary policy. It will offer a clearer understanding of the various prospects of capital flow liberalization through globalization and what it means for individual countries with special interest on the UK financial markets (Country Reports, 2014, 4). Policy-makers have are equally faced with a new task of addressing emerging needs in the domestic financial markets (Lane and McQuade, 2014, 220). The new issue calls for a new a rationale; a different perspective which is provided by the findings of this study. The findings of the study can be used as a basis for informed basis on decision making concerning monetary policy. In addition, it can be used as a foundation and guide for further research on the topic of capital flows and monetary policy.
Structure of the Dissertation
The primary purpose for this research is to find out and understand raw data and information concerning the topic of financial flow and its impact on the domestic monetary policy. The organization of the study will be organized in five sections; introduction, Literature review, research methodology, findings and analysis, and conclusion.
Chapter Two
Literature Review
Definition of terms
Capital flow
Capital flow can be described as the movement of finances for the purpose of business production, trade, or investment (Braasch, 2012, 130). This movement takes place within and across corporations in the form of capital spending on research and development and operations as well as in the form of investment capital. On much larger scale, it occurs through government direct capital flows acquired from tax into programs and operations as well as through cross-border transactions and trade (Imad’Eddine and Schwienbacher, 2013, 366). Individual investors also contribute through investment capital into securities like bonds, mutual funds, and stocks and direct savings. International capital flows entail
The financial feature of the international trade takes the form of imports and exports (Gordon et al., 2014, 161). If the total imports were to equal the total imports, then these financial transactions would balance at zero. A country’s current account balance is the balance of trade covering its income receipts, transfers, and trade in goods and services. When an economy is experiencing a surplus or deficit in the current account, an offsetting net financial flow exists in the form of securities, currency, and real property ownership claims (Melissa and Snyder, 2013, 56).
Monetary policy
Monetary policy implies the actions of the central bank in determining the size and rate of growth of the financial supply that in turn impacts on interest rates. Notably, monetary policy in any economy is maintained through initiatives such as changing the amount of money that banks require to keep in the vault and increasing the interest rates (Melissa and Snyder, 2013, 56). In UK, monetary policy is conducted by the Bank of England. It involves influencing the supply and demand for money (Dagnino et al., 2014, 1146). The main target of these initiatives is to achieve low inflation and in turn promote economic growth. Fiscal policy has to do with the effect of government spending and tax on the aggregate demand and economy. Deflationary fiscal policy is an attempt in reducing the aggregate demand and entails lower spending and higher taxes while expansionary fiscal policy focuses on increasing the aggregate demand and includes a higher government spending and lower taxes.
Cyclical Capital Flows
When a country’s economy is experiencing a boom, the government can opt to run a surplus, in other times in the cases of a recession, it opts to run a deficit. A pro-cyclical fiscal policy causes a pile on the spending and tax cuts during booms but reduces spending while raising taxes to respond to downturns (Ramrattan and Szenberg, 2014, 165).
Financial Integration
Dagnino et al. (2014, 1146) note that financial integration entails linking together of financial markets across neighbouring regions and global economies. This can take the form of financial institutions and information sharing. Firms raise, invest, and borrow funds in the international capital markets. Market imperfections and legal restrictions can hinder financial integration (Bougheas and Falvey, 2014, n.p). More financial integration can be achieved from elimination of restrictions in pertaining to cross-border financial operations to allow financial institutions to operate freely and allow businesses to raise and borrow funds directly.
Literature Review
Capital flow across nations has been instrumental in boosting the productive potential of most economies of the world. However, the economic benefits accrued to this are usually marred by a set of policy dilemmas (Hashimoto, 2012, n.p). Brafu-Insaido and Biekpe (2014, n.p) notes that the liberalization of capital accounts creates diverse expectations among investors and this in turn impacts on the capital flow movements across borders. In this regard, the financial flows can be correlated to the volatility of variables used by the central bank as intermediate targets of policy. These may include monetary aggregates, inflation, foreign exchange reserves, as well as the exchange rate (Dagnino et al., 2014, 1146). Apparently, the financial capital in the private sector has increasingly become mobile across the developed nations over the recent past. As postulated by Melissa and Snyder, (2013, 56), investors have in turn been more attracted to the emerging markets by the opportunity to diversify their investment portfolios and the relatively high rates of return. Consequently, liberalization of capital account has resulted in the realization by international investors of these opportunities in many economies.
Increase in global capital flow has significantly been shared across geographical boarders and financial categories. Moreover, an increase in the type of private flows has been noted in the global financial markets (Hashimoto, 2012, n.p). However, the implication of such developments varies across economies and is largely dependent on the capital controls as well as the financial and economic development (Dagnino et al., 2014, 1146). In the light of these developments, policy makers are tasked with the responsibility of ensuring appropriate frameworks and structures to deal with these changes. For instance, they are more focused now on the impact of financial flows on certain variables such as inflation and asset prices, current account balance, output growth, total domestic investment, and employment (Dagnino et al., 2014, 1146). Capital flow is attributed to both increase and decrease of these variables. Indeed, the impact of the financial flows on a country’s economy is dependent on the main purpose for their entry into the economy.
Financial inflows occur when foreign or domestic entities purchase domestic assets through foreign assets. The standard international classifications categorize capital flows into three broad levels; foreign direct investment (FDI) which occurs when non-residents get hold of about 10 percent of a domestic enterprise, portfolio investment which includes purchase of securities, tradable financial derivatives, and the equity shareholders, and other capital flows in form of non-tradable transactions such as trade credits, deposits, and loans (Brafu-Insaido and Biekpe, 2014, n.p). Literature reveals that policy in many world economies possesses a preference for certain flows over others (Melissa and Snyder, 2013, 56). Moreover, policy makers are increasingly concerned that financial flows should take a form that is not likely to leave the economy as a result of a sudden change in sentiment (Dagnino et al., 2014, 1146). In a situation when the economy is facing fragile monetary stability, the central bank may be concerned about the effects of short-term flows. As such, large flows of the short-term capital may heighten the need of banking supervision.
A beneficial outcome of the domestic capital and financial account liberalization is the enhancement in terms of efficiency of the financial system. In an economy with efficient financial system, the domestic entities are likely to get internationally competitive pressures especially in cost of borrowing. Nations that are able to fully liberalize their capital accounts are likely to achieve greater capital flows, as well as lower interest rate. In addition, attempts to resist certain flows could reduce the likelihood of realizing more efficiency within a country’s financial system.
The main challenge for policymakers is to identify the optimal mix of interest rates, fiscal policy, exchange rate, and financial rate in the new equilibrium. When faced with large capital flows, central banks usually will opt to sterilise (Dagnino et al., 2014, 1146). Inflow controls and greater exchange rate flexibility have been associated with non-sterilisation interventions. Capital flow controls can be more successful than outflow controls. Capital flow controls, direct or indirect, includes imposing of prudential limits on banks borrowing abroad as well as foreign exchange transactions.
Effect of Capital Flow on Monetary Policy
It is difficult to imagine how some government would like to make recessions worse for themselves and their citizens. The literature on the subject is fairly up to date, but indicates that governments in these countries capitalize on their interest, especially regarding monetary policy: when faced with some type of economic problems or incomplete financial markets, developing countries’ best choice is to expend according to their revenue (Bougheas and Falvey, 2014, n.p). According to Aliber (2009, 366) developing country governments would opt to use monetary policy to work against temporary reductions in gross domestic products (GDP), but they are unable to find the required finance.
Literature suggests that developing countries, mostly Latin American (LA) countries, experience far more macro-economic instability than industrial economies and those economic fluctuations in developing countries inflict a significant welfare loss to these countries (Aliber, 2009, 366). The literature also suggests that destabilizing monetary and fiscal policies are one of the major causes of this macro-economic instability.
Two problems are identified from this literature and hence attempt to address these issues. First, the literature on pro-cyclical monetary and fiscal policy is mainly descriptive, and few number of estimations done to find the problem use OSL regressions Houston et al., (2012, 1850). Moreover, pro-cyclical behaviour implies that monetary and fiscal policy affect economic growth thus creating the problem of endogenous regressors. Though the literature has identified pro-cyclical policy, it is argued that the possibility of endogenous regressors may create bias in existing conclusions. The issue of endogenous regressors is dealt with using a generalized method of moments (GMM) to investigate the vector auto regression (VAR) and the contemporaneous correlation to deal with the dynamic relationship between economic growth and policy (Benz et al., 2014, 466). The problem of simultaneous determination of left and right-hand side variables is avoided by use of these approaches. This analysis reveals that most of the developing countries engage in pro-cyclical monetary and fiscal policies even when controlling for endogenous regressors hence supporting previous results from the literature.
The second problem with the past research on the topic concerns the major cause of the pro-cyclical policy. Although the theoretical literature considers financial constraints as the basis for pro-cyclical flows is a major reason for destabilizing fiscal policy (Benz et al., 2014, 466). Moreover, other parts of the literature suggest that pro-cyclical fiscal policy is as a result of misallocation of resources, in the case where the government fails to produce enough surpluses during good times to be used in terrible times. For empirically investigating the above question, the direct impact capital flows have on monetary and fiscal policy decision is estimated (Dagnino et al., 2014, 1146). Once the policy behaves in pro-cyclical way, the relation between policy decisions and capital flows may not be unidirectional. Hence, in order to avoid endogenous regressors problem, the GMM and VAR estimation is again employed. The capital flows being experienced globally impacts on policy decisions directly in a way that cause pro-cyclical policy, with few exceptions (Brafu-Insaido and Biekpe, 2014, n.p).
Potential Determinants of the Capital Flows
Push and Pull Factors
On the basis of the open economy theory, pull and push factors are postulated as the principle determinants of both the magnitude and direction of the capital flow (Boschi, 2012, 1041). Consequently, the global factors/push factors occur when investment in developed countries seems less attractive to developing countries (Janus and Riera-Crichton, 2013, 16). The effect of this scenario is that capital flows are pushed into relatively higher risk-adjusted-return countries. In this regard, a decline in world interest rates in the developed nations creates a relatively attractive profit opportunities in the emerging markets. The country-specific factors help nations attract capital flow from across the border (Sherstnev, 2014, 67). Clark and Kassimatis, (2013, postulate that these factors are usually influenced by exchange rates regimes, effectiveness of fiscal and monetary policies, creditworthiness, domestic macroeconomic conditions, and financial and economic reforms. Moreover, capital flows in any country depend on the prevailing political conditions as well as the quality of the various institutions and frameworks.
Capital Flow Liberalization
Most of the empirical studies on capital flow have been focused on the impact of openness of capital flow across borders (Marjit and Kar, 2013, 574). Many of the policies including the relaxation in the entry barriers within the banking system, openness in the security market, privatization in the financial sector, and the elimination of interest rates can transaction costs, ownership and investment, qualitative limits, and change prices (Antràs and Caballero, 2009, 701). The financial policies impact the behaviour of the foreign and domestic investors which in turn impacts on the structure and movement of capital flows.
Pro-Cyclical Capital Flows
According to Melissa and Snyder, (2013, 56), pro-cyclical international capital flow to nations is fairly new. Analyses of Latin American for instance, external debt/economic crises carried out by Brafu-Insaido and Biekpe (2014, n.p) show that the financial constraint of the start of the decade has different impacts on economies at various levels of their development and structural organization. Initially, what most countries had in common was a strong capital flows reversal as well as the need to generate external surpluses to service their external debt. The economic recession that most economies are facing globally is, therefore, as a result of international financial constraints.
An increase in terms of the global financial supply has been noted to impact positively to growth especially the domestic credit booms (Hashimoto, 2012, n.p). A theoretical model provided by Brafu-Insaido and Biekpe (2014, n.p) explains the scenario of growth based on large external borrowing followed by a subsequent decline with no access to international liquidity. In this model the external credit evolves in a cylindrical way in developing Nations, creating conditions necessary for economic/financial cycle. The cycle demonstrates that the growth period is as a result of easy access to international liquidity, whereas the net capital outflow is consequence of exchange rates appreciation and the sequential decrease in profit opportunity reduces investments in these economies. Tille and van Wincoop, (2014, 31) states that during external crises, countries experience a decline in access to international liquidity and, as a result, domestic companies, and government compete for limited domestic resources. This process may cause a reduction in sales, a reduction in assets prices and a rise in interest rates can result to increased bankruptcies and reduction of investments.
In summary, it can be noted that pro-cyclical capital flows brings a decisive interpretation to capital inflows control and is controlled by business cycle. The need for external finances is created by the liberalization of the domestic financial system (Hashimoto, 2012, n.p).
Pro-Cyclical Fiscal Policy
Literature on this area is mainly based on financial constraints, and even though new and extensive. It is composed of theoretical and empirical studies that examine the question using econometric OSL regression (Hashimoto, 2012, n.p). Reinhardt et al., (2013, 63) contend that the switch to partial failure to pay regime is associated with financial weakness, where small change in basics like increase in government spending can lead to a large accumulation of debt. Evans (2012, n.p) argues that in developed countries, markets are complete; the relationship between government consumption and output is zero. However, it becomes optimal to let the government expenditure be pro-cyclical when markets are incomplete as in developing countries. Partial markets encourage extensive instability in both public and private consumption. As Reinhardt et al. (2013, 63) notes some developed countries that do not face external economic constraints practice pro-cyclical fiscal policy. It focuses on allocation mechanism problem where the government does not save during good times.
Aliber (2009, 366) contends that pro-cyclical responses are most evident during recessions, and may be associated with the inability by countries to access international capital markets especially during adverse economic times (Bougheas and Falvey, 2014, n.p). They infer that access to international financial markets is unstable and that the perceived creditworthiness. According to International Flows (2014, n.p) the solution for the pro-cyclical fiscal policy is on the spending side, given that fiscal revenue act in industrialized countries (Benz et al., 2014, 466). However, during bad times fiscal expenditure in most developing nations is strongly pro-cyclical. The reason for pro-cyclical fiscal policy is the idea that borrowing constraints are reinforced by hard economic times.
A study by Houston et al., (2012, 1850) report, the monetary policy in most European countries is primarily pro-cyclical. Brafu-Insaido and Biekpe (2014, n.p) argue that the pro-cyclical fiscal policy is as a result of structural feature of tax systems, volatility in capital flows and political expenditure. Fiscal policy is constrained by the unpleasant monetarists arithmetic of the fiscal policy and financial policy in the long run (Binici et al., 2010, 667). Financial liberalization also plays a role in monetary policy and macroeconomic volatility.
Pro-Cyclical Monetary Policy
According to Jin, (2012, 2111) the old Mundell-Flemming framework recommends that it is incompatible to manage fiscal policy and the exchange rate at the same time. Under the regime of fixed trade rates, financial policy is relatively passive and varies on the basis of the net flow of global capital (Matsuyama, 2014, 16). But under a balanced exchange rate regime, fiscal policy is active, allowing monetary authorities to decide domestic interest rates. The only way to decrease the pro-cyclicality of foreign capital flows is to take action during boom periods, dropping the level of nonfinancial firms’ external liability.
Errunza and Losq (2009, 1025) recommend that developing countries should have a flexible inflation-targeting structure to deal with external disaster. In this context, developing countries should permit for some short run exchange between inflation and recession for more adequate insurance incentives by loosing fiscal policy Shen et al., (2010, 515) identifies external finance constraints as a basis of pro-cyclical fiscal policy. In summary, literature identifies a more structured cause and existence of pro-cyclical fiscal policy, and less on fiscal policy. However, it is clear that the literature fails to examine the direct impact of capital flows on policy decisions.
Chapter Three
Research Methodology
This Chapter will discuss the research design that will be applied in the study, the target population and location of study, the sample size and sampling techniques; Data collection instruments and data collection procedures, Ethical considerations and finally the Data Analysis Plan.
Role of the Researcher
The researcher obtained a letter of permission to collect data from and presented a copy of this letter to the respective respondents. The researcher formed part of the research instruments in data collection. This was achieved through interaction and collaboration with respondents while gathering data. First, the researcher developed a questionnaire to be used in data collection. Secondly, he gathered contacts of the various bank managers to participate in the study. The researcher personally visited the selected participants with the letter of permission requesting them to participate in the study as well as informing them of the purpose and nature of the study. This was followed by sending the questionnaires to the respective respondents who agreed to take part in the study. The participants were requested to reply the questionnaires through email after filling them up. The researcher then embarked on analysing the data and interpreting the findings.
Research Philosophy
Research philosophy takes the form of the researcher’s opinion and views and the manner in which they understand the world. It forms the basis for the adopted research strategy and other practical considerations during the study. The research philosophy that drives this research is defined by the interest to build a bridge between the fields of monetary policy and the area of global capital flows. The goal of this research is to apply the economic principles and perspectives in underpinning the significance of international capital flow to domestic financial sector and these impacts on the daily operations and structures that are laid out by the various stakeholders including government. Ontology as such is about what exists, components that make it, and ways in which these components interact with each other (Tucker et al., 2005, 383). The research seeks to apply the economic principles of financial policy and processes in underpinning the prospects of domestic monetary policy in the UK. This is particularly vital when attempting to understand financial markets in the contemporary environment.
Justification of the Epistemological Approach
Relativist ontology assumes that reality is constructed intersubjectively through meanings and understanding that we develop experimentally and socially (Arais, 2012, 64). Findings claims are created as an investigation proceeds through dialogue in which various conflicting interpretations are negotiated among the members of the community. Moral and pragmatic concerns are critical considerations when evaluating interpretive science (Dow and Montagnoli, 2007, 808). Notably, fostering a dialogue between the respondents and the researcher is also imperative. It is through these dialectic processes that more sophisticated and informed understanding of the social world is created. Interpretive approaches heavily rely on naturalistic methods; questionnaires as used in this study. These methods ensure adequate dialogue to construct a meaningful reality.
Methodologies
Qualitative research comprises of various approaches and orientations that are adopted to generate new data. Qualitative research is interested in the way the world is understood, produced, or experimented by people’s behaviour and interactions (Osborn and Sensier, 2009, 24). It mainly takes interest in process, social context dynamics and change. A wide array of methods exists that can be used in qualitative measurements. In participation observation, the researcher becomes a participant within the context being observed. Direct observation involves the researcher taking a more detached perspective by watching rather than by taking part (Chowla et al., 2014, 169). Interviewing entails direct interaction between the respondent and the researcher. Case studies can be described as an intensive study of a specific context (Heinlein and Krolzig, 2012, 443). The preferred method for this study was the use of questionnaires. A questionnaire method is a means of eliciting experiences, beliefs, feelings, perceptions, and attitudes. Questionnaires can be either unstructured or structured and includes a set of preplanned, concise set of questions designed to yield some specific information concerning a topic (Sentance, 2008, 6). This information about the topic is acquired from respondents.
Instrumentation
Data collection instruments are tools used in gathering empirical evidence in order to gain new insights about a situation and to answer questions that prompted the undertaking of the research (Sharpe and Watts, 2013, 44). According to Nelson and Nikolov, (2008, 93) a researcher requires to devise tools and instruments with which to collect the necessary information. Since this research adopted the survey research design, the researcher used questionnaires to collect data. Sharpe and Watts, (2013, 44) assert that questionnaires are an appropriate way of accessing people’s perceptions, meanings, and definitions of situations, construction of reality and understanding others which basically explains the goal of this study
A questionnaire consists of a number of questions printed or typed in a definite order on a form or set of forms (Heinlein and Krolzig, 2012, 443). In this study, the items in the questionnaire will address each of the research questions. The questionnaire will include both open-ended and close-ended questions.
Data Collection
Data collection is simply the process of acquiring information concerning the topic of focus. A number of methods exist for data collection on the basis of survey design (Osborn and Sensier, 2009, 24). Questionnaires are the most appropriate method of data collection for this research because they are concise and are capable of gathering information about a pertinent topic. The questionnaire for this study comprised of a combination of both the close-ended and open-ended questions. Questionnaires are also easy to tabulate and interpret and as such enhance the validity of the study. The researcher tried out a few questionnaires on friends to ensure that they are appropriate before using them for the actual study. Questionnaires were sent out through emails to respondents taking part in the study. The use of email ensured that it is convenient for the respondents who are relatively busy (bank managers) to fill them in and send them back in their own convenient time. It also made it easy for the researcher in terms of cost, time, and analysis. However, the research was subject to some limitations as a result of using a questionnaire. It was difficult to obtain from respondents a sufficient number of responses and may not give very exact responses because of misunderstanding the questions. Accurate collection of data is imperative in maintaining the integrity of research.
Data Analysis
Data analyzing entails examining the collected information in ways that can reveal the patterns, trends, and relationships (Heinlein and Krolzig, 2012, 443). This may include statistical operations to establish the type of relationships among the study variables or comparing information collected with that from other groups (Dow and Montagnoli, 2007, 808). Since the data was filled online, it was automatically collated as a spreadsheet. A checklist was used to simplify and quantify the respondents’ perceptions. Analysis was done using the SPSS program because of the qualitative nature of the data. Presentations were done using graphs, tables, and charts to explain the findings of the study.
Limitations, Bias, and Ethical Issues
Human Participants and Ethics Precautions
Validity and Reliability
Validity can be viewed as the accuracy of inferences. It is simply how accurately the data is able to represent the variables of the study in order to have meaningful and accurate inferencesd trials (Dow and Montagnoli, 2007, 808). According to Osborn and Sensier (2009, 24) reliability can be achieved or measured by triangulation of collected information from the respondents using similar questions. Since the researcher used a combination of both open-ended and close-ended questionnaires to collect data, any bias in this study was countered, and in-depth information that may be missed was be minimized. The researcher to ensure validity and reliability conducted a pre-test of the tools on two staffs of the banks.
Summary
This chapter precisely gave an overview of the research design that will be applied as well as described the Population, Sample, Sampling procedures and Data Collection Procedures. How validity and reliability would be ascertained in the study was also discussed. Finally, the data analysis plan and ethical considerations to be followed were outlined.
Chapter Four
Findings, Analysis, and Synthesis
The respondents of this survey were a sample population of 24 managers of four UK banks; HSBN, Barclays, Co-op, and Standard Chartered banks. The questionnaire was created to gather information on increasing global capital flows and the monetary implications they have for monetary policy (a case study of the UK financial institutions). The researcher sent out an online questionnaire to several respondents, and the following are the respondents’ feedback. The findings acquired from the questionnaires were analysed and interpreted using charts, graphs, and tables and the respective percentages. The major objective of the study was to examine the impact of current global capital flows on UK’s monetary policy. The specific objectives were to examine the trends and prospects of capital inflows within the UK financial market, to evaluate how global capital flows impact on the local financial policy making as well as to ascertain the impact of international capital flows on the domestic financial market
Participants
Figure 4.1: Respondents’ gender
Majority of the study respondents were male, which is 61 %( 15) of the total respondents. The female participants were 9 in number that is 39%; although they are smaller in number compared to their male counterparts, they represent a decent percentage overall.
More than 95 percent of the total respondents’ age was younger than 50 years, those between 17 years and 20 years amounted to 19 percent of the total respondents while 23 percent of the overall respondents were between 21 years and 30 years. These two groups’ amounts to more than a-third of the total people participating in the survey.30 percent of the total respondents were aged between 31 and 40 years, this shows that these group is an important one for the study. People who were aged between 41 to 50 years amounted to 23 percent while those who are older than 50 years were 5 percent of the total respondents. Clearly the majority of the respondents i.e. 95 percent were younger than 50 years, this is the target group used in the survey
Figure 4.3: What type of work do you do?
The majority of the respondents 21% who participated in the survey were either on strategic or management department; this has amounted to nearly 70 percent of their total. Those who are working in the operations management or any other related job accounted for 21% while those in management on MIS departments were about 18 percent,
The existence of the different types of capital flows has different effects in terms of the stability and growth of the financial sectors and the economy at large. Most studies have shown that FDI flows, cross-border trade, and other forms of international capital flow result in economic growth either directly or indirectly through human capital improvement and technology spillover (Gemici, 2009, n.p). Many other studies also point out that portfolio flows including equity and bond investments can help energize economic growth by improving the allocation of global savings as well as the minimization of capital costs (Pavlos Petroulas, n.p). The field of international capital flow has since become a prime area of focus for economists and nations targeting to gain from these exchanges.
Financial development for a nation constitutes a potentially vital mechanism for long-term growth. Several surveys have demonstrated that the opening of the domestic economy to foreign competition and the establishment of appropriate economic systems and institutions is critical (Feldstein, 2009, n.p). Foreign investors play a very key role in the development of the UK financial system in regard to both the financial market and financial institutions (Chicago, 1999, n.p). This development is largely attributed to the financial and capital flow market liberalisation. Financial liberalization is one of the fundamental market-oriented reforms that was implemented in regard to the transformation in UK and included both the lifting of foreign exchange controls and reforms on the domestic policies. Capital account liberalization was done in 1979 and occurred in terms of reduction in entry barriers to the financial markets by new entries (Davis and Gallman, 2007, n.p). It also included a legal framework through new acts on foreign exchange controls. Liberalization of the financial sector in UK begun in 1985 (Petroulas, 2008, n.p). Concerning the impact of global capital flows on UK’s domestic financial market, the researcher obtained the following;
To ascertain the impact of international capital flows on the domestic financial market
Table 4.1 Has the increased capital flows across countries impacted on exchange rates?
| Capital flow across Countries | Percent |
| Foreign portfolio inflows have a direct impact on the demand | 31.8 |
| Capital inflows could increase the money supply and liquidity and in return boost asset prices | 36.4 |
| Capital inflows have the capacity to generate economic booms and increase asset prices. | 22.7 |
| No Comments | 9.9 |
| Total | 100.0 |
When asked whether the increased capital flows across countries impacted on exchanges rates, the majority of the respondents said that foreign inflows can directly impact on the demand for assets. Also, a section reported that capital flows can cause an increase in liquidity and money supply. Capital inflows are likely to generate economic booms resulting in an increase in asset prices.
Increased capital mobility makes it difficult for countries to adopt a fixed exchange rate strategy. However, some countries still operate a monetary policy regime that is based on fixed exchange rates. A smooth shift to a floating exchange rate regime is a complicated undertaking for economies (The International Flows, 2012, n.p). An alternative is the adoption of an eclectic monetary policy regime. Transition from a fixed exchange rate to a floating exchange rate regime can lead to high exchange rate volatility (Cailloux et al., 2008, n.p). This could then bring out loss of competitiveness and high economic costs. Monetary policy with a low, stable inflation can contribute to exchange rate stabilization.
To examine the trends and prospects of capital inflows within the UK financial market
Figure 4.4 Does global capital flows help to stimulate domestic financial markets?
On whether global capital helps to stimulate domestic financial markets the study established that it helps since global capital flow contributes immensely in the economic performance of a country, similarly it helps in that countries gain significantly from Foreign Direct Investment (FDI) as well as that it does positively affect the economic growth direct contribution.
Recent studies show that the presence of foreign banks is beneficial in terms of cost of credit to clients (Bombardini et al., 2012, 2343). An analysis of the credit situation in the country reveals that the lowest credit rates are offered by banks that are controlled by foreign entities and banks privatized with the engagement in foreign strategic investors (Von Hagen and Zhang, 2014, 66). This has been attributed to the better assessment of the credit risk. In addition, having strong strategic owners has led to lowering of the credit cost to banks themselves. This situation has impacted on the domestic banks’ rating positively while the strategic foreign owners have contributed to the stability of the domestic banks through other channels. Other contributions include creating a market for risk hedging instruments, diversifying the investor base, and increasing the liquidity of the financial markets (Evans and Hnatkovska, 2014, 14). The investor base expansion and diversification have significantly contributed to the stability of the markets by eliminating the negative impacts of the investment limits of domestic institutional investors.
Figure 4.5: How Important is the increase in capital mobility to financial institutions
Among the participants 34 percent as well as 28% rates as very important the increase of financial mobility of most banks in UK, only 20% mentioned as not important while 18% not sure the importance of increase of capital mobility of financial institutions in UK, which implies that level of financial integration among economies across the world has been increasing and has led to increased opportunities.
A surge of long-term inflows has a positive impact on the recipient economy’s stability and growth. Long-term capital flows to some extent impacts on the conduct of the monetary policy particularly in cases of inflation targeting framework (Bombardini et al., 2012, 2343). For instance, high levels of the foreign investor participation within the banking sector have the capacity to change the functioning of the credit channel within the monetary transmission mechanism. This is attributed to the enhanced ability of the local banks to source funding from foreign parent institutions. Besides, access to parent bank funding is likely to stabilize the supply of funds and the fluctuations emanating from the business cycles.
Table 4.2 Does global capital flows promote international coordination of monetary projects?
| global capital flows | Percent |
| Increased international coordination across nations | 28.9 |
| Promotes more international business transactions | 36.4 |
| More rapid spreading of financial innovation. | 22.7 |
| Technological advances in payment, settlement and trading | 10.1 |
| Increased competition can greatly enhance the efficiency in the financial sector | |
| Total | 100.0 |
The researcher similarly sought from manager on whether global capital flows promote international coordination of monetary projects and established the following, that global capital flows leads to increased international coordination across nations, promote more international business transactions, more rapid spreading of financial innovation, trading system settlements, increased competition, and advancement in technology can help to enhance efficiency in the financial sector.
Closer global integration and interactions in recent decades have comprised of increased trade across countries (Kalay, 2014, 457). As a result, global capital flows have increased substantially in recent years and have become a key aspect of the monetary system. They offer several benefits to countries although they could also be a source of risks in terms of policy due to their size and volatility. Capital flows have been found to have significant benefits including promoting financial sector competitiveness, facilitating greater productive consumption smoothing and productive investment, and enhancing efficiency (Bird and Rowlands, 2008, 47).
Figure 4.6 What are the identified risks on financial institutions by globalized monetary flows?
The study established that most of the managers identified risks on financial institutions by globalized monetary flows by suggesting that risks may cause financial instability as well as that risk may causes increased fraud cases. However, in the case of short-term inflows, the cost seems to outweigh the benefits. The trend towards financial liberalization is a critical factor for surges and changes in the nature of capital flow.
From the literature, it was established that strong foreign presence and capital inflows could also cause some negative consequences for both financial stability and development. Widespread foreign ownership of the financial institutions can create new channels of contagion from the parent banks and markets in which they operate (Favilukis et al., 2013, n.p). The way foreign investors operate can contribute to underdevelopment of some financial market segments.
Moreover, policies geared towards greater financial liberalization, for instance, the elimination of entry barriers in a country’s banking sector and restrictions on capital flow usually affects the financial system in turn (Kalay, 2014, 457). This implies that capital flow is bound to impact on the way a country designs their monetary policy with a view to spur greater international economic integration and economic development.
On the other hand, capital flows also present certain risks that can be inflated by gaps in the country’s institutional infrastructure. Capital flow liberalization has formed an integral portion of many countries’s development strategy especially in recognition of the many benefits that they stand to gain from such capital flows (Reinhardt et al., 2013, 63).
To evaluate how global capital flows impact on the local financial policy making
Table 4.3 What do you think are the implications of the current financial globalization on monetary and fiscal policies?
| Capital flow across Countries | Percent |
| affected the viability of the country’s fixed exchange rate regimes | 32.0 |
| fixed exchange rate regime less capable in withholding speculative movements and more flagile, | 30.0 |
| implications of current financial globalization has been seen in banks by increased capital mobility | 28.0 |
| No Comments | 10.0 |
| Total | 100.0 |
Among the participants 32 percent of them believes that the current financial globalization has affected the viability of fixed exchange rate regimes, 30% believes that capital flow has resulted in a more fragile exchange rate which is unable to withstand speculative movements, 28% believes that the implications of current financial globalization has been seen in banks by increased capital mobility may have intensified the contagious effects of crises.
Monetary policy implies the actions of the central bank in determining the size and rate of growth of the financial supply that in turn impacts on interest rates. Notably, monetary policy is usually maintained through initiatives such as regulating the amount of funds that banks require to keep in the vault and increasing the interest rates (Bird and Rowlands, 2008, 47). The main target of these initiatives is to achieve low inflation and in turn promote economic growth. Fiscal policy has to do with the effect of government spending and tax on the aggregate demand and economy.
Many of the policies including the relaxation in the entry barriers within the banking system, openness in the security market, privatization in the financial sector, and the elimination of interest rates can transaction costs, ownership and investment, qualitative limits, and change prices (Bombardini et al., 2012, 2343). The financial policies impact the behaviour of the foreign and domestic investors which in turn impacts on the structure and movement of capital flows.
Figure 4.7 How might financial globalization affect the country’s transmission mechanism of monetary policy?
On how financial globalization can be expected to affect the monetary policy’s transmission mechanism the study established that it necessitate the need to reevaluate policies as well as helps in that new policies are developed to match emerging trends. In addition to improving monetary policy, as Fry et al. (2012, n.p) note, the increased independence of central banks has triggered an evolution in terms of the monetary transmission mechanism.
In this regard, monetary policy greatly affects the economy more through exchange rates and inflation expectations. As such, the credibility of these policies has since become a very valuable asset.
It is widely acknowledged across the economic field that the transmission mechanism of the monetary policy evolves as domestic financial markets mature and develops (Bird and Rowlands, 2008, 47). This development in turn affects the relative effectiveness of the different monetary frameworks
Figure 4.8 How does globalization of capital flows impacted on borrowing policies across nations?
When asked how globalization of capital flows impacted on borrowing policies across nations,, the majority of them said Banks are able to borrow abroad in their own currencies, Banks are able to borrow abroad in their own currencies, Allows developed economies to finance large current account imbalances at relatively favourable rates, significant impact on international borrowing terms.
In summary, we can note from the analysis that capital flow across nations and in UK in particular has been instrumental in boosting the productive potential of most economies of the world. Capital flows have been associated with numerous benefits for countries with liberalized financial markets (Von Hagen and Zhang, 2014, 66). For instance, there is noted efficiency in the banking sector as a result of increased competition as well as exchange of expertise and technologies. In addition, international capital flow has provided a source of capital for banks to engage better in their services (Evans and Hnatkovska, 2014, 14). However, the economic benefits accrued to this are usually marred by a set of policy dilemmas. The liberalization of capital accounts creates diverse expectations among investors and this in turn impacts on the capital flow movements across borders (Cho et al., 2014, 360). In this regard, policy makers are now charged with the task of establishing the optimal mix of interest rates, fiscal policy, exchange rate, and financial rate in the new equilibrium. Capital flow also presents some risks and challenges which if unchecked could harm the financial market and the economy in general. Economies need to capitalize on the benefits of the increasing global capital flow through stronger and more efficient policies and frameworks while mitigating the risks posed by them. Furthermore, more financial integration can be achieved from elimination of restrictions in pertaining to cross-border financial operations to allow financial institutions to operate freely and allow businesses to raise and borrow funds directly.
Chapter Five
Conclusion and Implication
Increasing international capital flows facilitated by the liberalization of financial and capital account in most countries have created a new macroeconomic environment. Notably, the last decade across the globe can be viewed as a period characterized by globalization including economic liberalization coupled with an opening-up of economics to trade flows and international trade (Galvao and Marcellino, 2014, 219). Economic liberalization as such means the lifting of the various restrictions, entry barriers, and controls in specific sectors such as the banking. It also involved the focus on market-oriented reforms with many countries striving to open up their economies with the purpose of competing for the international capital (Nowotny, 2014, 229). This was characterized by nations reforming their economies in terms of policies, institutions, and frameworks in order to attract foreign investment. This scenario has in turn induced massive flows of capital and fluctuation in exchange rates. As a result, most eastern and central European countries including UK have experienced the transition from central planning to market economy.
Considering the case of UK, the analysis of the consequences of increasing capital flows for the conduct of the financial market stability and development and monetary policy. It is clear from this analysis that inflation targeting constitutes the appropriateness of the strategy to cope with the increasing capital flows as well as the negative consequences for stability of exchange rate associated with it (Díaz-Roldán and Monteagudo-Cuerva, 2013, 4). Low current accounts and low inflation as well as strong economic growth have been achieved in UK despite the exchange rate fluctuations and high capital flows. Hallett et al. (2014, 2) contend that the opening-up of the country’s capital account has enabled it to attract large FDI flows. In turn, these inflows have significantly contributed to the evolution, stability, modernisation, and efficiency of the UK’s financial system.
The presence of investors has additionally accelerated the development of the financial markets and frameworks. Foreign banks have immensely contributed to development of the banking sector. Additionally, economic integrations have been a source of technology diffusion and through competition in the various market segments. Foreign investors have had a positive influence on the stability of UK’s banking sector through restructuring in terms of capital injections (Alin Haralambie, 2014, 3). The findings of this study are a good starting point for policymakers in further liberalization of the financial flows in the country. It also forms the basis for students seeking to undertake further research monetary policy and structures field in relation to international capital flow.
Despite the numerous benefits that economies are likely to reap from liberalized capital flow, evidence suggests a number of challenges; for instance, acceleration of a country’s GDP growth in times of large capital flows can be followed by a substantial and persistent drop in the growth rates (Lildholdt and Wetherilt, 2008, 465). Also, there is a concern that international capital flows could create loss of monetary policy independence in an open economy macroeconomics in a case of a fixed exchange rate regime (Dale, 2013, n.p). Capital flows also present the challenges to monetary institutions in terms of inflation pressures and in turn necessitated policy adjustment (Paez-Farrell, 2009, 2044). Again, financial flows have the potential of increasing financial stability concerns due to the various risks of exposure.
This study was motivated by the desire to build a bridge between the fields of monetary policy and the area of global capital flows. The researcher sought to apply the economic principles and perspectives in underpinning the significance of international capital flow to domestic financial sector and these impacts on the daily operations and structures that are laid out by the various stakeholders including government. The findings acquired through this study are important in underpinning the prospects of domestic monetary policy and more particularly in the UK.
As a qualitative study that applied the questionnaire method, the research was subject to a number of limitations (Bredin et al., 2007, 887)). First, it was difficult to obtain a sufficient number of responses through the online questionnaires. Secondly, the respondents may not have given very exact responses because of misunderstanding the questions. However, the researcher was keen on minimizing these limitations by the use of appropriate questions. To further underpin the topic of monetary policy and capital flows, the researcher identified the need for more studies on this topic especially one focused on factors that contribute to positive impact on the monetary markets.
The cost that an investor incurs in any country is largely dependent on the size and depth of the financial markets in terms of return correlations and controls, information asymmetries, and capital controls (Dow and Montagnoli, 2007, 808). Concerning the financial market size, a larger financial market is likely to take the form of a more liquid market and as such minimize the cost of investing. Capital controls usually raise the cost of investing across the border. Concerning information asymmetries, the existing trade ties as well as the greater proximity are likely to minimize information asymmetries and also minimize the cost of investment between countries. A greater relative return within the host market makes its portfolio investment in the country more attractive. Better governance in a country raises the transparency of investment and in turn reduces the investment cost.
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Appendix
QUESTIONNAIRE
Dear respondents: This questionnaire is created to gather information on increasing global capital flows and their monetary implications for monetary policy (a case study of the UK financial institutions), which will be utilized to enhance my dissertation in fulfilment of a Master degree. Your legitimate response will only be utilized for academic purpose and will also be treated with supreme confidentiality.
- How important is the increase in capital mobility to financial institutions?
- What do you think are the implications of the current financial globalization on monetary and fiscal policies?
- Has the increased capital flows across countries impacted on exchange rates?
- How does globalization of capital flows impacted on borrowing policies across nations?
- Does global capital flows help to stimulate domestic financial markets?
- Does global capital flows promote international coordination of monetary projects?
- What are the identified risks on financial institutions by globalized monetary flows?
- How might financial globalization be expected to affect the transmission mechanism of monetary policy?
