Capital Flight Research Paper

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Capital flight is generally defined as an outflow of funds from a country motivated by an adverse change in the country’s economic, political, or social environment. Some believe that this definition is too broad. They distinguish between outflows that reflect “normal” international diversification motivated by marginal changes in riskadjusted returns and funds fleeing or propelled across national borders during a crisis. According to this view, only the latter category represents true capital flight. Related definitions restrict capital flight to short-term speculative outflows—“hot” money—or to an outflow of illegal transactions only. Some studies distinguish between the determinants of the outward flow of funds and those of the accumulated stock of capital flight over a period of time. To a great extent, the precise definition of capital flight used in any study is determined both by the purpose of the study and the available data.

Developmental economists tend to define capital flight broadly as the net unrecorded capital outflows for any reason from any capital-poor developing country. Other critics argue that this use of the term is more of a judgment than a definition—that capital flight is just a pejorative term for international diversification by a developing country. Defined in this way, capital flight presents developmental economics with a paradox. It is often observed that residents of a developing country engage in capital flight at the same time that entities in high-income countries are lending to or investing in the same developing country. How can both of these decisions be rational?

Burden of Capital Flight

If the scale of capital flight is large enough, it will have both short-term and long-term adverse impacts. An example of the former is the sharp increase in capital flight during the Asian financial crisis of the late 1990s. The ability of countries in the region to deal with the bursting of domestic asset bubbles was severely constrained not only by a rapid and large outflow of capital but also by the necessity to immediately impose higher interest rates and capital controls in an attempt to slow the capital flight, even though these policies worsened the domestic situation.

In the long-term, capital flight tends to reduce gross domestic product (GDP) growth. Especially in developing countries, domestic savings diverted into foreign holdings will not result in domestic investment. This is especially harmful because the marginal social benefit of investment in such countries tends to be greater than the marginal private benefit. Capital flight is also generally associated with an increase in a country’s foreign debt. Furthermore, the possibility of capital flight limits a government’s policy choices, as some monetary and exchange-rate policies will lead to an acceleration of such flight.

In addition, capital flight tends to not only shrink a country’s tax base but also make taxes less progressive. Wealthier families tend to have more opportunities to hide their funds abroad in order to conceal them from the tax collector. Capital flight facilitates corruption by providing concealment and sanctuary for ill-gotten gains. Finally, the possibility of large-scale capital flight discourages aid from international organizations and investment from other countries.

Estimating Capital Flight

Capital flight involves a balancing of secrecy, expected returns, and risk. Attempts to increase the secrecy of capital flight, perhaps to avoid detection by a tax authority, tend to reduce return or increase risk. This necessary compromise increases the likelihood that capital flight will leave indirect evidence. While there are many methods of estimating capital flight, most are variations of either the balance of payments method or the residual method.

The balance of payments method assumes that the most important characteristic of flight capital is that it is “hot” money. Small changes in perceived returns or risks could result in a rapid discontinuous transfer or wave of funds moving out of the country. This wave will come to an end when investors have adjusted the share of each country’s assets in their portfolios based on the new perceived return/risk profile. Based on this characteristic, the balance of payments estimate of capital flight is equal to the sum of (1) reported short-term capital exports by the nonbank sector and (2) the balancing entry, errors, and omissions. The inclusion of the latter reflects the belief that errors and omissions are largely composed of unrecorded short-term capital flows.

A more widely accepted method of estimating capital flight concentrates on capital flight as a residual. The current account balance, changes in international reserves, and the amount of net foreign direct investment determine a country’s necessary amount of international borrowing. If actual foreign borrowing exceeds this necessary amount, then it is assumed that the difference (or residual) represents additional borrowing to offset capital flight. The balance of payments method and the residual measure tend to provide a similar rough guide to the pattern of a country’s capital flight, but the residual method usually results in larger estimates of the size of these outflows.

Most studies of capital flight adjust their estimates to reflect the unique characteristics of each country both with respect to the treatment of foreign financial assets and liabilities, and the possibility of misinvoicing. Not all foreign financial assets are taken as evidence of capital flight; some may be necessary to facilitate foreign trade and finance and will have been reported to the developing country’s government. These “legitimate” foreign financial assets are often subtracted from capital flight estimates. Another common adjustment is to use creditor data to fill gaps in a country’s foreign debt statistics.

A more important adjustment is to correct for deliberate trade misinvoicing used to circumvent trade controls, avoid import tariffs, or facilitate capital flight. A resident may underinvoice his exports and then direct the unreported difference between the invoice amount and his actual receipts to some financial haven.

Underinvoicing of exports (or overinvoicing of imports) widens the reported trade deficit and therefore reduces the residual estimate of capital flight. Counterpart data can be used to correct for misinvoicing. The export (or import) numbers of a country are replaced by the import (or export) numbers, adjusted for the cost of insurance and freight, of any of its trading partners that are believed to publish more reliable trade data.

Determinants of Capital Flight

There is no consensus on the primary determinates of capital flight. The most widely held view is that capital flight results from attempts by portfolio holders to maximize risk-adjusted returns. The optimal portfolio will be based on the differential between domestic and foreign interest rates, beliefs about the relative over- or undervaluation of exchange rates, and expectations of monetary and credit policies at home and abroad as well as the relative risks that investors face in both countries. If one of these variables shifts in favor of another country, capital flight will occur. However, if the shift is in favor of the home country, there will be a repatriation of flight capital. The simple portfolio model fails to explain the paradoxical situation in which portfolio holders in a developing country engage in capital flight at the same time that portfolio holders in high-income countries are investing in the country. One explanation is that domestic and foreign portfolio holders face discriminatory treatment— that is, they face different risks or returns. A developing country may provide tax benefits to foreign investors from high-income countries, or these investors may believe that they face less risk of an adverse change in regulation because of the implied protection of their home governments. As discussed below, this differential in benefits may lead to round-tripping or revolving-door transactions.

Transaction costs may provide another explanation of this paradox. Transaction costs include the costs of gathering accurate information about an asset or liability, finding and evaluating the other parties involved, negotiating an agreement, and possibly enforcing this agreement. In well-developed financial markets, transaction costs tend to account for only a small fraction of the value of a financial transaction, and the costs associated with international transactions tend to be higher than those associated with domestic ones.

However, in developing countries, neither of these assumptions is necessarily true. Developing countries tend to have a lower capital/labor ratio than high-income countries, and therefore the real return on capital in developing countries should be higher. However, the existence of large transaction costs may motivate portfolio managers in developing countries to split their holdings based on desired maturity. Short-term holdings will be invested internationally where transaction costs are lower (capital flight). However, long-term holdings, with a desired maturity long enough to amortize higher transaction costs, will take advantage of the higher real return and be invested at home. Therefore domestic and foreign investors with a long enough maturity preference may be willing to invest in a developing country experiencing capital flight.

Capital flight and external borrowing tend to be highly correlated for a variety of reasons. Both may simultaneously increase as a reaction to poor economic management. Foreign borrowing may cause capital flight by increasing the likelihood of a debt crisis and therefore increasing economic uncertainty. Capital flight may cause foreign borrowing in order to replace lost capital and foreign exchange. Foreign borrowing may occur to provide the funds for capital flight. Finally, round-tripping or revolving-door transactions may simultaneously increase both flight and debt. Round tripping occurs when portfolio holders in developing countries send funds to foreign banks with the understanding that these banks will lend these funds to entities in the less-developed countries controlled by the portfolio holders. The usual motivation for round tripping is to take advantage of government guarantees for foreign loans.

Corruption, the abuse of public power for private benefit, is often associated with capital flight because corruption increases the risk of investing in a country. Also individuals may send funds abroad to hide them from corrupt government officials, and these officials may illegally shift funds abroad to launder the bribes that they received. Foreign banks may also facilitate capital flight by either lending to corrupt governments in return for generous fees or providing special saving facilities to help corrupt officials hide their loot. In addition, studies have found that capital flight tends to be a function of past capital flight, the general macroeconomic environment, and political factors, such as political instability and poor governance.

Capital Controls and other Means of Reducing Capital Flight

Capital controls seek to reduce capital flight by reducing its risk-adjusted returns. When controls are enforced, financial or trade activities associated with capital flight may require additional documentation, permission, fees, or the posting of bonds. Despite the widespread use of capital controls, they appear to be more effective as a means of slowing capital flight rather than of preventing it entirely. The value of capital controls is that by acting as a speed bump they provide decision makers with time to decide on policies, coordinate their efforts with international organizations such as the International Monetary Fund, and execute policies effectively before uncontrolled capital flight brings about a financial collapse.

However, there are at least four reasons why capital controls may fail to reduce net capital flight—capital flight minus repatriation—in the long term. First, imposition of capital controls may be a signal that a government intends to adopt perverse fiscal or monetary policies. Second, before they will repatriate existing flight capital, portfolio holders will now require a higher degree of confidence in future relative risk-adjusted returns because new controls will make future capital flight more difficult. Third, reporting requirements, currency controls, enforcement procedures, and bureaucratic influence intended to prevent capital flight may significantly reduce the risk-adjusted return on domestic investments. Finally, imposition of a particular set of capital controls may simply encourage a search for new methods of capital flight.

This policy-avoidance response may be as simple as bribing a new official, or it may shift capital flight into an entirely different channel. The longer capital controls are in place, the less effective they become.

A long-term strategy for reducing capital flight should focus on getting the economic fundamentals right. In addition to achieving reasonable exchange and interest rates, the adoption of a pro-growth economic policy may be the most important way to reduce capital flight and encourage repatriation. In developing countries, an aggressive anticorruption effort should also be a part of any pro-growth policy.

Bibliography:

  1. Boyce, James K. 1992. The Revolving Door? External Debt and Capital Flight: A Philippine Case Study. World Development 20 (3): 335–349.
  2. Cuddington, John T. 1986. Capital Flight: Estimates, Issues, and Explanations. Princeton Studies of International Finance 58. Princeton, NJ: Princeton University Press.
  3. Darity, William, Jr. 1991. Banking on Capital Flight. In Economic Problems of the 1990s: Europe, the Developing Countries, and the United States, eds. Paul Davidson and J. A. Kregel, 31–40. Brookfield, VT: Edward Elgar Publishing.
  4. Epstein, Gerald A., ed. 2005. Capital Flight and Capital Controls in Developing Countries. Northampton, MA: Edward Elgar Publishing.
  5. Gunter, Frank R. 2004. Capital Flight from China: 1984–2001. China Economic Review 15 (1): 63–85.
  6. Lessard, Donald R., and John Williamson. 1987. Capital Flight and Third World Debt. Washington, DC: Institute for International Economics.
  7. Ndikumana, Léonce, and James K. Boyce. 2003. Public Debts and Private Assets: Explaining Capital Flight from SubSaharan African Countries. World Development 31 (1): 107–130.
  8. Walter, Ingo. 1985. Secret Money: The World of International Financial Secrecy. Lexington, MA: Lexington Books.

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