Capital Flight

Determinants of Capital Flight

The determinants of capital flight are conditions that would cause an investor or asset holder to feel as though their capital was not secure in the country where it is located or would be better off and earn more interest somewhere else. Some of these conditions are:

• Political instability
• High inflation
• Low domestic interest rates
• Overvalued exchange rate

Political instability is a major factor influencing the economic conditions of a country. A country might be considered politically unstable if high-stakes elections are going on, disputed claims to leadership, there is a coup, or even an assassination of a politician as was the case in Mexico in 1994, where a factory worker assassinated the presidential candidate for the Institutional Revolutionary Party, Luis Donaldo Colosio, at a campaign rally.¹ Political instability causes uncertainty in economic policy and future financial decisions which could negatively impact the value of assets. Also, with political instability comes other nations' responses to the situation. If a foreign nation disagrees with the nation's behavior, it may respond by placing trade or travel restrictions to discourage or punish the disagreeable behavior. This can drive up the price of imports, reduce the demand and price of exports, and overall devalue the currency.

High inflation is another cause of capital flight because it means that the asset holder has less purchasing power per dollar. This means that if they have money invested, it is worth less when compared to a foreign currency. When the domestic currency is inflated, investors will want to move their capital into an economy that affords them a higher purchasing power. Similarly, when domestic interest rates are low, an investor will look to foreign markets to increase their returns. When interest rates are low, investors will not collect as much interest on the capital that they hold. To increase the income they earn from the capital that they own, they will move it to a place that offers higher interest rates to improve their earnings.

Capital flight can also be a result of an overvalued exchange rate. An overvalued exchange rate makes domestic goods appear expensive and imported goods appear cheaper. If an economy is already experiencing a slow growth period or a recession, an overvalued exchange rate is going to exacerbate the problem by reducing the demand for domestic goods and increasing the demand for cheaper foreign goods. Domestic investors will then look to buy cheaper foreign capital, especially when they can purchase more foreign capital than they can domestic capital.

Governments customarily want to prevent capital flight. They do this by setting up capital control policies. These are policies meant to limit and regulate the flow of foreign capital into and out of the domestic economy. Capital controls can be but are not limited to, laws regarding the amount of capital that can be transferred in a given period, restrictions on the type of capital, who can purchase the capital, or taxes on the transactions. Ironically, these types of restrictions can contribute to the problem of capital flight.

Effects of Capital Flight

The effects of capital flight are initially felt by the domestic currency. First, a domestic investor observes a situation that makes them want to remove their capital from the domestic market. This causes an increase in the net capital outflow which drives up the demand for loanable funds. Capital flight increases the demand for loanable funds since investors will be looking to borrow money so that they can fund the purchase of assets abroad.

Then, investors will be looking to borrow foreign currency with which they can buy foreign capital. Investors will be trading in their domestic currency for foreign currency, increasing the supply of domestic currency. Additionally, an overvalued exchange rate also makes buying foreign currency appealing to investors because the foreign currency appears cheaper.

Fig. 1 - Increase in the supply of domestic currency

Looking at Figure 1, we see that the increased supply of domestic currency will reduce the real exchange rate. The supply increases because investors are trading their domestic currency for foreign currency, making the domestic currency more readily available on the foreign exchange market. When the availability (supply) of a currency increases, its value decreases which is reflected by the decreased exchange rate. From this, we can conclude that capital flight causes the value of the domestic currency to depreciate.

This currency depreciation moves the country more towards a trade surplus rather than the trade deficit it experienced when the value of the currency was higher. This happens because imported goods appear more expensive and exports appear cheaper.

Effects of Capital Flight on Real Interest Rate

At the same time, the effect of capital flight on the real interest rate is an increase due to the rise in demand for loanable funds. The interest rate is basically the price of the loan and it is expressed as a percentage of the total loan. The real interest rate is when it has been adjusted for inflation. When the demand for loanable funds increases, the entire demand curve shifts to the right, indicating that at every interest rate, the demand has increased. Take a look at Figure 1 below.

Fig. 2 - Increase in demand for loanable funds.

Figure 2 depicts the market of loanable funds for the domestic currency. Initially, the equilibrium interest rate is at r₁ but with the rise in demand, the equilibrium shifts to the right along the supply curve. The new equilibrium is at a higher interest rate at r₂. The supply curve does not change because there has been no change to the supply of loanable funds, as only the demand for them has changed due to the investors' desire to buy more capital abroad.

As a result of capital flight, borrowing money becomes more expensive because of the upward pressure on the interest rate by investors' desire to buy more capital abroad. When borrowing money becomes expensive, domestic investors will borrow less, which means that they will be investing less in the growth and development of domestic capital. This cutback on investment reduces the rate of capital accumulation and the growth of the domestic economy.

Impact of Capital Flight on Economic Growth

The impact of capital flight on economic growth depends on which side of the transaction you are on. Of course, if your country is the one capital is fleeing from, it will negatively impact economic growth. It will reduce the growth rate by taking valuable resources out of the country and reducing the level of new investment that the nation experiences. New investment is lower partially because investors are looking abroad to invest and partially because of the high interest rates resulting from increased demand for loanable funds. Domestic businesses will be less likely to take out loans to invest in themselves to expand their businesses when interest rates are high since they mean that borrowing is expensive.

If investors are taking capital out of one country, by default, they are placing it into another. Logically, the country that is gaining the capital is a more stable country that offers more benefits to the investor. Historically, the countries that experience capital flight are less stable and less developed, so when investors remove their assets, they look for more stable and developed nations. Having this influx of capital into already developed and wealthier nations will not have the same impact on them as it does on the nation that is experiencing capital flight. The impact on them is positive but not as impactful as it is for the losing nation.

Disadvantages of Capital Flight

The disadvantages of capital flight are a loss of capital, a loss in tax revenue for the government, a decreased economic growth rate, and a loss of purchasing power for the consumer. Losing capital is the main disadvantage since it is what causes several other issues. The government losses tax revenue because if the capital that it was taxing exits the country it can no longer collect tax revenue on it. Also, when businesses are not borrowing as much to invest in new capital, the government is missing out on potential tax revenue as well.

The decrease in the economic growth rate is also a disadvantage because of the lost potential that the economy was not able to realize. Had the nation retained the capital, it could have profited from it and it would have been in a better financial position. The nation's citizens would have been in a better position too. Because capital flight decreases the exchange rate by causing an increased supply of domestic currency, the purchasing power of the consumer decreases. This means that the consumer can buy less of the same good than they could before, meaning people's paychecks do not go as far and they have less disposable income.