Capital Flight

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21 Aug, 2024

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Capital flight, in economics, refers to the outflow of a country's capital and assets due to certain negative sentiments. Several factors contribute to capital outflow, but the government's improper monetary policies are the primary reason. It reduces potential long-term tax receipts. It also hampers investment leading to less economic production.

Some economists call it hot money that reacts to political, economic, or financial news. Such a situation allows investors and businesses to cause the rapid withdrawal of their capital (domestic and foreign) from the economy. Hence, it negatively affects the nation's economy.

What Is Capital Flight?

Capital flight refers to the capital (money) that flies or goes outside the country resulting in negative events. For example, investors withdraw money from the stock market due to war.
The origin of theories of capital flight dates back to the 16th and 18th centuries in European countries.
The two types of capital flight are legal and illegal. Many political, economic, and financial crises result in the country's capital outflows.
Capital outflows result in low FDI and tax revenues, increased debt, and similar things.

Capital Flight Explained

Capital flight is when the invested capital or foreign direct investment (FDI) flies outside the country. Its primary cause is the fluctuation in demand for home currency and volatile interest rates. For example, if the euro's value falls, the investors will become skeptical (doubtful) about the economy. Thus, they will try to withdraw their money from that particular country. Both investors and businesses can perform the capital outflow.

Although it might seem like a fresh concept, the theories of capital flight existed from the 16th and 18th centuries. When King Henry IV abolished the Edict of Nantes in 1685, protestants refused to convert to Catholicism. It resulted in a short capital outflow in France. A major share of the coin, jewelry, wine, bills of exchange, and plates got transferred to Paris, Lyons, and other locations. In 1866, the Italian economy saw less capital outflow due to the country abandoning silver.

The texts state that political crises such as the Prussian mobilization against Austria, the Overend, and the Gurney crisis caused capital outflows. In addition, from 1919 to 1923, hyperinflation in Germany led to capital outflow. And to curb it, the Nazi (German)government came up with a standstill agreement in 1931. Likewise, a similar incident occurred in 1931 when many bank notes flew from Italy to Switzerland. According to capital flight data, in the late 90s, India also accounted for billions of capital outflows.

Types

Based on nature, there are two types of capital flight: legal and illegal.

Legal capital flight is when foreign investors try to withdraw their money back following certain laws and regulations of that country. For example, Companies translocate their business and property to escape the country's laws. However, illegal capital flight is the opposite. Here, the investors draw back their money as illicit financial flows (IFFS). Therefore, it results in vanishing the capital flight data from the database.

Causes

Let us look at the causes of the capital flights that can affect a country's economy:

#1 - Political Issues

Certain political issues due to policies drafted by the government can lead to capital outflow in the country. For example, a huge shift occurs from one type of government to another. Or else any political leader resigns from their position. Therefore, it can strike fear among investors. In addition, various monetary policies like high taxes or restrictions on imports and export can cause capital outflows in the country.

#2 - Economic Crisis

Every country releases its gross domestic product (GDP) and per capita income quarterly or yearly. If the figures are negative or lower, it can lead to the country's capital outflow. And the reason for economic crisis to occur is recession or inflation. Investors get doubtful about how long this recession phase exists and thus tend to withdraw their money.

#3 - Currency Devaluation

Currency devaluation has been one of the major reasons for capital withdrawal. Countries like Zimbabwe and Venezuela increased the currency supply to curb the economic crisis. However, it led to hyperinflation in the country. Also, the value of the currency depreciates faster with time. Thus, investors are allergic to such situations resulting in a capital outflow of their investments.

Effects

Let us look at the effects of capital flight and its related consequences:

#1 - Lower Foreign Investment And Tax Revenues

Since investors pull back their money from the economy, there has been a decrease in the country's foreign direct investment. Since FDI falls, the economy can face a loss of investment. However, investors with already invested money have no chance to withdraw it except the stock traders. When traders hear negative news, they can sell their shares and get their money back before the economy deteriorates.

In contrast, it can also lead to a reduction in tax revenues for the country. In simple words, capital outflow results in taxes leaving the country. In the long term, it affects the country's investment. Businesses will have a shortage of funds and finances. They will cut off employees to save on expenses. However, it will lead to lower tax receipts for the country.

#2 - Increased Government Debt

A decline in capital investment results in more debt by the country. Simply put, the government tries to borrow funds at a higher rate since no investor is investing in their country. For example, in 2012, the Greek government had no line of credit available. As a result, they have to pay higher interest rates.

#3 - Weakening Of Currency

The major consequence of capital flight is the weakening of the domestic currency. When capital outflow occurs, the demand for domestic currency also falls. In return, it leads to weakening or depreciation of that currency and disruption in the interest and exchange rates. For example, if there is political news around Sri Lanka, the investors will become skeptical about it. As a result of falling demand, they will draw back their investment, leading to a fall in the rupee's value and a rise in the dollar.

Examples

Let us look at the capital flight examples to comprehend the concept better:

Example #1

Suppose there is some news flying around in Asian countries. Investors had made a major part of their investment in China and India. After a few weeks, a huge tension arises in China. India bans Chinese products. Investors initially investing their money into Chinese companies have a drawback, resulting in capital outflow.

The Shanghai Stock Exchange saw a sell-off situation. Since investors have withdrawn their position, the government debt has increased. This is because the country borrows money from countries like the United States at a higher rate. So although it can be a good situation for an investor, the country might get affected badly.

Example #2

By the end of the first quarter of 2022, China saw a massive capital flight. After the Russia-Ukraine war situation, unusual outflows were occurring in China. In 2020, China experienced a similar outbreak during the Covid-19 virus. Other countries also saw increased capital outflows in the same year.

How To Prevent?

An effective way to prevent capital outflow is by implementing capital control policies. Countries that applied these policies in the late 20th century had less capital flight. However, no one method is effective. By balancing the inflows and outflows, countries can maintain a balance. Another way is to adopt the dual-exchange system. Here, the exchange rate for current transactions will remain fixed.

In contrast, speculative financial transactions will have a floating charge. Furthermore, the government can bring about positive changes in the political and economic spheres. For example, they can install a more robust method to stop illegal capital outflows.

Frequently Asked Questions (FAQs)

1. What are the advantages of capital flight?

Although there are no benefits for the country suffering from capital outflows, it can be for the investor. For example, he might suffer huge losses if he had not withdrawn money on time.

2. How does capital flight affect development?

Capital outflows can result in a weakening of the economy and domestic currency. In addition, the country will face a loss in terms of tax revenues.

3. How does capital flight affect the exchange rate?

Capital outflows result in a decrease in the demand for the currency. So, when the money flows outside, it moves from a risky to a safe place. As the demand increases or decreases, the exchange rates also fluctuate.

4. Why was the problem of capital flight so serious?

The problem of capital outflows is serious because it gives a negative impression in front of others. As a result, the suffering country tends to print more currency, resulting in hyperinflation. Also, they buy more loans to fill that gap, leading to higher debts.