By JAMES CHEN
Reviewed By ERIC
ESTEVEZ
From: Investopedia, updated Nov 30, 2020
What is Capital Flight?
Capital flight is a large-scale exodus
of financial
assets and capital from a nation due to
events such as political or economic instability, currency devaluation or
the imposition of capital controls. Capital flight may be legal, as is the case
when foreign investors repatriate capital back to their home country, or
illegal, which occurs in economies with capital controls that restrict the
transfer of assets out of the country. Capital flight can impose a severe
burden on poorer nations since the lack of capital impedes economic
growth and may lead to lower living
standards. Paradoxically, the most open economies are the least vulnerable to
capital flight, since transparency and openness improve investors’ confidence
in the long-term prospects for such economies.
Understanding Capital Flight
The term “capital flight” encompasses a
number of situations. It can refer to an exodus of capital either from one
nation, from an entire region or a group of countries with similar fundamentals.
It can be triggered by a country-specific event, or by a macroeconomic development
that causes a large-scale shift in investor preferences. It can also be
short-lived or carry on for decades.
Currency devaluation is often the
trigger for large-scale – and legal – capital flight, as foreign investors flee
from such nations before their assets lose too much value. This phenomenon was
evident in the Asian crisis of 1997, although foreign investors returned to
these countries before long as their currencies stabilized and economic growth
resumed.
Because of the specter of capital
flight, most nations prefer foreign
direct investment (FDI) rather than foreign
portfolio investment (FPI). After all, FDI
involves long-term
investments in factories and enterprises in a
country, and can be exceedingly difficult to liquidate at short notice. On the
other hand, portfolio investments can be liquidated and the proceeds
repatriated in a matter of minutes, leading to this capital source often being
regarded as “hot money.”
Capital flight can also be instigated by
resident investors fearful of government policies that will bring down the
economy. For example, they might begin investing in foreign markets, if a
populist leader with well-worn rhetoric about protectionism is elected, or if
the local currency is in danger of being devalued abruptly. Unlike the previous
case, in which foreign capital finds its way back when the economy opens up
again, this type of flight may result in capital remaining abroad for prolonged
stretches. Outflows of the Chinese yuan, when the government devalued its
currency, occurred several times after 2015.
In a low-interest rate environment,
“carry trades” – which involve borrowing in low-interest rate currencies and
investing in potentially higher-return assets such as emerging market equities and junk
bonds – can also trigger capital flight.
This would occur if interest rates look like they may head higher, which causes
speculators to engage in large-scale selling of emerging market and other
speculative assets, as was seen in the late spring of 2013.
During periods of market volatility, it
is not uncommon to see the expressions capital flight and flight to quality
used interchangeably. Whereas capital flight might best represent the outright
withdrawal of capital, flight
to quality usually speaks to investors
shifting from higher yielding risky assets to more secure and less risky
alternatives.
KEY TAKEAWAYS
- Capital
flight is the outflow of capital from a country due to negative monetary
policies, such as currency depreciation, or carry trades in which low
interest rate currencies are exchanged for higher-return assets.
- Governments
adopt various strategies, from raising interest rates to signing tax
treaties, to deal with capital flight.
How do Governments Deal With Capital
Flight
The effects of capital flight can vary
based on the level and type of dependency that governments have on foreign
capital. The Asian
crisis of 1997 is an example of a more severe
effect due to capital flight. During the crisis, rapid currency devaluations by
the Asian
tigers triggered a capital flight which,
in turn, resulted in a domino effect of collapsing stock prices across the
world.
According to some accounts,
international stocks fell by as much as 60 percent due to the crisis. The IMF intervened
and provided bridge loans to the affected economies. To shore up their
economies, the countries also purchased US treasuries. In contrast to the Asian
financial crisis, the purported effect of a 2015 devaluation in the Chinese
yuan that resulted in capital outflows was relatively milder, with a reported
decline of only 8 percent at the Shanghai stock market.
Governments employ multiple strategies
to deal with the aftermath of capital flight. For example, they institute
capital controls restricting the flow of their currency outside the country.
But this may not always be an optimal solution as it could further depress the
economy and result in greater panic about the state of affairs. Besides this,
the development of supranational technological innovations, such as bitcoin,
may help circumvent such controls.
The other commonly-used tactic by
governments is signing of tax treaties with other jurisdictions. One of the
main reasons why capital flight is an attractive option is because transferring
funds does not result in tax penalties. By making it expensive to transfer
large sums of cash across borders, countries can take away some of the benefits
gained from such transactions.
Governments also raise interest rates to
make local currency attractive for investors. The overall effect is an increase
in the currency's valuation. But a rise in interest rates also makes imports
expensive and pumps up the overall cost of doing business. Another knock-on effect
of higher interest rates is more inflation.
Example of Illegal Capital Flight
Illegal capital flight generally takes
place in nations that have strict capital and currency controls. For example,
India’s capital flight amounted to billions of dollars in the 1970s and 1980s
due to stringent currency controls. The country liberalized its economy in the
1990s, reversing this capital flight as foreign capital flooded into the
resurgent economy.
Capital flight can also occur in smaller
nations beset by political turmoil or economic problems. Argentina, for
instance, has endured capital flight for years due to a high inflation rate and
a sliding domestic currency.
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