Capital Flight From Developing Countries

Benu Varman-Schneider

• Publisher: Taylor & Francis
• Year: 2019
• Print ISBN: 9780367016395
• eBook ISBN: 9780429715006
• Edition: 1
• Topic: Politics & International Relations
• Subtopic: International Relations
• Index: Politics & International Relations

In this book, the author defines, measures, and explains the phenomenon of capital flight from developing countries. She attempts to incorporate the causes of capital flight in the measurement procedure.

1
Introduction

General Background

Traditionally capital flows between industrialized and developing countries were analyzed with the basic assumption that developing countries generally face scarcity of capital. This assumption is discussed in the framework of the two-gap approach of development.¹ The critical conclusion of this type of approach is that a developing country is likely to face two structural constraints of enormous significance, namely

1. a minimum requirement of imports to sustain a given rate of GNP growth and
2. an actual or potential ceiling on export earnings which is insufficient to finance the required imports.

The foreign exchange gap (the difference between the minimum required imports and total exports) shows that developing countries should be net borrowers in the development process. Thus, foreign capital flows into developing countries supplement domestic savings to finance desirable growth paths.²

Although this literature explains the overall borrowing decisions of developing countries, it cannot provide insights into a paradoxical phenomenon that received attention in the wake of the debt crisis in the early 1980s. While the external debt of developing countries reached peak levels in the late 1970s and early 1980s, significant amounts of capital flowed out of these countries as private residents in developing countries were building up foreign assets. In some cases, even after external flows tapered down, residents continued to export capital abroad. New theoretical and empirical questions emerged with the changing realities of the situation. This study does not aim to provide explanations for all the complexities of the new situation, but it attempts a modest beginning by defining, measuring, and explaining the phenomenon.

True Capital Flight versus Intermediate Capital Flight

As a rule, studies on capital flight are not based on a consistent definition of the term. Although it is clear that capital flight is a response to political and economic uncertainty, there is no unanimity on a precise definition of the term. The definition is often implicit rather than explicit. The magnitude of capital flight varies with the definition employed and ranges from all outflows of capital to outflows of capital which are a sub-set of gross capital outflows being treated as capital flight. These various definitions and the definition developed in this study will be discussed in Chapter 2. For our present purposes, we begin with a discussion of the distinction between true capital flight and intermediate capital flight. This distinction is crucial when discussing definitional divergencies.

True capital flight is defined as a one-way flow of capital out of a country, while intermediated capital flight is characterized as two-way flows of capital, both into as well as out of a country. Although the determinants of international capital flows provide an explanation for both one-way and two-way flows, the question remains as to how these normal flows are distinguishable from flight motivated flows.

Table 1.1 classifies the factors which give rise to international capital flows. The upper left-hand quadrant identifies the factors that explain normal one-way aggregate capital movements on the basis of the classic determinants of international capital flows i.e., the differences in risk-adjusted returns across countries. The upper right-hand quadrant explains the factors that give rise to normal two-way flows. Economic returns are the basis of two-way flows which include differences in risk preferences and the ability to diversify particular risks across national

Table 1.1: Factors Explaining International Capital Flows

	One-way flows	Two-way flows
Economic risks and returns	• Natural resource endowments	• Differences in absolute riskiness of economies
	• Terms of trade
	• Technological changes	• Low correlation of risky outcomes across countries
	• Demographic shifts	• Differences in investor risk preferences
	• General economic management
Financial risks and returns, relative to economic risks and returns	• Taxes (deviations from world levels)	• Differences in taxes and their incidence between residents and nonresidents
	• Inflation
	• Default on government obligations	• Differences in nature and incidence of country risk
	• Financial repression
		• Asymmetric application of guarantees
	• Taxes on financial intermediation
		• Different interest ceilings for residents and nonresidents
	• Political instability potential confiscation
		• Different access to foreign exchange denominated claims

Source: Lessard and Williamson (1987), p. 216, Table 9.3.

boundaries. In a world of economic uncertainty rational investors will not choose to put all their eggs in one basket. The optimal portfolio of a rational investor is likely to carry both home and foreign securities (Grubel 1966). Another view to explain simultaneous capital exports and imports is represented by the specific factors model (Caves 1971). According to Caves, foreign investment involves a bundle of capital, technology, and market skills. The appropriate model is, therefore, a specific factors model. Each sector has its own specific type of capital, technology, and market skills. Thus a country can export sector 1 capital and import sector 2 capital.

The lower left-hand quadrant indicates the factors which arise due to government intervention and drive a wedge between economic and financial risk-adjusted returns. These result in one-way flows in addition to those that arise on the basis of economic returns. This category of one-way flow is true capital flight. Studies which analyse this type of capital flight focus on the overall investment climate and which stress factors such as overvaluation, fiscal deficits, and inflation, which influence the financial attractiveness of source-country assets relative to the rest of the world assets. The lower right-hand quadrant outlines the factors that lead to asymmetric risk and generate two-way flows to arbitrage a yield differential. These round-trip variety of two-way flows is the intermediated variety of capital flight. Such two-way flows are incremental compared to those that would take place on the basis of the underlying economic risks and returns. They are explained by the discriminatory treatment of resident capital in the form of differential taxation, financial repression, different currency of denomination, or investment guarantees to foreign investors in the event of financial crisis. There are limits to the round-trip variety of capital flows. At some point in time, the stock of liabilities to nonresident investors may become sufficiently large so that it is worthwhile for the government to tax these asset holdings. Measures to reduce payments will yield greater revenue to the government as the stocks of liabilities grow. As the perceived risk by nonresident investors grows, the opportunities to arbitrage a risk differential between residents and nonresidents is reduced. Consequently, inflows of capital will taper down or even cease. If the domestic macroeconomic environment is unfavorable, then real capital flight will follow the intermediated capital flight.

Given the complexity of the phenomenon, analysis and policies to control and eradicate the problem necessitate a clear understanding of the type of capital flows taking place. The type of flows generated can vary from country to country, and also vary with the time period and the particular historical episode under consideration. Avoidance of true capital flight entails an improvement in the overall investment climate brought about by macroeconomic adjustment. Intermediated capital flight can be avoided by policies that root out the factors leading to discriminatory treatment of resident capital.

The Means of Financing Capital Flight

The previous paragraphs provide some indicators of sources that finance the outflow of capital into the acquisition of assets abroad. These sources can, for the sake of analytical convenience, be grouped into two categories:

1. real transfer,
2. countervailing inflows of capital.

Real Transfers

Domestic savings can be transferred abroad through the export and sale of valuables. When the value of a currency deteriorates in a period of hyper-inflation and virtually infinite depreciation, real erosion may be evaded by those exporting capital abroad. Goods are bought at home, smuggled out, and the proceeds retained abroad. This was notably true of Germany in 1922 and 1923. Valuables can also be dumped at home to obtain currency to transfer through the exchanges.

Foreign exchange control is one way of controlling a real transfer. Exporters can be required to report the receipts of foreign sales. When goods are smuggled out of the country this preventive measure will not cover such transactions. Even in the case where goods are shipped legally, underinvoicing of exports and overinvoicing of imports provide one way of evading this type of control.

Countervailing Inflows

Various types of countervailing inflows can finance capital flight. These countervailing inflows could take the form of government borrowing, loss of foreign exchange reserves, central bank borrowing, contractionary monetary policy at home which raise interest rates to attract capital inflows, and depreciation of the currency leading to speculative purchases in anticipation of a revaluation.³

Recent episodes of capital flight from many developing countries are believed to be financed by the inflow of funds loaned by the international banking sector. For example,

...commercial banks continued to lend in support of unsound economic policies long after the residents of the borrowing country had demonstrably lost confidence in their government's policies. The consequence was a substantial amount of bank lending that was used to finance capital flight from the borrowing country.⁴

An estimate by the Morgan Guaranty Trust Co. for selected countries for the year end 1985 (Table 1.2) illustrates the extent to which new debt financed capital flight, i.e., private residents who, fearing political instability and inflation, had acquired foreign exchange and transferred it out of the country.

Because foreign borrowing is cited as the main source of financing recent capital flight, the relationship between external debt and capital flight needs to be examined more closely.

External Borrowing to Finance Capital Flight

Th...

Table of contents

• Cover
• Half Title
• Title
• Copyright
• Dedication
• Contents
• Tables
• Figures
• Acknowledgments
• 1 Introduction
• 2 Defining Capital Flight
• 3 Measuring Capital Flight — An Evaluation of Estimating Procedures
• 4 Case Study 1: Measuring Capital Flight from the Indian Economy
• 5 Case Study 2: Measuring Capital Flight from the Philippines
• 6 Conclusion
• Appendix 1
• Appendix 2
• Appendix 3
• References
• Index