Capital flight

The Latin American "lost decade" of the 1980s has been an important case study for researchers. During that period, Latin American governments had great difficulty in servicing their external debt. Argentinean, Brazilian, Bolivian and Peruvian economies experienced both stagnation and hyperinflation, while at the same time the private sector increased its accumulation of foreign-exchange reserves. A very similar situa- tion repeated during the Russian and Argentinean crises of 1997 and 2001. The loans granted by the International Monetary Fund to these governments followed a similar fate: local elites hoarded most of the foreign exchange outside the country. What would have been the fate of Latin America had all that money been available to service external debts? Paradoxical situations like these were the main motivation of the literature on capital flight. (On the relationship between capital flight and Latin American debt crises, see Pastor, 1989.)

The definition of capital flight is an old question that goes back at least to the inter-war period. According to Kindleberger (1937), capital flight is that part of capital outflows motivated by political and economic risk.

In the modern literature, there are at least three alternative definitions of capital flight (Schneider, 2003). First, a "broad definition" that encompasses all short-term capital outflows by residents. Second, a definition that considers capital flight only as capital outflows associated with asymmetric risk, for example because regulations are more favourable to foreign capital; this definition implies that capital outflows by residents coexist with capital inflows by non-residents. Third, the "illegal transaction" concept of capital flight only takes into account illegal capital movements. These definitions, although more specific than Kindelberger's, are sometimes incomplete: capital flight involves more than illegal or short-term transactions.

Although the phenomenon is unobservable - because it is impossible to tell which capital flows are "normal" and which flows are "capital flight" - it is assumed to be widely prevalent in developing countries. Indeed, it is often said that it is easier to measure capital flight than to define it. However, there is no unique estimation technique; most scholars follow a more or less ad hoc procedure, by adding up different components of the balance-of-payment accounts (see Cumby and Levich, 1987; Dooley, 1988).

As regards the consequences of capital flight, it seems obvious that if all the money was reinvested in the local economy, the overall performance of the latter would be much better. Foreign exchange is a scarce asset in developing countries, and therefore capital flight limits the ability to finance the importation of essential capital goods into these countries. Private sector accumulation of large stocks of foreign assets, however, also undermines State regulation: the central bank becomes less able to conduct an independent monetary policy, tax collection becomes more difficult, and the democratic process in general is hampered, because the interest of wealthy people may shape the government's behaviour in order to avoid the withdrawal of funds. Some authors call this the "capital strike" (Epstein, 2005).

Can a central bank succesfully fight capital flight? It seems impossible to stop capital flights without attacking the roots of economic and political instability. Capital controls, although very useful for dealing with undesired capital movements, do not work if the incentives to move the money away are too big. However, this does not mean that central banks can do nothing to help. Some countries have mitigated the problems associated with capital flight by avoiding negative real rates of return on domestic assets.

As regards Brazil and Argentina, two countries with a long history of political and economic instability, one can see that even during critical episodes, the Brazilian central bank has mantained a positive yield on private deposits by indexing nominal returns to inflation, while in Argentina the crises have caused severe income losses to private savers, whose perception is that buying foreign assets is the best way to preserve the purchasing power of their savings. In fact, data show that the stock of foreign assets of Argentina as a fraction of its GDP is bigger than it is in Brazil. Overall, a combination of capital controls and a positive real interest rate seems to be the best mix, as it helped developing countries to avoid capital flights.

See also:

Capital controls; Financial crisis; Financial instability; International Monetary Fund; Negative rate of interest; Sudden stops.