Capital Flight
Any occurrence that involves the country experiencing an outflow of money, assets, or capital as a result of specific conditions
What Is Capital Flight?
Capital flight is a term made up of two parts: "capital" which refers to the amount of money or assets a country has, and "flight" which means the money is disappearing. In simple terms, capital flight is when a country experiences money, assets, or capital leaving for various reasons, whether those reasons are good or bad, and whether it's a short-term or long-term situation.
The country may see a cash outflow in foreign exchange or its internal currency.
"The Investors withdraw $20 million from the market, causing the index to drop from its record high to the two-year low."
These claims are occasionally found in the news and media these days. But have you ever questioned why an economy should be concerned about these issues?
This is because these are the real factors that can impact the country's entire economy in terms of liquidity, inflation, and the purchasing power of its citizens.
Key Takeaways
- Capital flight refers to the outflow of money, assets, or capital from a country due to various factors, impacting liquidity, inflation, and purchasing power.
- Factors like currency depreciation, political instability, tax changes, and investor preferences can trigger capital flight, causing economic challenges.
- Instances like the Asian Financial Crisis (1997) and Russian Financial Crisis (2014-15) demonstrate the impact of capital flight on economies, leading to currency devaluation and financial instability.
- Capital flight can be legal or illegal, short-term (hot money) or long-term (foreign debt), affecting investments, tax revenues, and currency exchange rates.
- Capital flight results in lower investments, reduced tax revenue, and weaker currency values, impacting overall economic stability. Governments use policies like taxation and interest rate adjustments to prevent excessive capital flight and stabilize their economies.
Reasons for Capital Flight
There can be various reasons for an economy or a nation:
1. Currency Depreciation
Currency depreciation is one of the most frequent catalysts for capital outflow from a country. Since no investor wants their investment to lose money, they withdraw the money they have invested in that nation to reduce losses. Even so, there is a fair probability that investors will return once the economy starts to stabilize and flourish.
2. Political reasons
Capital might leave the country for political reasons as well. Capital outflow frequently happens when the economy becomes politically unstable or when a new leader is elected, prioritizing nationalization over globalization.
Additionally, there is another situation where the Government favors foreign debt in the nation.
In this case, capital outflows would not occur immediately as interest is paid on the debt; a significant amount of capital may leave the nation as it is repaid.
3. Economic factors
If the country's tax structure were to alter, it would result in a drop in corporate and business earnings, lowering the overall return on the amount of venture capital and private equity investments made by foreign innovators.
4. Changes in investor's preferences
Capital flight from the country may also be triggered by the change in investors' preferences on the safety of the investments.
Venezuela and Zimbabwe have both been known to print vast sums of money. These nations have gone through an immense level of hyperinflation due to the Government's attempts to manipulate the currency.
For instance, if a corporation buys a stake in a company in Zimbabwe with the expectation of receiving a return of around $10 million, but the country manipulates the currency, resulting in the investors earning only about $6 million, and are forced to withdraw from the venture.
Examples of Capital Flight
Some of the examples include:
The Asian financial crisis of 1997 is one of the perfect examples of understanding the concept of capital outflow.
Because of the exchange rate drop, several Asian nations had to deal with a severe financial crisis. Many Asian nations lacked foreign exchange, especially in the US dollar. This made it difficult for the countries that relied on dollars for trade.
As a result, the region experienced capital outflow, a currency rate collapse, and a stock price drop.
In late 1997 and early 1998, countries like Indonesia, Korea, Malaysia, the Philippines, and Thailand saw net capital outflows of more than $80 billion.
2. Russian Financial Crisis
The most recent financial crisis to know more about the capital flight mechanism occurred in 2014–2015.
Russia occupied Crimea after invading Ukraine. As a result, the West implemented some severe sanctions that cost Russia billions of dollars. There was a $150 billion loss in capital outflow in 2014 due to the economic unpredictability and political danger.
A similar situation happened this year, too, in 2022, when Russia declared war on Ukraine. To protect Ukraine, not only the West but countries all across the globe put sanctions on the Russian market, leading to more capital loss in the economy.
3. French Wealth Tax
In 1989, France enacted a wealth tax levied on assets worth more than 800,000 euros, varying from 0.5 to 1.5 percent. Its objectives were to raise tax revenues and lessen inequality.
An increase in the overall tax rate leads to tax evasion in the entire country resulting in the general decline of revenue by 28%, according to economist Eric Pichet.
His research discovered that from 1989 to 2007, the wealth tax caused a capital flight of about 200 billion euros. Therefore, the wealth tax not only resulted in decreased revenues but also had a negative impact due to capital outflow.
Types of Capital Flight
Capital Outflow or Flight can be further segregated into:
1. Legal
If the law does something, it is legal. The same is valid for capital outflow; investors may withdraw funds as long as they do so legally and following established accounting rules.
2. Illegal
The opposite of a legal flight is called an illicit capital flight, which refers to any transaction that lacks a backdrop or source to back it up.
Financial transfers between nations are prohibited unless done legally and with proper documentation.
3. Short-Run
Short-run capital outflow happens when there is a minimal level of capital outflow, which means that the amount that would be leaving the economy would not have much impact.
Examples include local investors investing in foreign enterprises, individuals from the domestic market opening businesses abroad, etc. However, if we consider the case of foreign portfolio investment (FPI), it will significantly impact the economy in terms of capital outflow.
Since it concentrates on short-term investments and tends to liquidate its assets at a much faster rate than Foreign Direct Investments FDIs.
As a result, capital flight on a short-term basis will have a significant impact on the economy. This concept is also known as Hot Money.
4. Long-Run
Long-term capital outflow is also possible. This section can include anything that entails a long-term, ongoing outflow of capital.
One of the most notable examples is foreign debt, which requires regular interest and principal payments.
Sometimes the interest builds up to the point that the debt continues even after the maturity period, becoming a long-term capital flight.
Effects of Capital Flight
Various repercussions of capital outflow exist, each varying in intensity. Small amounts, for instance, might not have a dramatic impact, but they create a massive panic in the economy.
1. Lower Investments
Massive amounts of money leave the economy during a period of capital flight, which indirectly reduces the money supply to some extent and, in turn, lowers total investment in the economy.
The decline in FDI causes investors to lose faith in the nation.
If a business invests in a nation's economy via physical assets like the construction of a factory or something similar and then sells those assets after doing so, the investment money leaves the country.
However, the assets remain there, and the nation can still use them to its economic advantage.
2. Lower Tax Revenue
The Government's primary source of income comes from direct and indirect taxes. Thus if demand for goods and services in the economy declines along with people's income levels, the Government will eventually collect less in taxes.
This is because whenever capital departs a nation, it typically slows the rate of job creation and demand in the economy, ultimately reducing profits for firms and individuals.
3. Weekend Currency
Every time capital outflow happens, the exchange rate between the currencies, or, to put it another way, the currency of the country where the capital is flowing, changes.
For instance, if a US investor wants to expand his business in India, he must buy Indian Rupees (INR) to complete all necessary tasks.
However, if the investor decides to withdraw his investment, he must go to the exchange rate and exchange all of his INR for USD, which causes the exchange rate to worsen by lowering the value of INR relative to USD.
How to Prevent Capital Flight
The Government employs various majors to control the overall capital movement from the country. Some of them are:
1) Regulatory Policies:
The Government can implement a law or policy restricting foreign investors' ability to hold capital or invest in the domestic territory. However, doing so may have unintended consequences because, if the country's capital policies were rigid, no foreign investor would ever invest there in the first place.
In addition, such policies would further depress the economy, leading to increased panic among investors.
2) Transaction Taxes:
The Government may impose taxes on transactions involving such movement to prevent capital flight.
For instance, if the US wants to withdraw its investment from China and the Chinese Government imposes taxes on such capital movement out of the country, the US must consider how the investment's cost and return relate.
If the tax rate is high, it would be better for the US to hold onto its investment for a long time and withdraw it when the return exceeds the cost.
The nation that adopts such a policy stands to profit from the taxes levied.
3) Interest Rate Adjustment:
To stop capital outflow from the economy, governments can also increase interest rates to make local currency appealing to investors. It has the overall result of raising the currency's value.
However, a rise in interest rates drives up the cost of doing business and increases the price of imports. More inflation is a side effect of higher interest rates.
It would result in a reduction in the total outflow of money from the economy once the currency's value keeps a solid position in terms of the general exchange rate, making it profitable for the investors and advantageous for the Government and the economy.
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