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.