Capital flight refers to large amounts of money flowing out of a country due to citizens losing confidence in the economy or currency, the nation defaulting on its debt, a sudden steep hike in taxes, concerns over the imposition of capital controls, or political turmoil.
Sometimes, money may flow out of a country when a major economy announces an increase in interest rates. Interest rates are like magnets to money – the higher the rate the stronger the magnet.
Capital flight includes everything from crossing the border with suitcases full of cash in order to avoid facing an imminent increase in taxes, to lying about how much was gained from exporting products, and using the excess export earnings to buy property in Geneva.
A serious hemorrhage for countries
During capital flight a country literally bleeds money, which results in a sharp decline in the value of its currency. In a fixed exchange rate regime, the authorities are eventually forced to devalue.
As the currency declines in value internationally, the prices of imported goods rise, which usually has the effect of pushing up inflation.
Capital flight may start off by foreigners pulling their money out of a country, followed by its own citizens doing the same.
The exodus of money may be legal, as may occur when overseas investors repatriate their capital, or illegal, with local citizens transferring their assets through the black market.
According to ft.com/lexicon, capital flight is:
“The rapid movement of large sums of money out of a country. There could be several possible reasons – lack of confidence in a country’s economy and/or its currency (and thus the valuation of local assets), concerns over the imposition of capital controls, political turmoil, etc.”
Capital flight bad for poor countries
Capital flight can severely damage the economies of poorer nations. It is ironic that the countries with the least loss of capital tend to be the ones with the most open and least restricted systems.
In practice, measuring how much money flows out of countries experiencing capital flight is difficult, because much of it occurs illegally. One has to use standard data to measure all the money coming in, and then use basic data to estimate all the legally-registered outflows. If there is a discrepancy (residual) between these two measures, it might be the estimated capital flight.
Gerald Epstein, Professor of Economics at the University of Massachusetts, author of the book “Capital flight and Capital Controls in Developing Countries,” said:
“Capital flight can cause a financial panic – when money leaves the country it can cause the domestic currency to fall in value and that can even lead to a stampede out of the currency. This can lead to tremendous instability that can harm the entire economy.”
Video – Fragile states, capital flight and tax havens