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Capital flight – definition and meaning

Capital flight refers to large amounts of money flowing out of a country. Usually, it is due to citizens losing confidence in the economy or currency. People may lose confidence because either the country is defaulting on its debt or there is political turmoil.

A sudden steep hike in taxes may also lead to capital flight, as can the imposition of capital controls. Capital controls are measures the government takes to restrict how much money flows into or out of a country.

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.

Money can leave a country in many different ways. People may cross the border with suitcases full of cash. Citizens may lie about how much they gained from exporting goods. They then use their excess export earnings to buy property abroad.

Capital flight
Capital flight, when it turns into a stampede, can seriously damage a country’s economy.

Capital flight hemorrhages economies

During capital flight, a country bleeds money. The outflow of money results in a sharp decline in the value of a country’s currency. In a fixed exchange rate regime, the authorities eventually have to devalue.

As the currency declines in value internationally, the prices of imported goods rise. More expensive imports lead to higher inflation.

The monetary exodus may begin with foreigners removing their money from a country. Subsequently, the country’s citizens also take their money abroad.

The exodus of money may be legal, as occurs when overseas investors repatriate their capital. However, it may be illegal. For example, transferring assets through the black market is against the law.

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 developing countries

Money leaving an economy can severely damage developing countries. It is ironic that the nations with the least loss of capital tend to be the ones with the freest systems.

In practice, measuring how much money flows out of countries is not easy. It is difficult because some of that money leaves illegally.

We must use standard data to measure all the money coming in, and then use basic data to estimate all the legally-registered outflows. The discrepancy between these two measures is the estimated capital flight. Economists refer to this discrepancy as the ‘residual.’

 

Video – Fragile states and capital flight