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.
When we are talking about the money itself, we use the term ‘flight capital.’ If someone moves $2 million out of their country because they have lost confidence in the economy, the flight capital is $2 million — they are have conducted capital flight.
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, 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.
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.’
Examples
Moving savings overseas to avoid unstable currency
Scenario:
- A country is experiencing extremely high inflation and devaluation of its currency.
- People in that country worry that their savings will shrink in value if they keep them in local banks.
- As a result, many citizens start converting their money into a more stable foreign currency (like U.S. dollars or Euros) and then deposit those funds in overseas bank accounts.
Why it’s Capital Flight: Instead of keeping money within the domestic banking system, citizens are sending it abroad to protect their wealth from inflation and currency risks. This drains Country A of a portion of its capital reserves, making its economic situation more fragile.
Company relocating headquarters to a tax-friendly country
Scenario:
- A multinational corporation headquartered in a country faces higher corporate taxes or new, strict regulations.
- To reduce its tax burden and avoid complicated rules, the corporation decides to move its official headquarters to another country, which offers lower taxes and more business-friendly policies.
- Along with the headquarters, some senior management and parts of its business operations move, taking corporate profits and investments with them.
Why it’s Capital Flight: The company is moving financial assets, profits, and operations out of its home country to another. While headquarters relocation is often driven by taxes and regulations, it also contributes to capital outflow because the profits generated are no longer held in the home country.
These straightforward examples show how various economic and political conditions can lead individuals, corporations, or investors to transfer capital out of a country, creating a cycle that often exacerbates the very problems that caused the flight in the first place.