Private capital flight from developing countries has been of concern to policymakers, especially since the emergence of the debt crisis and the associated drastic decline in capital inflows from industrialized countries. Capital flight has been viewed as a constraint on economic growth because it implies a loss of resources that could be used for domestic investment. Moreover, it is often argued that a reversal of these capital outflows could significantly contribute to the solution of the debt crisis, and thereby to renewed access by developing countries to international capital markets. These considerations have led the authorities to consider policies that encourage the repatriation of capital flight or at least to stop such outflows. However, identifying the policies that can be most effective in achieving these objectives depends crucially on what factors initiated the capital outflows in the first place.
This study reviews the factors that have been identified as stimulating capital flight from developing countries. In this analysis, capital flight is associated with the fraction of a country’s stock of external claims that does not generate recorded investment income. Such external claims therefore do not generate a stream of income that can be used to service foreign debts or to finance domestic investment. Capital flight is thus distinguished from “normal” outflows of capital that would be undertaken to achieve portfolio diversification and that would yield a recorded flow of income. The analysis in this study suggests that increased risks in the domestic economic environment are likely to be key factors generating capital flight. In particular, two types of risk may have been particularly important: (1) default risk associated with the expropriation of domestic assets; and (2) the risk of large losses in the real value of domestic assets as a result of economic policies that lead to rapid inflation or to large exchange rate depreciations. Indeed, it is argued that the pattern of foreign capital inflows and capital flight from developing countries in the 1970s and 1980s can be associated with changing perceptions by domestic residents and foreign lenders of the risks of holding the domestic and external debt of indebted developing countries. While different perceptions of the risk of holding domestic assets can explain the simultaneous occurrence of large inflows of foreign capital and of large capital flight from developing countries during the 1970s and early 1980s, the emergence of the debt crisis and the accompanying policy responses reduced such differences and resulted in a decline of foreign capital inflows coupled with a continuation of capital flight.
This study first provides estimates of capital flight for a group of developing countries with recent debt-servicing problems, and then discusses the determinants of capital flight and examines measures of the risk of default associated with holding domestic financial instruments. It considers alternative policies for reducing capital flight, and finally the main conclusions are summarized.
Estimation of Capital Flight
Previous empirical studies have employed a broad range of definitions of capital flight. Some authors1 have adopted a “narrow” approach that identifies capital flight with short-term speculative capital outflows. Others2 have adopted a “broad” definition that identifies capital flight with total private capital outflows. An alternative approach based on a “derived measure” identifies capital flight with the fraction of a country’s stock of external claims that does not yield recorded investment income.3 This latter definition implies that a capital outflow should be considered capital flight only if it limits the resources available for either servicing the country’s external debt or financing development programs. Numerous studies have compared and critically evaluated these alternative measures,4 and no general agreement has been reached on the relative superiority of each.5 This study uses the “derived” measure to provide updated estimates of capital flight in developing countries that have faced debt-servicing problems, since this measure provides the most direct estimate of the economy’s loss of resources that could potentially be used for domestic investment.
Empirical estimates suggest that during 1978–88 the stock of flight capital increased for a group of developing countries that had faced debt-servicing problems (see Table 1).6 The aggregate stock of capital flight for this group of countries, which amounted to $47 billion at the end of 1978, increased continuously during the period and reached $184 billion at the end of 1988 (Table 1).7
Capital Flight in Ratio to Total External Debt and Total External Claims for a Group of Highly Indebted Developing Countries
(In billions of U.S. dollars)
Data refer to net capital flight, that is, the unrecorded stock of capital outflows less th e unrecorded stock of capital inflows. For methodology used, see fn. 6 in text.
The stock of external claims is defined as the net stock of recorded claims on nonresidents other than direct investment plus the net stock on unrecorded claims of residents.
Capital Flight in Ratio to Total External Debt and Total External Claims for a Group of Highly Indebted Developing Countries
(In billions of U.S. dollars)
| Capital Flight1 (1) | External Debt (2) | Ratio of Capital Flight to Total External Debt (1) + (2) | External Claims2 (3) | Ratio of Capita Flight to Total External Claims (1) + (3) | |
|---|---|---|---|---|---|
| 1978 | 47.30 | 113.70 | 0.42 | 71.62 | 0.66 |
| 1979 | 64.14 | 141.76 | 0.45 | 92.17 | 0.70 |
| 1980 | 75.41 | 179.06 | 0.42 | 119.41 | 0.63 |
| 1981 | 85.16 | 224.26 | 0.38 | 134.16 | 0.63 |
| 1982 | 99.95 | 261.30 | 0.38 | 142.57 | 0.70 |
| 1983 | 123.77 | 285.70 | 0.43 | 164.13 | 0.75 |
| 1984 | 136.43 | 301.05 | 0.45 | 182.52 | 0.75 |
| 1985 | 147.54 | 311.60 | 0.47 | 199.70 | 0.74 |
| 1986 | 152.67 | 326.39 | 0.47 | 210.30 | 0.73 |
| 1987 | 180.62 | 349.75 | 0.52 | 233.73 | 0.77 |
| 1988 | 184.01 | 360.43 | 0.51 | 239.14 | 0.77 |
Data refer to net capital flight, that is, the unrecorded stock of capital outflows less th e unrecorded stock of capital inflows. For methodology used, see fn. 6 in text.
The stock of external claims is defined as the net stock of recorded claims on nonresidents other than direct investment plus the net stock on unrecorded claims of residents.
Capital Flight in Ratio to Total External Debt and Total External Claims for a Group of Highly Indebted Developing Countries
(In billions of U.S. dollars)
| Capital Flight1 (1) | External Debt (2) | Ratio of Capital Flight to Total External Debt (1) + (2) | External Claims2 (3) | Ratio of Capita Flight to Total External Claims (1) + (3) | |
|---|---|---|---|---|---|
| 1978 | 47.30 | 113.70 | 0.42 | 71.62 | 0.66 |
| 1979 | 64.14 | 141.76 | 0.45 | 92.17 | 0.70 |
| 1980 | 75.41 | 179.06 | 0.42 | 119.41 | 0.63 |
| 1981 | 85.16 | 224.26 | 0.38 | 134.16 | 0.63 |
| 1982 | 99.95 | 261.30 | 0.38 | 142.57 | 0.70 |
| 1983 | 123.77 | 285.70 | 0.43 | 164.13 | 0.75 |
| 1984 | 136.43 | 301.05 | 0.45 | 182.52 | 0.75 |
| 1985 | 147.54 | 311.60 | 0.47 | 199.70 | 0.74 |
| 1986 | 152.67 | 326.39 | 0.47 | 210.30 | 0.73 |
| 1987 | 180.62 | 349.75 | 0.52 | 233.73 | 0.77 |
| 1988 | 184.01 | 360.43 | 0.51 | 239.14 | 0.77 |
Data refer to net capital flight, that is, the unrecorded stock of capital outflows less th e unrecorded stock of capital inflows. For methodology used, see fn. 6 in text.
The stock of external claims is defined as the net stock of recorded claims on nonresidents other than direct investment plus the net stock on unrecorded claims of residents.
Although the stock of capital flight showed a sustained increase over the period, the rate of change of capital flight did not follow a stable pattern. As is further discussed below, expansionary fiscal and monetary policies coupled with an increasing overvaluation of the exchange rate resulted in high rates of increase in the stock of capital flight during the period 1978–83.8 The adoption of stabilization programs in some of these countries reduced somewhat the rate of increase of capital flight during 1984–86, particularly in some Latin American countries which undertook comprehensive adjustment programs in 1985 and 1986. These programs, which included strong contractions of the fiscal deficits and major devaluations of the exchange rate, resulted in a sharp decline in the rate of growth of capital flight, which reached only 3 percent during 1986.
However, many of these programs were abandoned in 1987; fiscal deficits expanded once more, and inflation accelerated. As a result, the rate of growth of capital flight increased again and reached 18 percent during 1987. It decelerated in 1988 as some major countries initiated new adjustment programs.
It has been argued that given the magnitude of capital flight, repatriation of those capital outflows, or at least of the investment income that they generate, could significantly contribute to solving the external debt problems faced by these countries. A better understanding of the importance of capital flight relative to the countries’ external financial positions can be gained by analyzing the ratios of capital flight to total external debt and total external claims (Table 1).
During 1978–82, the ratio of capital flight to total external debt declined from 42 percent in 1978 to 38 percent in 1982, as the large inflows of foreign capital to this group of developing countries more than offset the increase in capital flight. This trend reversed during 1983–88, as the ratio of capital flight to total external debt increased from 43 percent in 1983 to 51 percent in 1988. This increase was the result of both a continuous increase in the stock of capital flight and a reduction in the amount of new private foreign lending available to developing countries.
The ratio of the stock of capital flight to total external claims increased from 66 percent in 1978 to 70 percent in 1982, consistent with the acceleration of capital flight during this period. Except for some temporary declines in 1985 and 1986, when comprehensive adjustment programs were successful in reducing the rate of expansion of capital flight, the ratio of capital flight to total external claims continued to increase during 1983–88, reaching 77 percent in 1988.
Despite the size of these estimates of the private holdings of external assets, it has been argued that this capital flight will have a highly adverse effect on an economy only if it generates a substantial transfer of real resources.9 For example, in periods when capital flight was offset by an inflow of foreign loans, the proceeds from exports and other external inflows were still used to finance imports, and therefore the impact of capital flight on growth was not necessarily severe. However, when access to external credit became limited after the emergence of the debt crisis in 1982, greater capital flight had to be “financed” either through a reduction in the country’s stock of international reserves or through an increase in net exports, thereby reducing the resources available to sustain economic growth. Data available support this hypothesis. During 1979–82, for example, a large inflow of foreign private capital to the indebted developing countries occurred, and their total external debt rose faster than the estimated stock of flight capital (Table 2). As a result, the aggregate for this group of countries showed a negative resource balance, implying that at least some of the external inflows were used to finance imports.10 This picture changed drastically after 1982: although the total external debt of these countries continued to increase (primarily because of inflows of official funds), capital flight resulted in net transfers of resources in most of the countries. This result implies that the continuation of capital flight after 1982 coupled with the deceleration of external loans led to a net decline in imports, which imposed an important constraint on growth.11
External Debt and Resource Transfer as Financing Components of Capital Flight for a Group of Highly Indebted Developing Countries/1979–88
(In billions of U.S. dollars—annual averages)
Defined as net exports of goods and nonfactor services.
External Debt and Resource Transfer as Financing Components of Capital Flight for a Group of Highly Indebted Developing Countries/1979–88
(In billions of U.S. dollars—annual averages)
| Change in Stock of Capital Flight |
Change in Total External Debt |
Resource Balance1 |
|
|---|---|---|---|
| 1979–82 | 13.16 | 36.90 | –4.50 |
| 1983–85 | 15.86 | 16.77 | 25.50 |
| 1986–88 | 12.16 | 16.28 | 11.90 |
Defined as net exports of goods and nonfactor services.
External Debt and Resource Transfer as Financing Components of Capital Flight for a Group of Highly Indebted Developing Countries/1979–88
(In billions of U.S. dollars—annual averages)
| Change in Stock of Capital Flight |
Change in Total External Debt |
Resource Balance1 |
|
|---|---|---|---|
| 1979–82 | 13.16 | 36.90 | –4.50 |
| 1983–85 | 15.86 | 16.77 | 25.50 |
| 1986–88 | 12.16 | 16.28 | 11.90 |
Defined as net exports of goods and nonfactor services.
Capital Importing Developing Countries with Recent Debt-Servicing Problems: Macroeconomic Variables Affecting Capital Flight as Suggested in Literature, 1978–88
Countries included are those classified, for purposes of the World Economic Outlook, as capital importing developing countries with recent debt-servicing problems.
For countries included, see footnote 7 in the text.
Defined as the six-month U.S. Treasury bill rate adjusted for the observed exchange rate change minus the domestic deposit rate.
Capital Importing Developing Countries with Recent Debt-Servicing Problems: Macroeconomic Variables Affecting Capital Flight as Suggested in Literature, 1978–88
| 1978 | 1979 | 1980 | 1981 | 1982 | 1983 | 1984 | 1985 | 1986 | 1987 | 1988 | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Inflation rate1 | 28.26 | 31.54 | 35.94 | 41.80 | 46.51 | 64.93 | 80.35 | 83.16 | 61.05 | 85.66 | 163.91 |
| Real GDP growth1 | 3.85 | 5.31 | 3.80 | –0.98 | 0.14 | –1.79 | 2.59 | 3.32 | 3.48 | 2.39 | 1.71 |
| Central government fiscal deficits2 (in percent of GDP) | 2.03 | 1.14 | 2.25 | 4.94 | 4.43 | 3.90 | 3.06 | 2.50 | 3.86 | 4.50 | 3.89 |
| Real effective exchange rate2 (1980 = 100) | 81.80 | 89.25 | 100.00 | 107.87 | 94.20 | 86.78 | 93.66 | 90.76 | 67.48 | 55.26 | 56.14 |
| Total of current account1 balances (in billions of U.S. dollars) | –29.62 | –23.38 | –27.93 | –82.26 | –83.28 | –31.76 | –15.50 | –10.96 | –33.38 | –15.99 | –18.28 |
| Disbursements of foreign loans as ratio to foreign debt2 | 26.48 | 28.40 | 21.93 | 23.49 | 17.45 | 11.93 | 8.06 | 7.24 | 7.68 | 6.80 | 6.63 |
| Domestic real interest rate2 | –4.57 | –7.32 | –15.52 | –22.97 | –24.08 | –15.47 | 21.17 | 26.24 | –27.96 | –16.00 | 26.53 |
| Interest rate differential in favor of foreign assets2, 3 | –3.09 | 0.23 | 13.53 | 32.93 | 27.99 | 12.37 | 8.48 | 2.31 | 20.61 | 5.26 | 8.41 |
Countries included are those classified, for purposes of the World Economic Outlook, as capital importing developing countries with recent debt-servicing problems.
For countries included, see footnote 7 in the text.
Defined as the six-month U.S. Treasury bill rate adjusted for the observed exchange rate change minus the domestic deposit rate.
Capital Importing Developing Countries with Recent Debt-Servicing Problems: Macroeconomic Variables Affecting Capital Flight as Suggested in Literature, 1978–88
| 1978 | 1979 | 1980 | 1981 | 1982 | 1983 | 1984 | 1985 | 1986 | 1987 | 1988 | |
|---|---|---|---|---|---|---|---|---|---|---|---|
| Inflation rate1 | 28.26 | 31.54 | 35.94 | 41.80 | 46.51 | 64.93 | 80.35 | 83.16 | 61.05 | 85.66 | 163.91 |
| Real GDP growth1 | 3.85 | 5.31 | 3.80 | –0.98 | 0.14 | –1.79 | 2.59 | 3.32 | 3.48 | 2.39 | 1.71 |
| Central government fiscal deficits2 (in percent of GDP) | 2.03 | 1.14 | 2.25 | 4.94 | 4.43 | 3.90 | 3.06 | 2.50 | 3.86 | 4.50 | 3.89 |
| Real effective exchange rate2 (1980 = 100) | 81.80 | 89.25 | 100.00 | 107.87 | 94.20 | 86.78 | 93.66 | 90.76 | 67.48 | 55.26 | 56.14 |
| Total of current account1 balances (in billions of U.S. dollars) | –29.62 | –23.38 | –27.93 | –82.26 | –83.28 | –31.76 | –15.50 | –10.96 | –33.38 | –15.99 | –18.28 |
| Disbursements of foreign loans as ratio to foreign debt2 | 26.48 | 28.40 | 21.93 | 23.49 | 17.45 | 11.93 | 8.06 | 7.24 | 7.68 | 6.80 | 6.63 |
| Domestic real interest rate2 | –4.57 | –7.32 | –15.52 | –22.97 | –24.08 | –15.47 | 21.17 | 26.24 | –27.96 | –16.00 | 26.53 |
| Interest rate differential in favor of foreign assets2, 3 | –3.09 | 0.23 | 13.53 | 32.93 | 27.99 | 12.37 | 8.48 | 2.31 | 20.61 | 5.26 | 8.41 |
Countries included are those classified, for purposes of the World Economic Outlook, as capital importing developing countries with recent debt-servicing problems.
For countries included, see footnote 7 in the text.
Defined as the six-month U.S. Treasury bill rate adjusted for the observed exchange rate change minus the domestic deposit rate.
Risk and Capital Flight
The recent literature explaining the causes of capital flight can, in general, be divided into two groups. The first (see, for example, Cuddington (1987), Dornbusch (1985), and Duwendag (1987)) has typically based its analysis on standard portfolio models where agents are assumed to allocate their wealth to maximize the overall risk-adjusted return on their portfolios. In this context, capital flight has been explained in terms of the effects of domestic macroeconomic variables on the relative returns between domestic and foreign assets. Since domestic interest rates in a number of the indebted developing countries that experienced capital flight were subject to controls,12 an overvaluation of the exchange rate, rapid inflation, and inconsistent and unsustainable fiscal and monetary policies have been identified as the major causes of capital flight. For example, if expansionary monetary and fiscal policies created an overvalued exchange rate, domestic agents would expect devaluation of the exchange rate to occur eventually, leading them to shift out of domestic assets into foreign assets. Moreover, a large fiscal deficit financed by monetary creation would create both inflation and incentives for capital flight as agents attempted to prevent losses in the real value of their domestic asset holdings.
Econometric studies relating capital flight to the macroeconomic variables, which have been suggested by the first group as being responsible for capital flight, have yielded divergent results.13 For instance, Cuddington (1986) found that currency overvaluation (measured as the deviation of the actual real exchange rate from its equilibrium level) was a significant variable explaining capital flight in Argentina, Mexico, Uruguay, and Venezuela during 1974–84, while Meyer and Bastos-Marques (1989) concluded that the inflation rate and the real return on domestic assets were the major determinants of capital flight in Brazil during 1971–88. However, one “identification” problem in these studies is that macroeconomic policies are likely to influence both “normal” capital outflows and capital flight. In addition, while this approach can basically explain the outflows of capital from developing countries, it cannot explain the simultaneous occurrence of capital flight and the increased inflow of foreign loans during the 1970s and early 1980s.
A second approach has taken the view that the residents and nonresidents of indebted developing countries have at times had differing views on the perceived risks of holding the domestic and external financial instruments of the indebted developing countries. In particular, such differences in perceived risks have been regarded as explaining the simultaneous decision of domestic agents to finance investment with foreign borrowing and to hold their wealth in the form of foreign assets. As pointed out by Lessard and Williamson (1987), while the portfolio-based approach concentrates on risk and return differences between domestic and foreign assets that can be held by domestic residents, the “risk differential” approach emphasizes the differences in the perceived risks to residents and nonresidents of holding capital in a developing country. While both approaches emphasize domestic policies as a major factor influencing capital flight, the risk differential approach also emphasizes the role of rigidities in the legal and institutional frameworks of developing countries as a channel through which adverse shocks to the economy will result in capital flight.
Several empirical studies have found considerable support for this risk differential hypothesis. For example, Khan and Haque (1985) argued that the perceived risks of investment in developing countries were larger than those of investment in industrial countries because of the “expropriation” risk. This expropriation risk reflected institutional and legal arrangements for protecting private property that were weaker in developing countries than in industrial countries. Facing this expropriation risk, domestic residents prefer to hold their assets abroad (where they earn a more secure rate of return) and to borrow external funds to finance domestic investment. With this strategy, domestic agents make their portfolios less accessible to taxation or expropriation. Eaton (1987) extended the Khan-Haque hypothesis of capital flight by linking the risk of expropriation (which in his model is identified with high taxation) of domestically owned assets to the existence of public and publicly guaranteed private foreign debt. Eaton argued that as the stock of publicly guaranteed private foreign debt increases, the emergence of any factors that increase the probability of a private borrower defaulting would also lead other residents to expect higher future taxes as the government assumed the obligations of the insolvent borrower. Domestic residents would therefore have an incentive to place their funds abroad.
The role of fiscal rigidities in creating risks was emphasized by Ize and Ortiz (1987), who examined capital flight using a fiscal framework where domestic government debt was perceived as “junior” relative to external government debt. They argued that fiscal rigidities prevent governments in developing countries from adjusting quickly to shocks that reduce their debt-servicing capacity. As a result, a major economic shock could increase the perceived risk that the government would be unable to service its obligations fully. Moreover, in this situation, the risk that the authorities would not fully service their domestic debt would generally be perceived to be higher than the corresponding risk of servicing foreign obligations because the cost of a default on foreign obligations (which could lead to a reduction in trade credits) would be higher. These differences in perceived risks stimulate capital flight by reducing the risk-adjusted return on domestic debt,14 and can explain the joint occurrence of increasing external debt and capital flight in developing countries during the late 1970s and early 1980s.
As the previous section has shown, capital flight continued to be a feature of developing countries during the rest of the 1980s, but since 1982 it has been accompanied by a drastic reduction in the inflow of new private external credit available to these countries. This study advances an hypothesis that aims to explain the recent joint behavior of capital flight and foreign lending.
It has been argued that the difficulties of dealing with structural fiscal deficits and rising inflation, as well as the limited access of many indebted developing countries to international capital markets, have reduced the costs of not fully servicing foreign obligations relative to the corresponding costs of not servicing domestic obligations.15 The increase in the perceived probability of default on foreign debt has been viewed as being reflected in the decline of the secondary market price for external bank debt issued by many heavily indebted developing countries. As the perceived difference of default risk between domestic and external debt declined, domestic debt would no longer be considered junior relative to external debt.16
Although differences in perceived risk between domestic and external debt declined after 1982, the total default risk of holding debt (either domestic or external) issued by these countries has increased as a result of the adverse developments and policies affecting the capacity of these countries to service their debt. Therefore, the continuation of capital flight coupled with the decline in foreign lending after 1982 can be explained by a “generalized” perception of an increase in the default risk of holding debt issued by these countries. If this increase in risk perception has occurred, the lack of external creditworthiness (that prevents countries from borrowing in the international capital markets) and the continuation of capital flight are both reflections of the same fundamental phenomena.17 As a result, policies oriented toward improving the attractiveness of holding domestic financial instruments of indebted developing countries would also help restore creditworthiness.
If the perceived differences in the default risk of holding domestic and external debt have been practically eliminated, then the default risk of holding external debt would be a good proxy for the corresponding risk on domestic debt. This hypothesis suggests, therefore, that the level of capital flight since the emergence of the debt crisis should be positively related to increases in the probability of default on external debt. If heavily indebted developing countries still had normal access to international capital markets, the spread between their borrowing costs and the London interbank offer rate (LIBOR) could potentially provide a measure of default risk. However, since the emergence of the debt crisis little or no spontaneous lending to these countries has taken place and therefore no representative interest rates exist. An alternative measure of the default risk can nonetheless be obtained from the secondary market price of external debt by subtracting the LIBOR rate from the implicit yield evident in the international secondary market price for external debt.18
Owing to the lack of data, it is not possible to use regression analysis to test directly the hypothesis that capital flight has responded positively to increases in the default risk on external obligations since the emergence of the debt crisis. However, for those countries for which sufficient data were available to estimate default risk, the correlation between capital flight and default risk on external debt is positive and very high (Table 4).19
Selected Highly Indebted Developing Countries Facing Debt-Service Problems: Correlation Between Capital Flight and Default Risk1
Countries shown are those for which the default risk could be calculated during 1982–88.
Data correspond to 1982–87.
Selected Highly Indebted Developing Countries Facing Debt-Service Problems: Correlation Between Capital Flight and Default Risk1
| Country | Correlation |
|---|---|
| Argentina | 0.640 |
| Brazil2 | 0.826 |
| Chile | 0.044 |
| Colombia | 0.892 |
| Ecuador | 0.718 |
| Jamaica | 0.824 |
| Mexico | 0.821 |
| Nigeria | 0.992 |
| Peru | 0.954 |
| Philippines | 0.604 |
| Venezuela | 0.067 |
| Yugoslavia | 0.960 |
Countries shown are those for which the default risk could be calculated during 1982–88.
Data correspond to 1982–87.
Selected Highly Indebted Developing Countries Facing Debt-Service Problems: Correlation Between Capital Flight and Default Risk1
| Country | Correlation |
|---|---|
| Argentina | 0.640 |
| Brazil2 | 0.826 |
| Chile | 0.044 |
| Colombia | 0.892 |
| Ecuador | 0.718 |
| Jamaica | 0.824 |
| Mexico | 0.821 |
| Nigeria | 0.992 |
| Peru | 0.954 |
| Philippines | 0.604 |
| Venezuela | 0.067 |
| Yugoslavia | 0.960 |
Countries shown are those for which the default risk could be calculated during 1982–88.
Data correspond to 1982–87.
Policies to Prevent or Reverse Capital Flight
Macroeconomic and Structural Policies
As already noted, many analyses of capital flight have emphasized the role of expansionary monetary and fiscal policies and institutional and legal arrangements as key factors increasing the risks of holding domestic assets. Sound macroeconomic policies and appropriate structural reforms are thus likely to be important elements in solving the problem of capital flight. In many countries, a sustained reduction of the fiscal deficit is typically an important first step in reducing the perceived risks of holding domestic debt. Large fiscal deficits financed with nonindexed domestic debt are likely to generate the expectation that the government will eventually use the inflation tax and/or a devaluation of the currency to reduce the outstanding real value of the debt.20
The consistency of exchange rate, monetary, and fiscal policies is another crucial element in stemming capital flight. While many countries have used a fixed exchange rate to provide an anchor for the domestic price level, problems have at times arisen when adverse shocks suddenly lead to a sharp fall in the stock of international reserves and thereby create the expectation of a devaluation and of possible abandonment of the adjustment program. Such expectations, which can lead to increasing capital flight and additional losses of reserves, arise because of rigidities that inhibit the government’s ability to adjust quickly to adverse shocks. In particular, rigidities induced by wage indexation schemes, minimum wages, laws preventing layoffs, controls on the prices of public goods, and inefficient tax systems often prevent a government from adjusting its fiscal deficit quickly to offset the impact of an adverse shock.
The role of appropriate structural and macro-economic policies in reducing (and reversing) capital flight is evident from the recent experience of several Latin American countries. The stock of flight capital in Argentina declined in 1986 (implying repatriation) following the adoption in June 1985 of a comprehensive adjustment program that was initially successful in reducing inflation and in fostering an economic recovery. However, sustained fiscal deficits led to renewed inflation, and capital flight apparently accelerated again. In Brazil, the introduction of the Cruzado plan in early 1986 was also followed by a decline in the net outflow of capital. However, inflation accelerated in 1987 and estimated capital flight increased sharply during that year. In December 1987, the Mexican authorities introduced a comprehensive economic program based on a social pact with labor and business that encompassed front-loaded fiscal and monetary corrections as well as a strong devaluation of the Mexican peso. As a result of the successful implementation of this program, empirical estimates suggest that Mexico experienced a net repatriation of capital flight in 1988, the first in the 1980s.
Many countries have also used a variety of other policies to stem or reverse capital flight. The effectiveness of these policies is now examined in terms of recent country experiences of implementing such policies.21
Capital Controls
It has often been argued that externalities and policy distortions imply that the social rate of return on domestic investment in developing countries is higher than the private rate of return. As a result, capital controls have been viewed as a means of ensuring that domestic savings are invested domestically. As noted in Gordon and Levine (1989), however, a fundamental problem with this argument is that it assumes that capital not invested abroad would be invested domestically; it therefore ignores the possible substitution between savings and consumption. In particular, the announcement of capital controls might bring expectations of further government intervention that would discourage domestic investment in favor of increased consumption. In addition, savings may be held in various inflation “hedges” (such as real estate or inventories) that have little impact on productive capacity.
Although capital controls are ineffective in promoting domestic investment, the experiences of some countries suggest that such controls have had a short-run effect on capital flight. For example, Brazil experienced a much lower ratio of capital flight to total external debt than Mexico although Brazil’s average inflation rate during the late 1970s and early 1980s was higher than Mexico’s. This could potentially reflect the more restrictive capital controls in Brazil. However, when capital controls are effective in stemming capital flight in the short run, the removal of such controls can be accompanied by large-scale capital flight, especially when expansionary macroeconomic policies lead to rising inflation and expectations of devaluation. As documented by Cuddington (1986), Argentina is a good example of sharp increases in capital flight following the removal of capital controls, which in turn increased the Government’s incentive to reimpose them.
Overall, experience suggests that although capital controls have sometimes helped in the short run to stem capital flight, the problems associated with them may be larger than the benefits. As capital controls by themselves constitute a distortion, they may lower domestic savings because domestic residents have been constrained to hold less diversified portfolios. Moreover, when capital controls are perceived as a policy instrument used on a discretionary basis, expectations that such controls will be imposed encourage capital flight. In the long run, therefore, they may decrease the real resources available for investment.
Debt-Equity Swaps
Debt-equity swaps can be attractive to investors because assets can be purchased in the debtor countries with external claims on those countries purchased at a discount in the secondary market. While this mechanism has sometimes been effective in reversing capital flight, its ability to increase net capital inflows may be limited for two reasons. First, the profitability of debt-equity swaps depends on the discount in the secondary market; and, if this market is very thin, increases in the demand for claims on debtor countries would raise the prices of those claims and reduce the profitability of debt-equity swaps. In this situation, only a limited amount of swaps could be undertaken. Moreover, even if commercial banks were willing to sell additional claims on debtor countries at a discount, the net inflow of funds to the countries would not necessarily increase significantly, since foreign commercial banks would still have no incentive to engage in additional voluntary loans.
Second, since some debt-equity swap schemes have involved reselling discounted paper for domestic currency at preannounced exchange rates, the money supply can increase as the swap occurs, thereby generating inflationary pressures. If more rapid inflation occurred, it would increase the risks of holding domestic assets and encourage additional capital flight, which might offset the initial inflow originated by the debt-equity swap. The Mexican debt-equity swap program initiated in May 1986 was suspended in late 1987 in part because the authorities wanted to limit the monetary expansion produced by these operations. In contrast, the Chilean program, introduced in 1985, allowed domestic residents to convert external claims on Chile into tradable domestic bonds, and this effectively sterilized the monetary impact of these operations.22 These experiences suggest that one of the key factors determining whether debt-equity swaps can be successful in repatriating capital flight is whether they are conducted in the context of an appropriate monetary policy.
Foreign Currency Deposits
Local deposits denominated in foreign currencies have been used as a mechanism to prevent capital flight in several countries (India, Mexico, Uruguay, and Turkey).23 While offering depositors some potential protection from exchange risk, they will not be viewed as carrying much lower risk than other domestic deposits if the authorities have in the past frozen or limited withdrawals or returns on these deposits. The freezing of the dollar-denominated accounts in Mexico in 1982 provides an example of such risk.24 However, these accounts, as well as some other financial instruments indexed to foreign exchange, may usefully contribute to stemming capital flight when the government is pursuing appropriate macroeconomic and structural policies but faces a credibility problem.25 If successful in eliminating exchange rate risk, indexed assets may stimulate domestic saving and contribute to lower domestic real interest rates and, thereby, lower the government’s costs of financing its domestic debt. However, while foreign currency-denominated deposits can potentially help stem capital flight with good policies, they can create additional difficulties when policies are inadequate. Rising inflation can lead to a rapid shift from deposits denominated in the domestic currency to those denominated in foreign currencies, thereby destabilizing domestic monetary relationships.
In Peru, for example, accelerating inflation and balance of payments deficits during the early 1980s led domestic residents to increase their holdings of bank deposits denominated in dollars, and by the end of 1984 these deposits, which amounted to $1.7 billion, were equivalent to more than 50 percent of broad money. Convertibility of these deposits into foreign currency was suspended in 1985.
Other Policies
Several other policies have been suggested to encourage the repatriation of flight capital. For example, tax treaties that would allow countries to tax assets held abroad by domestic residents were considered one alternative.26 However, as noted by Gordon and Levine (1989), it may be difficult to enforce such treaties unless they are implemented globally.27 Tax amnesty programs have also been used,28 but expectations of future tax amnesties might reduce the normal collection of taxes and might, paradoxically, motivate increases in capital flight at times when amnesties are not in place.
Another policy has been to tighten domestic credit to generate liquidity shortages sufficient to induce some liquidation of foreign asset holdings for financing domestic investments or firms’ working capital needs. However, repeated liquidity shortages might decrease the expected returns from domestic investments and might instead induce greater capital flight.
Conclusions
Capital flight implies a loss of resources that could have been used to increase domestic investment and that could in turn have significantly increased countries’ debt-servicing capacity. This study has argued that two forms of risk have been major causes of capital flight: the risk of direct default or repudiation associated with the fear of expropriation of domestic assets and the risk of large losses in the real value of domestic assets arising from inflation or large exchange rate devaluations. Moreover, the simultaneous occurrence of large inflows of foreign capital and large capital flight from developing countries during the 1970s and early 1980s reflected the different perceptions of foreign lenders and domestic residents of developing countries about the risks of holding domestic claims. In particular, for a variety of institutional reasons, foreign lenders perceived a lower default risk than did domestic residents. However, since the emergence of the debt crisis in 1982 the differences in perceived risks have been reduced and have resulted in a decline of foreign capital inflows coupled with continuation of capital flight.
Indeed, the adverse developments that accompanied the emergence of the debt crisis may have increased the perceived default risk of holding either the domestic or external debt of highly indebted developing countries. If this is true, the continuation of capital flight in the mid- and late 1980s, coupled with the decline in private foreign lending, can be explained by a generalized perception of an increase in the default risk of holding debt issued by highly indebted developing countries.
If concerns about default risks have played a major role in the portfolio decisions of the domestic residents of heavily indebted developing countries, the policies with the greatest chance of stemming capital flight are those that decrease the risks of holding domestic assets. In this situation, sound macroeconomic policies complemented by appropriate structural reforms would have to be key elements in stemming or reversing capital flight.
Once these core macroeconomic and structural policies are in place, other policies such as debt-equity swaps or foreign currency deposits—although insufficient by themselves to solve the problem of capital flight—can potentially contribute to reducing it. Capital controls are likely to be at best a short-run deterrent to capital flight and, by introducing additional distortions, could even accentuate the problem in the long run.
References
Calvo, Guillermo, “Controlling Inflation: The Problem of Non-Indexed Debt,” IMF Working Paper No. 88/29 (Washington: International Monetary Fund, March 1988).
Calvo, Guillermo, and Pablo E. Guidotti, “Indexation and Maturity of Government Bonds: An Exploratory Model,” in Public Debt Management: Theory and History, ed. by Rudiger Dornbusch and Mario Draghi (Cambridge; New York: Cambridge University Press, 1990).
Cuddington, John T., Capital Flight: Estimates, Issues, and Explanations, Princeton Studies in International Finance, No. 58 (Princeton, New Jersey: International Finance Section, Princeton University, 1986).
Cuddington, John T., “Macroeconomic Determinants of Capital Flight: An Econometric Investigation,” in Capital Flight and Third World Debt, ed. by Donald R. Lessard and John Williamson (Washington: Institute for International Economics, 1987).
Cumby, Robert, and Richard Levich, “On the Definition and Magnitude of Recent Capital Flight,” in Capital Flight and Third World Debt, ed. by Donald R. Lessard and John Williamson (Washington:. Institute for International Economics, 1987).
Deppler, Michael, and Martin Williamson, “Capital Flight: Concepts, Measurement, and Issues,” in Staff Studies for the World Economic Outlook, By the Research Department of the International Monetary Fund (Washington: International Monetary Fund, August 1987).
Diwan, Ishac, “Foreign Debt, Crowding Out and Capital Flight,” Journal of International Money and Finance, Vol. 8 (March 1989).
Dooley, Michael, “Country-Specific Risk Premiums, Capital Flight and Net Investment Income Payments in Selected Developing Countries” (Washington: International Monetary Fund; unpublished, March 1986).
Dornbusch, Rudiger, “External Debt, Budget Deficits, and Disequilibrium Exchange Rates,” in International Debt and the Developing Countries, ed. by Gordon W. Smith and John T. Cuddington (Washington: World Bank, 1985).
Duwendag, Dieter, “Capital Flight from Developing Countries: Estimates and Determinants for 25 Major Borrowers,” Societe Universitaire Européenne de Recherches Financieres, SUERF Series No. 52A, 1987.
Eaton, Jonathan, “Public Debt Guarantees and Private Capital Flight,” NBER Working Paper No. 2172 (National Bureau of Economic Research, March 1987).
Gajdeczka, P., and Daniel Oks, “Domestic Deficits, Debt Overhang, and Capital Outflows in Developing Countries,” AMEX Bank Review, annual series entitled Finance and the International Economy: 3 (1990).
Gordon, David B., and Ross Levine, “The ‘Problem’ of Capital Flight: A Cautionary Note,” World Economy, Vol. 12 (June 1989).
International Monetary Fund, Balance of Payments Statistics Yearbook (Washington: International Monetary Fund), various issues.
International Monetary Fund, International Financial Statistics Yearbook (Washington: International Monetary Fund), various issues.
International Monetary Fund, World Economic Outlook (Washington: International Monetary Fund, May 1990).
Ize, Alain, and Guillermo Ortiz, “Fiscal Rigidities, Public Debt and Capital Flight,” Staff Papers, International Monetary Fund, Vol. 34 (June 1987).
Khan, Mohsin S., and Nadeem Ul Haque, “Foreign Borrowing and Capital Flight: A Formal Analysis,” Staff Papers, International Monetary Fund, Vol. 32 (December 1985).
Lessard, Donald R., and Williamson, John, “The Problem and Policy Responses,” in Capital Flight and Third World Debt, ed. by Donald R. Lessard and John Williamson (Washington: Institute for International Economics, 1987).
Meyer A., and M.S. Bastos-Marques, “A Fuga de Capital no Brasil,” Fundacao Getulio Vargas, Instituto Brasileiro de Economia, Centro de Estudios Monetarios e de Economia Internacional, No. 06/89 (August 1989).
Morgan Guaranty Trust Company, “LDC Capital Flight,” World Financial Markets (March 1986).
Rodriguez, Miguel A., “Consequences of Capital Flight for Latin American Debtor Countries,” in Capital Flight and Third World Debt, ed. by Donald R. Lessard and John Williamson (Washington: Institute for International Economics, 1987).
World Bank, World Development Report (New York: Oxford University Press, 1985).
See Cuddington (1986).
See, for example, World Bank (1985), Morgan Guaranty Trust Company (1986), and Duwendag (1987).
See Dooley (1986).
See, for example, Deppler and Williamson (1987), Gordon and Levine (1989), and Cumby and Levich (1987).
Perhaps the most severe criticism of all the proposed measurements is contained in Gordon and Levine (1989). They argue that severe statistical problems prevent the proposed measurements from adequately capturing the scale of capital flight.
The methodology for estimating capital flight involves computing the stock of external claims that would generate the income recorded in the balance of payments statistics and subtracting this stock from an estimate of total external claims (see Dooley (1986)). Total external claims are estimated by adding the cumulative capital outflows, or increases in gross claims, from balance of payments data (which consist of the cumulative outflows of capital recorded in the balance of payments plus the cumulated stock of errors and omissions) to an estimate of the unrecorded component of external claims. This last estimate is generated by subtracting the stock of external debt implied by the flows reported in the balance of payments from the stock of external debt reported by the World Bank.
The countries included in this group and in Tables 1 and 2 are Argentina, Bolivia, Chile, Colombia, Ecuador, Gabon, Jamaica, Mexico, Nigeria, Peru, the Philippines, Venezuela, and Yugoslavia.
In fact, for this group of countries, the rate of increase in the stock of capital flight reached 24 percent in 1983.
See, for example, Deppler and Williamson (1987).
Important exceptions are Argentina and Venezuela. Rodriguez (1987) argued that in Venezuela the increase in external debt nearly matched the increase in the stock of flight capital.
Although the resource balance for most of these countries became positive after 1982, they experienced current account deficits in part because of interest payments on their external debt.
In recent years, several countries, including Mexico and Bolivia, have undertaken financial liberalization.
In contrast, Diwan (1989) argued that there are circumstances when domestic borrowers would prefer to default on foreign debt. For example, a sharp decline in the price of exports would reduce the cost of defaulting on foreign debt because the penalty associated with such a default (exclusion from foreign trade) would fall as export prices declined. As a result, domestic residents would prefer to finance domestic investment in the export goods sector with foreign (as opposed to domestic) loans. Moreover, given the total volume of savings, the availability of additional foreign resources would just crowd out the domestic component of total savings, leading to capital flight.
For example, see Diwan (1989).
Some have even argued that domestic debt should now be considered “senior” relative to external debt. This argument is intended to rationalize the simultaneous decline in private external lending and the continuous increase in domestic debt.
Although the differences in the perceived default risks of domestic and external debt have been reduced, the risks of a loss in the real value of domestic assets as a result of a discrete devaluation or an increase in inflation still remain a concern for holders of domestic debt.
Gajdeczka and Oks (1990) attribute capital flight after 1986 to the loss of creditworthiness of these countries.
The implicit yield to maturity for external debt (is) was obtained from the observed secondary market price on the country’s external debt (P) and the application of the following present value formula:
where the face value (FV) is set at 100 since the discount quoted in the secondary markets applies to $100 worth of contractual debt; the contractual coupon payment (C) is the interest rate on six-month U.S. Treasury bills (as a measure of the risk-free interest rate) plus the average interest rate spread agreed to by the country on signature of the contract; and n is the average maturity of the contract.
The risk of default on external obligations during 1985–88 was estimated by subtracting the six-month LIBOR rate from the calculated implicit yield on external debt.
The risk of default on external obligations during 1982–84 was approximated by using data on spreads between the loan rates charged to indebted developing countries on external bank loans and LIBOR provided by the Deutsche Bundesbank (spreads between public sector deutsche mark bonds issued by nonresidents and LIBOR) and the Bank of England.
Notice, however, that the implicit yield evident in the international secondary market price for external debt cannot fully represent the cost of borrowing, since it is derived under conditions of credit rationing.
However, as mentioned above, the lack of international creditworthiness and the continuation of capital flight appear to be two aspects of the same problem. Therefore, the risk of default on external debt is also an endogenous variable that should be simultaneously explained with the behavior of capital flight.
For further discussion of these issues see Calvo (1988).
The experiences reported here are largely based on previous studies undertaken by the staff of the International Monetary Fund.
Even if those operations can be made noninflationary, subsidized swap arrangements, such as those in Chile in 1983–84, can generate large operating deficits in the central bank.
As reported in previous studies undertaken by the staff of the International Monetary Fund, in Turkey the Dresdner Bank collected deposits from Turkish workers in Germany and transferred these deposits to the Central Bank of Turkey where they were kept as foreign currency deposits. As a result, workers’ remittances rose sharply and the stock of these foreign currency deposits reached $5.9 billion by the end of 1988.
During this freeze, withdrawals from dollar-denominated accounts were paid in Mexican pesos using the controlled exchange rate.
For a further elaboration on these issues, see Calvo and Guidotti (1990).
From 1967 to 1981, Brazil was negotiating a treaty with the United States, but no final agreement took place.
Moreover, if those treaties involve a symmetric treatment of taxes between countries, the total tax base of the domestic country may be reduced if holdings of domestic assets by foreigners are excluded from the tax base.
In 1986 Colombia introduced a tax amnesty on previously undeclared income and wealth.