IV: Repatriation of Flight Capital
- International Monetary Fund
- Published Date:
- January 1991
The flight of resident capital from developing countries during the 1980s reflected and contributed to their economic and financial problems. Conversely, the recent repatriation of flight capital in some of these countries, following the sustained implementation of comprehensive adjustment programs and appropriate debt restructuring, has reinforced the restoration of economic growth. This chapter discusses conceptual issues related to capital flight, policy conditions conducive to repatriation, and some techniques employed to this end in specific cases.
The main influence on most private capital movements is the expectation of returns in a comparative context. Specifically, in cases where repatriation has occurred, stabilization policies have altered expected relative returns (that is, interest rate differentials between domestic investments and investments in so-called “safe haven” countries adjusted for exchange rate expectations) and improved the comparative attractiveness of domestic assets. In some cases, such policies have been supplemented by specific measures directed at promoting capital reflows, such as tax amnesties, liberalization of domestic capital markets, issuance of offshore securities and foreign-currency-denominated assets, and the establishment of debt conversion programs. When implemented in a stable economic and financial environment, these measures have facilitated the return of flight capital, particularly at the beginning of a reform process. Such techniques have had little success in promoting capital repatriation, however, in the absence of accompanying financial and structural reforms.
Definition and Estimation Problems
The analysis of capital flight has been complicated by definitional and measurement problems. The first issue arises over disagreement as to whether capital flight should be defined in terms of its motivation or its consequences, and whether there is any clear-cut way of distinguishing capital “flight” from “normal” capital outflows.30 The most broadly accepted criterion based on motivation identifies flight capital as the component of private capital outflows resulting from attempts to avoid “exceptional sacrifices” on rates of return at home. Factors affecting expected rates of return include risks of expropriation and debt repudiation, the introduction or strengthening of capital controls, taxation, financial repression, and perceptions of the likelihood of inflation and exchange rate depreciation. These factors typically emerge under conditions of macroeconomic imbalance and structural distortion. An alternative view, which defines capital flight on the basis of its consequences, focuses on the national disutility of capital outflows. Such a notion encompasses all components of private capital outflows, on the premise that capital in developing countries is a scarce commodity whose loss will constrain economic development. Because of its breadth, however, “normal” capital outflows are also captured in this definition, for example, trade credits and normal flows associated with portfolio diversification. The usefulness of this broader concept arises in empirical applications where data are limited and deviations from trend levels of flows may be interpreted as indications of capital flight or repatriation.
Data problems often complicate measurement of the scope of capital flight. Difficulties are encountered at both source and destination. The very nature of capital flight movements complicates measurement from the vantage point of the source country.31 In addition, limited record-keeping and accounting resources in some developing countries have adversely affected the quality of nonbank and nongovernment accounts. Measurements based on “haven” country data also have limitations—arising primarily from a paucity of detailed data on the foreign asset holdings of nonresidents. Moreover, capital may follow circuitous routes, often passing through offshore centers with tight secrecy requirements. The most comparable source of inter-country data comes from bank data, which, however, capture only a small part of the phenomenon. In particular, bank data do not cover portfolio reallocation in favor of nonbank stores of value, such as real estate, equity, and other private- and public-sector securities.32 In view of such limitations, estimates of capital flight are usually derived from flows contained in national payments balances, which usually present aggregate statistics on private-sector flows.
Numerous empirical studies have attempted to analyze capital flight using the two definitions described above.33 Using the second definition, which does not attribute motivation to capital outflows, capital flight is estimated by measuring short-term private capital outflows or total private capital outflows, including errors and omissions. The adequacy of the choice depends on the country-specific set of transactions that are the most likely vehicle for capital flight; for example, in countries without capital controls, medium- and long-term outflows may be significant conduits for capital outflows. Conversely, empirical studies based on the first or “motivational” definition must generally make ad hoc adjustments to balance of payments data by ascribing “flight” motives to certain components of private capital outflows. An exception is the “derived approach,” which, in an attempt to formulate a consistent methodology, assumes that capital fleeing from exceptional risk will not lead to repatriated investment income. The stock of flight capital is thus calculated by subtracting from the total stock of external claims those imputed from data on investment income receipts. This methodology represents a lower bound to capital flight estimates, while the broader definition would represent an upper bound.34 Notwithstanding their limitations, studies covering the broadest set of countries indicate flight capital ranging from $200 billion to $300 billion during 1974–85 for capital-importing developing countries as a group.35 For the 13 most highly indebted countries, the derived approach estimates net capital flight at $184 billion by the end of 1988.36
In view of these conceptual and measurement problems, relatively timely indicators of capital flight or repatriation have had to be based on shifts in several measures of resident private capital flows. A primary indicator is the sum of errors and omissions and private-sector portfolio flows in balance of payments data. Other indicators, which may reflect conditions conducive to or conduits for capital flight/ repatriation, include the following:
the interest-rate differential between domestic and foreign assets adjusted for expectations of movements in the exchange rate, given that empirical analysis finds an association between overvalued exchange rates, high inflation, negative real rates of return on domestic assets, and capital flight;37
movements in the level of resident holdings in foreign banks, since foreign-held bank deposits are especially liquid;
changes in the level of foreign currency deposits held domestically, the interpretation of which depends on assumptions about asset holders’ confidence in the safety and risk-adjusted returns on domestic assets;
domestic stock market activity, since price indexes may reflect shifts into or out of equity instruments; and
the secondary market price for foreign-held indebtedness, which may indicate a generalized rise or fall in confidence in domestic economic and financial policies.
Policies and Practices Influencing the Repatriation of Flight Capital
In a number of developing countries, the implementation of unsound economic and financial policies in the late 1970s and early 1980s was compounded by adverse external shocks. Capital flight often resulted from consequent deteriorations in domestic rates of return—adjusted for expectations of exchange rate changes and other risk factors—relative to the returns available abroad. Tax policies at times compounded capital flight to the extent that domestic tax rates were relatively high, withholding taxes were not imposed by haven countries, or bilateral tax treaties between source and haven countries did not exist. In addition, movements to markets with broader selections of financial instruments were also encouraged by the limited availability of domestic alternatives. Finally, incentives for enterprises and individuals to maintain foreign exchange working balances abroad were sometimes created by restrictions on the purchase of foreign exchange in source countries.
The curtailment of external bank lending that began in 1982 obviously affected many heavily indebted developing countries. Capital flight worsened this situation in a number of ways.38 Resulting capital outflows created inflationary pressures by expanding fiscal imbalances as tax bases were eroded and debt-servicing costs rose. Inflationary pressures were also aggravated by the depreciation of exchange rates that followed capital outflows. In response to these difficulties, several countries implemented policies designed to attain macroeconomic stability and eliminate structural distortions, with a view to re-establishing confidence in the domestic economy, re-opening international capital markets, and encouraging the return of flight capital. As discussed previously, Chile, Mexico, and Venezuela, in particular, have in recent years recorded notable progress in this regard. Countries that have moved toward re-establishing confidence have (1) implemented adjustment policies aimed at reducing financial imbalances and inflation through better monetary and fiscal policy mixes; (2) sought to establish well-functioning markets for labor, goods, money, and foreign exchange, with wages, prices, interest rates, and an exchange rate generally in line with underlying demand and supply conditions; (3) pursued other structural reforms, such as trade liberalization and deregulation of domestic financial markets; and (4) restructured their external debt with a view to eliminating its potential disincentive effects on investment.
While the implementation of stabilization policies has been necessary to reverse capital flight, other measures or techniques have proven useful in accelerating or supporting the process. These have ranged from changes in tax policies to the reform of rules governing foreign direct investment.39 The following discussion reviews some of these mechanisms used to reverse capital flight.
Measures to Reverse Capital Flight
Amnesties attempt to repatriate flight capital that has remained abroad in order to avoid specific legal consequences. By excusing, for example, past violations of exchange control regulations and taxes on investment income, inflows of foreign exchange have been stimulated and, to a lesser degree, future tax bases have been broadened.40 To be successful, amnesties aimed at repatriating private capital must be implemented in conjunction with reducing or eliminating the original incentives for capital flight. Note that a 1982 amnesty in France failed, in part owing to the continued existence of a wealth tax. A second attempt in 1986—considered a success because it led to the repatriation of an estimated $1.6 billion—was implemented in conjunction with a repeal of the wealth tax, a reduction of the tax rate on repatriated capital, and the elimination of remaining capital controls. Experience has also shown that the success of amnesties is sensitive to any disincentives arising from their combination with other schemes. The 1987 Argentine amnesty, in conjunction with a debt-equity program, exempted from taxes all previously unreported income to be used for domestic investment purposes. But it required matching converted debt with new money. The unattractiveness of this one-to-one rule outweighed the benefits of the program and failed to induce repatriation, notwithstanding the tax exemption.
An amnesty may be of limited or extended duration. For developing countries, amnesties of limited duration are unlikely to have an enduring impact. Amnesties of longer duration generally appear to have had a greater effect and are the logical policy accompaniment to the liberalization of capital accounts. The Government of Mexico has had a standing amnesty since 1989. A stamp tax of 2 percent is assessed on repatriated capital in conjunction with an exemption for past tax evasion on interest income. Chile has an implicit standing amnesty since no questions are asked concerning the source of the repatriated foreign exchange used under Chapter XVIII of the country’s foreign exchange regulations. Similarly, Costa Rica encourages the repatriation of flight capital by permitting domestic foreign-currency-denominated deposits or local-currency-denominated certificates of deposits to be redeemed in foreign currency at maturity.
Capital Account Liberalization
The elimination of capital controls on outflows may induce capital repatriation to the extent that it reassures residents of their ability to “re-export” their financial holdings in the event of worsening economic conditions. Repatriation would also be encouraged to the extent that capital account liberalization is viewed by the market as a positive signal as to the underlying improvement in the economic situation and the authorities’ commitment to maintain appropriate policies. In the case of Chile, which has experienced significant capital repatriation, a parallel market for foreign exchange was transformed into a legal informal exchange market in 1990, when new regulations permitted all foreign exchange transactions other than those explicitly restricted by the Central Bank. In Peru, the liberalization of the capital account initiated in mid-1990 and followed up in early 1991—in conjunction with a comprehensive stabilization program—has been associated with private capital inflows exceeding $1 billion. Argentina has experienced several reversals in private-sector capital flows in the recent past, in line with changing expectations concerning the durability of stabilization policies; the fluidity of these capital movements is largely a result of relatively liberal capital and exchange control regimes. Similarly, in Uruguay, limited capital controls have attracted significant private capital flows.
Foreign-Currency-Denominated Domestic Instruments
Since exchange risk can provide an incentive for capital flight, some countries have allowed domestic assets, especially bank deposits and bonds, to be denominated in foreign currency. In addition to protecting residents’ holdings from unanticipated devaluations, such assets may also provide greater liquidity than assets held abroad. Foreign currency deposits have been prevalent in countries that have experienced episodes either of high inflation or currency overvaluation (for example, Egypt, Israel, Turkey, Yugoslavia, and most Latin American countries). Foreign-currency-denominated bonds have been issued in recent years in Argentina, Colombia, Mexico, Pakistan, and Uruguay.
Foreign currency assets may, however, have costly side-effects resulting from currency substitution. Such assets legalize and, other things being equal, encourage such substitution by decreasing the costs of obtaining foreign-currency-denominated assets outside the country. The negative implications of currency substitution are well documented; they involve weakened effectiveness of monetary policy, larger public-sector deficits because of reduced seigniorage, and higher central bank or commercial bank losses.41 These potential complications suggest that the use of foreign currency deposits be limited, either through preferential yields on domestic-currency-denominated assets or restraints on their share of total domestic financial liabilities. To the extent that capital flight has already occurred, foreign-currency-denominated instruments may lead to the repatriation of flight capital only if additional incentives are present, usually in the form of an interest rate premium with respect to the haven country.
Foreign-currency-denominated instruments placed in the international capital markets by developing countries, such as those that have recently reentered those markets, can tap the offshore holdings of residents hesitant to repatriate their savings because of transfer risk considerations. Such securities have a number of attractions for residents holding flight capital. First, the foreign currency denomination eliminates exchange rate risk relative to the domestic currency. Second, the assets provide anonymity and eliminate confiscation risk. This is accomplished by means of issuing bearer, rather than registered, bonds through foreign intermediaries. For equities, country funds can serve a similar purpose. Third, the tendering of securities in foreign markets limits the threat of discrimination against investors who are residents. Fourth, in the event that the countries in which the offshore security is placed tax on source rather than residency principles, the returns on such investments would not be subject to taxation back home. Similarly, the existence of bilateral tax treaties may limit the possibility of double taxation of interest income.
Debt conversion schemes may also promote the repatriation of flight capital to the extent that they provide attractive vehicles for acquiring domestic equity.42 The most common schemes involve exchange of debt for equity and debt for other domestic currency assets. For debt-equity conversions to provide vehicles for the repatriation of flight capital, residents must be permitted to participate through, for example, implicit or explicit amnesties, since they will be purchasing a registered instrument through an official intermediary. Alternatively, external intermediaries may be used, such as specific country funds. The attractiveness of such exchanges may be enhanced if the conversion is part of a program to privatize viable public enterprises.43 Several recent examples of debt-equity conversions associated with privatization programs may be found in Argentina, Mexico, Nigeria, and the Philippines. In Argentina, a Private Development Trust fund—whose objective is the privatization of 13 public enterprises—has been designed to permit residents to repatriate flight capital through the anonymous intermediation of foreign commercial banks. Similar funds are being developed in other countries, for example, the offshore South Andean Investment Fund in Chile and the Plan for Privatization and Development in Brazil. Residents have been allowed to participate in many such debt-equity conversions without discrimination. In Chile, however, residents participate in a separate program, under Chapter XVIII of current foreign exchange regulations. The Central Bank auctions the right to repurchase discounted debt bought in the secondary market with foreign exchange acquired either on the parallel market or from abroad. Despite intentional limitations on this program for monetary control reasons, it has nevertheless facilitated the repatriation of more than $3 billion since its inception in 1986.
Vehicles for the outflow of private capital include the use of parallel markets for foreign exchange, financing involved in the smuggling of precious metals or objects, improperly invoicing exports or imports, and various forms of parallel lending between residents and nonresidents.
An exception to the unavailability of nonbank data is the U.S. Treasury Bulletin, which contains breakdowns of holdings of U.S. securities by country of origin.
These include Chartered West LB Ltd. (1991), Cuddington (1986), Cumby and Levich (1987), Deppler and Williamson (1987), Dooley (1988), Dornbusch (1991), Kahn and Ul Haque (1985), Lessard and Williamson (1987), Morgan Guáranty (1986), Rojas-Suarez (1991), and World Bank (1985).
The shortcomings of these estimation methods have been amply discussed in the literature on capital flight. In brief, the criticisms of the broader measurements relate to (1) the inadequate estimates of capital flight arising from misinvoicing in the trade account; (2) the attribution of all errors and omissions to capital flight; (3) the omission of nonrepatriated investment income and other foreign exchange receipts; and (4) the overall inadequacies of many developing countries’ debt and capital account statistics, including adjustments for exchange rate valuation effects. Estimates obtained from the “derived measure” are also sensitive to the accuracy of investment income data and assumptions regarding interest rates used to capitalize investment income. Moreover, they neglect capital outflows for which repatriation/reporting of investment income does occur.
The 13 countries are Argentina, Bolivia, Chile, Colombia, Ecuador, Gabon, Jamaica, Mexico, Nigeria, Peru, the Philippines, Venezuela, and Yugoslavia. See Rojas-Suárez (1991).
This view implicitly assumes that the bulk of capital flight resources, if retained domestically, would have been used for growth-inducing domestic investment. For a criticism of this view, see Gordon and Levine (1989).
Tax amnesties have also been used for purposes of collecting domestic corporate and income tax revenue from delinquent enterprises and individuals. See Internal Revenue Service (1987), Leonard and Zeckhauser (1986), Stella (1989), and Uchitelle (1989).
The two effects on the public-sector deficit depend, respectively, on the rate of inflation and the extent to which exchange rates are depreciated in real terms and interest rates are forced to a level below the inflation rate. See Dodsworth, El-Erian, and Hamman (1987) and Fischer (1987) on currency substitution and foreign currency deposits, respectively, and El-Erian (1988), Ortiz (1983), and Ramírez-Rojas (1985) for case studies.
The attractiveness of such schemes will depend primarily on the conversion terms relative to those faced in obtaining the debt on the secondary market.
Such a combination also provides authorities with the added advantage that the conversion will not lead to additional domestic liquidity creation since the counterpart of the new investments will accrue to the governments.