In economics, capital flight is a phenomenon characterized by large outflows of assets and/or capital from a country due to some events, resulting in negative economic consequences to that country. Additionally, the term can be referred to as the rapid withdrawal of assets and capital from certain regions or cities within a country. (Note that capital flight may include the withdrawal of both foreign and domestic capital).
Types of Capital Flight
Capital flight can be either legal or illegal.
Legal capital flight usually takes the form of repatriation of invested capital by foreign investors. In this case, the capital outflows must be properly reported according to existing accounting standards and comply with the country’s laws.
Conversely, illegal capital flight generally appears in the form of illicit financial flows (IFFS). Essentially, illicit financial flows disappear from records within a country and do not return to the country. Note that illegal capital outflows are mostly associated with countries that impose strict capital control policies.
Impact of Monetary Flight
The sudden departure of large sums of money or assets is a detrimental event that triggers several negative consequences for the affected country. It reduces the strength of the economy – and of the government, as it means a loss of tax revenue. Additionally, rapid capital outflows reduce the purchasing power of citizens in the affected country, and major assets may be devalued. Finally, it can trigger a sort of domino effect if other people become panicked and start withdrawing their capital.
Capital flight can occur in both developed and developing countries. However, developing nations are more prone to significant and rapid outflows of capital due to less developed political and judicial institutions.
Also, economists generally believe that resource-based economies can frequently experience outflows of capital. One of the reasons that can explain the phenomenon is the high degree of volatility in the prices of natural resources that can significantly affect the investing environment.
Reasons for Capital Flight
Capital flight can be caused by a number of different events, as well as a combination of such events. The events that can lead to capital outflows may be generally categorized as political or economic.
Various political events frequently become the reasons for capital outflows from a country. For example, political turmoil (including political instability and risks of civil conflicts) may shake investors’ confidence regarding the country’s economic prospects, thus causing capital flight.
In addition, the government plans to pursue nationalization (i.e., seizing private assets and placing them under the government’s control) can be another trigger for capital outflows. Perceived discriminatory policies of a national government may result in capital and/or asset outflows. Economic or military aggression against another country may lead to sanctions imposed by other countries, followed by capital flight.
Economic reasons may also trigger capital flight. These reasons include a significant tax increase or declining interest rates. For example, after the French government introduced its version of the wealth tax, the country experienced an exodus of wealthy individuals and their private capital.
Additionally, the flight of capital can be triggered by some macroeconomic factors such as exchange rate fluctuations. The devaluation of the domestic currency lowers investors’ confidence, causing them to withdraw their capital from a country.
At the same time, the shift in investors’ preferences (e.g., from risky investments to safe investments) can also contribute to capital flight. This is especially common for developing countries that are generally distinguished by a high level of risk.
How to Prevent Capital Flight
The detrimental effects of capital flight cause governments and policymakers to develop effective methods and strategies to prevent the occurrence of the phenomenon. One of the methods of preventing capital outflows is the introduction of capital control policies. However, the institution of such capital control policies is one of the things that can actually cause capital flight to occur.
In order to prevent both legal and illegal capital outflows, governments and policymakers must develop a more complex approach to the problem. It may include the establishment of well-functioning political and judicial institutions that will ensure political stability within a country. Also, the government must implement steps to reduce the level of corruption that usually contributes to illegal capital outflows.
CFI offers the Financial Modeling & Valuation Analyst (FMVA)® certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following CFI resources will be helpful: