Capital Flight

Capital flight is usually a symptom rather than a cause of financial crisis. Occasionally, however, rumors of a devaluation can trigger capital outflows. Expectations of devaluation can become self-fulfilling, as depletion of the central bank's reserves force it to devalue. In these cases capital flight becomes a source of financial instability, much as withdrawals by worried depositors can cause an otherwise sound bank to fail.

Not surprisingly, episodes of capital flight are most frequent when exchange rates are unstable. In the twenties and thirties the demise of the gold standard led to numerous speculative attacks on the French franc and German mark. When the Bretton Woods system of fixed exchange rates began to break apart in the late sixties, the United States tried to defend the dollar with capital controls and by refusing foreign banks' demands to convert dollars to gold. (U.S. citizens were already barred from owning gold.) After exchange rates were set free in 1973, the U.S. dollar replaced gold as the flight vehicle of choice. Convertible to most currencies, dollars also earn interest in convenient offshore or Eurodollar accounts.

Since the Third World debt crisis in the eighties, the term "capital flight" has been applied more broadly to capital outflows from residents of developing countries. One reason that capital fled the debtor countries is that domestic investors felt their government would give precedence to its foreign rather than its domestic debt obligations. This situation contrasts with the earlier experience with direct foreign investment, when domestically owned assets were considered safe from expropriation while foreign-owned assets were at risk.

Offshore holdings are notoriously difficult to measure, so economists simply subtract foreign currency payments for imports, debt service, and additions to official reserves from total sources of foreign exchange (exports, borrowing, investment by multinationals, etc.). The difference—unaccounted-for dollars—is called capital flight.

Using this broad measure, the International Monetary Fund estimates that citizens of developing countries amassed about $250 billion worth of foreign assets between 1975 and 1985 (compared to a total foreign debt of $800 billion). Although Mexico had the largest dollar total ($40 to $50 billion), Venezuela's and Argentina's holdings were a larger proportion of national income (nearly equal to their foreign debt). Indonesia, Nigeria, the Philippines, and even South Korea also had substantial capital outflows during this period.

This second type of capital flight superficially resembles the classic variety of currency speculation. It is often most intense during periods of currency overvaluation or just after an exchange rate crisis, for example. But unlike "hot money" these funds tend to remain abroad after the currency crisis ends. The driving force behind these outflows is generally a perceived decline in the return, or an increase in the riskiness, on long-term assets held in the country. A loss of confidence may be caused by an excessively large foreign debt burden, large fluctuations in commodity export prices, or chronic government mismanagement of the domestic economy. Interestingly, though, nationalization was not a major cause of rapid capital outflows. The reason is probably that most nationalizations were of foreign-owned assets rather than assets held by the country's residents.

This flight capital is held offshore until conditions improve or until the source of uncertainty is resolved. The tens of billions of dollars that fled Mexico in the early eighties, for example, did not begin to return until 1990, after Mexico got debt relief under the Brady Plan, committed itself to liberalizing trade and finance, and announced it would sell the banks it nationalized in 1982. All of these measures helped to restore confidence in domestic financial markets and reduce fears of recurrent external debt crises.

While exporting countries often exaggerate the harmful consequences of capital flight, there are some legitimate areas of concern. Unlike movements of capital from Texas to New York, rapid international capital flows can disrupt financial markets and raise interest rates by causing unanticipated exchange rate movements, especially in small countries. Also, an unknown fraction of international funds transfers is due to tax evasion or to efforts to conceal illicit gains or embezzlement of public funds. The foreign holdings of the Philippines' Marcos family fall into this category. The use of offshore banks and Swiss accounts for tax evasion and money laundering taints all international capital flows to some degree.

Legitimate or not, once it starts there is no easy cure for capital flight, and preventive measures often have unpleasant side effects. Following the financial instability of the interwar period, currency speculation was reduced by fixing exchange rates and changing them very infrequently. The International Monetary Fund was set up to assist countries that ran into foreign exchange problems. This system fell apart in the early seventies, but some countries are still trying to return to fixed rates on a more modest scale (those joining the European Monetary System, for example).

When fixed exchange rates fail, governments often resort to capital controls, as the United States did in the sixties. Imposing controls during or just after a capital flight episode, however, is a little worse than closing the barn door after the horse has fled. Controls further reduce confidence in local financial markets and make capital that has flown less likely to return. Capital controls encourage black markets for foreign currency and other costly methods of evasion. Those who import or export goods can also export money by simply overstating the value of the goods they import or by understating their export earnings. Even the most draconian measures to limit capital flight often fail. Capital flight from the Weimar Republic continued in 1931, despite the fact that capital expatriation was made an offense punishable by death.

Another strategy that governments can use to limit capital flight is to make holding domestic currency more attractive by keeping it undervalued relative to other currencies or by keeping local interest rates high. The drawback to this approach is that raising interest rates and making imported equipment more expensive can reduce domestic investment. A more sophisticated defense against hot money flows, but one that is harder to execute, is for the central bank to occasionally turn the tables on speculators. A classic "squeeze" of this type was engineered by Lazard Frères for the French government in 1924. Using a $100 million loan from J. P. Morgan, they bid the franc from 124 to 61 per dollar in a few weeks. Speculators who had sold the franc short in the expectation that its value would fall were hit by big losses. Italy, the United States, and Sweden have also used this unexpected intervention tactic from time to time.

Yet another option is to reduce the tax benefits of capital flight by having rich and poor countries adopt new tax treaties and exchange data on income paid to foreigners. The U.S. government's termination in 1984 of the 30 percent withholding tax on U.S. portfolio income paid to foreigners and a similar lack of reporting by European governments are often blamed for encouraging capital outflows to those countries. But offshore tax havens and international competition for capital make new tax treaties unlikely.

In the end the most practical strategy for reducing capital flight is for governments to pursue fiscal and monetary policies that minimize the need for large changes in exchange rates. Agreements among countries and central banks can add to the credibility of these commitments. Tax evasion can be reduced by relying more on consumption or sales taxes and less on taxes on interest and profits. Developing countries in particular can also promote the development of domestic financial markets and trade in assets that offer investors a "safe" alternative to foreign assets. Brazil used this strategy with some success before 1988. Small countries with limited domestic financial markets and currencies that are more vulnerable to external shocks can hold a portfolio of foreign assets and try to diversify their exports over the longer term. During the seventies Indonesia, Kuwait, and tiny diamond-exporting Botswana, among others, used international financial markets to smooth their volatile revenues from commodity exports.

One encouraging sign is that private capital has begun to return to countries for whom future prospects have brightened. An estimated $10 billion has flowed back into Mexico since its successful 1989 anti-inflation, trade liberalization, and debt relief programs. To prevent future crises, Mexico set up a special contingency fund and uses futures markets to help stabilize its volatile oil earnings. Some combination of domestic reforms, debt relief, and improved foreign asset management may soon restore investor confidence in other countries as well.