Question

Why is capital flight a problem in most developing countries and what can be done to mitigate it?

word count is 1000 words

Answer 1

In economics, capital flight is a phenomenon characterized by significant outflows of a country's assets and/or resources due to certain events , resulting in adverse economic effects for that country. The term can also be referred to as the rapid removal of assets and capital from certain regions or cities within a country. (Note that the capital flight can involve both international and domestic capital withdrawals).

Legal capital flight typically takes the form of foreign investors repatriating spent money. In this situation, capital outflows must be accurately recorded in compliance with established accounting principles and in accordance with the laws of the country.Conversely, illegal capital flight occurs usually in the form of illicit financial flows (IFFS). Essentially, illegal financial flows within a country vanish from records and don't return to the country. Note that illicit capital outflows are mostly associated with countries that impose strict policies on capital control.

The sudden departure of large sums of money or assets is a detrimental event that is triggering several negative effects for the country concerned. It reduces economic strength – and government strength, as it means a loss of tax revenue. In addition , rapid capital outflows reduce citizens' buying power in the affected region, and large assets can be devalued. Finally, if other people are distressed and start withdrawing their money, it can cause some form of domino effect. Capital flight may take place in developed as well as developing countries. Developing nations, however, are more vulnerable to large and rapid capital outflows because of less developed policies and judiciaries

Economists often commonly think resource-based economies will also experience capital outflows. One of the reasons the phenomenon can be explained is the high degree of volatility in natural resource prices which can significantly affect the investment environment. Different political activities sometimes become the reasons behind a country's capital outflows. For example , political uncertainty (including political instability and civil war risks) can shake the confidence of investors in the economic prospects of the country, thus triggering the capital flight. Furthermore, government proposals to implement nationalization (i.e. seize private assets and position them under the control of the government) can be another cause for capital outflows. Perceived discriminatory policies may result in outflows of capital and/or assets from a national government. Economic or military aggression against another nation, followed by capital flight, may result in sanctions imposed by other countries.

Economic factors may also cause a flight of resources. These reasons include a significant increase in taxation or a fall in interest rates. For example, the country witnessed an exodus of wealthy individuals and their private property after the French Government implemented its version of the wealth tax. In addition, some macroeconomic factors such as exchange-rate fluctuations can trigger the flight of capital. Domestic currency devaluation lowers the confidence of investors, leading them to withdraw their capital from one country.

At the same time, the change in priorities of investors (e.g. from risky investments to stable investments) may also lead to capital flight. This is particularly common for developing countries, which are generally distinguished by high risk levels. The adverse effects of capital flight lead governments and policy-makers to develop effective approaches and policies to prevent the phenomenon from occurring. One way to avoid capital outflows is by the implementation of capital management policies. However, one of the factors that can potentially trigger capital flight is the implementation of these capital management policies.

Developing countries typically suffer from a foreign exchange shortage, so capital flight can be a significant financial obstacle to growth. It is likely that:The economic growth capacity is adversely affected as domestic investment is diminished by the capital flowing overseas. Reducing budget revenues as money kept offshore is not subject to tax from developed countries; this would make debt repayment more difficult and raise the tax burden on citizens within the country. Most of the money outflows create balance of payments issues on the capital account. Make international agencies less willing to provide additional financing to serve the debts.

Worsening the income distribution as the poor would be the community most impacted by the steps placed in place to meet the debt servicing requirements of the country, while the rich would gain interest from the international banks to which they have transferred their funds. One way to combat capital flight is to enforce stringent exchange restrictions on developed countries, but that would fly in the face of the global trend towards capital market liberalisation.

Another solution would be to take steps to create trust for investors through sound economic management, but that can be said more easily than done because people in a position to transfer capital around the globe are often more motivated by 'herd instinct' than anything of a more rational and socially responsible nature.

To avoid both legal and illegal outflows of capital, policymakers and policy makers need to develop a more nuanced approach to the issue. These can involve creating well-functioning political and judicial structures that will guarantee a country's political stability. The government must also introduce measures to reduce the degree of corruption that normally leads to the outflow of illicit money. If investors feared a country could default on its government debt, they would sell those government bonds to investors. This will cause the value of government bonds to fall and interest rates to increase. It will increase government costs of servicing the debt. This will also cause exchange-rate devaluation leading to a decrease in competitiveness. High wealth and asset taxes may induce rich investors to transfer their assets abroad to escape taxes. This form of flight of capital may or may not be legal. In France for example, the wealth tax has resulted in an outflow of money to avoid the tax.

Capital flight causes one nation to lose money and resources. Occasionally, however, the exchange-rate devaluation can be necessary to restore the economy 's competitiveness. For example, the devaluation of Iceland helped rebalance the economy To curb or prevent the flight of capital, a government may introduce capital controls to restrict the amount of money that people can take from a nation. Nevertheless, these capital flows can be difficult to control in full in a modern global economy.