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What is capital flight?

Capital flight

The capital flight definition refers to an economic phenomenon, which is characterised by large outflows of capital or financial assets from the country. It can be triggered by a variety of events, such as economic or political crisis, currency devaluation, the imposition of capital controls or a macroeconomic development that causes a large-scale shift in investor sentiment.

Moreover, the term is often used to describe the abrupt withdrawal of capital not only from the countries, but also from particular cities or regions within a country.

It is important to mention that capital flight may refer to the withdrawal of both domestic and foreign capital. The phenomenon can be short-lived or last for decades.

Capital flight typically results in several negative consequences for the affected country. Poorer nations, in particular, suffer from the capital outflows more severely than others, as the lack of capital hampers economic growth and may lead to lower living standards.  

Where have you heard about capital flight?

In the economics literature, the concept of capital flight has been around for at least the past six decades. Charles Kindleberger was one of the earliest adopters of this term.

You may have heard about capital flight from news reports, financial analysts or investment advisers.

What you need to know about capital flight…

Capital flight is a harmful event that always comes with many adverse outcomes for the affected country. It inhibits the development of major economic sectors and diminishes the overall economic performance. In addition, rapid capital deflux may result in a decreased purchasing power of citizens. Meanwhile, domestic assets also tend to lose their value.

Many reasons can eventually lead to capital flight. The factors that can trigger capital outflows may be generally categorised as economic or political. These, among others, include political turmoil, aggressive or discriminatory policies, a significant tax increase or declining interest rates. Each event or a combination of these can promote large capital withdrawal.

Capital flights can happen in both developing and developed nations. However, developing countries are more prone to large capital outflows, as their political, judicial and economic institutions are less developed.

Also, economists suggest that countries, which economies majorly rely on natural resources, more frequently experience capital outflows. The reason behind it is that the prices of the natural resources experience a high degree of volatility, which, in turn, can significantly impact the investing environment.

There are two types of capital flight: legal or illegal.

The legal capital flight usually refers to the retrieval of invested capital by foreign investors. In this scenario, the capital outflows must be complied with the country’s laws and properly reported according to existing accounting standards.

On the contrary, illegal capital flight usually refers to the illicit financial flows. These essentially disappear from records within a country. Illegal capital outflows usually take place in economies with strict capital control policies.

The negative effects of capital flight can vary according to the level and type of dependency the economy has on foreign capital. The detrimental aftermath of capital flight forces policymakers to develop a complex approach of different strategies and methods to prevent the event from recurring.

One of the most popular methods to prevent capital outflows is to introduce new capital control policies

These can include the establishment of efficient judicial and political institutions, ensuring the political stability within a nation. Another common tactic followed by many governments is to sign tax treaties with other jurisdictions.

Corruption, as a matter of fact, also contributes to illegal capital flight. Therefore, radical measures to reduce the level of corruption in the country must be taken.

Another way to fight capital flight is to raise interest rates to make a local currency more attractive for international investors.

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