What is Capital Flight?

Capital flight is a large-scale exodus of financial assets and capital from a nation due to events such as political or economic instability, currency devaluation, or the imposition of capital controls.

Capital flight can be legal, as is the case when foreign investors repatriate capital to their country of origin, or illegal, which occurs in economies with capital controls that restrict the transfer of assets out of the country.

The term “capital flight” covers a number of situations. It can refer to an exodus of capital from a nation, from an entire region, or from a group of countries with similar fundamentals.

It can be triggered by a country-specific event or macroeconomic development that causes a large-scale change in investor preferences. It can also be short-lived or continue for decades.

Currency devaluation is often the trigger for large-scale and legal capital flight, as foreign investors flee those nations before their assets lose too much value.

This phenomenon was evident in the Asian crisis of 1997, although foreign investors returned to these countries before their currencies stabilized and economic growth resumed.

Due to the specter of capital flight, most nations prefer foreign direct investment (FDI) over foreign portfolio investment (FPI).

A foreign direct investment (FDI) is a purchase of a stake in a company by a company or an investor located outside its borders.

After all, FDI involves long-term investments in factories and companies in a country, and can be extremely difficult to liquidate at short notice.

Capital flight can also be instigated by resident investors fearful of government policies that will bring down the economy.

For example, they might start investing in foreign markets, if a populist leader with hackneyed rhetoric about protectionism is elected, or if the local currency is in danger of being sharply devalued.

In a low-interest-rate environment, “carry trades,” which involve borrowing in low-interest-rate currencies and investing in potentially higher-yielding assets such as emerging market stocks and junk bonds, can also trigger a flight of capitals.

The effects of capital flight can vary depending on the level and type of dependence that governments have on foreign capital. The 1997 Asian crisis is an example of a more severe effect due to capital flight. During the crisis, rapid currency devaluations by Asian tigers triggered capital flight which, in turn, resulted in a domino effect of collapsing stock prices around the world.

Illegal capital flight generally takes place in countries that have strict capital and currency controls. For example, capital flight from India amounted to billions of dollars in the 1970s and 1980s due to strict foreign exchange controls. The country liberalized its economy in the 1990s, reversing this capital flight as foreign capital flooded the resurgent economy.

 

Capital flight can also occur in smaller nations beset by political turbulence or economic problems. Argentina, for example, has endured capital flight for years due to a high rate of inflation and a slipping national currency.

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