Capital Flight: Definition, Causes, Effects & Examples

Capital Flight: Definition, Causes, Effects & Examples

capital flight definition

What is Capital Flight

Capital flight occurs when investors or businesses remove their money from a country. This may be due to economic or political factors such as economic recessions or unstable governments. In reaction to such, investors may fear the loss of their funds and withdraw such an investment where it may be safer.

Capital flight can be identified when the total level of money and assets is negative. For example, the US may have $2 trillion coming in from investors, but if other investors remove over $2.5 trillion, then it is experiencing capital flight. This is because more investment is leaving than coming in.

Key Points
  1. Capital flight occurs when money and assets leave the country to find better investment opportunities elsewhere.
  2. There are many causes of capital flight, but the main ones stem from government intervention in the form of currency manipulation, political upheaval, or aggressive fiscal policy.
  3. Over the long term, capital flight can starve the country of the finance it needs for economic growth.

Capital Flight Examples

French Wealth Tax

France introduced a wealth tax in 1989 which ranges from 0.5 to 1.5 percent and is payable on wealth greater than 800,000 euros. Its goal was to increase tax revenues and reduce inequality. And although it increased tax revenues, tax evasion meant that total receipts were 28 percent lower according to a study by economist Eric Pichet.

In his study, he also found that the wealth tax led to capital flight of approximately 200 billion euros during the period 1989 to 2007. So not only did the wealth tax lead to lower revenues, but also capital flight and the effects that are associated with it.

Asian Financial Crisis

Another example of capital flight was that of the Asian Financial Crisis in 1997. Many Asian countries had to face a severe financial crisis due to the collapse in the exchange rate. Many Asian countries lacked foreign reserves, particularly the US dollar. This made it difficult for nations which relied on its link to the American currency. As a result, stocks tumbled, exchange rates plummeted, and capital flight occurred in the region.

An example of capital flight occurred in late 1997 and 1998, where Indonesia, Korea, Malaysia, the Philippines, and Thailand experienced net capital outflows of more than $80 billion.

This capital flight contributed to one of the regions worst economic declines in history. For example, Korea and Malaysia recorded economic growth of -5.8 percent and -7.5 percent respectively in the year 1998. The situation was much worse in Thailand and Indonesia where economic activity declined by over 10 percent.

Greek Financial Crisis

The Greek financial crisis really kicked in during 2012, but capital flight lasted well into 2015 where it reached a record. In the year between May 2014 and May 2015, capital flight reached 64 billion euros; the equivalent of a third of its entire economy.

What happened as a result is that businesses and governments were unable to obtain credit. Whilst previously businesses relied on foreign investment in order to create jobs and new stores; this is no longer available to them. Instead, the Greek government is now reliant on loans from organizations such as the IMF to prop up the space left behind from capital outflows.

Russian Financial Crisis (2014-16)

In 2014, Russia invaded Ukraine and annexed Crimea. The result was a list of heavy sanctions imposed by the West which cost Russia billions. The economic uncertainty and political risk meant that investors left the country in their droves, with $150 billion lost in capital flight in 2014 alone.

At the same time, there was a massive drop in the price of oil – which lost close to 50 percent in its value. With Russia significantly reliant on oil, government revenues took a huge hit alongside the economy which declined by around 3 percent in 2015.

Causes of Capital Flight

1. Higher Taxes

When the government increases taxes, it means consumers, investors, and businesses, all see their incomes fall. So whilst an increase in the corporation tax by 1 or 2 percent may have little effect; an increase of say 20 percent can potentially cause capital flight.

For example, Country A and Country Z both have a corporation tax level of 20 percent. Country A then proceeds to increase its rate to 40 percent. Investors and businesses in Country A are then put at a significant disadvantage. Why would they stay there and pay an extra 20 percent in tax? They are therefore incentivised to move their capital to Country Z where they can keep more of their profits.

If we look at France for example, President Hollande raised taxes on the rich in 2012. In turn, huge levels of capital flight which saw nearly €53 billion leave the country in the first two months.

2. Currency Manipulation

Countries such as Venezuela and Zimbabwe have been known to print significant levels of money. As a result, such nations have seen extraordinary levels of hyperinflation as the governments have looked to manipulate the currency.

Another example of currency manipulation can be seen in China, which manipulates its currency to gain an advantage in the export market. What this does is devalue the currency in relation to others. So investors who are making their money in a foreign currency are then gaining less when they transfer back to local currency.

For example, a US company may purchase a 50 percent stake in a Chinese firm. It gains around $10 million per year on its investment. However, after currency manipulation by government, those gains fall to $8 million per year as the exchange rate declines.

What this means is that the return on investment is significantly reduced. So firms and investors may look to move their capital to other nations whereby the returns are greater.

Furthermore, we also have the risk of hyperinflation, which can scare off many investors. This is because hyperinflation, as we have seen in Venezuela, can leave investors with absolutely nothing, thereby losing their whole investment.

3. Political Uncertainty

Political uncertainty is where there is the potential for huge shifts in policy, leadership, and condition of the country. For instance, there may be a shift towards a socialist or far-right government.

Policies offered by potential governments can strike fear into investors and businesses. For instance, high taxes and strict regulations are not favourable to investment. Subsequently, those who are already invested may look to move their money to a nation that faces greater levels of certainty.

4. Economic Performance

Investors generally flock towards economies that are growing rapidly as they offer the greatest potential for profit. So when a nation faces slow or negative economic growth, investors start looking elsewhere for their returns.

The reason is two fold. First of all, returns on investment tend to decline during economic recessions. Second of all, the level of risk increases. Investors do not know how long or deep the recession will be, nor whether their assets will be safe. So what we often see is some level of capital flight in order to protect investment.

If we look to Greece for instance, its economic crisis caused it to lose over a third of its GDP in capital flight. That was just in 2014 to 2015 as well.

Effects of Capital Flight

Capital flight has a number of effects, each depending on the severity. For instance, small levels may not have too much of a dramatic effect, but a huge panic like we saw in Greece and the Asian financial crisis can ripple throughout the economy.

effects of capital flight

1. Lower Investment

As capital leaves the country, there is less to invest in the domestic market. At the same time, it means the level of foreign direct investment is also declining. Investors are both looking to other nations to invest and withdrawing their capital.

Now it might not seem like such a bad thing if those investments have already been made. For example, Business A may sell its factory in China and withdraw its capital. The factory is still there, so the Chinese economy has already benefited. However, we also need to consider that capital flight also means that investors are equally reluctant to invest in the first place.

So during capital flight, not only does capital that could be used for investment move abroad, but it doesn’t enter the country in the first place either.

2. Lower Tax Revenue

If the amount of capital reduces, fewer profits are being made in that country. So when capital leaves a country, it also leaves the taxes that it was generating.

It also reduces potential tax receipts in the long term. This is because capital flight affects investment in the economy, meaning businesses are not creating as many jobs, factories, and other productive equipment. So the economic potential of a nation can decline as it is not receiving the same amount of investment.

This means that the economy would have been larger had capital stayed within the country. That’s more jobs and more productive workers. In turn, with fewer people employed and a smaller economy, governments will bring in less through income taxes, corporation taxes, and various others.

3. Weakened Currency

When capital flight occurs it means there is a fall in demand for the domestic currency. For instance, a US investor in China needs to purchase the Chinese Yuan to make an investment. However, during capital flight, the US investor will want to exchange their Chinese Yuan back again into US dollars.

What this does is send a signal to the exchange markets that the Chinese Yuan is losing demand, and the US is gaining demand. Therefore, the Chinese Yuan starts to lose value to the US dollar.

4. Economic Impact

The impact of capital flight on developing nations is much more pronounced because capital is in short supply. An investment of $1 billion is much more crucial to countries such as Vietnam than the US. So what we see as a result of capital flight is a significant economic impact that tends to affect developing nations in a greater way.

Nevertheless, significant levels of capital flight will affect any economy. Generally speaking, it does so as there is less capital available for investment. Investors may sell their debt and leave, thereby reducing the amount of available credit. Or, they may sell assets to domestic buyers and leave with their capital. In turn, it means there is less in the domestic market. If investment and available capital decline, businesses will stall as they cannot expand and grow.

5. Government Debt

As capital leaves the country, there is less available for both domestic firms and governments to borrow. There are fewer investors that are willing to lend. In turn, governments have to start paying higher interest rates in order to attract investment.

As we saw in Greece during the 2012 Crisis; investors left in their droves, leaving the Greek government without any line of credit. Interest rates of government debt increased rapidly to reflect the higher levels of risk. At the same time, debt increases further due to having to make higher debt payments on the interest.

FAQs on Capital Flight

What is the meaning of capital flight?

Capital flight is where investors and businesses rapidly remove their money and assets from one country. It occurs due to economic or political factors such as economic recessions or unstable governments.

What are the causes of capital flight?

There are 4 main causes of capital flight. They are:
1. Higher Taxes
2. Currency Manipulation
3. Political Uncertainty
4. Economic Performance

What are the effects of capital flight?

There are 4 main effects of capital flight. They are:
1. Lower Investment
2. Lower Tax Revenue
3. Weakened Currency
4. Economic Impact

About Paul

Paul Boyce is an economics editor with over 10 years experience in the industry. Currently working as a consultant within the financial services sector, Paul is the CEO and chief editor of BoyceWire. He has written publications for FEE, the Mises Institute, and many others.

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