Capital Flight

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    Capital flight occurs when investors lose confidence in an economy so domestic and/or foreign agents rapidly pull their money out of the economy. The economy suffers a rapid, dramatic and large outflow of capital. Maybe investors believe the economy will suffer lower growth (or negative growth) in the near future so the return on investment in the economy will be lower. Maybe investors believe the economy’s currency will depreciate in the near future so they cannot make a profit by waiting and selling the currency. Maybe investors believe their assets will be seized, this could occur if an authoritarian government came to power.

    Capital flight is bad for development because:

    1) Less Funds for Investment.

    Money leaves the economy, there are less savings, the domestic savings gap widens and there are less funds for investment. A restriction of investment means the PPF and economic growth is constrained.

    2) Less Tax Revenue.

    There are less assets and less investment in the domestic economy, profits are low or even negative, incomes are low and consequently tax revenues are low. So the government has less funds to use for development spending.

    3) Limits Vital Imports.

    Additionally, capital flight means foreign currency leaves the economy so the foreign exchange gap widens. Also, investors pull their money out of the economy so the exchange rate falls and imports become more expensive. This reduces the amount of imports into the economy so domestic consumers cannot buy foreign food and domestic firms cannot buy foreign capital goods.

    4) Default on Foreign Debt.

    Foreign currency reserves are depleting rapidly so the economy runs out of funds to repay its foreign debt.

    However, capital flight may not be a major constraint on development because: – The degree of capital flight is significant, if it is small then it may not be a problem. – Maybe the LDC could impose capital controls or freeze assets to stop money flowing out of the country. – Maybe other factors are more important development constraints.

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