Capital flight

Define the term ‘capital flight’

A large, sudden outflow of financial capital due to political and economic instability

What were the types of financial capital?

Hot money flows - Short term speculative flows of savings, chasing the highest rate of return

Share capital - When private investors are buying a stake in a private company

FDI - Long term private investment, by foreign companies purchasing illiquid assets (Land, Production factory and infrastructure)

How can civil war lead to capital flight?

Assets are at risk of being destroyed. In fear of losing wealth, might then cause capital flights as households and firms may move assets abroad.

How can a military coup lead to capital flight?

Assets are at risk of being destroyed. In fear of losing wealth, might then cause capital flights as households and firms may move assets abroad.

How do dictatorships lead to capital flight?

Higher risk of corruption. Uncertainty for households and firms as they may seize assets for their own self interest. Causes capital flight, as households and firms may move assets abroad. Also, Higher risk of corruption might suggest to private investors that there is increased regulation on private assets and so increases administration costs. This makes it unattractive to foreign direct investors, so they may move their assets abroad, leading to capital flight.

How do upcoming elections lead to capital flight?

Can create political uncertainty as there may be a transfer of power between political parties. This can decrease business confidence as firms may have uncertainty over changes in tax policy or new regulation.

Hoe does the rate of inflation influence capital flight?

If the rate of inflation exceeds nominal interest rates, this will lead to fall in real interest rates. This reduces the reward for saving, so foreign investors who seek a greater rate of return may move their assets abroad, leading to hot-money outflows. This leads to capital flight.

If the rate of inflation is high, firms may be unable to forecast future revenue, costs and profits. This may lead to a fall in business confidence, so firms may move their assets abroad, leading to capital flight.

How does an unstable financial sector lead to capital flight?

A banking crisis can trigger a run on the bank, as investors withdraw their savings deposits and move their assets into other financial havens, leading to capital flight. This causes banks to have a lack of liquidity, reduces banks access to credit, hence their willingness to lend.

How does unexpected tax hikes lead to capital flight?

A higher rate of corporation tax, which is levied as a percentage of a firms profits. This means that, firms now have lower levels of retained profits. Therefore, foreign investors may sell share capital, due to a lower rate of return and so purchase shares in other stock markets. This leads to capital flight, as foreign investors are no longer holding a stake in the private company.

How does capital flight lead to unstable exchange rates?

In the early 2020’s Argentina faced political uncertainty and excessive government borrowing under Macri. Foreign investors move their money and assets into safer countries. When capital flight occurs, Argentinian pesos are sold in the currency market because investors deposit assets in other financial havens. So, the supply of Peso’s increases relative to its demand from S1 to S2. This leads to a sudden depreciation of the exchange rate from er1 to er2. As a result, Peso’s becomes severely undervalued in the global market. The price of importing raw materials such as oil rises, as their Peso’s is now worth less in the global market. This causes Argentinian firms costs of production to rise as oil is a primary commodity used in the production of many manufactured goods, leading to a decrease in SRAS. This leads to an Increase in cost-push inflationary pressures as firms may pass these costs onto households in the form of higher average prices. In an attempt to curb inflation, this may induce a large and rapid increase in the base rate by the Argentinian central bank, increasing the cost of borrowing.

Why are unstable exchange rates problematic for LEDC’S

• Higher variable rate mortgages → Reduces the demand for housing → Downwards pressure on the price of housing → Negative wealth effect  → Consumption conponent of AD = C+I+G+(X-M) to decrease. → AD falls → Increase in deflationary pressures  → Contraction along LRAS curve → Real GDP falls → Unemployment rises → GNI/Capita falls to the point where absolute poverty may occur (>$2 a day) → Material living standards fall → Fall in HDI component → Development worsens.

• LEDC’s are likely small firms who need access to credit in order to expand → This reduces the incentive for firms to borrow as there is a higher cost of repayment. → Less internal finance made readily made available to them and so spend less on capital goods → Investment conponent of AD = C+I+G+(X-M) to decrease. → AD falls → Increase in deflationary pressures  → Contraction along LRAS curve → Real GDP falls → Unemployment rises → GNI/Capita falls to the point where absolute poverty may occur (>$2 a day) → Material living standards fall → Fall in HDI component → Development worsens.

• Also, a fall in investment → Existing capital stock depreciates → Long run productivity falls → LRAS falls → Fall in the productive potential of the economy → Cost of producing one unit rises → Increase in inflationary pressures → Less internationally price competitive → Export demand falls → Export revenue falls → Less corporation tax revenue → Less funds for development (Infrastructure), worsening development.