Sample Economics Research Paper on Capital Flight

Capital Flight

1. Background material leading up to the thesis
   1. Capital flight in general
      1. Definition

The increasing debt situation of third world countries, especially in South America and Sub-Saharan Africa, has shifted people’s attention to prevailing economic anomalies like capital flight. The directly proportional relationship between external debt and capital flight has raised significant questions on its contribution to this status quo. Capital flight, per Gulati (1988), is a phenomenon characterized by the large outflows of domestic assets and capital while simultaneously experiencing an unprecedented increase in external indebtedness because of the unfavorable economic or political environment. This definition tries to differentiate between capital flight and foreign investment. The latter is conducted as a business strategy to increase a portfolio’s risk-return through market diversification. The result is an increase in repatriations. Capital flight, however, does not lead to an increase in repatriation. It causes an increase in borrowing to cater to the ‘gone’ capital and assets. Moreover, foreign investments are well appropriated for in the international accounting standards and the flow of capital can be tracked and accounted for. Capital flight, contrastingly, involves the use of dubious, underhand, and illegal means that appear as illicit financial flows. This capital often disappears completely from the host country’s records. The illicit nature of capital flight is well shown by the increase in external debt relative to capital flight. In other words, external borrowings have been used to facilitate the private accumulation of foreign assets instead of budgetary current account deficits (Ndikumana & Boyce, 2011).

1. How capital flight works

Capital flight is triggered by unfavorable economic and political events as aforementioned. Economic conditions leading to capital flight include domestic currency depreciation, significant tax increases, diminishing returns, fluctuations in the exchange rate, and a shift in investors’ preferences. Domestic currency depreciation, like tax increases, foreign exchange volatility, and diminishing returns, reduce the expected returns on capital invested. Investors may also opt for safe investments at the expense of risky investments hence moving their capital to safe economies. Political events likely to result in capital flight include political instability, sanctions, nationalization policies, and corrupt political systems. Political instability will most definitely scare away investors. Inappropriate political dealings resulting in sanctions will also cause investors to shift their capital elsewhere. Perhaps the largest cause of capital flight in sub-Saharan Africa is corrupt political systems. Political figures mastermind and protect the process of capital flight in the best of their interest. Nationalization policies will also lead to capital flight if not properly pursued.

• Examples

The above two causes of capital flight have been well manifested in recent history. France is a good example of a nation whose unfavorable tax policies have led to capital flight (Moore, 2006). The country charges an extra wealth tax on top of capital gains, social security, income, and inheritance taxes. The wealth tax is levied on paper assets were they to be sold at the prevailing market prices. Rampant nationalization policies in Zimbabwe have led to massive capital flights as investors deem the country as unfit for investments (Makochekanwa, 2007). Political instability in Middle East nations like Yemen has led to unprecedented levels of capital flight as people escape the ravaging conflict. The Asian financial crisis of 1997 was a good example of capital flight caused by depreciation domestic currency (Staff, 1998). Investors lost confidence in the domestic currency and sought refuge in the West where currencies were stable. The effect was a debilitating financial crisis. The effect of economic sanctions on capital flight was well illustrated by the Russian Economic Crisis of 2014 following the annexation of Crimea. Crippling sanctions were imposed on Russia by the U.S. and E.U. leading to a one-sided economy that was heavily dependent on oil and gas (Kuepper, 2018). Plummeting oil and gas prices due to political instability in the Middle East destabilized economic conditions in Russia leading to capital flight.

1. Thesis: Capital flight has negative effects on developing countries.

Capital flight bears a very negative effect on the economies of developing countries. This claim is based on the following seven consequences of flight capital. First, it creates a shortage of savings and foreign exchange required to finance domestic projects. Secondly, it may destabilize exchange and interest rates in developing countries if it happens at once. Thirdly, it reduces national welfare by creating different private and social rates of return. Fourthly, it erodes a nation’s tax base as flight capital is not within the country’s tax bracket. Fifthly, it raises the marginal cost of borrowing by reducing a country’s credit-worthiness while increasing its level of external borrowing. Sixthly, it increases income distribution disparities since it only benefits the wealthy. Lastly, flight capital leads to increased taxation to service debt interests arising from increased borrowing. These consequences cut across both social and economic developments in developing countries.

1. Social development in developing countries
   1. The impact of capital flight on social development in developing countries
      1. Evidence

Social developments are aimed at increasing the overall wellbeing of citizens in a country; their health, education, and environment. Developing countries are often synonymous with poor social developments. Capital flight plays a very big role in ensuring this end. The reduced capacity of affected countries to mobilize domestic assets and access foreign resources leads to stalling of projects and a mismatch between domestic demand and supply of crucial goods and services. Affected nations have an insufficient supply of health, education, and other social facilities. As such, the social conditions degenerate. Per the BBC (), 74% of Zimbabwe lives on less than $5.50 a day, the unemployment rate is well beyond 60% of the population, 89% adult illiteracy rate, and a dismal life expectancy rate of 61 years (“Zimbabwe in 10 numbers,” 2018). The rising taxes due to ballooning debt interests also affects the social welfare of citizens. Their ability to invest is curtailed leaving them vulnerable to poverty.

• Economic development
  1. The impact of capital flight on economic development
     1. Evidence

Capital flight reduces and in intense scenarios stalls economic development. Capital is a very integral ingredient in economic development, the other being human resource. Countries experiencing flight capital fail to develop economically because of two profound reasons. Foremost, the lack of capital means a nation cannot develop its infrastructure, financial institutions or invests. The nation is forced to overstretch the remaining capital on providing crucial social services and maintaining its recurrent expenditure. Secondly, such countries have to cope with ever-rising debt and interest repayment volumes. These further worsen the economic position of the country. The resultant effect of these happenings is a vicious cycle of poverty that involves constant borrowings and repayments. Strong evidence of the adverse effects of capital flight on economic development is reducing income per capita. Russia, for example, experienced a reducing income per capita from $15,200 in 2013 to $9,230 in 2017 (“Russian Federation,” n.d.). This adverse economic trend is a direct effect of the aforementioned Russia Economic Crisis of 2014.

1. Role of Western countries
   1. The role of Western countries in capital flight
      1. Evidence

Western countries are equally to blame for the adverse effects of capital flight in developing countries as the countries themselves. They have been reluctant to improve the efficiency of commodity trading by implementing capital flows disclosure regulations. This system would ensure that the amount of capital leaving developing countries is known and also curb tax evasion and corruption by improving the transparency of the economic system. The lack of transparency seems to benefit Western countries. Per Diak (2014), the Swiss traders formed at least 30% of the buyers of identified national oil firm’s sales. Western countries have also failed to enforce capital outflow controls from developing countries. As such, even funds intended to be used as humanitarian aid ends up as capital flight in the same countries they came from. Thirdly, western nations have become capital havens for rogue and corrupt leaders in developing countries. These tyrants, embezzle public funds and put them is some western countries without any scrutiny of these funds.

1. Conclusion

Capital flight is a major problem affecting developing countries. It is caused by both political and economic reasons. This phenomenon has a negative impact on a nation’s social and economic welfare. It also makes it hard for an affected country to progress. Capital flight only benefits a little proportion of the populace as the majority are forced to deal with rising taxation and diminishing social and economic conditions. The problem of capital flight is, however, not confounded to developing nations alone. Western countries also play a key role in furthering this phenomenon. Acts such as failing to enforce capital flow controls and transparency measures only serve to facilitate capital flight. It is thus paramount to include the Western nations is any efforts aimed at curbing and eradicating capital flight.

 

References

Diak, D. (2014). A Look at Capital Flight from the Developing World. Giving what we can, https://www.givingwhatwecan.org/blog/2014-10-16/look-capital-flight-developingworld

Gulati, S. (1988). Capital flight: causes, consequences, and cures. Journal of International Affairs, 165-185.

Kuepper, J. (2018, August 30). What Caused the Russian Financial Crisis of 2014 and 2015. Retrieved from https://www.thebalance.com/what-caused-the-russian-financial-crisis-of-2014-and-2015-1979012

Makochekanwa, A. (2007). An empirical investigation of capital flight from Zimbabwe. University of Pretoria. Working Paper, 11.

Moore, M. (2006, July 16). Old Money, New Money Flee France and Its Wealth Tax. Retrieved from http://www.washingtonpost.com/wp-dyn/content/article/2006/07/15/AR2006071501010.html

Ndikumana, L., & Boyce, J. K. (2011). Capital flight from sub‐Saharan Africa: linkages with external borrowing and policy options. International Review of Applied Economics, 25(2), 149-170.

Russian Federation. (n.d.). Retrieved from https://data.worldbank.org/country/russian-federation

Staff, I. M. F. (1998). The Asian crisis: causes and cures. Finance and Development, 35(2), 18-21.

Zimbabwe in 10 numbers. (2018, July 25). Retrieved from https://www.bbc.com/news/world-africa-42013720

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