Saturday, June 2, 2012

Capital Flight Explained

Capital flight is an economic term used to describe the outflow of wealth from a country when it is experiencing severe economic difficulties. The most common causes of capital flight are widespread expectations of a significant currency devaluation, and/or fear that the government would give precedence to their foreign debt obligations ahead of their domestic ones.

The fear that the value of their wealth is not secure drives people and institutions to shift it to other economic jurisdictions they consider to be safer. This kind of outflow of wealth can be either be done legitimately through strategies such as the sale of shares and bonds and the widespread withdrawal of savings funds or illegally through corruption and tax evasion strategies.

Capital flight works as a kind of self-fulfilling prophecy; as confidence in the economy drops and more people disinvest, the performance of the economy is further weakened by lack of capital reserves, creating a further drop in confidence and a downward spiral of capital flight and economic contraction until the effected nation is forced to massively devalue their currency and default on their external debts.

There are two distinct forms of capital flight, the most common form in the western world occurs in economies that lack monetary autonomy, meaning that their governments can't gradually change the value of their currency to suit their economic circumstances. When the value of the currency is directly tied to an external value, such as the Gold Standard, the US Dollar or the Euro, there is little a government can do in order to alleviate economic problems. A lack of ability to gradually reduce the value of the currency in order to prevent a strong currency from crippling their export markets for example.

When the national currency is easily convertible to the currency of other economies this increases the ease with which capital flight is achieved. An example of this can be seen in the Argentine 1:1 currency peg with the US Dollar. As the Argentine economy deteriorated in the late 1990s, people rapidly converted their Argentine Pesos into Dollars in the expectation that a breaking of the peg in order to allow devaluation of the Peso was becoming inevitable. Another example can be seen in the Eurozone crisis where Euros are flowing out of countries like Greece and Spain at astonishing rates.

A second type of capital flight is more akin to simple corruption than a socio-economic process brought about by lack of monetary autonomy and falling confidence. This second type is much more common in the developing world where international aid and the profits from the sale of valuable mineral resources are siphoned out of the economy by the establishment elite over the course of decades.


The Gold Standard: One of the most commonly cited examples of capital flight came during the British Gold Standard between 1926 and 1931. Under this economic system paper money was redeemable in the form of gold bullion. This convertibility allowed foreign speculators to redeem large amounts of gold, forcing the British government to borrow billions from French and American banks in order to restock their gold reserves. In 1931 the flow of gold across the Atlantic to America and the ever increasing cost of replenishing gold reserves forced the British to suspend the gold standard in order to allow the the Pound to devalue to a more sustainable level, which in turn allowed direct stimulation of the economy through the lowering of interest rates.

The Argentine Peso: In the 1990s the Argentine government pegged their currency directly to the US Dollar and began enacting neoliberal reforms at such a pace that they became the poster boys of the IMF. Unfortunately the attacks on financial sector regulations and capital controls, the reductions in tax rates and the fire sale of heaps of state infrastructure to foreign investors in combination with the easy convertibility with the US Dollar increased the flow of capital out of the country to an unsustainable level. The huge growth in foreign corporate ownership in Argentina meant that profits were siphoned out of the country for the benefit of foreign investors and declining tax returns meant that the Argentine government struggled to maintain the large foreign currency reserves necessary to maintain convertibility with the Dollar. As confidence diminished, even more people withdrew their wealth from Argentina in the expectation of a significant currency devaluation, eventually when the devaluation happened in 2002 it was accompanied by the biggest sovereign default in World history. Once the default happened, the Argentines rid themselves of the IMF's brand of neoliberal pseudo-economics and set themselves on the road to economic recovery by taxing capital flows out of the country and investing in fiscal multipliers such as infrastructure projects, house building, welfare provision and education.

UK tax dodging: In 2009 it was reported that hundreds of wealthy financiers had withdrawn their capital from the UK after tax rises for the super-rich. The destinations of choice for the uber-wealthy elite to stash their wealth were British dependency tax havens such as Jersey, Guernsey, the Isle of Man and the British Virgin Islands.

The Eurozone crisis has intensified the amount of capital
flowing out of Greece, Ireland, Spain, Portugal and Italy.
The Eurozone crisis: As confidence in the European Single Currency project has waned, several countries have experienced massive scales of capital flight. Following the undecided Greek election it was reported that as much as €4 billion a week was flowing out of Greek banks, meaning that their leverage ratios were becoming more and more unsustainable. In May 2012 the Spanish Central Bank released estimates that showed nearly €100 billion in capital flight (nearly 10% of Spanish annual GDP) for the first three months of the year. Despite these economic difficulties the European Central Bank flatly refused to devalue to Euro, meaning that struggling Eurozone economies were stuck with a massively over-valued currency which was easily siphoned out of the country into stronger Eurozone economies such as Germany, making the exit from the Eurozone and default on their debts seem ever more likely options for crippled European economies like Greece, Ireland and Spain.

Embezzlement flight: The second form of capital flight normally occurs in the developing world. It is less to do with lack of monetary autonomy and more to do with outright corruption. The International Monetary Fund estimated that wealthy citizens of developing countries amassed at least $250 billion worth of foreign assets between 1975 and 1985. As dictators in countries such as Argentina and their cabal of supporters were showered with money by the IMF and western economies in return for implementing fundamentalist neoliberal reforms, a large proportion of that wealth was simply siphoned straight back out of the economy and stashed in bank accounts in Switzerland, America and UK administered tax havens. One of the regions most badly effected by this kind of capital flight is sub-Saharan Africa where capital flight has been estimated at more than $700bn since 1970, which is more than triple the region's outstanding external debts of around $175bn. Common mechanisms in this "economic rape" form of capital flight include inflated procurement contracts for goods and services, kickbacks to government officials, and diversion of public funds to politically influential individuals. A smaller proportion of of Africa’s lost capital has come from other sources, such as earnings from oil and mineral exports, but foreign loans are much simpler to embezzle since there is no need to bother with the hard work and expense of extracting natural resources in order to convert them into cash.
Capital flight is an extremely destructive economic phenomenon, the long term damage of corruption funded capital flight has severely damaged many developing countries as their political leaders have pillaged their own economies in order to fill their personal bank accounts in Switzerland, The US or British administered tax havens. Even though the free flow of capital out of poor economies is severely damaging, the IMF have a history of actively lobbying against "third world" countries introducing capital controls to slow down the outward flow of capital from their own economies

When capital flight occurs in the West it is often a strong indicator that the effected economy is about to undergo a dramatic currency devaluation. This is what made the astonishing scale of capital flight out of Spain in the first quarter of 2012 such important news, with disastrous implications for the Eurozone project and holders of Spanish government bonds.


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