Print Reference This Reddit This

Relationship Between Capital Flight And Foreign Direct Investment

Since 1993 foreign direct investment acted as largest source of finance for the developing nations which reached up to 38% in 1995. While on the other hand in developing countries its contra account is also very much active that is the capital flight. According to Kuczynski (1992) around USD 300 billion of residents of Latin America alone are invested abroad. According to Classens and Naude (1993) six out of ten countries were experiencing the highest average annual rates of capital flight during the period of 1981 - 1991 and the eight out of ten countries also suffered from high ratio of capital flight to GRP or external debt.

A major cause of accumulation of foreign debt and capital flight is due to the guarantees that are provided by the governments when private investors borrow from abroad. From here few question arises:

Whether capital flight takes place in coincidence with the foreign direct investment inflows?

Does foreign direct investment facilitate capital flight because of rising foreign exchange availability or vice versa?

Dominant causes of capital flight and foreign direct investment can be revealed by answering to these questions.

Capital flight being a complex issue has been analyzed by most of the researchers from two perspectives, i.e.

Attractiveness of investment climate in the country.

Discrimination in treating residents and non-residents differently with respect to capital investment and actual or perceived risk.

Analysis of the above mentioned perspectives will always confront to the different definitions of capital flight being used by different authors. Such as Kindleberger (1937) in his study defines capital flight as “money that runs away” while on the other hand Tornell and Velasco (1992) defines it as a flow of productive resources from poor to rich countries. Exact measurement of capital flight also varies with the definition and methodology adopted by various writers. Hence three questions will be addressed here:

Whether foreign direct investment facilitates capital flight or vice versa?

Does their relation is dependent on the specific measure being used for capital flight?

Is the dominant cause of capital flight general economic mismanagement, or is it discriminatory treatment against residents’ capital? Similarly, is foreign direct investment explained by a generally attractive investment climate, or is it explained by preferential treatment given specifically to such investment?


Foreign Direct Investment:

According to IMF (1993) foreign direct investment is an “investment that reflects the objective of obtaining a lasting interest by a resident entity in one economy in an enterprise resident in another economy. . . . The lasting interest implies the existence of a long-term relationship between the direct investor and the [foreign] enterprise and a significant degree of influence by the investor on the management of the enterprise.” From it we can deduce that the elements of influence and control are the major factors that distinguish foreign direct investment from the foreign portfolio investment.

One statistical issue of interest is how to treat reinvested earnings from foreign direct investment. If capital flight is defined as all outflows from poor countries, irrespective of whether or not the outflow constitutes repatriated earnings of a nonresident, then reinvested earnings imply reduced capital flight. This is so because balance of payments accounting focuses on transactions involving an exchange of value between residents and nonresidents of a country, rather than an

exchange of payments. Reinvestment of earnings from foreign direct investment is therefore treated as a capital inflow in the balance of payments statistics.

According to World Bank (1993) across the developing nations foreign direct investment is rising rapidly, particularly in Asia. Some recent developments in foreign direct investment should be remarked:

Increase in the foreign direct investments in developing countries is a recent phenomenon. From 1970 to 1980, it rose only slightly, from $3.7 billion to $4.7 billion, although commercial loans to oil importers during the same period trebled, and from 1981 to 1985, it actually declined, at an average annual rate of 4 percent. In 1986, however, the rate of investment began to increase, and from 1986 to 1990, it grew at an average annual rate of 17 percent. The increase since 1990 has been more dramatic. Although foreign direct investment has decreased globally since 1990, flows to developing countries have increased each year—by 40, 33, 47, 17, and 13 percent, respectively, for 1991 through 1995. The result is that developing countries now receive an unprecedented 38 percent of the world’s total FDI.

The share of FDI in all external flows to developing countries is also high. Indeed, foreign direct investment is the main form of alternative financing found in the developing world—as opposed to traditional financing, which is guaranteed or intermediated by the public sector (Miller and Sumlinski, 1994; World Bank, 1995; UNCTAD, 1994).

Clavo et al (1993) in their research argued that whether the recent enormous capital inflow into Latin America will be accompanied by the similar and sudden capital outflow as was witnessed in the 1930s and mid 1980s which resulted in domestic financial crisis. In contrast to the inflows during the 1920s, however, and during the years from 1978 to 1981, the largest single source of capital inflows to developing countries is now foreign direct investment. In 1991 and 1992, direct inflows for Latin America and the Caribbean constituted 33 percent of overall inflows (including both guaranteed and nonguaranteed loans as well as grants and technical assistance); portfolio inflows during those years accounted for only 18 percent of the total. The corresponding percentages for East Asia and the Pacific are 35 percent (FDI) and 6 percent (portfolio).

According to Claessens et al (1995) the time it takes for an unexpected shock to a flow to subside is about the same for both short and long term flows (as so labeled in the balance-of-payments data). Still, a direct investor is likely to have a longer view than a portfolio investor. A multinational corporation, for example, will probably have sunk costs, committed technology, and strategic objectives (a commitment to defend its brand name, for example). A direct inflow is thus likely to reverse more sluggishly as capital flight than a portfolio inflow will.

Capital Flight:

As discussed earlier, one of the questions raised about foreign direct and portfolio inflows

into developing countries is whether they mark the return of flight capital held abroad by the residents of those countries. There are varying estimates of the magnitude of residents’ hoardings abroad. As mentioned above, Latin Americans are thought to have as much as $300 billion abroad (Kuczynski, 1992).

Claessens and Naude (1993) report, for example, that the ratio of flight-capital stock to GDP in 1991 was highest for North Africa and the Middle East (118 percent) and that the ratios for Sub-Saharan Africa (85 percent) and Europe and Central Asia (40 percent) were also higher than the ratios for Latin America and the Caribbean (35 percent). In East Asia and the Pacific, Korea and the Philippines have also experienced substantial capital flight. Capital flight is clearly important for virtually all regions of the developing world.

Any analysis of the relation of capital inflows to capital flight from developing countries must confront the differences in the definitions of capital flight. Kindleberger (1937) defines capital flight as “abnormal [flows] propelled from a country . . . by any one or more...fears and suspicions,” he emphasizes the volatile and abnormal nature of the outflows. Other economists include long-term capital flows in the definition of capital flight, on the grounds that many long-term flows are also quite liquid. The broadest definition for capital flight is that used by Tornell and Velasco (1992), who define it as all flows of productive resources from poor to rich countries.

Measurement of capital flight by virtue of different definitions varies markedly. Eggerstedt et al (1993) reported that using different definitions of capital flight changes the estimated amount of capital flight from Mexico for the 1970-85 period from a low of $26.5 billion to the high of $48.6 billion—that is, by a factor of almost two. In addition, no matter which method or source of data is used, there are usually large statistical errors involved in the calculations.

Most of the measures or definitions of capital flight are either direct or indirect. The direct method of measurement identifies specific variables that constitute capital flight and seeks data directly for these variables. The indirect method defines capital flight indirectly, as, for example, a residual of some other variables. It also generally uses a broader definition of capital flight. These two methods of measurement and the different measures they use for capital flight are described below.

Direct Measures:

The direct method seeks data from the balance-of-payments statistics. It identifies capital flight as one or more categories of short-term capital outflows and views it as a rapid response to investment risk. It thus involves “hot money,” money that responds quickly to political or financial crisis, to expectations of tighter capital controls or the devaluation of the domestic currency, or to changes in after-tax real returns. This is presumably also money that has the potential for returning quickly to the country when conditions change.

Cuddington (1986) in his study defines capital flight as a short-term speculative capital exports by the private nonbank sector, although in some cases banks and official entities may also be involved. He starts with the “errors and omissions” in the balance of payments statistics. This line accounts for the difference between credit and debit entries in the balance of payments and is taken as a proxy variable for concealed or unrecorded short-term capital outflows (net of any concealed or unrecorded capital inflows). To this line is added data from the “other short-term capital, other sectors” (that is, data that exclude the official sector and money-center banks). Let the total of these be called “Hot Money II” and it has two variants:

“Hot Money I,” adds only the “other assets” subcategory of the line item “other short-term capital, other sectors” to the “errors and omissions” line. This “other assets” subcategory means short-term capital flows that cannot fit into any other clearly defined category in the balance of payments. Hot Money I thus identifies capital flight with somewhat inexplicable flows across countries.

“Hot Money III,” adds to Hot Money II the portfolio investments in bonds and corporate equity. Thus, to somewhat unknown flows, these volatile short-term capital movements are added. Note that in all three measures, numbers from the balance of payments data are multiplied by −1 so as to get positive numbers for capital flight.

Direct measurement method is also followed by criticism from other researchers, such as,

An investor, reacting to unfavorable conditions at home, is free to acquire different types of assets abroad: short-term, long-term, real (including real assets), and financial. The motivations for all such acquisitions, as well as their effects on the investor’s home country, will generally be identical (although some assets, such as real estate, are considerably less liquid than others).

Even if one wishes to restrict oneself to components of those assets that can flow and reflow quickly, it seems best to look beyond short term capital flows. Long-term foreign financial assets, for example, are close substitutes to short-term assets, because active and deep secondary markets in long-term assets exist.

The errors and omissions line includes not only unrecorded capital flows but also true measurement and rounding errors, unreported imports, and registration delays. In response to these criticisms, some authors have chosen to follow the indirect method of measuring capital flight.

Indirect Measures:

In one version of the indirect method, capital flight is taken as a residual of four balance-of-payments components: the increase in debt owed to foreign residents, the net inflow of foreign direct investment, the increase in foreign-exchange reserves, and the amount of the current account deficit. The premise is that the two inflows finance the two outflows, so that any inability of the two “sources of funds” to finance the two “uses of funds” is indicative of capital flight. Note that this view does not identify capital flight with a sudden response to policy changes. It attempts, instead, to measure the buildup of net foreign claims by the private sector without trying to distinguish between speculative or non-speculative flows or between “normal” and “abnormal” flows.

One of the first such measures of capital flight was proposed in the World Bank’s World Development Report 1985 (WDR85). This measure differs from the Hot Money measures, not only in the method of measurement used, but also in the source of the data on foreign debt. Instead of using figures from the balance-of-payments statistics for the flow of foreign debt, the World Bank used its World Debt Tables to measure the year-to-year changes in the stock of foreign debt. There has been some criticism of this measure, because the stock of foreign debt may be affected by exchange-rate revaluations, debt reclassification and relief, and discoveries of existing debt. Claessens and Naude (1993) in their study have corrected the WDR85 estimates by reducing the change in debt stock due to cross-country exchange-rate fluctuations, while adding back to the annual change the forgiven or reduced debt and debt service.

Two variations of the WDR85 measure are put forward by the Morgan Guaranty Trust (1986) and by Cline (1987). The Morgan Guaranty measure excludes from WDR85 the acquisition of short-term foreign assets by the country’s banking system and monetary authorities. Thus, the accumulation of private foreign assets by the nonbanking sector only is identified as capital flight. Morgan Guaranty Trust (1986) offers no justification for treating the foreign acquisitions by firms and individuals differently from those by the banking system. One possible explanation is that the foreign-exchange transaction motive for holding these assets is likely to be far stronger for the banking than for the nonbanking sector.

The Cline method modifies the Morgan Guaranty measure by suggesting that reinvested investment income on bank deposits (and other assets) already held abroad should not be considered capital flight. That is, if residents do not repatriate income from assets held abroad, this should not be considered as additional capital flight. Similarly, income from tourism and border transactions should be excluded from the current-account component of the residual measure, because these earnings are traded in the free rather than the official market.

The rationale for these adjustments is as follows.

Potential foreign creditors can only insist on reduction in the measure of capital flight as modified by Cline, because that amount is directly under the control of the debtor-country government.

It is the extent to which any inflow of funds is potentially available for additional capital flight that is significant. The presence of a surplus from tourism that is not garnered by the government or of private interest earnings abroad that are not repatriated has little to do with whether any freshly obtained capital is used as capital flight or otherwise.

The Dooley Measure:

Dooley (1987) in his study suggested a hybrid measure of both direct and indirect methods for the measurement of capital flight. He defines capital flight as the stock of claims on nonresidents that do not generate investment income receipts in the creditor country’s balance-of-payments statistics. Although capital flight is defined directly by this method, there is no category or line in the balance-of-payments statistics that directly meets this definition. It is therefore necessary to compute indirectly the data for outflows motivated by a desire to place assets beyond the control of domestic authorities (to avoid the domestic risks associated with holding foreign earnings as domestic financial assets).

Relationship between Foreign Direct Investment and Capital Flight:

During the 1980s debt crisis, many lending countries feared that providing external funds to cash starved developing countries would be futile if a large part of the increased lending were to flow right back out as capital flight. Cuddington (1987) and Pastor (1990) also confirmed this erosion of debt inflows by capital flight during this period. During the period of 1990s, the main sources of external finance to developing countries are nonguaranteed private inflows and the most important among these was foreign direct investment. Whether FDI inflows also facilitate capital flight or whether they inhibit it is a question generally examined from one of the two perspectives. These are discussed below.

The Investment Climate Perspective:

From the investment climate perspective, capital flight depends on the rate of return appeal of foreign as compared to domestic assets when adjusted for the exchange rate. The comparison is between the returns attainable in the foreign country as opposed to those attainable at home; it is based on the location of the assets.

Cuddington (1987) also emphasizes this approach. He employs a standard three asset portfolio adjustment model using domestic financial assets, domestic inflation hedges (such as land and buildings) and foreign financial assets. He defines capital flight as the year to year increase in domestic holdings of foreign financial assets. Amounts allocated to the different assets depend on the domestic interest rate, the foreign interest rate augmented by the rate of expected depreciation of the domestic currency and the domestic inflation rate. In addition, he includes foreign lending to the country as a factor explaining capital flight.

The Discriminatory Treatment Perspective:

The discriminatory treatment perspective does not relate capital flight to the usual determinants of net international capital movements, such as international yield differentials. It highlights, instead, the fact that host countries often favor nonresident investment (and, by implication, discriminate against resident investment) in the form of differential taxation, investment or exchange rate guarantees, and priority over resident claims in the event of a financial crisis. It is this discriminatory treatment, and the resulting differences in the actual or perceived risk by residents and nonresidents in holding claims on residents, that explains capital flight. This approach has been used by Khan and Ul Haque (1985), Eaton (1987), Dooley (1987) and Rojas-Suarez (1990),

among others. Their models and analyses are briefly described below.

Khan and Ul Haque (1985) start with the standard intertemporal optimizing model of external borrowing and investment. At the beginning of the first period, households are endowed with a stock of domestic capital; this is used up during the first period and is transformed into output. The household may consume the first period’s output; it may also invest that output, either at home or abroad. Investment abroad is risk free. Foreign borrowing is allowed, but it may be used only for domestic investment and may not be repudiated.

Domestic uncertainty is also permitted in the form of the possible expropriation of the domestic firm and its debt obligations with no compensation offered to the domestic owners of the expropriated assets, or, equivalently, domestic instability that reduces the firm to bankruptcy. Khan and Ul Haque (1985) show that positive values for both domestic and foreign investment are possible because of this uncertainty, even with positive levels of debt accumulation. Foreign lenders lend to the country because foreign debt may not be repudiated. At the same time, the risk of expropriation or of bankruptcy in the home country encourages capital flight.

Eaton (1987) builds his study on the above mentioned facts emphasizes that the risk of expropriation may also mean the threat of high levels of domestic taxation in the future. In addition, because foreign lenders generally have little ability to assess the solvency of a particular private borrower in a developing country, at least relative to the ability of the government of that country, loans for private borrowers may be channeled through the government, or lenders may require that such loans be guaranteed by the government of the borrower.

In contrast to Khan and Ul Haque, Eaton allows for the possibility that borrowers may invest borrowed funds abroad (foreign lenders may not, however, use these deposits as collateral against outstanding loans). The potential national takeover of private debt encourages a low level of effort by borrowers to service their debt and may even induce outright fraud. Because one borrower’s default increases the expected value of the future tax obligations of other borrowers, the other borrowers’ incentive to repay their debt diminishes and their incentive to place their funds abroad increases. Capital flight thus becomes contagious.

Dooley (1987) in his study has also utilized the differences in the guarantees given by governments to foreign and domestic investment to explain the differences in the perceptions residents and nonresidents have regarding the risk adjusted returns for claims held on residents. For non-residents, the risk of default is the main concern. For residents, default is of less concern, because contracts between residents are better protected by the country’s legal system than are contracts between residents and nonresidents. Fears of domestic inflation and exchange rate depreciation, however, are of greater importance to residents than to nonresidents. Non-resident claims on debtor countries are typically denominated in foreign currencies, and although this fact alone does not make them immune to inflation and exchange rate risk, they are less affected by these factors than are claims by residents.

Rojas-Suarez (1990) also refers to government guarantees to explain the simultaneous flight of capital from and large foreign loans to developing countries during the 1970s and early 1980s. She explains, in addition, that the debt crisis of the mid-1980s reduced, and perhaps eliminated, differences in risks faced by residents and nonresidents, so that domestic debt was no longer considered “junior.”

As Lessard and Williamson (1987) in their study pointed out that the investment climate perspective cannot explain the simultaneous movement of capital into and out of the country. By this explanation, capital flight depends on the attractiveness of foreign as compared to domestic assets once the rate of return is adjusted for the exchange rate. Assets in the host country are either more or less attractive than assets in the foreign country, so that flows in both directions do not occur. The discriminatory treatment perspective, however, can explain simultaneous flows. In fact, this explanation was specifically put forward to explain the coexistence of private foreign lending (implicitly or explicitly guaranteed by governments) and capital flight.

As remarked above, the major capital inflow to developing countries in recent years has not been international lending but private foreign investment, in which the foreign investor faces the additional risk of variability in the nominal value of his return. The factors affecting international lending, however, are also applicable to private foreign investment. Both foreign lenders and investors find it difficult to assess the solvency (or profitability) of a particular private borrower (or project) in a developing country, and both are subject to a far greater risk of market failure resulting from the relative non-enforceability of contracts for foreign as compared with domestic lending or investment. Private foreign investors (as well as foreign lenders) may therefore require that their investments be guaranteed or at least be favorably treated by the recipient’s government. Many developing-country governments do, as mentioned, offer private investors favorable treatment in the form of differential taxation, investment or exchange-rate guarantees, or priority over resident claims in the event of financial crisis.

The investment climate perspective suggests that capital flight ought to decrease if the investment climate improves and foreign direct investment increases; the relation between FDI inflows and capital flight will therefore be negative. If, however, foreign direct investment is the result of preferential treatment given to foreign as compared with domestic investment, FDI inflows will likely be accompanied by continued and accelerated capital flight; the relation between the two will therefore be positive.

If the discriminatory treatment view overrides the investment climate perspective and FDI inflows occur, a capital inflow of one kind will be accompanied by an outflow of another kind, so that the net effect of the inflow will be minimal. In this event, specific policies such as tax amnesties or treaties, the offering of domestic instruments denominated in foreign currencies and capital control programs may be needed to restrain outflows of capital and to induce repatriation of flight capital. If the investment climate explanation is dominant, however, and the relation between capital flight and FDI inflows is negative, the policies that stimulate investment in general will also entice flight capital to return and capital flight to decrease, so that the effect of FDI inflows on the economy will be magnified.

Because many developing countries are only now emerging from the debt crisis (partly caused by capital flight) following the 1978-81 boom in commercial bank loans, their wariness regarding the short and long term financial implications of the current spurt in private foreign direct investment (as well as portfolio) investment is not surprising.


Three sets of conclusions can be drawn from the above mentioned literature:

Foreign direct investment is invariably negatively related to capital flight. In contrast to external borrowings guaranteed by governments, FDI inflows may therefore be expected to reduce capital flight and to have magnified effects on the economy.

A similar relationship holds for portfolio inflows and capital flight.

The dominant reason for FDI inflows (and reduced capital flight) is not specific policies favoring foreign (and discriminating against domestic) investment; it is, instead, an improvement in the general investment climate.

Need help with your literature review?

Our qualified researchers are here to help. Click on the button below to find out more:

Literature Review Service

Related Content

In addition to the example literature review above we also have a range of free study materials to help you with your own dissertation: