How do Governments Deal With Capital Flight?

The effects of capital flight can vary based on the level and type of dependency that governments have on foreign capital.....

 

The Asian crisis of 1997 is an example of a more severe effect due to capital flight. During the crisis, rapid currency devaluations by the Asian tigers triggered a capital flight which, in turn, resulted in a domino effect of collapsing stock prices across the world.

According to some accounts, international stocks fell by as much as 60 percent due to the crisis. The IMF intervened and provided bridge loans to the affected economies. To shore up their economies, the countries also purchased US treasuries. In contrast to the Asian financial crisis, the purported effect of a 2015 devaluation in the Chinese yuan that resulted in capital outflows was relatively milder, with a reported decline of only 8 percent at the Shanghai stock market.

Governments employ multiple strategies to deal with the aftermath of capital flight. For example, they institute capital controls restricting the flow of their currency outside the country. But this may not always be an optimal solution as it could further depress the economy and result in greater panic about the state of affairs. Besides this, the development of supranational technological innovations, such as bitcoin, may help circumvent such controls.

The other commonly-used tactic by governments is signing of tax treaties with other jurisdictions. One of the main reasons why capital flight is an attractive option is because transferring funds does not result in tax penalties. By making it expensive to transfer large sums of cash across borders, countries can take away some of the benefits gained from such transactions.

Governments also raise interest rates to make local currency attractive for investors. The overall effect is an increase in the currency's valuation. But a rise in interest rates also makes imports expensive and pumps up the overall cost of doing business. Another knock-on effect of higher interest rates is more inflation.
 

 

Example of Illegal Capital Flight

Illegal capital flight generally takes place in nations that have strict capital and currency controls. For example, India’s capital flight amounted to billions of dollars in the 1970s and 1980s due to stringent currency controls. The country liberalized its economy in the 1990s, reversing this capital flight as foreign capital flooded into the resurgent economy.

Capital flight can also occur in smaller nations beset by political turmoil or economic problems. Argentina, for instance, has endured capital flight for years due to a high inflation rate and a sliding domestic currency.