Capital movements ; Developing countries ; Debts, External

Steven Plaut

English

Research Papers in Economics

FABSF WEEKLY LETTER
January 8, 1988
Capital Flight and LDC Debt
The very high level of the foreign debts of many
developing countries, currently around $300 bil-
lion in aggregate, are a source of great concern
for bankers, investors, governments, and the
general public. A phenomenon that has attracted
much less attention is the exact opposite of the
LDC debt problem, namely the "flight of capi-
tal" from debtor developing countries. Capital
flight is problematic because it represents a
drain of a resource that could have had produc-
tive domestic uses, and it offsets imported capi-
tal. Reversing capital flight could restore a major
source of development funding for the countries
involved.
Plight of the boat dollars
"Capital flight" used here refers to the export
of savings by citizens of the same developing
countries that owe such large amounts to west-
ern lenders. It takes various forms, including the
investment of funds by these citizens in banks
outside their home countries, the holding of
other foreign financial assets, and even the hold-
ing of foreign currency as cash. In some cases,
capital takes flight because businesses in a coun-
try require foreign currency reserves in their
operations. In many cases, capital flight is ille-
gal, but occurs nevertheless.
By its nature, capital flight is difficult to measure
accurately because it is not directly observed in
most cases. Nevertheless, a number of studies
have been made to estimate its magnitude.
These studies generally attempt to infer the capi-
tal outflows using balance of payments data
from the countries concerned. The estimates
vary from study to study, largely due to different
definitions and methodologies. Nevertheless,
they indicate that capital flight could represent
an enormous flow of international lending and
investing away from developing countries.
Capital flight, its causes and implications, has
become the focus of a growing body of research.
For example, between 1974 and 1982, Argen-
tina borrowed $32.6 billion. Estimates of the
level of capital flight from Argentina over the
same period range from $15 billion to over $27
billion. This would mean that capital flight
amounted to between half and four-fifths ofthe
entire inflow of foreign capital to Argentina.
Argentinian residents "exported" this sum to
their own foreign bank accounts, overseas hold-
ings, or foreign currency cash holdings.
For Venezuela, the inflow was $27.0 billion
over the same period, with capitalflight esti-
mated at between $12 billion and $22 billion.
The inflow for Mexico was $79 billion between
1976 and 1984; the outflow has been estimated
at between $26 billion and $54 billion for the
same period. Other debtor countries have also
had large capital outflows. And some analysts
believe even these figures are too conservative.
"Country l'isk" starts at home
Observers have often overlooked a basic fact of
life regarding "country risk". Country risk is the
set of risks to investment peculiar to a country,
and is often discussed in the context of invest-
ments abroad. For most people in the world and
in most countries of.the world, country risk starts
at home. The country risk that most concerns
these people is the loss of their capital and sav-
ings to expropriation, taxation, and inflation,
some or all of which they perceive as possible in
their own countries.
In unstable political regimes and in some stable
ones, wealth is not secure from government sei-
zure, especially when changes in regime occur.
Savings maybe shifted to overseas institutions to
protectthem. Hong Kong is a good recent
illustration of a country responding toantici-
pated future changes in regime; Many of its
citizens seem to be hedging much of their sav-
ings by exporting them. In countries where infla-
tion is high and domestic inflation hedging is
difficult or impossible, investors may hedge by
shifting their savings to foreigncurrencies
deemed less likely to depreciate. They also may
make the shift whendomestic interest rates are
artificially held down by their governments, or
when they expect a devaluation of overvalued
currency.
Taxation also may be a major factor inducing
capital flight. Savings and wealth may be hidden
overseas to avoid taxes on interest and capital
gains. A more important motivation might betheFRBSF
hiding of income from investments and opera-
tions associated with the activities of the "under-
ground economy" in developing countries.
Underground sectors actually consist of produc-
tive economic activities (but also some criminal·
activities) where earnings and profits are not
reported to local tax authorities.To preventtheir
detection,funds may be transferred to overseas
bankswhere localtax inspectors presumably are
incapable of finding them or of tracing them to
their points of origin, In Somecases the transfer
is performedby couriers carrying outphysical
cash notes. Banks in countries where disClosure
ofdepositor identification is protected would be
the safest havens. Fllndsheld outsidethe coun-
try, withoutthe use of the tax identification
numbers used domestically,would be difficult to
trace eveHwhen overseas banks cooperate fulIy.
The size ofthe undergrollnd economy in various
countries cannot, of course, be directly
observed. (If it could be observed, tax collectors
would be the first to do so.) It can only be
guessed at. "Gllesstimates" often putthesize of
the underground economy irl the United States
at around 15 percentof recorded GNP, although
one study atthe Board of Governors ofthe
Federal Reserve System estimated the size at
two~thirds ofrecorded GNP. Ifthis were correct,
the underground economy would probably be
even bigger in many developing countries.
The case of the missing cash
Capital flight canexplain a seemingly unrelated
mystery thathas puzzled many economists and
reglliatorsforyears. We knowthe total stock of
u.s. dollars outstandingbased on Federal
Reserve bookkeeping (currently about$100bil-
lion). But accordingtohousehold surveys,
Americans report holding onlyabollt one·sixth
of the currency notes thattheyshould be hold-
inghasedon the Clllantitiesof minted notes out-
standing. So where's all the cash?
A likelyansweristhat much of it is being held
overseas. As such,itwould represent a form of
capital ftight by foreigners from their owncur-
renciesand from·the financial institutions in
their owncountries. In effect capital·flight has
taken place without the literal fleeing of capital
to geographic areas ou.tside the foreigners' home
borders.
Capitalflightto U.S. dollar bills/likeothercapi-
tal flight,mightbe motivated by fears of expro-
1
priation, taxation and inflation. But it has the
advantage over distant overseas bank accounts
in providing the investor/saver with ready
liquidity that can be used to make payments
with no advance planning, no paper trail, and
no complex financial manipulations.
U.s. dollar bills are used for domestic transac-
tions in many foreign countries, inCluding, iron-
ically, many communist countries. Not only are
black market transactions in these countries
often conducted in dollars, but in some cases,
official foreign currency stores sell hard-to-find
commodities to local residents only when they
pay in foreign currency.
For the United States, foreign holdings of cash
dollars represent a zero-interest loan to the
federal government. We benefit from the loan as
long as the cash is held. In effect, the U.S.
obtains real goods and services while giving up
only "pieces of paper," at least for as long as
that paper is not exchanged for American goods
or assets. Even sharp fluctuations in foreign
willingness to hold dollars would probably have
little impact on U.s. economic stability. More-
over, fluctuations in overseas holdings could be
neutralized by u.s. monetary policy.
Policy issues
Capital flight from developing countries raises a
number of concerns and questions. For investors
an unavoidable question must be, "Do those
people know something I don't?" After all, resi-
dents of debtor countries presumably have a
better feel for conditions and governmental
intentions there than do outsiders. Sometimes
they are concerned aboutpolicies that hurtthem
alone, and not foreign investors. When thinking
aboutthese countries' risks, one factor U.S.
lenders should bearin mind is the apparent
unwillingness of the countries' citizens to invest
and lend their savings to theirown countries.
Another concern is thatitis often foreign invest-
ment and aid to developing countriesthat makes
capital flight from those countries possible. Most
of the countries involved have controls on pur-
chases offoreign currency and restrictions on
the foreign exchange markets. Butthe foreign
exchange used in fleeing capital must come
from somewhere. In the absence of capital
inflows that evade those controls, virtually no
capital outflows couldoccur. Withoutcapital
inflows, LOt savers would find itdifficult toobtain dollars or other western currencies to
stash away. That is, real goods or assets would
have to be exported by LDC citizens seeking to
"export" their savings. This would necessarily
mean an improvement in their own country's
balance of payments and debt position, as
export earnings would rise.
The inflow ofwestern capital may eliminate
such a requirement. As we have seen, a signifi-
cant share ofthe capital lent to or invested in
many LDC nations never produces any expan-
sion in production in those countries. Itmerely
provides a source of hard western currency that
finds its way to savers in those countries, who
then hoard the cash or hide the same funds in
overseas investments. The LDC then faces the
worst of all possible worlds: a skyrocketing level
of debt andlittle real productive economic
expansion that could service that debt.
Moreover, by holding overseas financial assets,
LDC owners of fleeing capital in a sense magnify
the debt exposure of their own governments.
Foreign assets held by private citizens would not
ameliorate the government's burden of servicing
its debt. The fact that domestic citizens maintain
foreign bank accounts or hold other assets
denominated in foreign exchange does nothing
to alter the magnitude of the government's own
debts. The government cannot "net out" these
assets from its own liabilities.
Gross vs. net debt levels of LDes
A developing country's government must bear
and service a debt burden based on its "gross"
liabilities. Its credit rating and the interest rate
that it wiII be charged by foreign lenders are
functions ofthis gross number. Thus, if capital
that has fled were to be repatriated, the debt
burdens of LDC debtors could be reduced sub-
stantially. Moreover, credit ratings would
improve along with loan terms.
In accounting terms, the total "national debt" of
a country is the net outstanding level of its debts,
that is, its gross debts minus gross holdings of
foreign assets by all domestic citizens. However,
this measure of debt is irrelevant for most pur-
poses. If capital that had flown were to return
home, and government debt were to be reduced
in tandem, the accounting measure of net
national debt would show no change. But the
burden of servicing that debt and the ability to
raise new funds abroad would doubtless
improve.
Another way of saying this is to note that the
same financial institutions from developed coun-
tries that lend to LDC debtor nations are not
necessarily the same institutions where residents
of those LDCs hide their funds. And even if they
were, the banks' exposure would not generally
improve. The exposure ofthe banks is based on
their gross holdings of LDC debt because the
banks cannot "net out" or seize the deposits of
those savers in the event of default by the gov-
ernment (or other borrowers) of the LDC. The
depositors are different parties.
In sum, a useful source of hard currency funds to
finance future debt service and real industrial
investments in LDCs may be the foreign
exchange savings of their own citizens. There
have been some cases where changes in eco-
nomic policy did induce some reversal of capital
flight. COnvincing their citizens to make these
funds available at home is a major economic
challenge facing the governments of developing
nations.
Steven Plaut
Opinionsexpressed in this newsletterdo not necessarily reflect theviews ofthemanagementofthe Federal Reserve BankofSan
Francisco,orofthe Board ofGpvernorsofthe Federal Reserve System.
Editorialcommentsmaybeaddressedtotheeditor(GregoryTong) ortotheauthor..•.FreecopiesofFederal Reserve publications
can beobtainedfrom the Public Information Department, Federal Reserve BankofSan Francisco, P.0. Box 7702, San Francisco
94120. Phone(415) 974-2246. .uo~6U!4S0m 4o~n U060JO OpOA0U
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and liabilities
Large COl11mercialBanks
Amount
Outstanding
12/9/87
Change
from
12/2/87
Change frorT~ 12/10/86
Dollar Percent?
215 1,079 3.3
3,993 5,953 22.4
1,178 0.5
2,199 1.1
694 1.3
5,469 8.1
4,443 10.7
180 3.2
3,523 27.0
147 1.9
3,518 1.6
4,827 8.5
2,578 6.5
1,561 8.2
252 0.1
Loans, Leases and Investments1 2
Loans and Leases1.. 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U. S. Treasury and Agency Securities2
OtherSecurities2
Total Deposits
Demand Deposits
Demand Deposits Adjusted3
OtherTransaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000or more
Other Liabilities for Borrowed MoneyS
207,122
183,229
51,526
72,445
36,958
5,421
16,548
7,345
207,114
51,866
36,832
20,467
134,782
44,145
31,614
20,612
510
499
318
159
172
2
26
14
2,228
2,033
188
45
149
227 2,701 5.7
Two WeekAverages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+l/Deficiency(-)
Borrowings
Net·free reserves.(+l/Netborrowed(__l
Period ended
11/30/87
105
9
. 96
Period ended
11/16/87
18
6
12
1 Includes loss reserves, unearned income, excludes interbank loans
2 Excludes trading accountsecurities
3 Excludes U.S. governmentanddepository institution deposits and cash items
4 ATS, NOW, Super NOWand savings accounts with telephone transfers
S Includes borrowingvia FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items notshown separately
7 Annualized percentchange

Capital flight and LDC debt

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Capital flight and LDC debt

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