Interview with Gerald Epstein

Gerald Epstein, PERI’s co-director, is the editor of a new volume, Capital Flight and Capital Controls in Developing Countries, available from Edward Elgar Publishing.

What is capital flight?

Gerald Epstein: There are many different definitions, but they all point to one idea: capital flight occurs when rich people and government officials move financial assets out of a country in order to avoid actual or expected government interventions that could substantially reduce the value of their assets. It includes everything from carrying cash across the border in suitcases in order to avoid an expected increase in taxes, to lying about the amount of receipts gained from exporting products, and using the excess export earnings to buy a condo in Florida.

In practice, it is difficult to measure because we’re often talking about illegal or underground money and asset flows. So we have to use an indirect measure to estimate capital flight. We use standard data to measure all the inflows of capital, and then use basic data to estimate all the legitimate recorded outflows. If there is a discrepancy – a residual – between these two measures – what goes out minus what comes in – we call that our estimate of “capital flight.” For this reason, our measure is called the “residual” measure. There are many other possible ways to measure it and these are described– possibly in excruciating detail – in our book.

Some think of capital flight as any “undesirable” movement of financial assets out of the country. So, for example, US workers who lose jobs when a company closes its US plant and re-opens another one in China because costs are cheaper there might call this plant moving a form of “capital flight." We have not termed this capital flight because it is not a response to government attempts to control or reduce the profitability of capital. But some might want to broaden the definition to include this behavior – it's an example showing that capital flight is not the only type of capital flow that might be bad for workers.

Is capital flight related to currency speculation?

GE: It could be. For example, if a country has capital controls which limit the amount of foreign exchange that can be bought by domestic citizens, and those citizens are worried that there might be a devaluation of the domestic currency, then they might try to send money outside the country to buy foreign assets, and then, if and when the domestic currency does go down in value, they can bring the foreign exchange back in, buy domestic assets on the cheap, and make a killing. In fact, this has happened in a number of recent financial crises in developing countries, and has greatly enriched financial elites who have done this type of maneuver involving capital flight.

How does the issue of capital flight differ in the developing versus the developed world?

GE: In most developed countries, these days, at least, there are very few if any controls over inflows and outflows of capital. So wealthy people can take money in and out of the country any time they like – as long as they are not breaking the law. So, in that case, capital flight is mostly related to money laundering from illegal activities such as drug running, weapons sales, tax evasion and theft by CEOs and CFOs from their corporations, accounting scandals and the like.

In developing countries you have all of these forms, but you also have capital flight to avoid capital controls in order to enable wealth holders to speculate on currencies, accumulate wealth abroad in case there is political instability or an unfavorable government comes to power that would confiscate wealth or tax it, or regulate it heavily.

What causes capital flight from developing countries? Corruption? High foreign debt? High military expenditure? Conflict?

GE: All of the above. Capital flight connected to foreign borrowing is one of the more pernicious forms. Typically, the government borrows money, say, from a multinational bank. The government – and therefore the country’s taxpayers now are responsible for paying interest on and eventually repaying that debt. BUT, instead of the borrowed money being used for productive purposes at home – like to build irrigation ditches or roads, buy technology, etc., much of the money is taken by government officials out of the country and deposited in banks abroad – sometimes this is even facilitated by the SAME bank that lent the money in the first place. Of course, that bank gets hefty fees for arranging all this. So the country’s citizens are left holding the bag, the corrupt official has a nice nest egg abroad, and the bank gets its fees and the interest and repayment of the debt from the country's taxpayers.

Another pernicious form is capital flight from foreign aid flows. Again, corrupt government officials, non-governmental organizations, and companies manage to ferry money out of the country that was intended to help poverty stricken people or to build the country’s infrastructure.

But capital flight can also be caused by private businesses and rich individuals who don’t like government policies, think they should have more freedom to invest their money abroad and, for some reason – either because it is illegal or simply because they don't want the publicity – take their money out of the country surreptitiously. Then the flows are unrecorded and we would pick it up as capital flight.

What are the effects of capital flight?

GE: Capital flight can have serious negative effects on economic stability, growth, and inequality. It is also a matter of economic justice.

Capital flight can cause a financial panic – when money leaves the country it can cause the domestic currency to fall in value and that can even lead to a stampede out of the currency. This can lead to tremendous instability that can harm the entire economy.

Capital flight can also lead to lower economic growth, especially in very poor – or “capital scarce” countries. Rather than being invested in education, roads, technology, clean water, the money sits in a bank account of a fat cat abroad. To make matters worse, then the citizens must pay back the money with interest anyway!

Finally, it is a matter of economic justice. The wealthy people who have control over the resources send them abroad, while those without resources are subject to the consequences at home. Some of the most glaring examples have occurred in countries like the former Zaire, where loans and foreign aid were given to Mobutu – the corrupt leader – even though it was well known that he would steal much of the money.

Who are the authors included in the volume?  How did they come together?

GE: The authors are PhD graduate students from the economics department at the University of Massachusetts, Amherst as well as professors from U Mass and elsewhere. The book grew out of a class project in my PhD level class in International Finance – and then just took on a life of its own. I initially got the idea for the project from my friend and colleague at PERI, Jim Boyce, who, along with our colleague, Leonce Ndikumana, has done path-breaking work on the conceptualization and measurement of capital flight.

Can you describe the common methodology employed in the book’s chapters?

GE: We call this the Boyce-Ndikumana method. More technically, it is the “residual method” and is simply as described above. We add up all the money coming into the country – including, for example, loan receipts, foreign aid, export revenues and the like – as tracked by standard data, and added up all the money leaving the country plus what is recorded as having been added to the country’s reserves. The difference is “unrecorded outflows” or the “residual." We call this "capital flight."

What country studies are included?

GE: South Africa, Turkey, Thailand, Chile, Brazil, countries from the Middle East and North Africa, and China.

What are capital controls? What policies are available to governments to control capital?

GE: These are good questions. I would have to write a whole other book to answer them fully, but I will give a brief response here.

Capital controls, or more broadly, “capital management techniques” are designed to limit and/or channel the inflows and/or outflows of financial assets, usually in order to serve governmental or social purposes. They include limitations on how much foreign currency domestic residents can take out of the country when they go on vacation, what domestic assets foreigners can buy – for example, can they open bank accounts, can they buy shares in the domestic oil company, etc. – how much foreign debt can a domestic company borrow, how much tax does a foreign investor have to pay to put money in a bank account in a foreign country. These are all examples of types of capital management techniques or capital controls. More technically, capital controls place limitations or taxes on the buying or selling of foreign assets; exchange controls place limitations or taxes on the buying or selling of foreign exchange. Some domestic financial regulations (or so called “prudential controls”) also limit or raise the cost of trading in foreign assets or exchange. These are also types of capital management techniques.

Capital management techniques, then, include capital controls, exchange controls and financial regulations that affect the buying and selling of foreign assets.

How effective are capital management techniques?

GE: Studies show that these controls can be effective in the short to medium term if they are strongly enforced and if other policies in the country are effective. They are less effective the longer they stay on and the less consistent and effective are the other domestic policies.

Would capital controls be more effective if administered by an international body?

GE: International enforcement of controls will often work better than domestic ones alone, but domestic controls can also work well, as indicated by the large number of developing countries that use them.

Can capital management techniques have negative consequences?

GE: All policies, indeed almost all actions taken by individuals lead to complex outcomes, some of them unintended – some good, some bad. In the case of capital controls, there is plenty of evidence that they can be effective with minimal unintended consequences, but only if they are part of a whole package of pro-developmental policies. Like any single tool, they are no panacea.

Who do you think should read this book?

GE: Students of economics – be they formal students or people who are just interested in economics – especially those who are curious about the negative impacts of current international financial arrangements on the prospects for widespread prosperity in the developing world.

Policy makers who deal with financial regulation, foreign aid and economic development should also read the book. It will help them see the underside of financial liberalization and capital mobility.

Why should ordinary people care about capital flight?

GE: People on both sides of the equation – in the aid giving and lending countries – and in the capital flight countries – should care a lot about it. Recently there has been a push to increase foreign aid and write-off debt, especially for Africa. The capital flight issue is extremely relevant in two ways.

First, with respect to the debt write-off. Much of the debt that is weighing down desperately poor countries in Africa is really “odious debt” – debt that was taken on by corrupt regimes or dictators, often where, as described above, the people of the country never saw a dime of the aid – it was just sent out of the country as capital flight – and now the citizens of the country are saddled with re-paying the debt. So capital flight is one compelling reason why this debt should be written off.

But second, it also means that people should insist that protections against capital flight be implemented when sending new aid. Otherwise, we might simply see a repeat of the aid/debt – capital flight – inequality/poverty cycle that we have seen much too often in the past.