Capital flight refers to the major scale departure of money and financial assets out of a country. This usually occurs because of geopolitical events including economic volatility or political instability, capital controls, or deliberate currency devaluation. There are times when such a flight of capital is legal. An example of this is when investors choose to repatriate their foreign-based capital home to their own nation. It is often illegal, as when individuals in countries which have capital controls choose to move their money away from their home economy anyway.
Such capital controls attempt to limit the ability of citizens and foreigners in their nation to transfer their personal or business assets away to another country. This is a major reason why governments impose capital controls in the first place. They feel like they must stop capital flight from their own nation and economy, particularly if they are a poor state. Poor countries simply can not afford to have their little bit of national capital stock withdrawn without this causing significant financial and economic harm. Fleeing capital slows down economic growth and also causes living standards to decline.
Ironically, those economies which are most open and transparent turn out to be the least likely to suffer from capital flight. The reason for this is that openness and transparency give investors greater confidence in the longer-term outlook for these economies and nations and their future.
Capital flight as a phrase can actually relate to a variety of scenarios. It might describe the literal departure of money and investments from only a single country, from a whole region of the globe, or from a grouping of nations that possess similar characteristics and economic fundamentals. It is possible that a single national event might cause such flight. Alternatively it could be a macroeconomic situation which leads to a major shift in the confidence and intentions of investors. This flight of capital from a nation could be a multi-decade event or a short term and temporary development.
Where illegal capital flight occurs, this typically happens in those nations which enforce tough currency and capital controls in the first place. A classic example of such a regime is India. Their flight of capital during the 1970s and 1980s equaled billions because of their strict currency controls. The Indians were able to reverse this dilemma through liberalizing their economy starting in the 1990s. Foreign capital actually reversed and returned to India in droves as the economy surged from these years.
It is also possible for capital flight to plague those smaller countries which struggle with economic or political chaos. Another good example of this is Argentina. They have suffered from a flight of capital for decades because the inflation in Argentina was high while their own national currency continued to plunge in value.
This currency devaluation often leads to the legal and substantial flight of capital when foreign investors attempt to send their money abroad before their assets decline too severely in value. This became the case in the Asian Currency Crisis of 1997. Foreign investors did come back into these economies some time later once their economic growth restarted and their currencies had re-stabilized.
It is this fear of a future tainted by the flight of capital that causes the majority of nations to favor FDI Foreign Direct Investment instead of FPI Foreign Portfolio Investment. This is because the FDI revolves around investments of a longer-term nature in businesses and factories in a given nation. This makes it very complicated to sell or withdraw from the investment and country without long term planning. Those investments which are portfolio related can be simply sold off and withdrawn in only minutes. This is why critics of such capital sources refer to this type of investment as “hot money.”