Q8|FE102

8. In the light of a theory of capital flight from less developed countries, discuss policies that could reverse it.
Khan, M.S. and N.UI Haque (1985) 'Foreign Borrowing and Capital Flight: a Formal Analysis', IMF Staff Papers, vol 32, no 4 December
Policy problems:
a. Debt overhang
b. Dual exchange rates causes a problem since most models are based on one exchange rate instead of one for transaction on the current account of the balance of payments (the commercial rate) and the one for capital account transactions (the financial rate).
c. Parallel Foreign Exchange Markets is the results of having ‘unofficial rates’ as well ‘black markets’.
d. Currency Substitution is when residents of a country uses currency of another country (e.g. Israel and Mexico during the 1980’s). Should have led to a North America Union.

Possible solutions:
Tobin Tax
Multiple Exchange Rates
Raising Interest Rates and eliminating Financial Repression
Formation of stable Fiscal and Monetary policies over the long term. Short term flight may derive from instability over long periods.
Non-discriminatory towards domestic savings.
Capital controls for the short-term period.
Measuring the Two or Three Gap models and determining if Capital Flight is a problem or may just be Capital Allocations across countries to diversify risks.
Avoiding the government making implicit or explicit guarantees to foreign investment-especially if denominated in foreign currencies. Thus avoid Moral Hazards created by guaranteeing capital coming into the country.

Obviously, providing a stable financial and macroeconomic environment would go a long way toward reducing domestic uncertainty. The experiences of the major debtor countries show that capital flight was most pronounced in those countries that had relatively higher and more variable rates of inflation, larger fiscal deficits, and overvalued currencies.

"Full compensation of domestic investors in the event of government expropriation". But this opens a variety of other questions about when is it 'expropriation'.
Expanding the menu of financial instruments or more broadly increasing investment opportunities domestically-depth and width.
Dooley, M.P. (1988) 'Capital Flight: a Response to Differences in Financial Risks', IMF Staff Papers, vol 35, no 3 September

For the purposes of this paper, flight capital is defined as the stock of claims on nonresidents that do not generate investment income receipts in the creditor country's balance of payments data.

...

...external criditors may have access to explicit or implicit government guarantees not available to residents. In this case the capital outflow to avoid the inflation tax would be matched by a capital inflow that is protected from the inflation tax because of its currency denomination and that also enjoys a government guarantee.

Exactly as said earlier. Moral hazards are insured by the government for foreign investments but not domestic. Factors of Capital Flight:
Domestic Inflation
Financial Repression
Risk Premium
Political Risk Premium