Capital flight : measurement, determinants and policy implications

Churchill, Samuel H. (2006). Capital flight : measurement, determinants and policy implications Honours Thesis, School of Economics, The University of Queensland.

       
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Author Churchill, Samuel H.
Thesis Title Capital flight : measurement, determinants and policy implications
School, Centre or Institute School of Economics
Institution The University of Queensland
Publication date 2006
Thesis type Honours Thesis
Total pages 121
Language eng
Subjects 14 Economics
Formatted abstract Capital flight is a key element in the macroeconomic behaviour of developing nations. Understanding its role and the factors that drive it enables policymakers to formulate an appropriate response to the challenges it presents. Using a sound theoretical framework, a dataset is constructed for capital flight using the most comprehensive version of the residual method available that includes innovative methods unique to this thesis. This process confirms that capital flight is large and on the rise. An investigation of the determinants of capital flight reveals the significance of foreign exchange channels in facilitating unrecorded capital outflows. The asymmetric impact of variables such as growth and the interest rate differential are also observed, revealing that the behaviour of capital flight is highly conditional and that poor macroeconomic policies encourage it. In the context of an increasingly integrated global capital market it is concerning that large potentially destabilising capital flows would go unrecorded. An increased regulatory presence may be justified to safeguard against the growth retarding and crisis inducing impacts of capital flight.

Following an appraisal of the literature, capital flight is estimated for 35 developing nations over the period 1984-2003, using an improved residual estimation method. The method is the most comprehensive measure of capital flight used in the literature. However, a number of adjustments and innovations are made to further improve the process and set the procedure apart from its predecessors. These include an adjustment for equity portfolio investment, the misinvoicing of trade data using f.o.b. data, currency fluctuations in USD-denominated debt and debt forgiven. The improved residual method provides arguably the most comprehensive measure of capital flight to date.

The complex estimation process is accompanied by an extensive analysis of country-specific and global events, their impact on net unrecorded capital flows and the corresponding implications for policy. Ecuador for instance experienced two quantitatively significant spikes in capital flight in consecutive years due to the combined impacts of a financial crisis, a subsequent coup and political unrest. Another example is that of China around the time of mounting Renminbi devaluation pressure in the early 1990s. This period coincided with acceleration in capital flight thought to be the product of currency speculation.

This thesis then uses panel regression models to identify the determinants of capital flight. The regression models incorporate a range of economic, political and policy-related explanatory variables. Several major shortcomings of the literature are addressed at this point. The most significant of these involves the implicit inclusion of variables in both the left hand side (LRS) and right hand side (RRS) of capital flight regressions. It is further identified that the issue of endogeneity is given scarce consideration in the majority of panel regressions. Both these issues are addressed accordingly.

The regression analysis also makes the important step of identifying variables likely to behave asymmetrically or non-linearly. The use of variable transformations and interaction terms in the regression model generates some new findings. Further policy inferences are discussed in light of the findings of the regression analysis, including the effectiveness of capital controls and the management of economic crises. The focus in both cases is on reducing a country's vulnerability to highly liquid financial flows whilst maintaining a policy environment that is conducive to economic development.


 
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