What’s it: Capital outflow refers to the going-out capital from a country. If a massive outflow of capital occurs, we call it a capital flight. Several factors trigger capital outflows, which are generally attributed to a combination of political and economic factors.
Capital outflow explained
Capital outflows are a source of risk to a country’s economy. It can lead to severe depreciation and exchange rate crises, leading to economic crises like Indonesia and Thailand in 1998. Economic crises impact economic stability and cause social problems such as unrest, poverty, and hunger.
Capital outflows and inflows within a country are actually commonplace. When a country adopts an open economy, capital flows are a counterweight to the current account. If the country’s current account is a deficit, foreign capital flows in to buy domestic assets. The opposite condition applies when the country runs a current account surplus. Thus, the balance of payments remains in equilibrium.
In relatively stable political and economic conditions, investors usually look for countries that offer relatively high returns. Some of them are long term oriented, such as in foreign direct investment.
Meanwhile, some foreign investors are short-term oriented. They target asset classes in the capital market. We call this flow of capital as hot money. They quickly leave and enter a country to take short-term gains.
Foreign investors will look at several variables to assess returns and future growth prospects. The four leading indicators are economic growth, interest rates, inflation, and exchange rates.
Furthermore, when some of these indicators deteriorate, capital will come out. Such incidents usually go hand in hand with increased risk at home. Or, investors find better alternatives abroad. When the outflow of capital is significant, it destabilizes the domestic economy.
Owners of capital, both foreign and domestic, sell their holdings and transfer their money to other countries. They will look for countries with politically stable and offering potential for higher economic growth.
If the capital outflow is significant, the government may limit the outflow by imposing capital controls.
Factors affecting capital outflows
Increased domestic risk leads to outflows. Better returns prospects in international markets can also affect capital outflows.
Domestic risks increase for several reasons:
- Weak economic growth. For example, during an economic recession, the real sector’s prospect falls, and foreign investors will move away from the stock market because stock prices tend to fall.
- Political crises, such as wars, riots, and coups. That brings uncertainty to the investment climate.
- A decrease in domestic interest rates. Assuming foreign interest rates unchanged, it makes returns on the home market less attractive. Foreign investors choose to invest in countries that offer higher returns.
- High government debt burden. That increases the risk of default on government payments. To repay debt, the government may implement an austerity policy, which puts a strain on economic growth in the short term.
- Speculation. Take exchange rate speculation, for example. Speculators temporarily drop the exchange rate of the domestic currency. Such attacks can trigger panic and lead to currency crises, especially when governments are less credible enough to intervene due to insufficient reserves.
Capital controls are one way of limiting capital outflows. It can take various forms such as taxes, restrictions on withdrawing money from the banking system, and transaction volume.
In some cases, controls may be adequate to avoid worsening economic stability. Capital controls were one of the reasons Malaysia avoided the 1998 crisis. In September 1998, the Prime Minister of Malaysia, Mahathir Mohamad, imposed strict exchange controls and restricted portfolio investment outflows.
However, in some cases, such responses may end in failure. If the government enforces it suddenly, it can trigger panic and an outflow of capital. It sends a signal that there are problems in the economy and could make things worse. Investors are increasingly convinced that something is wrong with the domestic political and economic conditions, increasing their confidence to leave.
Impacts of capital outflow
Capital outflow affects the exchange rate of the domestic currency, causing depreciation. Relatively small outflows are normal for the economy. That leads to a small depreciation, which should help to boost exports.
When capital goes out, more people sell their domestic currency and convert it into foreign currency (for example, US dollars). As a result, the domestic currency exchange rate falls. Depreciation makes domestic products cheaper for overseas buyers. Since domestic goods are cheaper, it should encourage an increase in export demand.
At the same time, depreciation causes the price of imported products to be more expensive. That weakens import demand.
As a result, depreciation should improve the trade balance, assuming other factors are constant. The improvement in the trade balance stimulates domestic economic growth.
The above conditions are ideal impacts. You need to remember that international trade depends on exchange rates and other factors such as product competitiveness (quality), inflation, and the elasticity of export and import demands.
Furthermore, significant capital outflows harm the domestic economy. That causes sharp depreciation and can lead to an exchange rate crisis.
One of the effects of the sharp depreciation of the exchange rate was a spike in the burden on foreign currency-denominated debt. For example, when the rupiah exchange rate against the US dollar falls, Indonesian borrowers have to collect more rupiah to pay interest and principal. It can disrupt their cash flow. To overcome this problem, they may buy up US dollars in anticipation of the next payment.
However, buying US dollars will only make things worse. This made the rupiah exchange rate fall even further. This kind of situation was one of the reasons the Indonesian currency crisis became more acute during 1998.