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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.
Understanding capital outflow
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.
Investors in relatively stable political and economic conditions 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 hot money. They quickly leave and enter a country to make 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 flow out. Such incidents usually accompany 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 offer the potential for higher economic growth.
If the capital outflow is significant, the government may limit the outflow by imposing capital controls.
Factors triggering capital outflow
Several factors can trigger capital outflow, which is when investors move their money out of a country. This can be driven by both increased domestic risks and attractive opportunities abroad.
Domestic risks
Weak economic growth: During a recession, businesses struggle and stock prices fall. This discourages foreign investors who seek promising growth opportunities. Companies in a stagnant economy may not offer the high returns they expect.
Political crises: Wars, riots, and coups create uncertainty and instability. Investors are hesitant to put their money in a country with a volatile political climate. Unrest can disrupt businesses and damage the overall economy.
Low interest rates: If domestic interest rates fall compared to other countries, foreign investors get a smaller return on their investments. They may be lured to invest elsewhere where they can earn a higher return.
High government debt: A large government debt burden raises concerns about the country’s ability to repay its loans. This can lead to fears of government default, which discourages investors from putting their money in the country.
Speculation: Currency speculators sometimes try to manipulate exchange rates for short-term gains. If they anticipate a decline in the value of a currency, they might sell it heavily, putting downward pressure on the exchange rate and potentially sparking a currency crisis. This can lead to capital flight as investors lose confidence in the currency.
External factors
Rising global interest rates: When global interest rates rise, emerging markets become less attractive to investors compared to developed economies offering higher returns. This can lead to capital flight from emerging markets.
Global economic slowdown: A slowdown in the global economy can dampen investor confidence and reduce demand for emerging market assets. Investors may seek safer havens in developed economies during these periods.
Changes in investor risk appetite: Investors’ risk tolerance can fluctuate. If they become more risk-averse, they may withdraw their investments from emerging markets perceived as having higher risks.
Emerging market-specific issues: Political or economic instability within a specific emerging market can trigger capital flight even if global conditions remain favorable. For example, a sudden policy change that discourages foreign investment can lead to capital outflows.
Attractive opportunities abroad
Higher returns: If other countries offer significantly higher returns on investments compared to a domestic market, investors may be incentivized to move their capital abroad.
Political stability: Investors seek stable and predictable environments for their investments. If another country offers greater political stability, it can attract capital away from a country perceived as having higher political risk.
Currency strength: A strong and appreciating currency in another country can be an attractive proposition for investors seeking capital gains. This can lead to capital outflows from a country with a weaker or depreciating currency.
Capital controls as a response
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 reason 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 fail. 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 in leaving.
Impacts of capital outflow
Capital outflow can have both positive and negative consequences for a country’s economy. Let’s break down the key impacts:
Exchange rate depreciation
Potential boost for exports: When capital leaves a country, the demand for the domestic currency falls. This can cause the currency to depreciate, meaning it becomes cheaper compared to foreign currencies. Cheaper domestic currency makes a country’s exports more attractive to foreign buyers, as they can purchase them for less in their own currency. In theory, this can lead to a rise in export volumes and a boost to economic growth.
Import costs rise: However, depreciation also has a downside. Imported goods become more expensive for domestic consumers and businesses. This can lead to inflation, as businesses raise prices to cover their increased costs. Additionally, if a country relies heavily on imports for essential goods, like food or fuel, a sharp depreciation can strain household budgets and lead to social unrest.
Trade balance
Theoretical improvement: In an ideal scenario, the increase in exports from depreciation outweighs the rise in import costs. This can lead to a positive trade balance, where a country exports more than it imports. A positive trade balance can contribute to economic growth.
Reality check: The positive impacts of depreciation on trade aren’t guaranteed. Several factors can influence the outcome. The competitiveness of a country’s exports (quality, price) and the elasticity of demand for exports and imports (how much demand changes with price fluctuations) all play a role. Additionally, if other countries experience similar depreciation, the overall impact on export competitiveness might be lessened.
Foreign currency debt burden
- Debt trap: Companies and governments that borrow in foreign currencies can be severely impacted by capital outflow and depreciation. When the domestic currency weakens, they have to pay more of the local currency to service their foreign debt (interest and principal). This can strain their cash flow and potentially lead to defaults.
Indonesian rupiah crisis example: The 1998 Indonesian Rupiah crisis is a prime example of this. Significant capital outflow led to a sharp depreciation of the Rupiah. Companies and the government, having borrowed heavily in US dollars, struggled to meet their debt obligations as the Rupiah weakened. This created a vicious cycle, as attempts to buy US dollars to pay debts further pressured the Rupiah’s value. The crisis ultimately led to a severe economic recession and social unrest.
