View original document

The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.

FABSF

WEEKLY LETTER

January 8, 1988

Capital Flight and LDC Debt
The very high level of the foreign debts of many
developing countries, currently around $300 billion in aggregate, are a source of great concern
for bankers, investors, governments, and the
general public. A phenomenon that has attracted
much less attention is the exact opposite of the
LDC debt problem, namely the "flight of capital" from debtor developing countries. Capital
flight is problematic because it represents a
drain of a resource that could have had productive domestic uses, and it offsets imported capital. Reversing capital flight could restore a major
source of development funding for the countries
involved.

For Venezuela, the inflow was $27.0 billion
over the same period, with capitalflight estimated at between $12 billion and $22 billion.
The inflow for Mexico was $79 billion between
1976 and 1984; the outflow has been estimated
at between $26 billion and $54 billion for the
same period. Other debtor countries have also
had large capital outflows. And some analysts
believe even these figures are too conservative.

Plight of the boat dollars

"Country l'isk" starts at home

"Capital flight" used here refers to the export
of savings by citizens of the same developing
countries that owe such large amounts to western lenders. It takes various forms, including the
investment of funds by these citizens in banks
outside their home countries, the holding of
other foreign financial assets, and even the holding of foreign currency as cash. In some cases,
capital takes flight because businesses in a country require foreign currency reserves in their
operations. In many cases, capital flight is illegal, but occurs nevertheless.

Observers have often overlooked a basic fact of
life regarding "country risk". Country risk is the
set of risks to investment peculiar to a country,
and is often discussed in the context of investments abroad. For most people in the world and
in most countries of.the world, country risk starts
at home. The country risk that most concerns
these people is the loss of their capital and savings to expropriation, taxation, and inflation,
some or all of which they perceive as possible in
their own countries.

By its nature, capital flight is difficult to measure
accurately because it is not directly observed in
most cases. Nevertheless, a number of studies
have been made to estimate its magnitude.
These studies generally attempt to infer the capital outflows using balance of payments data
from the countries concerned. The estimates
vary from study to study, largely due to different
definitions and methodologies. Nevertheless,
they indicate that capital flight could represent
an enormous flow of international lending and
investing away from developing countries.
Capital flight, its causes and implications, has
become the focus of a growing body of research.
For example, between 1974 and 1982, Argentina borrowed $32.6 billion. Estimates of the
level of capital flight from Argentina over the
same period range from $15 billion to over $27
billion. This would mean that capital flight
amounted to between half and four-fifths of the

entire inflow of foreign capital to Argentina.
Argentinian residents "exported" this sum to
their own foreign bank accounts, overseas holdings, or foreign currency cash holdings.

In unstable political regimes and in some stable
ones, wealth is not secure from government seizure, especially when changes in regime occur.
Savings maybe shifted to overseas institutions to
protectthem. Hong Kong is a good recent
illustration of a country responding toanticipated future changes in regime; Many of its
citizens seem to be hedging much of their savings by exporting them. In countries where inflation is high and domestic inflation hedging is
difficult or impossible, investors may hedge by
shifting their savings to foreigncurrencies
deemed less likely to depreciate. They also may
make the shift when domestic interest rates are
artificially held down by their governments, or
when they expect a devaluation of overvalued
currency.
Taxation also may be a major factor inducing
capital flight. Savings and wealth may be hidden
overseas to avoid taxes on interest and capital
gains. A more important motivation might be the

FRBSF
hiding of income from investments and operations associated with the activities of the "underground economy" in developing countries.
Underground sectors actually consist of productive economic activities (but also some criminal·
activities) where earnings and profits are not
reported to local tax authorities. To preventtheir
detection,funds may be transferred to overseas
banks where local tax inspectors presumably are
incapable of finding them or of tracing them to
their points of origin, In Somecases the transfer
is performed by couriers carrying outphysical
cash notes. Banks in countries where disClosure
ofdepositor identification is protected would be
the safest havens. Fllndsheld outside the country, withoutthe use of the tax identification
numbers used domestically,would be difficult to
trace eveHwhen overseas banks cooperate fu lIy.
The size of the undergrollnd economy in various
countries cannot, of course, be directly
observed. (If it could be observed, tax collectors
would be the first to do so.) It can only be
guessed at. "Gllesstimates" often putthesize of
the underground economy irl the United States
at around 15 percent of recorded GNP, although
one study at the Board of Governors of the
Federal Reserve System estimated the size at
two~thirds ofrecorded GNP. If this were correct,
the underground economy would probably be
even bigger in many developing countries.

The case of the missing cash
Capital flight can explain a seemingly unrelated
mystery that has puzzled many economists and
reglliatorsforyears. We know the total stock of
u.s. dollars outstanding based on Federal
Reserve bookkeeping (currently about $100billion). But according to household surveys,
Americans report holding onlyabollt one·sixth
of the currency notes thattheyshould be holdinghasedon the Clllantitiesof minted notes outstandi ng. So where's all the cash?
A likelyansweristhat much of it is being held
overseas. As such,it would represent a form of
capital ftight by foreigners from their own currenciesand from· the financial institutions in
their own countries. In effect capital· flight has
taken place without the literal fleeing of capital
to geographic areas ou.tside the foreigners' home
borders.
Capitalflight to U.S. dollar bills/like othercapital flight, might be motivated by fears of expro-

1

priation, taxation and inflation. But it has the
advantage over distant overseas bank accounts
in providing the investor/saver with ready
liquidity that can be used to make payments
with no advance planning, no paper trail, and
no complex financial manipulations.
U.s. dollar bills are used for domestic transactions in many foreign countries, inCluding, ironically, many communist countries. Not only are
black market transactions in these countries
often conducted in dollars, but in some cases,
official foreign currency stores sell hard-to-find
commodities to local residents only when they
pay in foreign currency.
For the United States, foreign holdings of cash
dollars represent a zero-interest loan to the
federal government. We benefit from the loan as
long as the cash is held. In effect, the U.S.
obtains real goods and services while giving up
only "pieces of paper," at least for as long as
that paper is not exchanged for American goods
or assets. Even sharp fluctuations in foreign
willingness to hold dollars would probably have
little impact on U.s. economic stability. Moreover, fluctuations in overseas holdings could be
neutralized by u.s. monetary policy.

Policy issues
Capital flight from developing countries raises a
number of concerns and questions. For investors
an unavoidable question must be, "Do those
people know something I don't?" After all, residents of debtor countries presumably have a
better feel for conditions and governmental
intentions there than do outsiders. Sometimes
they are concerned aboutpolicies that hurt them
alone, and not foreign investors. When thinking
about these countries' risks, one factor U.S.
lenders should bearin mind is the apparent
unwillingness of the countries' citizens to invest
and lend their savings to their own countries.
Another concern is thatitis often foreign investment and aid to developing countries that makes
capital flight from those countries possible. Most
of the countries involved have controls on purchases of foreign currency and restrictions on
the foreign exchange markets. But the foreign
exchange used in fleeing capital must come
from somewhere. In the absence of capital
inflows that evade those controls, virtually no
capital outflows could occur. Without capital
inflows, LOt savers would find itdifficult to

obtain dollars or other western currencies to
stash away. That is, real goods or assets would
have to be exported by LDC citizens seeking to
"export" their savings. This would necessarily
mean an improvement in their own country's
balance of payments and debt position, as
export earnings would rise.
The inflow of western capital may eliminate
such a requirement. As we have seen, a significant share of the capital lent to or invested in
many LDC nations never produces any expansion in production in those countries. It merely
provides a source of hard western currency that
finds its way to savers in those countries, who
then hoard the cash or hide the same funds in
overseas investments. The LDC then faces the
worst of all possible worlds: a skyrocketing level
of debt and little real productive economic
expansion that could service that debt.
Moreover, by holding overseas financial assets,
LDC owners of fleeing capital in a sense magnify
the debt exposure of their own governments.
Foreign assets held by private citizens would not
ameliorate the government's burden of servicing
its debt. The fact that domestic citizens maintain
foreign bank accounts or hold other assets
denominated in foreign exchange does nothing
to alter the magnitude of the government's own
debts. The government cannot "net out" these
assets from its own liabilities.

Gross vs. net debt levels of LDes
A developing country's government must bear
and service a debt burden based on its "gross"
liabilities. Its credit rating and the interest rate
that it wi II be charged by foreign lenders are
functions of this gross number. Thus, if capital
that has fled were to be repatriated, the debt
burdens of LDC debtors could be reduced substantially. Moreover, credit ratings would
improve along with loan terms.

In accounting terms, the total "national debt" of
a country is the net outstanding level of its debts,
that is, its gross debts minus gross holdings of
foreign assets by all domestic citizens. However,
this measure of debt is irrelevant for most purposes. If capital that had flown were to return
home, and government debt were to be reduced
in tandem, the accounting measure of net
national debt would show no change. But the
burden of servicing that debt and the ability to
raise new funds abroad would doubtless
improve.
Another way of saying this is to note that the
same financial institutions from developed countries that lend to LDC debtor nations are not
necessarily the same institutions where residents
of those LDCs hide their funds. And even if they
were, the banks' exposure would not generally
improve. The exposure of the banks is based on
their gross holdings of LDC debt because the
banks cannot "net out" or seize the deposits of
those savers in the event of default by the government (or other borrowers) of the LDC. The
depositors are different parties.
In sum, a useful source of hard currency funds to
finance future debt service and real industrial
investments in LDCs may be the foreign
exchange savings of their own citizens. There
have been some cases where changes in economic policy did induce some reversal of capital
flight. COnvincing their citizens to make these
funds available at home is a major economic
challenge facing the governments of developing
nations.

Steven Plaut

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Gpvernors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author ..•. Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.0. Box 7702, San Francisco
94120. Phone (415) 974-2246.
.

uo~6U!4S0m

040PI

!!omoH

4o~n

O!UJO~!I0)

U060JO
ouozPI;)

OpOA0U
o~soll;)

O)SI)UOJ:::I UOS
~O ~U08
aAJaSa~

IOJapa:::l

~uaw~Jodaa 4)JOaSa~
BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and liabilities
Large COl11mercialBanks

Amount
Outstanding

12/9/87

12/2/87

Loans, Leases and Investments 1 2
Loans and Leases 1.. 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U. S. Treasu ry and Agency Secu rities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Change frorT~ 12/10/86
Dollar
Percent?

Change
from

2
26
14
2,228
2,033
188
45
149

1,178
2,199
694
5,469
4,443
180
3,523
147
3,518
4,827
2,578
1,561
252

0.5
1.1
1.3
8.1
10.7
3.2
27.0
1.9
1.6
8.5
6.5
8.2
0.1

44,145

227

2,701

5.7

31,614
20,612

215
3,993

1,079
5,953

3.3
22.4

207,122
183,229
51,526
72,445
36,958
5,421
16,548
7,345
207,114
51,866
36,832
20,467
134,782

510
499
318
159
172

Period ended

Period ended

11/30/87

11/16/87

Reserve Position, All Reporting Banks
Excess Reserves (+ l/Deficiency (-)
Borrowings
Net·free reserves.( + l/Net borrowed( __ l
1

2

3
4

S
6
7

105
9

.

96

18
6
12

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.S. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change