Appendix Capital Flight and Capital Controls

Liliana Rojas-Suárez, and Donald Mathieson
Published Date:
March 1993
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Letting wt equal stock of wealth at time t, then the analysis in the main text suggests that desired holdings of domestic (DA) and foreign (CF) assets will be given by

where d denotes the desired proportion and v is the vector of expected returns and risks associated with domestic and external assets.

In the presence of capital controls, it may take time for domestic residents to shift from domestic to external assets when, for example, the risks associated with holding domestic assets increase. A simple stock adjustment model can allow for this possibility. Thus,

The stock of broad money (M2) is used as a proxy for the stock of domestic assets. To the extent that other domestic assets can escape the inflation tax or expropriation risk, then using M2 could bias the results. In particular, if domestic residents were to substitute M2 assets for other domestic assets that were either insulated from the inflation tax or free from expropriation risk, the ratio CF/M2 would rise even if no foreign assets were accumulated. However, the limited domestic financial markets of the countries in the sample typically do not offer a broad range of financial instruments that constitute good inflation hedges; nor are they free from expropriation risk. As a result, a rise in expropriation risk is likely to entail a portfolio substitution away from all domestic financial instruments toward external assets. In this situation, the ratio CF/M2 will represent the general flight to external assets.

Equation (3) was estimated in levels with the lagged ratio (CF/M2)t–1 on the right-hand side (with coefficient 1-λ). In addition, different future (time t+1), current, and lagged values of the government deficit and risk variables were employed to gauge the factors influencing expectations regarding fundamentals. In all cases, the estimated λs were not statistically different from one, implying that portfolios were adjusted within the year. The coefficients on most of the future and lagged values of the fundamentals proved to be statistically insignificant; thus, equations (4) and (5) report only the most significant current and lagged values of the fundamentals for the two groups.

R2 = 0.96

R2 = 0.96

where the values in parenthesis represent f-statistics. The constant terms consist of a general intercept term and a dummy variable for all but one of the countries. Equation (4) corresponds to the set of countries with modest or significantly reduced capital controls, and equation (5) corresponds to the set of countries with extensive or tightened capital controls. Using the sample means for each group’s variables, the elasticities of the capital flight variable with respect to the risk and deficit variables are .44 and .36, respectively, for the countries with less restrictive capital controls, and .13 and .51, respectively, for the countries with highly restrictive capital controls.


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Article VI, Section 3 states that

Members may exercise such controls as are necessary to regulate international capital movements, but no member may exercise these controls in a manner which will restrict payments for current transactions or which will unduly delay transfers of funds in settlement of commitments, except as provided in Article VII, Section 3(b) and in Article XIV, Section 2.

Frenkel (1982) has often used this distinction in his discussions of capital controls.

For example, Yeager (1976) examines the experiences of the major industrial countries in the 1950s and 1960s and provides an extensive bibliography. Baumgartner (1977) analyzes the experiences of a number of European countries (including Germany) with capital controls in the 1970s, and Argy (1987) compares the Australian and Japanese experiences with capital controls in the 1960s and 1970s. Dooley and Isard (1980) provide a general framework for analyzing the effects of capital controls.

For example, Argy (1987) argued that such controls were much more effectively and efficiently administered in Japan than in other industrial and developing countries.

Horiuchi (1984) showed that officially controlled real interest rates in Japan were relatively high by international standards, which may have played a key role in limiting residents’ incentive to shift funds abroad.

The close relationship between the interbank rate and international rates could have reflected the fact that authorized dealers (selected banks) were not prohibited from acquiring foreign exchange deposits and incurring foreign currency debts as long as their total spot-against-forward position did not exceed the long and short limits set by the Central Bank.

The methodology for estimating capital flight in Table 2 involves computing the stock of external claims that would generate the income recorded in the balance of payments statistics and subtracting this stock from an estimate of total external claims (see Dooley, 1986). Total external claims are estimated by adding the cumulative capital outflows, or increases in gross claims, from balance of payments data (which consist of the cumulative outflows of capital recorded in the balance of payments plus the cumulative stock of errors and omissions) to an estimate of the unrecorded component of external claims. This last component was estimated by subtracting the stock of external debt implied by the flows reported in the balance of payments from the stock of external debt reported by the World Bank.

A more comprehensive analysis of capital flight during 1978–88 is contained in Rojas-Suárez (1991). A similar pattern of capital flight is evident if such capital flows are measured by the so-called residual approach, which estimates capital flight by adding the increase in a country’s recorded external debt to the capital inflow from direct investment and subtracting the current account deficit plus the increase in official reserves. See Morgan Guaranty Trust Company (1988).

Kamin (1991b), p. 45. He also reported that the experience with unstable and high inflation contributed to dollarization in Argentina. This has been evident in the quoting of prices in U.S. dollars by retailers and the use of dollars in the purchase of automobiles, real estate, and other big-ticket items. He estimates that the stock of capital flight at the end of the 1980s exceeded $20 billion and argues that about $5 billion in U.S. currency circulated inside Argentina. This compares with domestic Ml and M2 monetary aggregates (measured using the official exchange rate) of $4.5 billion and $7.7 billion, respectively, at the time of their mid-decade peak in December 1985.

This was defined as the sum of the foreign interest rate and the expected rate of depreciation of the exchange rate.

Edwards and Khan (1985) provided the initial framework for this analysis.

Given a conventional demand for money, they argued that it would be a function of income, lagged money, and the closed economy money supply (that is, the money supply net of the monetary effects of capital flows).

These preconditions for establishing capital account convertibility are discussed in Section V.

These efficiency gains can be reduced if asset prices are distorted by such variables as tax differentials.

Studies of these liberalizations have been undertaken by Corbo, de Melo, and Tybout (1986); Hanson and de Melo (1983); and Sjaastad (1983).

For a review of financial liberalization in Mexico, see Coorey (1992).

By the end of 1991, the 12-month rate of inflation was down to 20 percent.

It was only in May 1990 that the Mexican authorities reduced the depreciation of the exchange rate to 0.80 peso per U.S. dollar a day. In mid-November 1990, the depreciation was established at 0.40 peso a day, and in November 1991, the depreciation was further reduced to 0.20 peso per U.S. dollar a day.

See Rojas-Suárez (1992b) for evidence on the Mexican case.

For the case of Argentina, see Calvo and Fernandez (1982).

For the case of Mexico, see Khor and Rojas-Suárez (1991).

See Mathieson and others (1989) for a more detailed discussion of the use of these instruments.

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