The Association between U. S. Investment Incentives and Capital Flight from Latin America: A Historical Analysis.

• Author: Fatehi, Kamal

INTRODUCTION

Investment, in general, is sensitive to two factors, the rate of return and the degree of risk associated with the investment. Higher returns attract more investment if the associated level of risk is acceptable. Risks could be classified into two categories: financial and political. In developed countries, investors are mostly concerned about financial risk and have little concerns about political risk. This situation is different for developing countries where both financial and political risks are present and the two are often intertwined. The value of savings and investment can dramatically decline with the looming occurrence or the actual presence of political instability or crisis (Asiedu, 2006; Fatehi-Sedeh & Safizadeh, 1988; Julio & Yook, 2012).

Capital flight increases when there is a possibility of investment loss or depreciation in the value of savings and investment. Heavier taxes, financial crisis and instabilities, a prospective tightening of capital controls or devaluation of domestic currency, and actual or emerging hyperinflation are the other contributing factors to capital flight (Cuddington, 1986; Alam & Quazi, 2003). Incentives offered by some developed countries to foreign investment also siphon money away from developing countries. The economic conditions in the industrialized countries and particularly the U.S. have a noticeable impact on developing countries (Shabri Abd Majid & Hj Kassim, 2009).

Capital flight from developing countries could be attributed to a relatively larger perceived risk associated with investment in these countries as compared with the investment in developed countries (e.g., Fatehi, 1994; Kant, 2000).

This difference in relative investment risk is due to lack of well established political and constitutional arrangements that could provide an infrastructure for smooth and timely market transactions. In these countries, for example, adequate institutional and legal protection of private property may not exist. Transaction and insurance costs may increase during the periods of political instability and risk. Dramatic and frequent political and economic change could create investment uncertainties and instabilities.

The purpose of this paper is to examine the impact of the U. S. interest rate on capital flight from Latin America. It follows both recommendations of Lessard (1987). First, it uses a large set of data to enable us to extrapolate the findings into the future. Second, it employs data on non-residents' deposits in U.S. banks as an indication of capital flight. It, also, examines the Latin American portion of Claessen's (1997) suggestion that indicated a rise in global interest rates in 1970 and early 1980s may have contributed to capital flight in these years. This period falls within the time span that is covered by the present study.

The understanding of the relationships between investment inducements offered by the U.S. and Latin Americans' capital flight could pave the way for the formulation of more realistic solutions to some of the pressing economic problems of these countries. In the period immediately after WWII until the 1980s, compared to other countries, the U.S. was a very attractive alternative for investment. It was only in the 1990s that some other economies became as attractive investment destinations for foreign money. This is the period covered by the present study.

The study is divided into six parts. First, capital flight is defined. The second part elaborates on the consequences of capital flight. Then, in the third section, its magnitude and measurement is presented. The fourth section deals with the methodology and data. The fifth section discusses data selection through an examination of capital flight estimation. Finally, the last part deals with conclusion and discussion of the finding.

CAPITAL FLIGHT DEFINITION

Do all forms of capital outflows from developing countries constitute capital flight? Should any large scale capital outflow be considered frightened money that flees these countries? How should capital flight be measured? There is no agreement on answering these questions. The definition of capital flight depends on the point of view and concerns for certain factors. Those concerned with economic growth consider any outflow of capital detrimental to these countries, therefore, they define all outflow of money as capital flight, regardless of short-term or long-term, portfolio, or investment in equities (Khan & UI Haque, 1987). This broad definition is based on the fact that developing countries are generally poor in capital and in great need of capital investment. Any capital outflow from these countries reduces available investment money and dampens growth potential and, therefore, should be regarded as capital flight.

Although the logic behind this definition is clear, it is impractical to consider all capital outflow from developing nations as capital flight and consequently detrimental to their economic progress. A more practical definition would take into account only that portion of the capital outflow which is for short-term speculative purposes and is triggered by an imbalance between the risks associated with investment in domestic versus foreign market risks.

Taking the speculative, short-term point of view, the term, capital flight, is usually used to indicate the outflow of capital, often through hidden means, from developing countries to more advanced, industrialized countries. This definition carries a negative connotation. Monetary substitution, which is the consequence of the normal demand for foreign currencies and is derived from ordinary transactions such as trade or tourism, for which legal means of exchange is used, do not fall under the definition of capital flight (Ramirez-Rojas, 1986). Monetary substitution takes place when resident and nonresidents exchange their holdings of domestic and foreign currencies simultaneously. This means that demand for both domestic and foreign currencies exist among nonresidents and residents respectively.

In the case of capital flight, however, there is no demand for domestic money by nonresidents (Ramirez-Rojas, 1986). This is an important distinction between the normal capital outflow and capital flight that could be regarded as "hot money." It is because of this lack of demand for domestic money by nonresidents that often capital flight is channeled through nonofficial intermediaries and secret deals. This is a more commonly used definition of capital flight. The definition offered by Khan and UI Haque (1987) takes these factors into account. They have defined capital flight as speculative, short-term capital outflows that are taking place because of economic or political uncertainties in a country. Other researchers have used the same point of view and similar definitions (Cuddington, 1986, 1987; Dornbusch, 1987; Ramirez-Rojas, 1986). Similarly, this study defines capital flight as short term, speculative capital outflows that are triggered by, among other factors, incentives offered to foreign investments by the United States.

CONSEQUENCES OF CAPITAL FLIGHT

Capital flight adversely influences the economy (e.g., August et al., 2006; Feinberg & Williamson, 1987; Khan & UI Haque, 1987; Ramirez-Rojas, 1986). The following are harmful impacts of capital flight:

1. destabilizes...