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


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.


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.


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:

a) destabilizes interest rates and reduces the ability of authorities to control credit and monetary aggregates and to design an appropriate monetary program,

b) contributes to erosion of the domestic tax base,

c) reduces domestic investment,

d) drives up the marginal cost of foreign borrowing,

e) causes the erosion of the legitimacy of the economic systems that combine free market and government planning and control, or so called mixed economies.,

f) indirectly may instigate government borrowing from abroad or seek foreign aid.

A resolution of the capital flight problem, therefore, not only reduces the need for borrowing from abroad, but it helps to create a more favorable environment for economic development.

The reversal of capital flight is a top priority among the various solutions suggested for Latin America's foreign debt problem (Dornbusch,1987). In the words of de Vries (1987, p, 37), the former Senior Vice President of Morgan Guaranty, "if capital flight is given a free ride in the caboose of the debt train, the train is going nowhere but off the rails [it is] both necessary and feasible that capital flight be handled up near the front of the train." Without a change in the conditions that have caused capital flight, its reversal is impossible.

Beside the harmful consequences listed above, capital flight could distort economic development efforts. In developing countries, an officially kept low exchange rate compared with the free market rate may cause a preference for capital intensive projects that would make over-invoicing possible. Buying hard currencies at low exchange rates and selling them at higher rates in an open free market would be highly profitable. Since these types of transactions are illegal, this could encourage corruption and could retard the economic development process (Winston, 1974).

In 1970, for example, in Pakistan the dollar was traded for 4.75 rupees in the official market, but two to three times higher in the free market. This difference in exchange rates made over-invoicing highly profitable. The purchase of equipment, therefore, would create the opportunity for over-invoicing. This method was used to purchase cheap dollars for resale in the black market. It was highly profitable to industrialist, under these circumstances, to make the amount of authorized industrial investment as large as possible. Consequently, since the amount of total capital import largely determined the foreign aid, it was necessary to promote the inflow of foreign aid and at the same time increase the share of sanctioned investment from a given amount of foreign aid. All of this would end up choosing foreign capital- intensive techniques of production. This meant investing in those industries that used much foreign capital at the expense of those that used little. It was also more profitable for industrialists to purchase more expensive new equipment and spend as little as possible on the maintenance of the existing ones and their utilization. In this case, the Pakistani government was an unwitting facilitator of capital flight and depressor of economic development projects that were most useful and suitable to the country.


The magnitude of developing countries' capital flight is very large and has been accumulating rapidly (Ramirez-Rojas, 1986). Sesit, Witcher, and Hertzberg (1986) estimated that 18 major debtor developing countries had $198 billion in capital flight in the mid-seventies to mid-eighties. This was almost half of the amount that these countries borrowed from abroad. According to another estimate, in 1981 and 1982, $51 billion moved out of the 18 major debtor developing countries, while they borrowed $81 billion from foreign banks. In 1984, there was as much capital moving out of 15 major debtor Third World countries as the amount of money borrowed from abroad by these nations, with an estimated $9 billion in foreign loans and $8.7 billion capital flight (Hector, 1985). The magnitude of capital flight from developing countries is so large that by one estimate if one fourth of capital flight was repatriated to Sub-Saharan African countries, they would lead other developing countries in terms of domestic investment instead of being well behind (Fofack & Ndikumana, 2010).

It could be argued that capital flight has aggravated economic problems of developing countries. As Aizenman et al. (2007) showed, countries with faster growth had more self-financing (the portion of domestic capital that was financed with domestic savings) than those with low self-financing throughout the 1990s. More self-financing is possible when there is less capital flight from the country.

Given the relatively safe investment climate of industrialized countries and the risk and possibility of financial loss in investing domestically, it is not unexpected that the residents of these countries invest abroad while their governments borrow huge sums for economic development projects. A recent study by Ndikumana and Boyce (2003), for example, found a significant link between capital flight from 30 sub-Saharan African countries and the external debt in the region. This finding is another sign that there is an association between capital flight and foreign or external debt. Alam and Quazi (2004) asserted similarly that in addition to attractive interest rates abroad and rising corporate taxes, the most significant factor encouraging capital flight from Bangladesh was political instability.

Cuddington (1987), using 11 years of the International Monetary Fund (IMF) Balance of Payment Yearbook data for seven Latin American countries, found that in Mexico and Venezuela high interest rates in the United States seemed to have exacerbated capital flight. The comments of Lessard (1987) on these findings were that in different countries the U. S. interest rates may have played very different roles. The sample on which Cuddington's (1987) findings were based was for a short time span, therefore, Lessard (1987) suggested doing different and more accurate research based on nonresident bank deposits data in the United States. This study follows that suggestion.

Various channels are employed for capital flight. In countries where there are no restrictions on capital outflow, funds can openly and at the prevailing exchange rate be transferred abroad. Where governments have imposed restrictions and control on capital outflow, other means of capital transfer are used. Businesses could use export under-invoicing, imports over-invoicing, and simple money smuggling to circumvent restrictions and control. The Indian government, for example, did not allow the residents to move capital abroad during the 1990s. This encouraged trade mis-invoicing (Patnaik & Vasudevan, 2000) resulting in a large-scale capital flight.

No records are kept for capital outflow that use these surreptitious means. It is, therefore, difficult if not impossible to have a precise measurement of capital flight. If no restrictions exist for transferring funds abroad, however, and because reporting of financial transactions are imprecise in the balance of payments of countries, it is difficult to measure it and to determine its size. A study by Lane and Milesi-Ferretti, (2007), for example, showed a discrepancy between estimated foreign assets and liabilities globally.

There is a more recent way that can be used for capital flight. Globalization or the integration of markets for everything including banking and investment markets has contributed to capital flight in a, more or less, legal form. Even when there is capital control in a home country, an investor can buy shares of equity stocks at home in the local money denomination and then trade the same abroad in foreign currencies. This type of trade in securities is referred to as 'mirror image trading. Such a transaction requires that the security in question be cross listed in both local and foreign stock markets. When there is a capital control, financial transactions of this type can be used to transfer money abroad without facing hurdles that usually involve other forms of capital flight. This type of capital flight may be reflected in the errors and omission figures in a country's balance of payment account. Also, the foreign bank deposits by non-residents may include such transactions. The discrepancies between import s and exports figures would not reflect this type of capital flight.

Capital flight cannot be measured but can only be estimated. There are various methods to estimate capital flight. In the case of export under-invoicing and imports over-invoicing, comparison of trade data for the partner-country canbe used (Bhagwati, Krueger, & Wibulswasdi, 1974; Gulati, 1985). Another method is using the difference between the average international prices and the average invoiced prices for import-export transactions (e.g., Pak, Zanakis & Zdanowicz, 2003; Tikhomirov, 1997). The Russian government, for example, estimated that, in the late 1990s, Russia had lost nearly six billion Euros annually in customs revenues and taxes (de Boyrie, Pak, & Zdanowicz, 2005). Likewise, Pak, Zanakis and Zdanowicz, (2003) estimated that, in 1995, Greece had lost well over $5.5 billion to import over-invoicing and export under-invoicing.

Many believe, also, that a country's data on net errors and omissions in balance of payments represents capital flight transactions. This figure, therefore, canbe used to estimate capital flight (Cuddington, 1986, 1987; Khan & UI Haque, 1987). Another method calculates capital flight more directly through examining data on deposits by private entities other than banks in major industrial countries (Khan & UI Haque, 1987; Ramirez-Rojas, 1986). (Note that this method is used by the present study). Even when there is capital control, if there is a cross-listing of securities (ADRs), investors can purchase ADRs by using local currency and convert them into dollar-denominated shares abroad to deposit the proceeds in foreign banks. In such a case, cross-listing shares confound government's policies (Auguste et al., 2006).

As Table 1 indicates, capital flight from these countries for 1974-82 was estimated from $58.3 to $90.05 billion and, for 1984 alone, capital flight from these countries was $24.1 to 46.9 billion. Based on the Department of Treasury reports of short-term deposits by foreigners in U.S. banks, the present study estimates that capital flight from these seven countries into the U.S. was around $60 billion for the 1974-1982 period and $24.1 for 1984 (U.S. Department of Treasury, 1950-1983).


The present study proposes that, in addition to other factors such as political risk, improper economic policies, and exchange controls, there is a link between the rate of interest on investment in the U.S. and capital flight from Latin American countries into the U.S., therefore, the following hypothesis.

Hypothesis: A positive relationship exists between U.S. short term interest rates and the flight of capital.

Latin American residents' bank deposits to the U. S. bank were used as the estimate of capital flight from these countries. These figures were reported by the U.S. Federal Reserve System (Federal Reserve 1951-1988). Nonresident bank deposits in the United States represent only part of the total capital flight. As Lessard (1987) has asserted, however, there is no indication that these figures do not move in tandem with the total capital flight. Khan and UI Haque (1985) have argued, that this method of measuring capital flight, has greater reliability, as compared with the estimated data used in other studies.

The data on bank deposits by the residents of Latin American countries in the U.S., however, underestimates capital flight. It does not include investment in real estate, stocks, bonds, and business ventures. But considering other alternatives, and the fact that the purpose of this study is to show a link between financial incentives on capital flight and not the total scale of capital flight, it could be regarded as the most suitable for the purpose.

All the data in this study are based on the Federal Reserve System reports. The interest rate on 9-12 issues prior to 1959 was used in this study. Also, for the period 1959-1982, the interest rates are based on the average of market yield on 6-month issues. The reason for the lack of uniform interest rate for the entire period under investigation is that prior to 1959 the Federal Reserve reported short term interest rates for the combined 9 and 12-month issues. After 1958, it reported the short term interest rates for 6 months and 12 months, respectively (Federal Reserve Bulletin, 1951-1988).

One could argue that instead of using U.S. interest rates, the differences between interest rates offered by the U.S. and those of the Latin American countries should have been used. That would have been a more accurate demonstration of the relationship between financial incentives offered by the U. S. and capital flight from Latin American countries. Such an argument would be valid if we were to study the movement of capital between industrialized countries where investment risks are mostly financial, not political. It is widely accepted that investments in developing countries face additional risks particular to these countries (Kobrin, 1978). Therefore, in the absence of political risk, the differential in interest rates would be influential in determining the direction of capital movements, meaning that the destination countries have to offer much higher interest rates than those of originating countries. In such an argument, to stem the outflow of capital from a country, a very high interest rate might have to be applied. Some developing countries such as Iran, for example, offer interest rates of up to 20% (Keyhan, 2016) to attract domestic investors. Even the higher domestic interest rates may not be of much consequence to capital flight. As Cuddington (1986, 1987) has stated, capital flight and interest rate can rise at the same time. This would be the case when there is a political crisis in a developing country, which could lead to capital flight and rising interest rates. In some cases, the real interest rates of industrialized countries are much higher than the nominal official rates. For example, due to the elimination of tax withholding on nonresident asset holdings in the U. S., foreigners may use the U.S. financial system as a tax haven. In this case, not accounting for the other risks, to be competitive with the tax-free U. S. return, developing countries have to offer a few extra percentage points (Dornbusch, 1987).


Correlation analysis was applied to capital flight data for all Latin American countries to the United States and the U.S. interest rates for 1950-1987 period. The sample included all Latin American countries for which capital flight data were available (see Table 1).

The results of correlation analysis for the Latin American countries are presented in Table 1. Depending on the number of years for which data were available, the period under investigation for each country ranged from 9 to 35 years. As Table 1 indicates, except for Cuba, correlation coefficient for all countries in the sample are positive and, except for the Bahamas, Cuba, Dominican Republic, and El-Savador, are significant. Correlation coefficient for Cuba is negative and is discussed below. In comparison with other countries, the average capital flights for Dominican Republic and El-Salvador are very small and could be considered inconsequential. The Bahama case cannot be easily explained and should be considered an exception.

A close examination of the data on capital flight from Cuba reveals that, from 1950 to 1959, capital flight hovered around $255 million annually, with a high of $314 million and a low of $164 million for 1953 and 1959, respectively. After the Cuban revolution in 1959, the communist government of Fidel Castro took power and altered the relationship with the U.S. Due to the new situation, capital flight from Cuba declined drastically with a high of $77 million in 1960 and a low of $7 million in 1969. For the rest of the period under investigation, up to 1987, capital flight fluctuated between $6 to $13 million. In essence, the advent of the Cuban revolution resulted in the reversal of the trade and business pattern with the U. S. and a concomitant decline in the opportunities for siphoning hard currencies out of the country, hence, the existence of a negative correlation between U.S. interest rates and capital flight from Cuba.

Overall, the results of correlation analysis indicate the existence of a positive relationship between capital flight from most South and Central American countries and United States interest rates.


Capital flight is considered one of the major financial problems plaguing South and Central American countries.

Capital flight is not a new phenomenon. Cases of capital flight have been chronicled as far back as the 1600s A. D. (Kindleberger, 1987). The massive capital outflow from some developing countries, particularly Latin America, however, has alarmed the world financial community. Some bankers, in industrialized countries have cited capital flight as a major reason for their reluctance to further lend to developing countries.

Industrialized countries have been the source of capital needed for development projects in developing countries. The infusion of foreign capital has not brought about the expected results in these countries, in particular Latin America. On the contrary, it has created an alarmingly high rate of foreign debt which has imposed additional burdens on their meager financial resources for the payment of interests and premiums. While these nations are borrowing from abroad, their citizens are pulling their money out and investing abroad.

The continuation of capital flight from developing countries could hinder their economic development. Any remedy for the plight of capital flight would ease the financial burden on these countries. Admittedly, developed countries particularly the U. S., have and are contributing to the exodus of capital from developing countries. In addition to high interest rates and financial incentives, for example, it has been reported (Glynn & Koenig, 1984; Lessard & Williamson, 1987; Sesit, Witcher, & Hertzberg, 1986) that many big U.S. banks with major loans to developing countries have actively solicited flight capital through their private banking departments.

The safe environment and ample investment opportunities available to foreign investors in the United States may have made it a major destination for "frightened money." It is also suggested by this paper that the investment inducements offered by the U.S., in the form of attractive interest rates, may have contributed to capital flight from Latin American countries. The test of the hypothesis and the findings of this study provide further support for those who argue that the capital flight from these countries in part might be due, among other factors, to more attractive interest rates in the United States. It, therefore, seems that to develop effective strategies to stem the tide of capital flight from these countries, the cooperation of developed countries, and in particular the United States, is needed. The implication is that strategies employed to stem the tide of capital flight from these countries has to be matched by economic policies, particularly the U. S.


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Kamal Fatehi, Kennesaw State University

Kaveh Teymournejad, Azad University

Countries            Mean  Std. Dev.  Min.   Max.    Sum  Years   N

Argentina        1026.429  1432.975    37     160  35925  54-88  35
Bahamas           521.577   852.133    63    3373  13561  60-88  26
Bolivia            15.667     1        14      17    141  54-62   9
Brazil            453.029   711.461    58    2635  15856  54-88  35
Chile             387.2     577.383    41    2074  13552  54-88  35
Colombia          477.857   692.038    31    2441  16725  54-88  35
Cuba               24.629    35.208     5     129    862  54-88  35
Dominican Rep.     22.778     6.037    16      32    205  54-62   9
Ecuador           484.75    347.021   117    1119   5817  77-88  12
El-Salvador        15.333     1.581    14      19    138  54-62   9
Guatemala         419.647   415.915    15    1123   7134  78-88  17
Jamaica            67.727    30.754    13     107    745  78-88  11
Mexico           2772.971  4050.676   114   12931  97054  54-88  35
Panama            980.914  1533.46     53    4918  34332  54-88  35
Peru              260.171   366.852    39    1450   9106  54-88  35
Trinidad-Tobago   100.917   103.276    18     375   1211  62-88  12
Venezuela        1821.866  2596.777    64    7617  63766  54-88  35
Uruguay           273.257   400.66     30    1332   9564  54-88  35

Countries        Corr.    P

Argentina         0.4406  0.004
Bahamas           0.0617  0.382
Bolivia           0.4828  0.094
Brazil            0.3378  0.024
Chile             0.3337  0.025
Colombia          0.4117  0.007
Cuba             -0.5694  0
Dominican Rep.    0.3183  0.202
Ecuador           0.5022  0.048
El-Salvador       0.2267  0.279
Guatemala         0.4022  0.055
Jamaica           0.424   0.097
Mexico            0.5065  0.001
Panama            0.4071  0.008
Peru              0.3203  0.03
Trinidad-Tobago   0.5026  0.048
Venezuela         0.4932  0.001
Uruguay           0.3308  0.026
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Author:Fatehi, Kamal; Teymournejad, Kaveh
Publication:Competition Forum
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Date:Jan 1, 2017
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