1. 1 Background to the Study

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2.3.5 Risk and Uncertainty in Capital flight

Politics can affect asset distribution in an open economy, with politics being seen as an investment risk. Capital flight has been seen to arise as a result of risks, actual or imminent, especially when the risk of reduction in capital value or returns in the assets holdings is anticipated. In practical sense, capital flight is defined as the difference between total private capital outside the domestic economy and that part for which interest income is identified and reported. By the non-reporting of the returns, it can be said that such capital is lost to the country. Collier et al (2001 and 2002) have concluded that the incidence of capital flight anywhere in the world is in response to portfolio choice and risks.

The discussion on political risks is terse and more economic risks are assumed in the works of previous researchers. Cerra et al (2005) is of the contention that researchers have started directing attention to non-macroeconomic variables such as political risk factors. For instance, Gibson and Tsakalotos (1993) had earlier concluded that political risk and expected depreciation of the currency were significant determinants of capital flight in five European countries they studied. Similarly, Fatehi (1994) took it further by inferring that political instability often adversely influences inflow of Foreign Direct Investment into a country. Fatehi argues “whatever keeps foreign investors away from a politically volatile country should influence capital flight as well”. Also, Lensink, Hermes, and Murinde (1998) examined the relationship between political risk and capital flight for a number of developing countries.

Conclusively, Schneider (2003) defines capital flight as that part of the outflow of resident capital that is motivated by economic and political uncertainty. This implies that the political uncertainty will involve likely change of government or governmental policies as denoted by country instability and all forms of minor and major changes in the political arrangement in the country, which returns the argument back to Vu Le and Zak (2001). They concluded that no matter how capital flight is defined conceptually and (or) measured, political risk factors matter in the case where no other macroeconomic variables are taken into account. In all of these, no definition was provided for politically induced capital flight, which affects confidence in the economy of the country, Cerra et al (2005) concludes.


Borrowings and debt acquisitions that become capital flows into a country through government and official sector have proved to be veritable sources of capital flights in Less Developed Countries (LDCs) as found out by Ajayi and Khan (2000). There was a drastic increase in the level African countries debt from $18 billion dollar in1975 to $220 billion in 1995. One of the ratios used to measure sustainability of debt, the GNP/Export ratio moved from 51 percent to 270 percent with South Africa and 300 percent without. Specifically, in the case of Nigeria, Ajayi believes that the debt problem arose because of the specific structural defects inherent in the economy, and goes on to show, after testing econometrically, that the most significant variables are nominal effective exchange rate (NEER) and the terms of trade (TOT).

The tests in Ajayi and Khan (2000) reveal that there are more capital flight episodes under the military than under the civilian administration, and more flight took place in the oil boom years than the lean years of oil sales. The study was not emphatic as to conclude that the military governments encouraged capital flight or not since the level of economic performance during these periods were not the same. These constituted the legal capital flights.

Cardoso and Dornbush (1989) first hinted at the possibility of illegal capital flight when they refer to the type of capital flight that took legal channels being dominated purely by profit motive, since capital flight is more of a private sector activity. Baker (1999) established the strongest link between capital flight and political corruption, when he divided capital flight into two: legal and illegal. The legal aspect of capital flight covers the movement of capital out of the economy, which involves the proper transfer of after-tax profits, which is documented as it passes through the borders and remains in the books of the entity from which it is transferred.

On the other hand, the illegal component is tax evading and therefore illegal from the country from which it originates and thereafter disappears. Of the $7.3 trillion assets under management by the offshore banks around the world for various purposes, among which is corruption, as at March 2001, about $500 billion of these assets is said to have emanated from transitional and developing economies into western bank accounts or some other offshore bank accounts. Baker (1999) insists that the motivation for the two forms differ as the legal capital flight flees to safety, while illegal capital flight flees to secrecy to transform or metamorphose. Legal capital flight that flees to safety might return after a return of the economic environment to a more clement situation, but little of illegal capital that flees to secrecy ever return. When it does return, it is as foreign direct investment, or as interest on principal loans and dividends on share capital: but it never fully returns.

The basic components of illegal capital flight are:

  1. Corruption through government officials, which arises out of misappropriation or embezzlement of public resources, bribe resources and kick-backs received and paid into foreign bank accounts

  2. Trade misinvoicing and transfer pricing and tax evasion to generate illegal returns.

  3. Criminal money from the illegal trade in drugs, children and women, arms, counterfeit goods and other like activities.

The ease with which these types of capital moves around stems from elaborate tax havens, secret jurisdictions, shell banks, dummy corporations and fake foundations. Baker (2007) says that in the case of illegal capital flight it might be impossible to trace out a misinvoicing. This is because of possible agreement between the parties on the method of transfer right from onset. He illustrated with two perfect hypothetical examples. One of the reasons for the furtherance of underground economy is that corruption and other anti social vices are allowed and can thrive. The line of difference between money laundering and illegal capital flight is fuzzy, as money laundering is seen as movement of illegal proceeds (from terrorism, drug trafficking and the like) through the financial system to clean it of illegality and criminal trace.

The World Financial Governing Institutions seemed helpless in the scourge of illegal capital flight which was generally ignored until the shout by Baker. Kaufmann (2007) in a conference on Illicit Financial Flows organized by Global Financial Integrity Network agreed that reporting problems exist, but that the World Bank is looking at a way to attack them frontally. There are two general options: an upstream approach (anti-money laundering) or a downstream approach (recovery of stolen assets). He added that the World Bank intended to lecture the developing countries on the evils of financial corruption but it is the responsibility of rich countries to recover stolen resources stashed with them.

Table 2.2

Estimated Cross -Border Flows of Dirty Money US$ Billions (1999)

Illegal Financial Flows Globally From Developing and

Transitional Economies

Corruption $30 to $50 $20 to $40

Criminal $331 to$ 549 $169 to $238

Commercial $700 to $1000 $350 to$ 500

Total $1.061 to $11,599 $539 to $778

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