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In the simplest form, capital flight can be defined as a short-term speculative capital outflow (Cuddington, 1986). However, what entails and consist of this definition, depend on how broadly or how narrowly we want to define the term. Tracking back to the most traditional definition, where Kindleberger (1937) defined capital flight as a transfer of real resource from one country to another motivated by the economic and political uncertainty. The inevitable mobility of capital in today’s global economy has forced us to make some refinement to this traditional definition. In order to consider normal component of resident international activity like- foreign trade for change in inflation rate, or foreign investment for change in interest rate, we define capital flight as a capital export by the private nonbank sector (Cuddington, 1986).
Many countries suffer severely from capital flight in terms of reserve shortage, low national revenue in tax and tariffs. In developing countries, capital flight is a major obstacle for long term sustainable growth. Globally $829 billions of annual capital flight from developing countries are observed, while annual aid flow renders $104 billion (Baker, 2005). Therefore, it will be no surprise if developing country loses as much as 10% of GDP annually due to capital flight.
While capital flight can be seen as an outcome of individual agents profit maximizing incentives, the quantitative importance of such activity cannot be ignored. In addition to illegal transaction the opportunity cost of capital flight to the society is much higher than individual return (Schneider, 2003). Capital flight is thought as an outcome of failure in economic governance (Ndikumana, Boyce & Ndiaye, 2014). For instance, Gunter (2017) implied that acceleration of capital flight might lead to reduced government revenue, capital loss and increased foreign debt. Indeed, Researchers pointed out capital flight as a trap (Beja, 2007; Ndikumana, Boyce & Ndiaye, 2014). Countries with historical capital flight are more often than not found themselves in a cycle of chronic capital flight problem. As persistent capital flight weakens and demoralizes financial regulation and accountability, it erodes institutional competence and ultimately allows capital flight to exist forever. It is also very difficult to curve the tendencies once residents become used to it (Cuddington, 1986).
Moreover, Capital flight itself certainly is not a standalone economic problem. Capital flight brings economic instability in the country (Hasnul & Masih, 2016). Ndikumana, Boyce & Ndiaye (2014) considered capital flight as a symptom of structural problem. Investment diversion theory also directs that macroeconomic uncertainty in the country coupled with simultaneous favorable qualitative and quantitative situation in foreign countries encourage the outward capital flow from the country.
The very definition of capital flight provides us an in important insight about the reasons for capital flight. While the economic uncertainty or more precisely profit maximizing opportunity in foreign investment is widely studied, the political part is yet to explore. Good economic-performance discourages capital flight by instilling hope to the savers while poor economic indicators like low GDP and fluctuating inflation encourage capital flight. As political scientists and economists believe that there is significant association between economic performance and institutions (Saxena, Rishi & Cerra 2005), we assume thereby that institutional quality also have some direct linkage to the capital flight. Therefore, the main objective of this study is to test if institutional quality, i.e. good governance has any threshold effect on the level of capital flight of a country. Good governance is a measure of public institutional ability to ensure rule of law, accountability, and transparency. It also ensues political stability in the country. Good governance has been used in various studies as a prime determinant for economic growth. In our study we are improvising this idea to test whether it has any bearing in the capital flight problem. Absence of good governance represents a structural inefficiency or weakness of the government that hinders the economy to count the outflow of fund in a legal way.
Figure 1. Net capital flight. Source: (Economic Intelligence Unit, 2017).