The effect of macroeconomic determinants on capital flight in Sri Lanka

Abstract

Introduction

Capital flight is one of the most important problems for developing countries which often lack the necessary financial resources to promote growth and development. Capital flight is a large-scale exodus of financial assets and capital from a nation due to events such as political or economic instability, currency devaluation or the imposition of capital controls. The UK Overseas Development Institute (ODI) defines capital flight as “the outflow of resident capital which is motivated by economic and political uncertainty.” Capital flight can impose a severe burden on poorer nations since the lack of capital impedes economic growth and may lower living standards. The challenge posed by capital flight have always engaged attentions of policymakers, economists and the government in Sri Lanka. It denied the country of enormous resources which would have been used to promote the rate of economic growth and improve the welfare of its citizens.

Capital flight causes various serious negative consequences on the domestic economy of any country. Momodu, (2006); Onwioduoki, (2001); Ajayi, (1995); and Razin and Sadika, (1991) identified such consequences by incoperating reduction of domestic tax base, reduction of domestic investment, reduction of monetary control, destabilization of interest rate, underdevelopment of domestic economy, and reduction of per capita income into the model. Other consequences of capital flight is that capital 'flighted' never comes back, it skews income distribution, and drives up the marginal cost of foreign borrowing. Based on the above, Ajayi, (1997) states that income and wealth created and held abroad are outside the purview of the domestic authorities, and cannot be taxed. Capital flight hampers domestic revenue, depresses the incentive to save, inflicts welfare losses, discourages investment, causes inability to service debts, leads to overshooting of the exchange rate, and contributes to imbalances of trade.

Several studies have been carried out on capital flight worldwide; however, a few studies have focused on the causal factors, measurements, and macroeconomic determinants of capital flight in developing countries. The magnitude of the impact of macroeconomic varieables on capital flight is given less priority. Thus, this study is an attempt to fill this gap considering the capital flight issues of Sri Lanka.