Not just a quibble over semantics

July 22nd, 2010

The last issue of the Review of Development Economics published the paper “Capital Flight: China’s Experience,” written by two professors of Economics, Yin-Wong Cheung and XingWang Qian.  In this article Cheung and Qian use statistical analysis to explain what variables explain changes in capital flight from China.

While there is no one definition, “capital flight” is generally synonymous with the term “illicit financial flow,” which describes the cross-boarder movement of illicit funds out of developing countries.  In some contexts, however, capital flight can include licit forms of capital as well.  There is also a difference in use and sentiment in these terms. Capital flight is the term usually preferred by academics and it is more widely used in the economic literature.  Illicit financial flow is generally used by advocates and policy makers, though some institutions, such as the World Bank, have recently been showing movement toward the phrase as well.

The difference is a divergence in intonation.  Capital flight seems to place the whole of the problem on “them” (the developing world) as illicit financial flow acknowledges that a movement of capital is a two way street.  More on this later.

Cheung first estimates capital flight from China using the World Bank residual method, though he considers a variety of other models, as well.  Illicit financial flows are illegal transfers, and therefore are unrecorded, so their volumes are often extremely difficult to measure.  The World Bank residual method compares a country’s sources of funds with its uses of funds and, as the sides must balance, takes the excess of recorded source over use as an outflow.  This method is also used in the Global Financial Integrity paper, “Illicit Financial Flows from Developing Countries: 2002-2006.”

Cheung’s method reveals volatility in the pattern of Chinese capital flight, with estimates plunging and peaking wildly between 1982 and 2008, particularly in the recent decade.  Cheung notes that these volatile patterns occur despite China’s relatively strong capital controls (which are meant to regulate outward flows of currency).  He explains that “a good share of historical capital movements occurs outside of formal regulations,” and that “capital flight is attributed to corrupt officials running state-owned enterprises and beneficiaries of corruption and economic crimes.”  Finally Cheung notes that Chinese banks and corporations often take advantage of “regulatory loopholes” and “shuttle money in and out of the economy via, say, unrecorded cross-border transactions and mis-invoicing.”

Cheung then examines a variety of different variables and factors which might explain capital flight in China.  Some these variables are economic indicators, such as the spread between the China-U.S. interest rates, net foreign direct investment, and the current account deficit.  The model also takes into account policy decisions, such as China’s trade openness, its Strategic Economic Dialogue, and a Political Risk Index, among others.   While I don’t have space to get into specifics, the variables do a good job of explaining capital flight, an in particular, the country’s own history plays an important explanatory role.

But the major deficit I see in this paper, as with the majority of the research on capital flight, is its myopic emphasis on the domestic economy of the developing country.  Though this paper takes into account the U.S. interest rate and inflation rate (as compared to China’s) to help explain capital flight, it does not acknowledge the two-way nature of illicit financial flows.  Domestic policy considerations are not the only applicable variables.  There are also foreign policies that can ease or restrict these flows.  I would like to have seen a variable for changes in U.S. and European policies affecting foreign corruption or changes in behavior of tax havens and developed country banks.  Though there is no index, there is an ebb and flow of such policies that could be examined quantitatively and included in the model.

And that is why the term “capital flight” is so restricting, both in definition and for academic studies.  It’s not just a quibble over semantics.  The first step toward solving this problem is understanding it; something which cannot be accomplished without fully exploring its drivers.   Illicit financial flow is a much more complete term; one which academics would do well to adopt soon.

Written by Ann Hollingshead

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