Capital Flight and Exchange Restrictions

Many less-industrialized countries (LIC\u27s) maintain exchange restrictions in order to ration foreign exchange. This is the only way to support an overvalued domestic currency without exhausting foreign exchange reserves. Such rationing allows authorities to restrict unwanted imports (generally speaking, any imports which compete with domestic industries), and also to monitor foreign investments. But some investment flows can be hidden from this monitoring system, just as the trade in smuggled goods is hidden. Foreign investments can be purchased with foreign currency acquired without the knowledge of domestic monetary authorities- for example, foreign currency purchased on a black market, or export receipts hidden by underinvoicing. In this paper, capital flows which are undeclared in their country of origin will be referred to as capital flight. As capital flight is not recorded, it is difficult to measure. Governments of LIC\u27s generally view capital flight as income accruing to residents which is secretly being spirited abroad in order to escape domestic taxes, and try to curtail it by imposing capital controls - exchange restrictions which hamper all outward capital flows. This paper will analyze the effects of some common capital controls on capital flight. In this paper, capital flight is defined as the sum of all unrecorded capital outflows from a country which are financed by its private residents. However, past researchers have not agreed on the definition of this term; hence, it has been used very loosely