Strong institutions can staunch capital flight

• Author: Valerie Cerra/Meenakshi Rishi/Sweta C. Saxena
• Position: IMF Institute/Seattle University/University of Pittsburgh
• Pages: 24-25

Page 24

In the ongoing battle against global poverty, debt cancellation and new foreign aid are being made available to poor countries. But many poor countries, including some that stand to benefit from the IMF's recent Multilateral Debt Relief Initiative, have lost more resources through capital flight than through debt servicing. If debt relief prompts capital flight, this could jeopardize the international community's efforts to increase the amount of resources available for investment. A new IMF Working Paper, "Robbing the Riches:

Capital Flight, Institutions, and Instability," explores the complex relationships between capital flight and foreign aid, and between capital flight and debt. It argues that bolstering the macroeconomic policy environment and strengthening institutions can help stop and prevent capital flight.

The causes of underdevelopment are myriad and controversial. Enduring poverty and low growth are often blamed on poor macroeconomic and structural policies. Some economists attribute low levels of development to such factors as a high incidence of disease, low agricultural productivity, and high transport costs, which may be related just as much to geography as to policies. Any of these factors can engender low saving rates and a level of capital that falls short of the threshold level required for industrialization. In this case, domestic saving would need to be supplemented by foreign aid to provide sufficient resources to spur growth and reduce poverty.

Another view, which has gained popularity in recent years, points to weak institutions as the main hindrance to long-term growth and development and a major contributor to economic volatility. Capital flight may be one of the channels through which weak institutions contribute to volatility and suppress development. Countries with a poor track record on macroeconomic fundamentals often have poor institutions-for example, a weakly constrained government executive. And capital flight may be a by-product of redistributive tools employed by a weakly constrained government executive to divert resources to favored elites-thereby "robbing the riches" of the country.

A country's loss of domestic savings through capital flight reduces the resources it has available for investment. But how do unsound macroeconomic policies and weak institutions contribute to capital flight?

...