What is Capital Flight? How the US Fed’s interest rate policy may trigger capital flight?

Capital flight denotes large scale outflow of capital (investment etc.) from an economy. Such a mass movement or exodus of money mainly invested in a country’s financial markets occur either due to some undesirable development in the domestic economy or due to some positive development in other economies.

Usually capital flight occurs in developing countries who accepts huge amount of foreign capital to promote domestic investment.

Cause of capital flight

Both domestic (push) and external (pull) factors may create capital flight. The term flight is obviously used from the angle of the host developing economy like India which holds such capital (in the form of foreign investment mostly).

An example for (push) is the increase in interest rate by the US Fed may make high returns for US financial assets. Increase in US interest rate implies more interest rate in US banks. Here the US investors who have invested in India may find that US is also attractive now because of the rate of interest hike there.

Another reason (pull) is the trouble in the domestic economy. an example here is the East Asian crisis of 1997 where failure of many East Asian banks triggered mass withdrawal of foreign deposits.

Impact of capital flight

On the impact side, because of capital flight, foreign currencies may become scarce in domestic foreign exchange market. Such a situation will cause depreciation of the domestic currency. it will reduce money available for domestic investment. If the capital flight is big macroeconomic crisis may appear.

US Fed’s new interest rate policy and potential for capital flight

The US Fed indicated that it will raise the policy rate three times in 2017. In such a situation, US may become an attractive market for financial investment. Bank deposits and bonds will get high returns. Similarly, many other assets become attractive. Such a high return will tempt the US investors who parked their money in foreign countries to bring it back to the US. In this way, the foreign investors may exit from several emerging market economies together and this may create a situation of capital flight.

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