Basil Oberholzer

The threat posed by capital flight (or the large-scale exodus of capital assets) makes ambitious economic policy in developing countries powerless. This article examines the current monetary system to propose potential reforms which would give back scope of action to the countries which are prone to such flight of capital.

In November 2020, the government of Zambia was unable to continue to serve a part of its foreign debt. It had issued Eurobonds in 2012 to get access to international currency. Growing debt was affordable as long as commodity prices, namely the price of copper, remained high. After several years of low prices, the coronavirus crisis definitely dried up global demand and export returns while multinationals kept transferring profits abroad. It remains to be seen whether creditors and financial institutions are willing to agree on debt restructuring and what austerity requirements will be imposed on the country.

Zambia’s debt crisis is just the most recent example of a long history of currency crises and, unfortunately, probably also not the last one in the near future since there are many other developing countries whose levels of external debt have surpassed affordability. The consequences of these crises are exchange rate depreciation, imported inflation, a higher weight of foreign debt, spikes in lending rates, and, finally, austerity measures imposed by the government and/or international creditors to reduce the need for foreign currency. Austerity tends to further move an economy towards collapse.

Capital Flight and Balance of Payments as Constraints on Growth

These phenomena refer to the very fundamental problem of the balance of payments problem, also known as Thirlwall’s law: when a country experiences relatively high economic growth, its imports increase while the exports remain unaffected as they are determined by demand from the rest of the world. Consequently, growth tends to give rise to a trade deficit, and thus, may trigger exchange rate depreciation and potentially a debt crisis. To prevent this, growth must not be too high. In other words, there is a certain maximum growth rate that is in line with a balanced current account. The balance of payments constraint, thus, is a growth constraint signifying a serious obstacle for developing countries.

But the problem is even bigger than that. In order to implement a successful development strategy, a developing country needs active economic policies such as taxation, redistribution and, particularly, public investment to increase the economy’s production capacity. These measures are public interventions that are beneficial for society but may potentially be against the interests of private capital. Wealth owners, thus, move capital out of the country in order to escape any measures that jeopardize their profits. Capital flight means that, even if imports are matched by exports, a country loses foreign currency and faces increasing trouble to meet its external obligations. Capital flight, thus, may give way to a currency crisis even before any policy action has had the chance to set in motion a growth process. While active economic policy has a high potential to foster economic development, it is powerless in face of international financial flows. One may almost be tempted to recommend a neoliberal way of policymaking, that is, no government intervention such that market forces including financial flows are not distorted.

The Vicious Cycle Caused by the Current Payment System

This issue of balance of payments problems includes an important element that economists either do not notice or simply accept as a natural matter of fact. It concerns the way international payments are made in the current global monetary system. The system is asymmetric because the US Dollar is the main global reserve currency supplemented by a few currencies with regional importance. All other currencies are only used within their own respective countries. To make international payments, developing countries have to get hold of a reserve currency, say, the US Dollar.

Let us take the example of a country paying for its imports: the importer pays in domestic currency as her bank deposit is reduced by the amount of the import bill. However, the foreign exporter has to be paid in US Dollars. The country’s banking system, including its central bank, thus, needs to access a foreign loan to make this payment in US Dollars on behalf of the importer. Now, crucial to understand, the payment in domestic currency and the payment in US Dollar are not the same but add to one another. The payment takes place twice. First, the payment in US Dollars requires a foreign loan. Second, the payment in domestic currency involves the destruction of those domestic monetary units: the money deducted from the bank deposit of the importer goes nowhere but is simply deleted from the bank’s balance sheet.

In the case of exports, the opposite happens: the country earns US Dollars, which go to the central bank’s reserves. Simultaneously, the exporter’s bank account is credited with domestic currency, which are newly created for this purpose. This means that to the extent that imports are met by exports, the payments are balanced such that there is neither net destruction nor creation of domestic currency. When a country incurs a current account surplus, the abundance of domestic currency increases. In the opposite case of a current account deficit, which applies to many developing countries, net payments to foreign payees mean a continuous loss of domestic currency. At the same time, foreign debt piles up due to the double payment.

A loss of domestic currency is tantamount to a loss of domestic demand because those monetary units cannot be spent for domestic goods anymore. A current account deficit, thus, shrinks domestic demand and, consequently, employment, investment and production capacity. Deficit countries are caught in a vicious cycle of deficits and debt servicing, which involves the loss of domestic economic resources, thus, increasing deficits further. An increase in foreign debt and a reduction in domestic demand come together and add up to a double payment. Capital flight has the same effect as a current account deficit because it also involves the loss of domestic currency while the country additionally gets indebted in foreign currency. But capital flight can be even more dramatic than a trade deficit, especially when it develops self-enforcing dynamics.

As an example, let us have a look at India’s trade account, which was in deficit of $166 Billion in 2018. Indian importers paid this amount in Indian Rupees while the country’s banking system had to get indebted in US Dollars in order to pay for the deficit. India will have to run an export surplus in the future in order to repay foreign debt. It, thus, sacrifices a share of future output while also losing a share of current output via the loss of domestic currency. Hence, the double weight of the deficit.

Reforming the Payment Settlement System to Unleash Growth Potential

Let us outline what a solution to the problem of the balance of payments constraint and currency crises may look like (more details can be found here). This will also make clear why the recognition of the duplication of international payments is important. Let us assume a reform that works as follows: imports still have to be paid in foreign currency. At the same time, the importer pays in domestic currency. However, in the reformed payment system, these domestic monetary units are not just lost but transferred to a new institution, which is responsible for the settlement of the country’s international payments. It can make use of this money received by investing it in the domestic economy. The institution pays the foreign exporters in US Dollars such that nothing changes for the latter. It remains true that a foreign loan is needed to make this payment. Alternatively, bonds can be issued. Yet, in both cases foreign debt is matched by the real assets, which the institution generates via the reinvestment of the domestic currency. The country is not a net debtor anymore and would not have to forego the value of its next year’s exports.

The advantages of this reform are manifold: instead of constantly losing economic resources, a deficit country now is able to build up capacity and productivity thanks to the reinvestment of domestic currency. Moreover, there is no more pressure on the exchange rate of a deficit country because it is not a net debtor anymore. Finally, capital flight is not harmful anymore because capital is lost no more but reinvested in the economy. Thanks to such a reform, developing countries get back their scope of action to pursue ambitious development strategies via public investment.

The solution to relieve developing countries from the constraint of global capitalist dynamics exists. However, it has been a blueprint so far. It requires more debate and applications specifically designed for the countries thinking about implementing it.

Mr Oberholzer is a macroeconomist working in the field of ecological economics, development economics and sustainable development who received his PhD at the University of Fribourg, Switzerland. He is also a Member of Parliament in the Cantonal Legislature of St. Gallen, Switzerland and is the author of Development Macroeconomics: Alternative Strategies for Growth. He tweets at @basiloberholzer.

Image Credits: Haymarket Media Ltd.