Political risk and capital flight in South Africa.
Developing countries have low levels of capital. They are usually net borrowers, supplementing their low domestic savings with external finance. During the 1970s and 1980s many developing countries borrowed from international financial institutions on a large scale. Surprisingly, private citizens of these developing countries were investing in foreign assets at an increasing rate. This observation raised a great deal of interest among academics, policy-makers and the general public concerning capital flight from developing countries . Some of the effects of capital flight on the domestic economy of a developing country are as follows : Firstly, capital flight causes a reduction in available resources to finance domestic investment. This leads to a decline in the rate of capital formation and adversely affects the developing country's economic growth rate. Secondly, capital flight reduces the government's ability to tax all the income of its residents because the government experiences difficulty in taxing wealth held abroad as well as income that is generated from that wealth. Capital flight thus reduces government revenues and the ability to service external debt. Thirdly, as the government revenues fall with the erosion of a tax base there is an increased need to borrow from international financial institutions thereby increasing the foreign debt burden. Capital flight conforms to the portfolio allocation theory , which states that capital flows are determined by rates of return and risk. Capital flows respond positively to higher rates of return and negatively to risk. The present study investigates the effect of political risk on the magnitude of capital flight in South Africa over the period 1960-1995. South Africa is a good test case because the country experienced high political risk and capital flight for many of the years between 1960 and 1995. We replicate the Fedderke and Liu's study (1999) by recollecting the data from original sources. After conducting tests for cointegration we estimate the impact of political risk measured by a political instability index on capital flight. We find support for the hypothesis that higher instability results in greater capital flight. This is the result we are able to replicate thus supporting Fedderke and Liu. We also use our results to show how capital flight can depreciate the exchange rate. Finally we point to. some possible policy implications.