Capital Outflow

Article byGayatri Ailani
Reviewed byDheeraj Vaidya, CFA, FRM

Capital Outflow Meaning

Capital outflow is the movement of capital out of the country. A country experiencing the outflow treats it as an unfavorable event and implements capital controls to restrict the outward movement of the capital.

Capital Outflow

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It results in the flow of assets from the domestic country to the foreign country because of better opportunities and economic stability in the foreign markets. It creates a mix of negative and positive impacts on the domestic country. Massive outflow is a source of economic risk for a country. It can cause severe depreciation and exchange rate crises, leading to economic crises.

Key Takeaways

  • Capital Outflow is the flow of money out of the country due to political and economic factors. 
  • The unexpected departure of large sums of money, capital, or assets can adversely affect event that hurts the country’s domestic economy. It weakens the nation’s economy and government spending as the tax revenue collection decreases.
  • A country with sufficient foreign currency reserves will be able to maintain its financial markets stable in the wake of capital outflow.
  • The opposite concept is capital inflow. The net purchases of domestic assets by non-residents are the capital flowing into the country.

Capital Outflow Explained

Capital outflow portrays the departure of capital or asset as an adverse event that adversely affects the country’s domestic economy. It weakens the nation’s economy and government by reducing tax revenue. Rapid capital outflows also reduce citizens’ purchasing power in the affected country, and asset value depreciates automatically. Finally, people start withdrawing their capital.

Restrictions on capital outflows can be used for various purposes in addition to serving as one of the most effective barriers against undesirable inflows. In addition, capital controls on withdrawals may be essential during severe crises to prevent a currency’s sharp decline and a bank run.

Both developed and developing nations go through this scenario of capital outflows. However, developing countries are more vulnerable to significant and rapid capital outflows. Capital outflow takes place for two main reasons: economic and political instability but several other factors cause a flow of capital from one country to the other. 

  • Economic Instability:  Capital outflows can occur because of fluctuations in the country’s exchange rate that cause depreciation in the value of the domestic country. The decrease in the value of the domestic country directly impacts the investors who withdraw their capital and start investing in foreign markets. In addition, the decrease in tax revenue or change in the tax laws directly impacts the country economically and socially since it decreases government spending on social and welfare schemes. 
  • Political Instability: Various political events triggers capital outflows from a country. Political unrest may shake investors’ confidence in the country’s economic prospects. Furthermore, the government intends to pursue nationalization or follow restrictive trade policies from foreign countries, which could be another catalyst for capital outflows.
  • Debt Burden: If the government is under a debt burden, to repay debt, the government may impose austerity measures, which impact the country’s economic growth, causing investors to shift to other foreign markets.
  • Interest Rates: If interest rates in the foreign market remain unchanged, returns in the domestic market become less attractive. Foreign investors prefer to invest in countries with higher returns and stability.

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Impact Of Capital Outflows

Capital outflows impact the exchange rate of the domestic currency, which causes depreciation. Small outflows are typical for the economy. When capital leaves the country, more people sell their national currency and convert it to foreign currency. As a result, the value of the domestic currency falls. Depreciation makes domestic products more affordable to foreign buyers, and the export of goods and services increases the economy. 

It’s questionable how capital flight affects the domestic labor market. Specific studies show that foreign direct investment (FDI) is suitable for employment in emerging nations, but foreign portfolio investment is unfavorable for domestic employment generation. However, in industrialized nations, there is little correlation between foreign direct investment and employment.

Example

Let us look at capital outflows examples to understand the concept better: For example, a

significant semiconductor producer in Taiwan benefitted from the trend of working and studying from home during the COVID-19 pandemic. Still, that demand is declining as the world economy is experiencing recession and inflation.

In September 2022, Finance Minister Su Jain-rong of Taiwan said that “Capital outflows are a “temporary phenomenon” and Taiwan, with its foreign currency reserves, has enough capacity to maintain its financial markets stable.” 

Worries over slowing global economic development, aggressive interest rate rises in the United States, and the strength of the US dollar have all contributed to the recent collapse of Taiwan’s stock market (.TWII) and currency.

According to Taiwan’s stock market, foreign investors sold $33.8 billion worth of equities as of the end of August. As a result, the benchmark stock index in Taiwan is down 26%, one of the worst results in Asia, while the Taiwan currency has declined 13% versus the greenback (US dollar) so far this year. As of August, Taiwan has $545.48 billion in foreign exchange reserves, which would be more than enough to maintain the currency and economy.

Capital Outflow vs Capital Inflow

  • Capital Outflow is the flow of capital from domestic to foreign countries. In contrast, capital inflow is the flow of capital from foreign countries to the domestic country. 
  • Capital outflow generally occurs due to political and economic instability. In contrast, capital inflow occurs due to the expansion in the domestic economy, domestic boom, trade openness, scenarios and regulations influencing foreign direct investment in the country, etc.

Frequently Asked Questions (FAQs)

What are capital inflow and outflow?

Capital outflow refers to the movement of capital from domestic to foreign countries. On the other hand, capital inflow is the flow of capital from foreign countries to the domestic country.

What is net capital outflow?

A nation’s net flow of money invested overseas during a specific period is known as its net capital outflow (NCO). NCO is one of thessentialnt metrics used to describe how a nation interacts with the rest of the world economically and financially.

How does capital outflow affect the exchange rate?

Capital outflows affect the domestic currency’s exchange rate, which leads to depreciation in the domestic currency. More people sell their local currency and exchange it for foreign currency when capital leaves the country. The value of the local currency decreases as a result. Depreciation lowers the price of domestic goods for foreign consumers, boosting the economy’s export of goods and services.

This has been a guide to what is Capital Outflow. Here, we explain its example, impact, and comparison with capital inflow. You may also find some useful articles here –

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