Board of Governors of the Federal Reserve System

July 1995

Capital Flight from the Countries in Transition: Some Theory and Empirical Evidence

Nathan Sheets

Abstract:

The first portion of this paper develops a simple framework that decomposes home demand for a domestic risky asset into a portfolio diversification incentive, a relative risk incentive, and a relative return incentive. It shows that capital flight may be caused by factors that increase the relative riskiness of the home asset or by structural distortions (such as financial sector inefficiency), which reduce the relative return of the domestic asset. The second portion of the paper provides empirical estimates of capital flight from Poland, Hungary, Czechoslovakia, and Russia for the 1988-93 period. The analysis concludes that the implementation of "shock therapy" reform programs has been accompanied by substantial capital flight. This has apparently occurred because such reform programs have initially generated increased economic and political uncertainty: prices have jumped toward world levels, property rights have been redistributed, and new institutions have been established. As these reform programs have progressed, however, the quantity of capital flight has declined. Hungary's experience is significantly different from that of the other three countries. Hungary pursued gradual reform and never experienced significant capital flight.

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