Debt relief, foreign aid should be accompanied by solid macro policy, says IMF working paper

By Reshmi Basu

New York, Oct. 26 - Macroeconomic policy variables and conditions have a significant influence on capital flight, according to a new International Monetary Fund working paper. Therefore, foreign aid or debt relief should be complemented by sound macro policies.

Furthermore, the institutional environment should be supportive in providing available resources for projects within the country, according to the paper, which does not reflect the views of the IMF.

Titled "Robbing the Riches: Capital Flight, Institutions, and Instability," the paper by Valerie Cerra, Meenakshi Rishi and Sweta C. Saxena said the intention behind debt relief and foreign aid is to give poor countries the chance to exit poverty through domestic resources instead of resorting to domestic savings to service debt.

However, many poor countries, even those targeted by the debt relief initiative, are losing more resources through capital flight than through debt servicing, according to the working paper.

Recent schools of thought have linked the determinants of capital flight to non-macro variables such as political risk factors. Another camp connects the association between capital flight and other perverse macroeconomic outcomes such as low rates of growth.

The paper examines whether capital flight in developing countries acts as a mediating channel between weak institutions and poor macroeconomic outcomes.

The authors contend that countries with a poor track record on macroeconomic fundamentals may also have weak fundamentals. "Therefore, capital flight may be a byproduct of redistributive tools designed by a weakly constrained executive that is interested in 'robbing the riches,'" the authors write.

Through empirical analysis, the authors' findings show that the political and business environment is related to capital flight. Institutional quality also plays a determinant role.

"Consistent with our robbing the riches hypothesis, resources from the banking system are drained out as capital flight in the presence of weak institutions," the authors note in the report.

There is also strong evidence of the revolving door relationship between borrowing and flight.

The paper finds "debt-fueled capital flight" as well as a "financing need" channel working in the opposite casual direction.

"Debt tends to stimulate capital flight, while FDI (foreign direct investments) and aid tend to reduce flight. Short-term debt accumulation has the most severe impact on capital flight," the authors argue.

Weak institutions instigate capital flight, therefore underpinning a rise in debt accumulation.

"The loss of domestic saving associated with capital flight is partly offset by increases in foreign financing."

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