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IntroductionSince the 1980s, the problem of capitalflight has received-substantial attentionin Nigeria, particularly, given thedownward slide of the economy duringthisperiod.Despitethis attention,capitalflighthas remaineda particularlyelusivephenomenon both conceptually andempirically. The conceptual problemhas existedbecause it is not immediatelyclear what differentiates capital flightfrom 'normal' capital outflows. Theempiricalproblemshavebeenevenmoredifficult to confront. The quality ofbalance of payments data in lessdeveloping countries (LDCs) is

these, we have looked at the researchwork already done in this area and havehad to conclude that Nigeria has greatlysuffered as a result of capital flight. Thispaper also addresses the potentialoptions available to Nigeria, so that hergrowth and development could besustained optimally in the future.

* Dr. Hamilton Isu is the Special Adviser (Econs) tothe Vice President, Nigeria and a former Dean,College of Business Administration, Abia StateUniversity, Uturu and was a former Bank andFinance Analyst, Federal Reserve Bank of NewYork, U.S.A.

Nigeria's external debt problems havehad pervasive effects on the macroeconomy. Inflation remains a"hydraheaded" problem, with itsnegative effect on growth and capitalaccumulation. Close to the heels ofunsatisfactory inflation andunemployment levels are oscillatoryexchange rates with adverseimplications for investment decision.Crime has been on the increase, creatingan atmosphere of fear and uncertaintyin the environment. In the midst of allthese, government has tried to introducepolicies with potentials for reversingthese negative developments. During the1970s and 1980s, we witnessed grossflight from the country of capital andhuman resources, denying the economyof very important growth inputs. Intrying to analyse the implications of all

HAMILTON O. ISU, Ph. D, ODE*

CAPITAL FLIGHT AND NIGERIA'S DEVELOPMENT:AN ANALYTICAL REVIEW

4

IIIIIII,,

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that israther than

'-''''LiLll,.,1.l ,~:,,",,",,>:.,-,u.by long-termAccording to

this definition, night wouldconsist of all short-term private capitaloutflows plus the 'net errors andomissions' items on the balance ofpayment accounts, that is, the items thatcannot be otherwise accounted for.

Given the difficulty in definingcapital flight and the channels throughwhich it moves, obtaining accurate anddirect information on the size of theflows is nearly impossible.' At best, onlyindirect calculations, with large marginsof error can be made. The margins oferror for countries like Nigeria could

r....

generally poor, flight is oftenintentionally designed to avoid officialdetection.

Different writers often use differentconcepts when discussing capital flightand particularly measuring it. Atone extreme, all private capital outflowsfrom developing whethershort-term or long-term are classified ascapital flight. This is because developingcountries are generally capital-poor.Capital outflows, therefore, reduce theresources available to these countries andimpede their ability to address theirdevelopmental problems. Khan andUlttaque 987) maintain that the termis generally associated with short-termoutflows resulting from economic orpolitical uncertainties in the homecountry

Hamilton O. fsu32

even be greater, given the high incidenceof smuggling that takes place across herseemingly "porous" borders. Capitalflight movements, which respond toheightened domestic economic andpolitical uncertainty, affected manydeveloping countries during the 1980sand 199'08and have proved very difficultto reverse in Nigeria.

In to this, there is abundantevidence that many Nigerianprofes s, namely" doctors,erigmeers, accountants, scientists,architects' etc" migrated abroad for"greener" This massive drift,out of the by thousands ofNigeria's experienced professionals andtechnocrats have had adverse effects onthe economy. country's ability todevelop is also greatlyhampered adverse evolutions.

Doole,y'longerare the economicactivity, a country that isheavily dependent on external financing.One can agree a country like Nigeriaperfectly fits into this description and thatthe level of domestic macroeconomicmismanagement generates domesticallyundiversifiable risk that can significantlyreduce the returns to local investment.Schine1ler (1997) adds that anecdotalevidence suggests that a dramaticdeterioration/improvement in thedomestic investment climate tends tounderpin flight and flight reversal.

This paper will attempt to evaluatethe financial implications of the

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Given the definition of capital flight as

-Dlt=D2t= 1/2W(=Dt ... (4.4)

DB ~ Ia'w - "12+ r - rwl. wt ••• (4.3)a2 Oa 2p P ,

--'

Theta (0) is the coefficient of relativerisk aversion. The properties of thisdemand equation are not surprising.Demand for the horne asset rises linearlywith wealth (reflecting the CRRAproperty) as highlighted by Gordon andLevine (1998).

Demand for the two assets can thenbe expressed as:

Solving the agent's optimization problemyields the demand function for the homeasset thus:

WI=(a (1 +r )+(1- a) (1+fw))WI'" (4.1)

alp = (al a2 + (1-a)2a2w +2a (1-a)a12) •.!(4.2)

Utility is increasing in expected end-of-period wealth w.anddecreasing in thevariable ofthe portfolio's return a2p' Theagent invests a share of wealth a in thedomestic asset, which has expectedreturn rw and variance a2 w. Thecovariance between the two assets is a12.

The expression for expected end-of­period wealth and the variance of theportfolio take the following form:

33

Some Theoretical Considerations

The literature examining capital flighthas emphasized that the "normal" desire'of investors to diversify their investmentportfolio does not constitute capital flight(Cumby and Levich, 1987). Portfoliodiversification arises from the fact thatholding return constant, it is possible toreduce the variance of a portfolio byinvesting in several imperfectlycorrelated assets. Equivalently,diversification allows investors toachieve a higher return for a fixed levelof risk.

Based on this, capital flight will bedefined in thispaper as a subset of capitaloutflows that is due to excessivemacroeconomic risk or structuraldistortions such as financial sectorrepression and poorly enforced propertyrights (Sheets, 199,5). Capital flightreflects the efforts for individuals toprotect themselves from economic andstructural instabilities.

Consider an agent who allocateswealth between two risky assets. Thefirst asset is available only in the homecountry, which is assumed to be acountry in financial distress, and thesecond asset is sold only in worldmarkets. The agent's utility function is"constant relative risk aversion"(eRRA) and takes the form U["Wt a 2 p}

persistence of capital flight in the nation'smacro economy and suggest ways ofstemming the tide so that the nation canmove "forward" economically.

Capital Flight and Nigeria's Development: An Analytical Review

of individualstoprotectthemselvesfrom.economic and structural liabilities(Sheets, 1995).

Many developingcountries,Nigeriainclusive,have inefficientand immaturefinancialsectors.Thishas reflectedbotha lack of relevant human capital and theexistence of incentive structures thathave tended to subsidise inefficiency.Sheets (1995) has maintained thatfinancial sector inefficiency has tendedto increase the level of systematic riskin the LDCs and also reduce the realreturn on domestic financial assets.

One can also deduce from theforegoing that financial sectorinefficiency has intensified systematicrisk because inefficient financialinstitutions have also tended to beunstable institutions. Rapid moneygrowth has reduced the value ofdomestic currencies when measuredagainst their foreign counterparts. Thishas resulted in inflation, exchange ratedepreciation and general macro­economic instability. In response,Nigerians have tended to purchasetangible goods and to hold foreigncurrenciesand foreignassets in an effortto shield themselves from the decliningvalue and increasing instability of thedomestic currency - the naira.

Political risk which refers touncertainty regarding the future courseof government policy could greatlyexcite unmitigated capital outflows. Itmay encompass awide range of factors,including fearof expropriation,concern

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1':...

capital outflows due to excessivemacroeconomic risk and structuraldistortions, equation (4.5) suggeststwochannels through which capital flightmay occur.

1) Capital flight may result frommacroeconomic and structuralpolicies that increase the varianceof the domestic assets, thusincreasingthe thirdtermof equation(4.5)andreducingdemandforhomeassets; and

2) Financialsectorinefficiency,heavytaxation, or loosemonetarypolicy,breakthe linkbetweenthe marginalproducts of capital and the returns.on domestic assets. This reducesthe second-term of equation (4.5)and also reduces the demand forhome assets.

A related conclusion can be drawnfrom equation (4.5). One is that, ingeneral, investors are not motivated byportfoliodiversificationincentivesalone.Another is that investors also considerrelative .returns and relative risks.Investors will base decisions solely onportfolio diversification incentivesonlyif return and risk differentials do notexist.

Moreover, equation(4.5) suggeststhat the interaction between assetcharacteristicsis important.Asportfoliodiversification demands increase,investors are more sensitive to changesin relative returns and relative risk.Capital flight thereforereflects the effort

Hamilton O. Isu34

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1. Overvaluation of Exchange RateThis would tend to encourage reckless

Factors that Provoke Capital Flight

The following factors have tended toencourage capital flight inNigeria sincethe 1970s.

1995). The soundness of theNigerian banking system wasadversely affected during the sameperiod of capital flight i.e the late1980s and early 1990s.

Another channel through whichflight may reduce welfare is decreaseddomestic investment. If someportion ofthe capital that flees the economywouldhave been invested domestically, in theabsence of the flight, then capital flightreducesdomestic investmentwhichmayin tum, reduce social welfare in at leasttwo ways:1. Lower domestic investmentresults

in a lower capital-labour ratiowhich reduces labour productivityand puts downward pressure onwages; and

11. The pace of economictransformation inmost developingeconomies depends on theavailability of capital to financereform; emerging firms needfunding to begin operations,existing firms need investment tomodernise and expand the capitalto develop the physicalinfrastructure necessary to supporta market economy.

35

IV. Finally, if capital flight is fundedby drawing down domestic bankdeposits, capital flight mayjeopardise the soundness of thecountry's banking system (Sheet,

Welfare Effects of Capital FlightLiterature examining capital flightgenerallyacceptsas axiomaticthe notionthat it reduces welfare in the homecountry. Revealed preference analysissuggests, however, that capital flightshould leave, at least, some segment ofsociety better off, namely the "capitalinvestors".Thewelfareeffectsof capitalflightmust, therefore,be asymmetricandredistributive while capital flightinvestors are better-off.

One channel through which thisredistributionmay occuris the following

1. Capital flight tends to exacerbatealready existing, macroeconomicinstabilities, for example, duringa period of economic uncertainty;

11. Large capital outflows maydestabilise the exchange rate;

1ll In addition, as capital leaves thecountry, the tax base may shrink,which limits the government'scapacity to raise revenues andweakens the country's fiscalsituation; and

about future inflation, uncertainty aboutthe tax requirements and doubtconcerning the government'scommitment to reform.

Capital Flight and Nigeria's Development: An Analytical Review

i. The "HotMoney" MeasureThis is a capital flightmeasureproposedby Cuddington(1986)which focusesonshort-term capital movements. Heobserves that the term "Capital flight"typicallyrefersto short-termspeculativecapital outflows. It involves "HotMoney" that responds to "political orfinancial crises" and measures capitalflight as a subset of short-term capitaloutflows plus the "errors and omission"line in the balances of payments. The

not readily available, instead they mustbe constructedsincethere is no universaldefinition of capital flight (Dooley,1986). The literature offers severaldifferentapproachesfordevisingcapitalflight estimates. In fact there is asignificant gap between conceptualanalyses and the empirical approachesused to measure capital flight. That istrue for two reasons:

1. Significantdataproblemsexist.Forexample,balanceofpaymentsdata,particularlyobservationson capitalflows are incomplete andoften in-accurate. Capital flightinvestorsroutinely evadedetectionby domestic authorities; and

11. There is no clear procedure fordistinguishing portfolio diver­sification flows from risk inducedor distortion-induced flows.

Let us evaluate the adequacy of threecommon empirical measures of capitalflight as highlighted in Sheets (1995).

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Estimates of Capital Flight inNigeria: Financial ImplicationsCapital flight statisticsand estimatesare

importation of goods and services, ashappened in Nigeria in the late 1970sand 1980s. This would also discouragedomestic production.

2. Financial Sector ConstraintsControls on interest rate structures inNigeriahaveoftenworkedin furtheranceof capital flight. In such situations, it isoften rational for the domestic investorto seek out foreign assets that yieldhigher returns.

3. Fiscal DeficitsCapital flight from major debtorcountries are often associated withgrowing fiscal deficits. A wideningfiscal deficit financed by "printing"money creates inflationary pressures.This often provides an incentive forresidentsto reducetheirdomesticmoneybalances to avoid an erosionofthe valueof these assets. In Nigeria, moneygrowth has been rapid, propellinginflationary tendencies in amanner thathas proved inimical to national well­being.

4. Risk FactorThis has been brought about by theabsence of well-established politicalstructures, with adequate constitutionalarrangements that provide for aninstitutional infrastructure that isconducive for saving and investing.

Hamilton O. lsu36

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it classifies all accumulation of foreignassets by the domestic private sector ascapital flight; it does not seriouslyattempt to differentiate risk-inducedoutflows fromportfolio diversification.Given the empirical difficulty ofdistinguishing between various types ofcapitalmovement,thisapproachmaynotbe appropriate for evaluating capitalflight situations inNigeria, andwill notbe used.

iii. The Bank oj InternationalSettlement (BIS)Measure

By this definition, capital flight is thechange in deposits of domestic residentsin foreign banks. The major strength ofthis approach is that it does not rely onany balance of payments data. It has,however, numerous weaknesses,notably:a. Since most Central Banks keep a

portion of their reserves in foreigncommercialbanks,theBISmeasuremay include official reserves aswell as privatedeposits; and

b. Capital flight investors attemptingto evade domestic authority maynot truthfully disclose theirnationalitywhenregisteringaccountsabroad.

Resulting from the defects of theBroad and the BIS measures we shalluse the "HotMoney"highlightedearlier,in our attempt to ascertain the naira anddollar values of capital flight fromNigeria during theperiod under review.

a. The Broad measure explicitlyincludes bothlong-term and short­term capital flows, and

b. The Broad measure is calculatedusing the change in the stock ofgross external debt, generallyobtainedfromtheWorldBank.The"Hot-Money" measure depends ondebt-creatingflowswhicharetakenfrom the balances of paymentstables ofLDCs.

Discrepancies between the stock ofthe external debt and cumulative debt­creating flows often arise, reflectingvarious reporting inaccuracies andinappropriate netting of transactions inthe balance of payments. The apparentweakness of the Broad measure is that

ii. The Broad MeasureThis measure has been developed by avariety of researchers including WorldBank (1985), Erbe (1985), MorganGuaranty (1986) and Dooley, Helkie,Tryon and Underwood (1986). Thismeasure calculates capital flight as thechange in gross external debt plusforeigndirect investment(FDI) lessboththe current account deficit and thechange in official reserves.

The Broad measure differsnumerically from the "Hot Money"measure for at least two reasons:

latter is included because capitaloutflows are conducted surreptitiously,such that they will only be captured inerrors and omissions (If they arecaptured at all).

37Capital Flight and Nigeria's Development: An Analytical Review

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38 Hamilton O. Isu .

Table 4.1

Capital Flight Estimates of Nigeria (1970-1991) using the "Hot Money" (inN Million)

Years Short Term Capital Errors andOmission Total Estimate ofOutflow Capital FlightNMillion N Million NMillion

1970 76.8 46.6 113.41971 116.4 117.4 233.81972 62.4 57.2 119.61973 9.2 197.5 206.71974 136.7 3,102.2 3,238.91975 15.2 157.5 172.71976 32.2 339.0 371.21977 84.2 527.2 611.21978 96.3 1,293.6 1,389.91979 6.1 1,868.9 1,875.01980 145.4 2,402.5 2,547.91981 96.4 3,020.8 3,117.21982 2,444.1 1,398.3 3,842.41983 1,361.9 301.3 1,663.21984 10.4 354.9 365.3

r- 1985 2,030.2 349.1 2,379.3...

1986 1,745.2 767.7 2,512.91987 8,467.7 1,226.6 9,693.91988 6,567.8 1,382.0 7,949.81989 18,254.0 1,003.9 19,257.91990 24,945.7 1,247.8 26,193.51991 3,124.6 969.1 4,093.7

Total 91,959.40

N92.0 billion approxi.

Source: Nigeria's Balance of Payment (BOP), Central Bank of Nigeria (CBN) - Several Years.

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Capital Flight and Nigeria's Development: All Analytical Review J9

The "Hot Money" measure of capitalTable 4.2flight estimates, the hotmoney elements

of the capital outflows by the non-bank CapitalFlight and AverageNaira Exchangeprivate sector and the errors and Rates During the Period 1970- 1991omissions are classified as residentcapital outflowsmotivated by distorting Year (1) (2)

domestic policies (Dornbusch, 1988). Capital Flight US DollarinN Million Exchange Rate

As alreadyhighlighted,capital flighttakes place in various ways. If there are 1970 113.4 0.7143no exchange or capital controls in 1971 233.8 0.6955operation, domestic residents simply

1972 119.6 0.6579transfer funds abroad at the prevailingexchange rate. Exchange controls may 1973 206.7 0.6579 .

increase the implicit costs of having 1974 3,238.9 0.6299funds abroad, but experience shows that 1975 172.7 0.6159such controls can be circumvented. 1976 371.2 0.6265Commonways of doing this are under- 1977 611.2 0.6466invoicing of exports, over-invoicing of 1978 1,389.9 0.6060imports and even outright smuggling of 1979 1,875.0 0.5957commodities.

1980 2,547.9 0.5464As long as the receipts from suchoperations are kept abroad and not 1981 3,117.2 0.6100

recorded in the balance of payments 1982 3,842.4 0.6729

accounts, they represent wealth and 1983 1,663.2 0.7241interest income loss to the country and 1984 365.3 0.7649is clearly capital flight under our "Hot 1985 2,379.3 0.6938Money Measure" and the channels in 1986 2,512.9 2.0206which it moves, obtaining accurate and 1987 9,695.9 4.0179direct information on the size of the

1988 7,949.8 4.5367flows is quite difficult and this difficultyis recognized in this paper. 1989 19,257.5 7.3916

From Table 4.1 highlighted above, 1990 26,193.5 8.0378it is clear that Nigeria has lost a lot to 1991 4,093.7 9.9095this "hydra-headed" problem, given the

Source: CBN:Monetary and StatisticalBulletinnaira value of92.0 billion lost to capital (Several years).flight during this period.

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Source: Derived from Table 4.2 above by dividing(1 by 2)

Total $44,583.00or $44.6billion Approx.

1990 3,258.801991 413.12

1,243.642,413.181,752.322,605.38

1986198719881989

1970 158.751971 336.161972 181.791973 314.181974 4,141.921975 280.401976 592.501977 945.251978 865.441979 3,147.561980 4,663.071981 5,110.l61982 5,710.211983 2,298.921984 477.581985 2,662.00

Year US ~ Equivalent(inMillion)

USDollar Equivalent of Capital Flight inNigeriaUnder the "HotMoney" Approach

(in $US, Million)

Table 4.3

flam ilion O. lsu40

Concluding Observations

Haltingandeventually reversingcapitalflight in Nigeria is definitely a worth­while venture, given its adverseconsequences on the economy. Unlessthe effects of capital flight are fullyrecognised, there is little chance thatpolicy actions can succeed in restoringconfidenceinNigeria's financialsystem.The factors that have tended toexacerbate the problem of "fleeing"capital from Nigeria's domesticeconomy must be tackled withdetermination coupled with prudentpolicy actions. Government mustappreciate the need to encouragefreedomof action in policy application,guaranteeingadequateinbuilt incentivesto domestic entrepreneurs.

It is well-known that monetarypolicy tightening effectively poses adilemma for flight capital, whileunderscoringthe effortsof the authoritiesto stabilise their external value. Ofcourse, the impact of policy tighteningwill be tocreate new strains for thedomestic economy.

We have made it clear in this paperthat capital flight is a subset of capitaloutflows that is due to excessivemacro­economic risk or structural distortionsuch as financial sector repression,distortionary taxation and poorlyenforcedproperty rights. We also knowthat foreign investors are presumablysolving aparallel optimisationproblem,constructingtheirportfoliosbasedon thesame considerations as domesticinvestors.

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3. Cuddington, J. "Capital Flight:Estimates, Issues, andExplanations", PrincetonStudiesinInternational Finance. No. 58,Princeton, New Jersey, M~y, 1986.

4. Cuddington, J. "MacroeconomicDeterminants of Capital Flight, AnEconometric Investigation"; inCapital flight and Third WorldDebt,D. Lessard and 1.Williamson(eds.), Institute for InternationalEconomics, Washington D.C.,1987.

5. Cumby, R. and Levich, R. "On theDefinition and Magnitude ofRecent Capital Flight", in CapitalFlight and Third World Debt, D.Lessard and J. Williamson (eds.),Institute for InternationalEconomics,Washington D.C., 1987.

6. Dooley, M. W. Helkie, R. Tryon,J. Underwood, "An Analysis ofExternal Debt Position of EightDeveloping Countries through1990". Journal of DevelopmentEconomics, May, 1986.

7. Dooley, M. "Country-specific RiskBusiness, Capital Flight and NetInvestment Income in SelectedDeveloping Countries",UnpublishedPaper, IMF, March, 1986.

8. Dooley, M. "Capital Flight: AResponse to Differences inFinancial Risk," Staff Papers,International Monetary Fund,Washington D.C., September,1988.

References

1. Balance of Payments StatisticsYear Book International MonetaryFund, Washington D.C., USA,1993.

2. Claessena, S. and Naude, D."Recent Estimates of CapitalFlight". International, The WorldBank Working Paper 1186,September, 1993.

For this reason, financialliberalisation may be associated with aninflow of foreign investment, asforeigners rebalance their portfolios toinclude the domestic asset. However,just as high risk and repressed returnsmay generate capital flight, these factorsmay also inhibit foreign investment (Isu,1993).

Within the period of study, Nigeriais assumed to have lost resources inexcess of $45billion to capital flight.There is no doubt therefore that capitalflight reduces welfare in the homeeconomy. Capital flight tends toexacerbate already existingmacroeconomic instabilities as has beenthe case in Nigeria. The element ofuncertainty in Nigeria's macro economyoccasioned by an unpredictable politicaltransition, unpredictable economicenvironment, unpredictable livingstandards and unpredictable productivitylevels should be forcibly removed fromthe Nigerian environment to make for areversal of the capital outflowssyndrome.

41Capital Flight and Nigeria's Development: An Analytical Review

20. Williamson, J. and D. Lessard"Capital Flight: The Problem andPolicy Responses ", Institute forInternationalEconomics,WashingtonD.C., November, 1987.

21. World Development. The WorldBank, Washington D.C., July,1985.

19. Sheets, N.Capital Flight fromCountries in Transition: SomeTheory and Empirical Evidence.International Finance DiscussionPapers, Washington D.C., July1995.

18. Kindlebegerger, C. "Capital Flight:A Historical Perspective" inCapital Flight and Third WorldDebt.D. Lessard and 1.Williamson(eds.), Institute for InternationalEconomics, Washington D.C.,1987.

17. Isu, H.O. "Exchange RateDetermination in Nigeria in the1980s: The Relevance of thePurchasing Power Parity (PPP)Doctrine", TheNigerianFinancialReview Vol. 1, No.4, December,1993.

16. Isu, H.O., "Solving the ThirdWorld Debt Crisis: The Non­Conference of Prescription"Finance India (A Journal ofIndianInstitute of Finance) Vol.lI, June,1988.

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IS. Isu, H.O. "Country Risk andForeign Investment in Nigeria,1970-1984, A Critical Appraisal"Nigerian Forum. NIIA LagosJuly/August, 1987 .

11. Easton, Jonathan "Public DebtGuarantees and Private CapitalFlight", World Bank EconomicReview May, 1987.

12. Erbe, S. "The Flight of Capitalfrom Developing Countries", Inter­economics,NovlDecember, 1985.

13. Gordon, D. and Levine, R. "TheCapital Flight Problem".International Finance DiscussionPaper No.320, Board ofGovernors of the FR System,Washington D.C., August, 1988.

]4. Khan, M. and N.Ulttaque ForeignBorrowing and Capital Flight: AFormal Analysis", Staff Papers,IMF, Washington D.c,December,1985.

9. Dooley, M. and K. Kletzer"Capital Flight, External Flight,External Debt and Policies",NBER Working Paper No. 4793,June, 1994.

10. Dornbusch, R., "Exchange RateRisk and the Macro-economics ofExchange Rate Determination", inExchange Rates and Inflation,Pree: Cambridge, Massachussets1988.

Hamilton 0. lsu42

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