Explainer

What is capital flight?

You may have heard unionists and some in the independence movement warning about ‘capital flight’. This is used either as an argument against independence or against an independent Scotland having its own currency. So what is capital flight and how worried should independence supporters be?

What is capital flight?

Capital flight isn’t complicated. All it means is that if people with a lot of money fear that an economy is about to get into big trouble or a currency is going to drop in value suddenly they may try to take their money out of the country and keep it somewhere else or they may convert their money into another currency.

Currency flight is people taking their money somewhere else if they are worried about the place they are currently keeping it

There are a few potential causes of currency flight. One would be if people with money fear that the currency they have the money in is going to drop in value suddenly. Another would be if an economy they are invested in looks like it could face a crisis. Another is if a country starts to become ‘lawless’ and they risk not being able to access their money.

It happens when someone thinks their money isn’t safe or that it will quickly lose its value

Capital flight can either be money which has been invested into the country by overseas investors or it can be money that wealthy inhabitants of the country move to try and protect the value of their savings.

Capital flight can be both foreign investor taking their money out or residents sending their money elsewhere

What harm can it do?

The first problem that capital flight poses is for those who are trying to find sources of investment in the affected economy. If investors panic and take their money out the country then businesses and even the government can struggle to find sources of investment.

Capital flight can harm rates of investment in an economy

It can also create a vicious circle. If people think a currency or an economy is risky and they pull their money out, it can cause others to worry which can cause the currency to devalue – and so on.

It can create a panic which can reduce the value of the currency

But it is also about confidence. Economies rely on people having confidence in them and if people start to see an economy or a currency as doing badly it can reduce overall confidence in the economy. That can make it more difficult for businesses to be successful.

A panic reduces confidence in an economy which can harm businesses

What can be done to protect agains capital flight?

The first way to protect against currency flight is to carefully control the value of a currency using the country’s monetary policy. A number of policies (and in particular a large foreign currency reserve) can help to stabilise the value of a currency and so reduce the level of risk that investors see.

Central banks can carefully manage a currency to stop the panic starting in the first place

Another good way to prevent capital flight from starting is to make sure that your economy is strong and offering lots of good investment opportunities which will produce reliable returns on the investment. People won’t pull their money out of an economy if there is money to be made.

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A strong economy with good investment opportunities makes people want to keep their money where it is

But if capital flight does look like a real risk then it is possible to use capital controls. These simply make it illegal to withdraw more than a certain amount of currency from the economy so there is a limit on how much capital is lost. But it does create the risk that by introducing capital controls you actually fuel the panic you’re trying to prevent so it’s not always a good solution.

Capital controls can be used to prevent capital flight – but should be used very carefully

Should an independent Scotland worry?

In the early years of independence when a new currency is introduced, no-one will be forced to convert their Sterling to the new Scottish currency. They’ll need to convert some to pay taxes and buy things in shops, but it is very likely that at first most people will keep a fair bit of their savings in Sterling and that value of that won’t be affected.

People can still keep their savings in Sterling so there is no need to worry

This would create a problem if the economy then found it hard to source investment, but that just isn’t a problem in the world just now. Globally there is so much money looking for productive returns that a productive economy won’t find it hard to source investment. But Scotland would need to make sure its early economic policy was encouraging that kind of productive economy.

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Finding investment won’t be difficult as long as there are good investment opportunities

And before Scotland introduced a new currency it would need to create a central bank with proper foreign currency reserves. This gives Scotland the full range of powers to protect the currency and the economy – from setting interest rates to pegging the value of the currency (maintaining it at the same value as Sterling) to quantitative easing for investment.

An independent Scotland with its own currency would have lots of tools to protect and defend that currency

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