Determinants Of Capital Flight From Beautiful Places: The Case Of Small Open Economy Of Trinidad And Tobago

According to the conventional neoliberal view, financial liberalization should improve resource allocation, increase stability, increase growth, and reduce the incentive for capital flight. However, this is not always the case, as financial liberalization can lead to uncontrolled capital flows, asset price bubbles, and exacerbate capital flight. Capital flight is a challenge faced by many economies and this paper examines the determinants of capital flight pre and post financial liberalization in the case of Trinidad and Tobago, a resource rich small open economy. The 41 year study period 1971-2011, covers about 23 years pre liberalization and 18 years post liberalization using the residual measure of capital flight, with adjustments for trade misinvoicing. The econometric analysis utilizes a combination of the Ordinary Least Squares (OLS) technique and the Generalized Method of Moments (GMM) technique. The GMM estimation was used to complement the analysis, and test the robustness of the OLS results. The results indicate that although there is evidence of a slight change in dynamics of the determinants of capital flight post financial liberalization, the main variables such as: external debt, lagged external debt, lagged capital flight, GDP growth, excess liquidity, and interest rate differential remained significant. Importantly, the proxy variable for financial liberalization also had a positive sign, implying that, contrary to the standard view, capital flight increased significantly post financial liberalization. For the case of a small open economy, the obvious solution is to remove the causes of capital flight to curb its self-reinforcing nature, whereby higher levels of capital flight induce more capital flight. Thus, there is a need to maintain the levels of external debt, the interest rate differential, and excess liquidity arising during periods of higher oil revenues to discourage capital flight. Alternatively, measures could be put in place to create non-interest bearing incentives that will encourage local saving, domestic investment and growth.