Policy Credibility and Capital Flight: The Role of Monetary Policy Efficiency and External Debt in Developing Economies

The theory of capital flight induced by external debt proposes the possibility that the rising external debt might lead investors to expect losses in their currencies, fiscal problems, or the imposition of capital taxes in the future, which could cause funds to be diverted abroad. The present study investigates the factors influencing capital flight in developing economies, with particular reference to monetary policy efficiency and external debt. By employing the Panel Mean Group approach, which is based on the panel AutoRegressive Distributed Lag model, this study analyses the short-run and long-run relationships between the variables for twelve developing economies over the sample period 2000 Q1 to 2023 Q4. This study utilizes quarterly panel data for twelve developing countries to investigate the short-run and long-run relationships between the variables of interest. Capital flight is measured using the residual approach, while monetary policy efficiency captures the ability of central banks to stabilize inflation and output, and external debt is expressed as a ratio to GDP. The empirical results reveal that monetary policy efficiency has a significant negative effect on capital flight in the long run, thereby underscoring the significance of credible monetary policy for mitigating capital flight risk in developing economies. On the other hand, external debt has a significant positive effect on capital flight, thereby validating the debt-induced capital flight hypothesis. This study finds that capital control measures are effective in reducing capital flight risk, while trade openness enhances capital mobility. Exchange rate volatility does not have any long-run effect.