Political risk and capital flight

Capital flight often amounts to a substantial proportion of GDP in developing countries. This paper presents a portfolio choice model that relates capital flight to return differentials, risk aversion, and three types of risk: economic risk, political instability, and policy variability. Estimating the equilibrium capital flight equation for a panel of 45 developing countries over 16 years, all three types of risk have a statistically significant impact on capital flight. Quantitatively, political instability is the most important factor associated with capital flight. We also identify several political factors that reduce capital flight, ostensibly by signaling that market-oriented reforms are imminent.