Foreign aid and capital flight: A case study of Bangladesh

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Over the years Bangladesh has received a massive inflow of foreign capital, mostly in the form of foreign aid, which has coincided with a substantial outflow of domestic capital. This flight of domestic capital from a capital-scarce country like Bangladesh undoubtedly poses a formidable hurdle to achieving its long-term development objectives. A hypothesis can be put forth that the inflow of foreign capital directly contributes to the oufflow of domestic capital. This paper applies the Engle-Granger cointegration procedure to estimate the short-run dynamic and the long-run equilibrium behavior of capital flight from Bangladesh. The estimated results support the hypothesis that the inflow of foreign aid has in fact significantly contributed to the flight of domestic capital. Furthermore, the estimated results suggest that lower real GDP growth, increases in corporate taxes, financial repression and political instability also significantly contribute to capital flight from Bangladesh. These results yield crucial insights into the mechanics of capital flight from China, the source country of most flight capital in the Asia-Pacific region, that suggest that, regardless of the domestic investment environment, availability of foreign exchange, provided by either foreign aid or FDI, can support the flight of domestic capital abroad. © 2004 Taylor & Francis Ltd.

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