draining development.pdf - Khazar University

Governance and Illicit Flows 49An even more important example concerns policies to overcomemajor market failures such as those constraining technological capabilities.Growth in developing countries is typically constrained by low profitabilitybecause of the absence of formal and informal policies to addressmarket failures and, in particular, the problem of low productivitybecause of missing tacit knowledge about modern production processes(Khan 2009). In the absence of policies that assist technological capabilitydevelopment, capital is likely to flow out of the developing countrydespite low wages. Countervailing policies, variously described as technologypolicies or industrial policies, involve the provision of incentivesfor investors to invest in particular sectors and to put in the effort toacquire the missing tacit knowledge. In the presence of such policies,some restrictions on capital movements may be potentially beneficial.The provision of incentives to invest in difficult processes of technologyacquisition and learning may be wasted if domestic investors can claimthe assistance without delivering domestic capability development.Unrestricted financial outflows may allow domestic investors to escapesanctions attached to poor performance. If the policy is well designedand the state has the capability to enforce it, restrictions on financialoutflows may be socially beneficial. Some amount of capital flight maystill take place, and liberal economists may want to argue that this is ajustification for removing the policy and returning to a competitivemarket. However, if the market failures constraining investments are significant,this may be the wrong response, if a credible technology policyexists. The restrictions on capital flight in East Asian countries in the1960s and 1970s worked dramatically because they combined significantincentives for domestic investment with credible restrictions on capitalflight. In such cases, capital flight would be directly damaging in thesense of lost investment and not have any indirect positive effects either.It would therefore be illicit according to our definition.The mirror image of this is capital flight driven by the absence of profitabledomestic opportunities in a country without effective technologypolicies. Capital is likely to seek offshore investment opportunities. Evenif this capital flight appears to be damaging in an immediate sense, itmay not be. This is because attempting to block capital fleeing low profitabilityis unlikely on its own to solve the deeper problems of growth.Indeed, enforcing restrictions on capital outflows in a context of low