The Nexus of Official and Illicit Capital Flows The Case of Hong Kong

Abstract

The revival of strong capital flows to emerging economies in the aftermath of the 2008-9 Global Financial Crisis has rekindled the debate on the adverse effects of excessive capital inflows. In this study, we study effects of official and illicit capital flows on Hong Kong, which is a small and open economy with minimal restrictions on cross-border fund movements and is susceptible to international capital flows. To illustrate the differential impacts of different types of capital flow, we study the effects of two measures of official flows and two measures of illicit flows on Hong Kong’s equity and residential housing markets.It is found that these official and illicit capital flow measures reflect different facets of flow movements and have different effects on the economy. Specifically, they exhibit differential effects on the equity and residential housing markets. The results highlight the complexity of managing capital flight, and the relevance of polices targeting specific sectors.Further, it is found that, compared with capital flows, economic variables tend to offer a relatively higher level of explanatory power. Anecdotal evidence suggests that Hong Kong manages the effects of capital flows using various macro-prudential policies, which are deemed to be effective. One interpretation is that an effective governance framework and prudential regulatory environment improve market confidence and reduce vulnerability to economic and financial risks. In other words, it is important to keep one’s house in order, practice pre-emptive macro-prudential policies, and have an efficient infrastructure to accommodate capital flows. Our results indicate that Hong Kong has done quite well in the last few decades in enhancing its market efficiency and conducting macro-prudential policies.