One of the challenges faced by developing countries is to stimulate investment for achieving higher growth rates. On the other hand, the phenomenon capital flight, which is defined as unrecorded capital outflows by the residents of a capital-scarce country, causes detrimental outcomes on the economies of many developing countries. In this paper, I investigate the potentially devastating effects of capital flight on investment, saving and current account as well as how these effects change over time with financial liberalization policies; a topic that remains largely unanalyzed for developing countries. In order to test the impact of capital flight, first, I calculate capital flight estimates for the 29 emerging market economies between 1970 and 2004 by using the so-called "residual method." Afterwards, I employ a dynamic panel methodology that controls for country-specific effects as well as accounting for the potential endogeneity of the explanatory variables. The results suggest that capital flight has a significant and negative effect on investment and current account, however, the importance of this effect seems to have declined after the 1990s as the emerging markets attracted more capital inflows from developed countries. If developing countries can prevent capital from fleeing by implementing sound macroeconomic policies, these funds could be used not only to enhance investment, but also to reduce the dependency on foreign capital. (JEL Classification: F29, F40).
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