Final answer:
Capital flight is a significant indicator of political risk, signaling investor confidence loss due to economic instability or concerns over a country's financial health. High budget and trade deficits, along with short-term foreign investments, can be precursors to capital flight and economic instability.
Step-by-step explanation:
One good indicator of political risk is capital flight. Capital flight occurs when investors move their capital from one nation to another due to fears of economic instability or the anticipation of poor returns on investments. A serious level of capital flight would indicate that investors are losing confidence in a country's economy, which can be due to high budget deficits and trade deficits, among other factors.
Moreover, the inflow of capital not leading to long-term physical capital investment, but rather going into short-term portfolio investments such as government bonds, can be a sign of vulnerability. Foreign investors closely monitor these economic indicators for any sign of trouble that may affect the country's exchange rate or its ability to repay debts, which could lead to massive outflows of capital upon the slightest negative economic news.
A sustained pattern of high budget deficits and high trade deficits can be particularly alarming, as it may not sustain the inflow of foreign capital investments in the long term. These are precursors to economic instability that might trigger capital flight.