Prof .R. Vaidyanathan
Every year huge sums of money are transferred out of developing countries illegally. Actually they strip resources from developing countries which could be used to fund public services, from security and justice to basic social services such as health and education. The illicit financial flows also weaken their financial system and impact economic development. Given their smaller resource base and markets-the social and economic impact on developing countries is more severe. Most of them come from Non-Governmental organizations and the estimates vary greatly and are heavily debated one of the most quoted is that of Global Financial Integrity [GFI] –a Washington based think tank. We rely significantly on the data from GFI in this chapter
Global Financial Integrity (GFI), provides estimates of the illicit flow of money out of the developing world–as a whole, by region, and by individual country–from 2003-2012, the most recent ten years of data availability. We quote extensively from the study [GFI 2014]
The study finds that between 2003 and 2012, the developing world lost US$6.6 trillion in illicit outflows. In real terms, these flows increased at 9.4 percent per annum. After a brief slowdown during the financial crisis, illicit outflows are once again on the rise, hitting a new peak of US$991.2 billion in 2012 – as given in the table below:
Table 1 – Illicit Financial Flows from Developing Countries, by Region, 2003-2012 (in billions of nominal U.S. dollars)
To put this in perspective, the cumulative total of official development assistance (ODA) to the developing countries in this report from 2003 to 2012 was just US$809 billion In 2012, the last year in this study, ODA to these countries stood at US$89.7 billion, according to OECD data sourced from the World Bank. That means that for every single one of those US$89.7 billion in development aid that entered these developing countries in 2012, over US$10 in illicit financial flows (IFFs) came out. If the problem of illicit financial flows is allowed to grow unchecked, development aid will continue to fight an uphill battle.
This report also compares illicit outflows to foreign direct investment (FDI) in the developing countries that are found in this report from 2003 to 2012. Though FDI was significantly larger than ODA at US$5.7 trillion over the 10-year period, it was still less than illicit outflows. Even FDI and ODA combined come in at slightly less than illicit outflows, at US$6.5 trillion.
GFI measures illicit financial outflows using two sources: 1) outflows due to deliberate trade misinvoicing (GER) and 2) outflows due to leakages in the balance of payments, also known as illicit hot money narrow outflows (HMN). The vast majority of illicit financial flows- 77.8 percent in the 10-year period covered in this report – are due to trade misinvoicing (see Table 2)
Table 2 – Illicit Financial Flows from Developing Countries, by Component, 2003-2012 (in billions of nominal U.S. dollars)
Asia continues to be the region of the developing world with the greatest volume of illicit financial flows, comprising 40.3 percent of the world total over the ten years of this study. It is followed by Developing Europe at 21.0 percent, the Western Hemisphere at 19.9 percent, MENA (the Middle East and North Africa) at 10.8 percent and Sub-Saharan Africa at 8.0 percent.
MENA saw the largest percent increase in illicit outflows from 2003 to 2012, at 24.2 percent per annum. Sub-Saharan Africa followed at 13.2 percent with Developing Europe at 9.8 percent, Asia at 9.5 percent, and the Western Hemisphere at 3.5 percent.
According to Global Financial Integrity [GFI] for 2012, the global figure was close to USD 1 trillion [GFI, 2014]-China accounting for quarter of the total and Russia/Mexico/India/Malaysia are the other prominent losers.
Table 3 – Illicit Financial Outflows from the Top 10 Developing Economies, 2003-2012 (in millions of nominal U.S. dollars or in percent)
Asia’s regional total is driven by the People’s Republic of China, the leading source of illicit financial flows from developing countries for nine of the ten years of this study. Similarly, Developing Europe’s large share of global IFFs is primarily due to the Russian Federation, the number two country for nine of the ten years of the study, which briefly surpassed China in 2011 to become the world’s top exporter of illicit capital before ceding this place back to China in 2012.
The top five exporters of illicit capital over the past ten years on average are: China, Russia, Mexico, India, and Malaysia. Compared to GFI’s estimates in Illicit Financial Flows from Developing Countries: 2002-2011, hereafter referred to as the 2013 IFF Update, these rankings have changed only slightly—India and Malaysia switched ranks in this report, with India moving up to the number four slot. This is due to a continuation of India’s upward trend, which began in 2009, and Malaysia’s downward trend that began in 2010. China registered a particularly large increase from 2011 (US$162.8 billion) to 2012 (US$249.6 billion). This is due primarily to its return to a trend of large and increasing HMN outflows that began in 2009 but dropped off precipitously in 2011. See Table-3
There has been minimal academic research on the topic, but some scholarly critiques of the GFI approach can be found in a recent volume of essays from the World Bank. For example, Nitsch (2012) suggests that the GFI estimates make unrealistic assumptions about trade-related transport costs and ignore many other factors that could account for errors in international trade and finance statistics] but there is a general consensus that illicit financial flows likely exceed aid flows and investment in volume. The most immediate impact of illicit financial flows (IFFs) is a reduction in domestic investment and expenditure, both public and private. This means fewer hospitals and schools; fewer roads and bridges. [OECD 2014]
“It also means fewer jobs. Furthermore, many of the activities which generate the illicit funds are criminal; and while financial crimes like money laundering, corruption and tax evasion are damaging to all countries, the effects on developing countries are particularly corrosive. For example, corruption diverts public money from public use to private consumption. We know that in general private consumption has much lower positive multiplier effects than public spending on social services like health and education. Proceeds of corruption or criminal activities will generally be spent on consumption of items such as luxury vehicles, or invested in real estate, art, or precious metals. [World Bank, 2006]
The social impact of a Euro spent on buying a yacht or importing champagne will be very different from that of a Euro spent on primary education.
On another front, money laundering is harmful to the financial sector: a functioning financial sector depends on a general reputation of integrity, which money laundering undermines.
In this way, money laundering can impair long-term economic growth, harming the welfare of entire economies”.
– [OECD2014] report
They are generated in contravention of national laws by methods/practices to transfer financial capital out of a country. These could be due to Money Laundering [defined as the possession, transfer, use and concealment of the proceeds of the crime] tax evasion; bribery by global companies; trade mispricing. The source of the illicit flows could be smuggling; counterfeiting arms smuggling etc. Sometimes source could be legal but transfer may be illegal like tax evasion. Also intended uses of funds are not clear.
The [OECD 2014] report adds
“They may be intended for other illegal activities, such as terrorist financing or bribery, or for legal consumption of goods. In practice, illicit financial flows range from something as simple as a private individual transfer of funds into private accounts abroad without having paid taxes, to highly complex schemes involving criminal networks that set up multi-layered Multi-jurisdictional structures to hide ownership”.
Much attention has been given to kleptocrats such as Sani Abacha (Nigeria), Valdimiro Montesinos (Peru) and Ferdinand Marcos (Philippines). Each looted their countries whether through direct control of the central bank (Abacha), extortion of defense contractors (Montesinos) or confiscation of businesses (Marcos). When they left power– whether through death, political upheaval or criminal conviction– each was found to have invested overseas in a wide variety of assets. Also other lower level officials like the governors of two Nigerian states recently convicted in London courts of having acquired assets in the United Kingdom with funds stolen from state development funds. The money was generally moved by carrying of cash in large denominations across borders or as wire transfers through complicit banks
The reasons for these dictators to keep money abroad are varied. It is to protect confiscation or taxation by new regimes or to access luxury goods available abroad or to get favors from leaders abroad etc. Much less is known about the outflows associated with tax evasion, perhaps the most ubiquitous of the sources of illicit financial flows. These can add up to a substantial sum of drainage of home country resources.
Among the various methods mentioned—in generating illicit funds in tax havens—trade Misinvoicing is an important one. Trade Misinvoicing is basically moving the funds to tax havens by way of under invoicing its exports and over invoicing its imports.
Trade misinvoicing is a method for moving money illicitly across borders which involves deliberately misreporting the value of a commercial transaction on an invoice submitted to customs. A form of trade-based money laundering, trade misinvoicing is the largest component of illicit financial outflows measured by Global Financial Integrity. [GFI]
By fraudulently manipulating the price, quantity, or quality of a good or service on an invoice, criminals can easily and quickly shift substantial sums of money across international borders.
Why is Trade Misinvoicing Used?
According to GFI, there are three primary reasons criminals misinvoice trade:
- Money laundering – Criminals or public officials may seek to launder the proceeds from crime or corruption. Directly Evading Taxes and Customs Duties – By under-reporting the value of goods, importers are able to immediately evade substantial customs duties or other taxes.
- Claiming Tax Incentives – Many countries offer generous tax incentives to domestic exporters selling their goods and services abroad. Criminals may seek to abuse these tax incentives by over-reporting their exports.
- Dodging Capital Controls – Many developing countries have restrictions on the amount of capital that a person or business can bring in or out of their economies. Investors attempting to break these capital controls often misinvoice trade transactions as an illegal alternative to getting money in or out of the country.
As many countries attempt to process customs transactions quickly, in an effort to promote trade and boost economic growth, trade misinvoicing has become a fairly low-risk endeavor for criminals—especially those who only moderately misinvoice their transactions by, say, 5 to 10 percent.
How Does Trade Misinvoicing Work?
In this case of import over-invoicing, the Indian importer illegally moves $500,000 out of India. Although he is only buying $1 million worth of used cars from the U.S. exporter, he uses a Mauritius intermediary to re-invoice the amount up to $1,500,000. The U.S. exporter gets paid $1 million. The $500,000 that is left over is then diverted to an offshore bank account owned by the Indian importer.
[Reuter 2014] gives an example for trade misinvoicing –
Fraudulent trade invoicing in five African countries cheated taxpayers out of a combined $14.4 billion in revenue in the 10 years to 2011 and in Uganda’s case losses amounted to an eighth of annual government revenue. The tax authorities in the five countries studied by Global Financial Integrity (GFI) – Ghana, Kenya, Mozambique, Tanzania and Uganda – lacked the trade, tax and deals data to curb the illicit flows, it said in a research report. Over- and under-invoicing in the five countries facilitated the illegal inflows or outflows of more than $60 billion during that decade, GFI said.
Kenya lost an estimated $1 billion each year through export under-invoicing, where sellers deflate the true value of their exports so they can channel the difference to a foreign account. Tanzania, on the other hand, lost a similar amount to export over-invoicing, which over-values shipments so parties can collect export credits. Uganda had $813 million in import over-invoicing, which can lead to lower corporate taxes as companies puff up the cost of imports to hide capital outflows.
GFI said its study was “extremely conservative” as it left out incorrect invoicing for services, bulk cash deals or hawala transactions, a form of money transfer used in the Muslim world. “Trade misinvoicing is perhaps the most serious economic issue plaguing these countries,” GFI president Raymond Baker said in a statement. Ghana had more than $14 billion in mis-stated invoices over the entire 10-year period, equivalent to 6.6 percent of its gross domestic product, while Mozambique’s $5.3 billion was equal to 9 percent of national output”.
Africa and Illicit Financial flows
Chart 3. Illicit Financial flows in Africa
The report, Illicit Financial Flows and the Problem of Net Resource Transfers from Africa: 1980–2009, found that cumulative illicit outflows from the continent over the 30-year period ranged from $1.2 trillion to $1.4 trillion. The Guardian, a British daily, notes that even these estimates—large as they are—are likely to understate the problem, as they do not capture money lost through drug trafficking and smuggling.
“The traditional thinking has always been that the West is pouring money into Africa through foreign aid and other private-sector flows, without receiving much in return,” said Raymond Baker, president of Global Financial Integrity, in a statement released at the launch of the report earlier this year. Mr. Baker said the report turns that logic upside down, adding that Africa has been a net creditor to the rest of the world for decades.
In other words Africa loses more in terms of illicit financial outflows than what is received as Aid and FDI for its development.
That is the saga of many developing countries that eagerly wait for FDI and development Aid without realizing that the money gets drained by trade misinvoicing and other illicit outflows.
In other words they are net losers even though projected as villains!!
Author is Professor of Finance at Indian Institute of Management, Bangalore – Views are personal.
- Global Financial Integrity (GFI-2014), Illicit Financial Flows from Developing Countries 2003-2012, Dev Kar and Joseph Spanjers , Global Financial Integrity, Washington, DC, available at: http://www.gfintegrity.org/report/2014-global-report-illicit-financial-flows-from-developing-countries-2003-2012/
- Nitsch, Volker (2012), “Trade mispricing and illicit flows”, in Reuter, Peter (ed.) Draining Development? Controlling Flows of Illicit Funds from Developing Countries, The World Bank, Washington, DC, available at: https://openknowledge.worldbank.org/bitstream/handle/10986/2242/668150PUB0EPI0067848B09780821388693.pdf.
- International Bank for Reconstruction and Development/World Bank/IMF (2006), Reference Guide to Anti-Money Laundering and Combating the Financing of Terrorism, World Bank, Washington DC, available at: http://siteresources.worldbank.org/EXTAML/Resources/3965111146581427871/Reference_Guide_AMLCFT_2ndSupplement.pdf.
- Global Financial Integrity (GFI-2013) Dev Kar and Brian LeBlanc, Illicit Financial Flows from Developing Countries: 2002-2011 (Washington, DC:, 2013).
- Global Financial Integrity http://www.gfintegrity.org/issue/trade-misinvoicing/