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«Illicit Financial Flows and Capital Flight A Re-Define Briefing Paper Sony Kapoor Sony.Kapoor Background The mobilization and proper ...»

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Illicit Financial Flows and Capital Flight

A Re-Define Briefing Paper

Sony Kapoor



The mobilization and proper utilization of domestic resources lies at the heart of the process of sustainable

development. In development parlance, 'financing for development' is about increasing resources and 'good

governance' is about deploying them to meet development needsi.

Illicit financial leakages from developing countries and resultant Capital flight undermine both. These leakages are estimated to have reached alarming proportions in excess of $500 billion a year, far in excess of resource inflowsii.

Domestic Resource Mobilization, the central theme of the UN Monterrey Consensus is a two step process – marshalling resources from in-country sources and preventing their leakage. It is the second step, plugging the leaks, which has been a major area of focus of the ‘Landau reportiii’ and the ‘Action against hunger and poverty reportiv’ both linked to the ongoing Leading Group Processv.

Recognizing the growing magnitude and seriousness of illicit financial leakages and capital flight, Norway has set up an international task force under the aegis of the Leading group to help plug these leaksvi. One central aim is to influence the Financing for Development (FfD) process leading up to the next FfD conference in Doha in 2008vii.

The public policy challenge The problem of illicit cross-border financial flows is not new. In the immediate aftermath of the WW II and then at the height of the Latin American debt crisis in the 1980s, the problem of capital flight (out of Europe and Latin America respectively) was serious enough to attract the attention of policy makers at the highest levelviii. But a lack of initiative and action then has meant that the problem has been allowed to grow.

Liberalization of trade and finance, growth of Multinational Corporations (MNCs) and cross-border banking, mushrooming of financial centres, technological innovation etc have also contributed to help increase both the scale and the scope of capital flight.

This increase is partly responsible for the acute shortage of resources needed to meet the Millennium Development Goals. It is also strongly linked to the lack of public accountability, high levels of perceived corruption and the dearth of confidence in both public and private institutions that exists in many developing countries today.

Illicit financial flows have been implicated in thwarting development, fostering corruption, encouraging crime and facilitating the financing of terrorism.

The only thing more remarkable than the exponential growth in the scale and pernicious impact of capital flight and illicit financial flows is how little attention they have attracted from the development community thusfar. This must change.

Tackling these flows and accompanying capital flight to help maximise domestic resource retention for developing countries will help kick-start a new era in development, reduce corruption, hurt crime and thwart terrorism. Plugging the leaks is surely one of the top public policy challenges of our day.

What constitutes Illicit Financial Flows and Capital Flight?

Developing countries have registered a massive growth in cross-border financial flows in recent years. Most analysts classify these flows into categories relating to aid, debt, investment, trade, migrant remittances and

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But this is not the complete picture. Beneath the surface lurks a category of substantial financial flows which has interchangeably been referred to as ‘illicit financial flows’, ‘capital flight’ or ‘dirty money flows’.

While these terms may be used differently by different experts, all references to them include a number of shared implicit characteristics which can be broadly listed as

• these flows are largely unrecorded (not captured by the BoP and other official statistics)

• these flows are often associated with active attempts to hide origin, destination & true ownership etc (they seek secrecy)

• these flows are usually associated with public loss and private gain because no (or little) tax is paid on them or because they may be comprised of bribes paid

• these flows constitute domestic wealth permanently put beyond the reach of domestic authorities in the source country

• these flows are not part of a ‘fair value’ transaction and would not stand up to public scrutiny if all information about them was disclosed In most cases, these flows violate some law or the other in their origin, movement or use.

Sometimes, such as when exports are under-priced or when bribes are paid into offshore accounts, there is no actual cross-border flow of money. Capital has fled nonetheless.

What is the scale of the problem?

As would be expected in the case of a financial statistic which is by definition ‘unrecorded’, data on capital flight is patchy at best. Estimates have to be made using indirect methods such as looking at discrepancies between data sets such as the direction of trade statistics. However, sufficient estimates exist to highlight that capital flight is by far the most serious threat to domestic resource mobilization in developing countries.

The global estimate of $539 billion - $829 billion of annual capital flight from developing countries dwarfs the annual aid flow of $104 billionix. Country level estimates show that it is not unusual for a developing country to lose as much as 5% - 10% of GDP annually to capital flight.

South Africa, for example, is estimated to have been losing an average of 9.2 per cent of GDP (losing US$13 billion in 2000), China 10.2 per cent of GDP (losing US$109 billion in 1999), Chile 6.1 per cent of GDP (losing US$4.7 billion in 1998) and Indonesia 6.7 per cent of GDP (losing US$14 billion in 1997)x. Russia is estimated to have lost as much as $400 billion between 1990 and 1995 alonexi.

Cumulatively, more than $230 billion is believed to have fled Nigeria and some 17 sub Saharan African countries are estimated to have lost in excess of 100 per cent of GDP since 1970xii.

The graph below, which compares the financial flows in and out of South Africa through various channels in the decade following the end of apartheid, highlights the seriousness of the problem of capital flight. South Africa is by no means an exceptional case with many other developing countries facing similar inflows and outflows.

Major inflows and outflows for South Africa between 1994 and 2003xiii

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Capital flight undermines

• investment, economic growth and sustainable development

• government revenue, social expenditure and meeting the MDG targets

• a fair distribution of wealth

• good governance in both the public and private sector

• the development of systems of accountability and a vibrant democracy The sustainable development of a country is only possible if it mobilises and retains sufficient resources domestically. These resources are needed for spending on social and welfare programmes, and for investment to help increase the stock of productive capital. Capital flight undermines sustainable development by increasing dependence on external resources such as aid that are needed to replace the gap left by the fleeing of domestic capital.

Where resources stay within a country, they can be locally consumed or invested to promote economic activity. The escape of such funds depresses economic activity and has a negative impact on long-term growth rates.xiv The flight of domestic resources abroad undermines the development of an accountable and participative relationship between the state and its citizens. This is reached when citizens’ resources are mobilised to fulfil domestic needs – in other words, citizens pay taxes and then hold their governments to account to ensure that the money is utilised properly towards priorities defined by them. If a large amount of such wealth is transferred offshore, incentives to participate in the establishment of a just and functioning domestic society diminish significantly.

Much of the capital that flees a country is untaxed, this reduces the tax base by shifting wealth and resources beyond the government’s reach. Thus capital flight depresses both budget revenues, which are needed to finance the provision of essential services such as health and education, and the investments needed to meet the MDGs and the country’s overall development. It also worsens the distribution of income by shifting the tax burden away from capital and onto less mobile factors, especially labour and consumption.

The infrastructure that facilitates capital flight by allowing vast amounts of capital to flow across borders unchecked and in secret, is also vulnerable to being used by terrorist and criminal networks and thus puts our collective and individual security at great risk.

This infrastructure also makes it easier to engage in corrupt behaviour, especially through the payment of bribes to, and the diversion of funds by, domestic political and business elites. Such funds are usually stashed offshore, protected by secrecy and privacy which makes detection difficult and hence increases the rewards that can be earned by engaging in corrupt behaviour.

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Capital flight from developing countries deprives their citizens of a future. The poorest and most vulnerable are those most affected when resources that could otherwise have been used for life-saving and life-sustaining expenditure on basic healthcare and other essential services are illicitly taken out of a country.

What are the main mechanisms used for capital flight?

The mechanisms most commonly implicated in the flight of capital include

1. The mis-invoicing of trade transactions. This can be done by:

• Under-invoicing the value of exports from the country from which cash is to be expatriated. The goods are then sold on at full value once exported with the excess amount (constituting flight capital) being paid directly into an offshore account

• Over-invoicing the value of imports into the country from which cash is to be expatriated, the excess part of which constitutes capital flight and is deposited in the importer’s offshore bank account.

• Misreporting the quality or grade of traded products and services to assist value over or understatement for the reasons noted above;

• Misreporting quantities to assist value over or under-statement for the reasons noted above;

• Creating fictitious transactions for which payment is made. As has been noted: One well-worn wheeze is to pay for imported goods or services that never materializexv For example, it has been reported that Gum Arabic was exported from Nigeria to the United States at a price of $0.69/ kg, a fifth of the prevailing world price. On the other side, cassette recorders were imported into Nigeria from the US at an inflated price of $1,410 per unit, 2500% of the prevailing world pricexvi. In both cases, capital fled Nigeria for the United States through the channel of trade.

2. Transfer mis-pricing This is the manipulation of prices of cross-border transactions between related affiliates of MNCs. The motives and mechanisms are similar to those above. However, the practice is made easier and is harder to detect as the transactions are now done between related parties – so no outside party is involved.

Around 60 per cent of trade takes place between subsidiaries of MNCs. As these transactions occur between different parts of the same company, there is ample scope for mis-pricing and, as a result, shifting of profitsxvii.

Detecting transfer mis-pricing is complicated within the highly complex international production networks that exist today and where companies use trade marks, brands, logos and a variety of company specific intangible assets. Finding independent benchmark valuations for many of these is highly problematic.

For example, oil companies such as Chevron, Texaco and Caltex are estimated to have avoided US$8.6 billion in taxes by using a novel design of accounting and tax transactions with domestic and foreign governments between 1964 and 2002xviii.

3. Using mis-priced financial transfers, such as intra-corporate financial transactions – for example, loans from parent to subsidiary company at exaggerated interest rates – to shift profit out of a host country is another way illicitly transferring capital out. Real estate, securities and other forms of financial trades can also be mispriced to facilitate capital flight and exaggerated payments for intangible such as goodwill, royalties, franchising rights and use of patents etc is yet another channel for the flight of capital.

For example, Microsoft has been accused of siphoning exaggerated payments of royalties to its low tax Irish subsidiary to which it had transferred many of its main patents and copyrightsxix.

4. Unscrupulous wire transfers. These involve a bank or a non-banking financial institution transferring money out of a country illicitly. Wire transfers are of course a legitimate way of moving money between countries but it is when such transfers violate laws, or are used to avoid taxes or hide ill-gotten wealth that they constitute illicit capital flight. Banks can mis-report the source, destination or ownership of funds to help disguise illicit transactions.

For example, the US General Accounting Office (GAO) determined that private banking personnel at Citibank helped Mr Salinas (the brother of the then Mexican president) transfer US$90-100 million out of Mexico in a manner that ‘effectively disguised the funds’ source and destination, thus breaking the funds’ paper trail’xx.

–  –  –

The widow of Sani Abacha, for example, was stopped at Lagos airport, trying to leave with tens of suitcases stashed full of cashxxii.

6. The payment of bribes and corrupt monies offshore. In many instances involving bribes payable to public officials by commercial organisations there is an element of capital flight involved. The payment of a bribe always means that the recipient country will not get a fair value on the commercial activity undertaken by the firm paying it and that both tax evasion and capital flight will deprive the country of scarce resources.

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