Financial Transparency Coalition

Cyprus a “Laundry Machine for Dirty Russian Money”

Illegal Inflows of Capital Estimated at US$552.9 Billion; Driving Underground Economy, Crime, Tax Evasion

US$764.3 Billion in Total Illicit Flows (Inflows + Outflows) Measured

Russia’s Underground Economy Averages 46% of GDP, 35% in 2011; Weak Governance and Endemic Tax Evasion Lead to Increasing Outflows

WASHINGTON, DC – The Russian economy hemorrhaged US$211.5 billion in illicit financial outflows from 1994—the earliest year for which data is available following the dissolution of the Soviet Union—through 2011, according to a new report released Wednesday by Global Financial Integrity (GFI), a Washington, DC-based research and advocacy organization.   The study, titled “Russia: Illicit Financial Flows and the Role of the Underground Economy,” [HTML | PDF] also measures massive illicit inflows to the Russian economy of $552.9 billion over the 18-year time-span, raising serious questions about the economic and political stability of the nation currently chairing the G20.

“Russia has a severe problem with illegal flows of money,” said GFI Director Raymond Baker.  “Hundreds of billions of dollars have been lost that could have been used to invest in Russian healthcare, education, and infrastructure.  At the same time, more than a half trillion dollars has illegally flowed into the Russian underground economy, fueling crime and corruption.”

Underground Economy

GFI Lead Economist Dev Kar and GFI Economist Sarah Freitas, the authors of the study, estimate the size of Russia’s underground economy at a massive 46% of GDP per year over the time period.  Moreover, illicit outflows and inflows were found to drive the domestic underground economy, which includes—among other things—drug smuggling, arms trafficking and human trafficking. Thus, illegal capital flight was determined to contribute to a deterioration in governance.  Growth in the underground economy likewise was shown to drive illicit flows, creating “a snowballing effect, whereby both the underground economy and illicit flows continue to grow at an increasing rate unless policy measures and institutions intervene,” according to Dr. Kar, the principle author of the report, who worked as a senior economist at the International Monetary Fund before joining GFI.

A 1% increase in the size of the underground economy was found to increase the cross-border flow of illicit money by 7%.

The report reveals that, according to World Bank staff, Russia’s underground economy is 3.5 times larger than corresponding G-7 economies like the U.S., France, and Canada, and Russia lags far behind every G-7 country in all six dimensions of governance measured by the World Bank.

Further, illicit flows and the underground economy both grew significantly over the 18-year period studied, driven in large part by an overall deterioration in governance and widespread tax evasion.

The study highlights that in 3 out of the 6 key governance factors measured by the World Bank—voice and accountability, control of corruption, and regulatory quality—Russia’s standings have deteriorated since the fall of the Soviet Union, while remaining poor in the other categories—rule of law, government effectiveness, and political stability.

“So long as the Russian authorities fail to shrink the underground economy, Russia will continue to hemorrhage scare capital, both illicit and licit, to the detriment of economic and political stability and undermining the nation-state,” write Dr. Kar and Ms. Freitas in the 68-page report.

Unrecorded Wire Transfers

Unrecorded wire transfers detected by GFI’s Hot Money Narrow (HMN) model were the primary method for moving money illicitly out of Russia.  HMN, which accounted for $135 billion or 63.8% of illicit outflows over the period studied, is one of two models used by GFI to estimate illicit financial flows—the other being the Gross Excluding Reversals (GER) model, which tracks trade-based money laundering through the fraudulent misinvoicing of customs declarations.  Still, trade misinvoicing accounted for the remaining 36.2%, or $76.5 billion, of illicit outflows, and it is growing in significance.

The prevalence of unrecorded money transfers through banks is not surprising when considering the state of the Russian banking system.  Citing research by the Financial Action Task Force, Dr. Kar and Ms. Freitas note serious weaknesses in Russian banks including that:

1. Some banks are still believed to be owned and controlled by criminals and their front men;
2. There is no requirement to investigate the background and purpose of suspicious transactions or to record and maintain such information for follow-up by regulatory agencies;
3. While credit institutions are prohibited from opening anonymous accounts, there is no specific provision that prohibits banks from maintaining existing accounts under fictitious names;
4. Gaps in monitoring wire transfers remain;
5. Sanctioning powers and the sanctions themselves are in general completely inadequate;
6. A key weakness is the lack of effectiveness of financial sector supervision regarding AML/CFT compliance; and
7. The existing AML/CFT regime and its implementation do not effectively deal with the illegal alternative remittance systems operating in Russia.

“There will continue to be massive illegal outflows of money through unrecorded wire transfers as Russia neglects to address these shortcomings in the banking system,” adds Dr. Kar.

Illicit Inflows

While HMN (e.g. unrecorded wire transfers) was the predominant technique for transferring money illicitly out of Russia, trade-based money laundering through the misinvoicing of customs invoices (GER) was the primary method for moving money illicitly into Russia, accounting for $542.9 billion or 98.2% of all illicit inflows into the country from 1994-2011.

These illegal inflows, which—combined with HMN inflows—totaled $552.9 billion, funneled into the underground economy, fueling crime, corruption, and tax evasion and further deteriorated governance in the country.

These massive illicit inflows—combined with the $211.5 billion in strictly illicit outflows—mean that a total of $764.3 billion in illegal money flowed into and out of Russia over the past 18 years.

$782.5 Billion Lost through “Broad Capital Flight”

In addition to presenting their findings on illicit financial flows that were strictly illicit, Dr. Kar and Ms. Freitas also present estimates of broader capital flight (CED+GER), which measures illicit outflows but may include some licit outflows as well.  The broader capital flight methodology determined the Russian economy suffered an outflow of US$782.5 billion between 1994 and 2011, a massive figure that is nevertheless in-line with previous estimates of capital flight from Russia.

“Conservative Estimates”

Referring to both the broader CED+GER methodology and the strictly illicit HMN+GER methodology, Dr. Kar commented “The estimates provided by either methodology are still likely to be extremely conservative as they do not include trade mispricing in services, same-invoice trade mispricing, hawala transactions, and dealings conducted in bulk cash.  This means that much of the proceeds of drug trafficking, human smuggling, and other criminal activities, which are often settled in cash, are not included in these estimates.”

Indeed, same invoice faking—one of the methods that we cannot capture in our economic models—has been aggressively utilized by Russian companies for years.  “Beginning in the 1990s, many Russian corporations established subsidiaries in Europe to function as buying offices. In addition, hundreds of corporations established their own “pocket” banks to handle their trade documentation and financial transfers. By selling exports to their foreign subsidiaries and by buying imports from their foreign subsidiaries and by utilizing their own pocket banks to handle the transactions, Russian corporations have been able to transfer hundreds of billions of dollars out of their country. None of this shows up in our data or in other analyses of flight capital from the country,” writes GFI Director Raymond Baker in his forward to the report.

“When you control the exporting party, the importing party, and the bank conducting the transaction, you can pretty much get away with anything,” commented Mr. Baker, who worked as an international businessman for decades importing and exporting shipments to and from the developing world before founding GFI.

Oil Prices

A notable finding of the report is that higher oil prices were found to drive licit capital flight as well as the broader definition (CED+GER) of capital flight from the country.

“With oil exports accounting for more than half of Russia’s total exports in 2011, such a significant link cannot be ignored,” said Ms. Freitas, the GFI Economist.  “Our study shows that Russia’s dependence on oil, combined with its lack of fundamental reform and its endemic corruption, explain massive outflows of both licit and illicit capital.”

Cyprus

As European and Russian officials currently weigh the merits of bailing out the Cypriot economy, GFI’s study raises serious concerns about the legitimacy of Cyprus’ financial sector.

The report notes that Cyprus, a tiny island nation with a GDP of just $23 billion, is the largest source and destination of Russian foreign direct investment (FDI) from 2009-2011.  According to the IMF, Cyprus sent $128.8 billion in FDI into Russia in 2011, more than 5 times the size of Cyprus’ GDP.  “The recorded FDI positions merely reflect the round-tripping of prior illicit deposits from Russia into Cyprus,” write Dr. Kar and Ms. Freitas in the report.

“Cyprus is a laundry machine for dirty Russian money,” added Dr. Kar.

Possible Solutions

In addition to the banking reforms mentioned above, there exist a number of steps the Russian government can take to ameliorate the problem of illicit flows of money into and out of the country.  According to the report:

• The Russian government should significantly boost its customs enforcement, by training its officers in better detecting the intentional misinvoicing of trade transactions. There exists software that can be used to assist governments in detecting invoices that fall outside the normal range of prices for a particular good. Russia could make use of this software to catch individuals deliberately misinvoicing their trade transactions to launder money;
• Transactions involving tax haven jurisdictions like Cyprus and Switzerland should be treated with the highest level of scrutiny by customs, tax, and law enforcement officials; and
• The Russian Government should require that all banks in Russia know the true, human, “beneficial” owner of any account opened in their financial institution. Often banks do not know who owns or controls the accounts in their institution – they might have the name of an anonymous shell company, but they don’t know the person controlling that shell company. Hence, the banks cannot monitor the accounts for money laundering. Requiring knowledge of the beneficial owner is a simple step that would significantly help curtail the problem.

Global Financial Integrity recommends that Russia use its influence in global fora such as the G20, G8, and United Nations to increase the transparency in the international financial system and curtail the illicit flow of money into and out of Russia.  Policies advocated by GFI include:

• Addressing the problems posed by anonymous shell companies, foundations, and trusts by requiring confirmation of beneficial ownership in all banking and securities accounts, and demanding that information on the true, human owner of all corporations, trusts, and foundations be disclosed upon formation and be available to law enforcement;
• Requiring the country-by-country reporting of sales, profits and taxes paid by multinational corporations;
• Requiring the automatic cross-border exchange of tax information on personal and business accounts;
• Harmonizing predicate offenses under anti-money laundering laws across all Financial Action Task Force cooperating countries; and
• Ensuring that the anti-money laundering regulations already on the books are strongly enforced.

In addition to curtailing outflows from Russia, such policies would curtail the illicit flow of money world-wide, which is estimated by GFI to cost developing countries nearly $1 trillion per year.

A December 2012 report from Global Financial Integrity, titled “Illicit Financial Flows from Developing Countries: 2001-2010,” ranked Russia as the 5^th-largest exporter of illicit capital over the past decade, behind China, Mexico, Malaysia and Saudi Arabia, respectively.

Funding

Funding for the new report, “Russia: Illicit Financial Flows and the Role of the Underground Economy,” was generously provided by the Ford Foundation.

To schedule an interview with GFI spokespersons on this report, contact Clark Gascoigne at +1 202 293 0740, ext. 222 / cgascoigne@gfintegrity.org. On-camera spokespersons are available in Washington, DC.

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Notes to Editors:

• Visit the report website at russia.gfintegrity.org to learn more and download complete data tables and resources.
• To download the full PDF of the new report, click here. [PDF | 3.7 MB]
• All monetary values are listed in US dollars (USD).

Contact:

Clark Gascoigne
cgascoigne@gfintegrity.org
+1 202-293-0740 ext.222

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Global Financial Integrity (GFI) is a Washington, DC-based research and advocacy organization which promotes transparency in the international financial system as a means to global development.

For additional information please visit www.gfintegrity.org.

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