So Why Should We Care? Illicit Financial Flows and Growth Potential

October 1st, 2009

GFI has been known to repeat (and then repeat again) that for every $1 of aid that enters the developing world through the front door, $10 escapes out the back in illicit financial flows (for my explanation of these flows and their the magnitude, see: 10 times ODA, but what is that in Apple Pies?).  While many people grasp the enormity of this number, few seem to appreciate what this means or how these flows can affect development.  Some people even go so far as to say, “Why should we care?  That money wasn’t going to build a well or buy vaccines for children.”

The truth is: it does matter.  And the macroeconomic reasons for “mattering” are going to be the topic of this blog (and a few others to come).

Reason 1: Illicit Financial Flows reduce the growth potential of developing countries by diverting domestic savings away from investment.

Let’s start at the beginning.  Broadly speaking, income can be used either as consumption to buy goods and services (clothing, cars, going out to eat) or it can be saved (ideally in a bank and not under the mattress).  Deposited savings are invested by banks, which produce “fixed capital,” like factories and machinery.  The total (domestic + foreign) savings of a country must equal total investments, which makes savings vital to increasing fixed capital.  In turn the accumulation of fixed capital plays an essential role in development.  With more machinery comes more jobs, with more jobs comes more income, and with more income comes more consumption.  This is economic growth.

When developing countries are bleeding illicit financial flows (and so reducing domestic savings) they likely face three options.  One, they can turn to foreign savings to finance investments.  But this will result in a heaping of external debt as countries borrow money from abroad.  Debt can be problematic for development, not least of which because indebtedness has a limit–there is a point where foreigners are not willing to lend the country any more.   Two, they can accept less growth, which may result in an increase in poverty.  Or three, they can choose to improve domestic savings, which can in part be accomplished by stemming illicit outflows.

This can be illustrated with a simple example of a wealthy man in Thailand. Suppose the Thai man is an investment banker and this year he receives a big bonus (he obviously didn’t invest in Citibank).  He can choose to spend his money on goods, like one of those fancy new Hondas, or he can save in a bank and receive interest.  If he chooses to deposit the money, the bank will write a loan to an upstart businessman who, after watching one too many episodes of The Office, wants to create a paper company.  The Thai businessman will buy a paper machine with the loan and will employ two workers to operate the machine and sell the paper.  He will pay them both a decent wage and they will be able to choose to spend on goods like clothing or they can save in a bank.

But if the original wealthy man had sent his money to the Cayman Islands, instead of depositing in a bank in Thailand, the money would have stayed abroad and Thailand would have been unlikely to see the proceeds.  There would be no bank loan to an aspiring Thai businessman, no new paper machines, and no jobs for our two paper workers.

Economist’s Disclaimer: Of course, this is a simplified example.  There are no universal “laws” in Economics.  But I’m sure you get the gist of it.

Written by Ann Hollingshead

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