New Report from GFI on Illicit Financial Flows: Answering Common Questions

December 12th, 2013

Yesterday, Global Financial Integrity released the report, Illicit Financial Flows from Developing Countries 2002-2011, which found that developing countries lost $947 billion in illicit financial flows in 2011, and $5.8 trillion over the ten-year study period.

The subject of illicit financial flows is still a new one, and can be confusing. To help answer some common questions about the report, we’ve put together a quick FAQ below:

What Are Illicit Financial Flows? What Does This Report Measure?

Illicit financial flows are cross-border transfers of funds that are illegally earned, transferred, or utilized. These kinds of illegal transactions range from corrupt public officials transferring kickbacks offshore, to tax evasion by commercial entities, to the laundered proceeds of transnational crime.

Illicit Financial Flows from Developing Countries 2002-2011 does not measure all illicit financial flows. It uses two primary methodologies to estimate two different methods for illegally transferring funds across borders.

The first, Hot Money Narrow (HMN), looks at money that has disappeared from the balance of payments. GFI infers that is likely to represent kickbacks, bribery, and other forms of unrecorded wire transactions. Countries that are rich in natural resources, like oil, tend to have higher HMN numbers relative to others. HMN accounts for about 20.3% of illicit financial flows estimated in this report.

The second, Gross Excluding Reversals (GER), looks at trade misinvoicing, a common method used by commercial entities for the cross-border movement of illegal money. Exporters and importers manipulate trade invoices to over-represent or under-represent the value of the goods they are shipping. Often, this will involve re-invoicing the goods through a secrecy jurisdiction. The result is that a certain sum of money disappears on one side of the border—either from the importer or exporter. We detect this by comparing what a country says it is exporting, and what the rest of the world says it imports from that country, and vice versa.

Certain types of trade misinvoicing are used for different purposes. Drug cartels and terrorist networks have been known to use it to launder money. Importers and exporters use it to evade customs duties. Other tax evaders, criminals and corrupt public officials in developing countries use it to hide wealth or ill-gotten gains. GFI’s methodology is unable to distinguish between the different sources of trade mispricing.

What Impact Do Illicit Financial Flows Have?

US$947 billion is a tremendous amount of money to drain out of developing countries. It represents roughly ten times the amount of official development assistance (ODA) flowing in from advanced economies (.xls). In fact, a report by GFI found that even after you account for all types of financial flows, including investment, remittances, debt forgiveness, and natural resource exports, the continent of Africa is a net creditor to the world. GFI has not yet applied this analysis to the rest of the developing world.

Further, illicit financial flows have a subversive effect on government in a few ways. First, they encourage corruption, by allowing corrupt public officials to siphon money away from public coffers and into secret offshore bank accounts. Second, every country case study that GFI has performed has shown that increased illicit financial flows grow a country’s underground economy. As the underground economy expands, criminal elements become more powerful and more difficult for law enforcement to fight. To make matters worse, the research also shows that as a country’s underground economy grows, criminals respond by moving more money out of the country, and so on. This vicious cycle helps to explain why illicit flows grew at 10% per year from 2002-2011.

Finally, illicit financial flows are one of the world’s biggest, and least talked about, drivers of inequality. Those with the wealth and resources to use highly sophisticated money laundering techniques to smuggle money out of the country are almost exclusively powerful and affluent, and their victims are ordinary citizens.

What About Abusive Transfer Pricing?

Abusive transfer pricing is frequently cited as a resource drain out of developing countries, and can easily be confused with trade misinvoicing. Multinational corporations use transfer pricing to allocate costs and revenues between their webs of subsidiaries. Abusive transfer pricing occurs when the multinational corporation seeks to distort the prices its subsidiaries pay each other in transactions solely for the purpose of shifting profits from high-tax jurisdictions—such as most developing countries—to low-tax jurisdictions, like tax havens.

The trade misinvoicing numbers in this report should not be confused with abusive transfer pricing. Abusive transfer pricing generally does not involve two different invoices on different sides of the border. Instead, abusive transfer pricing involves placing false values on single invoices. This is a serious problem for developing countries, but it is not detected by GFI’s trade misinvoicing methodology. As abusive transfer pricing tends to occur with one single invoice on both sides of the border, there is no discrepancy between what is reported in the exporting country and what is reported in the importing country. Without the discrepancy, GFI cannot detect it.

The motivations and driving factors behind abusive transfer pricing and trade misinvoicing may also differ, requiring potentially different policy solutions. Abusive transfer pricing is driven mainly by a motivation to reduce corporate taxes for an entity, while trade misinvoicing is often used to move or launder money for tax evasion as well as many other crimes.

Written by EJ Fagan

Follow @FinTrCo