Part 1: Illicit Inflows: Are They the Remedy for Illicit Outflows?

June 2nd, 2010

Global Financial Integrity Economist Devon Cartwright-Smith analyzes the relationship between illicit financial outflows and illicit financial inflows in developing economies in this two-part series.

When determining the amount of money that flows out of developing countries, a question naturally arises once the calculations are complete: “Why do some of these countries have huge negative outflows?”  If outflows are measured as positive figures, negatives must indicate inflows.  So are developing countries really recipients of huge swaths of cash, brought in through illicit channels?  If these inflows were legitimate and intended to help alleviate the damage done by illicit outflows, developing countries shouldn’t need quite so much foreign aid from the wealthier countries of the world.  Plus, they should be able to pay off all that odious outstanding external debt.  Unless, of course, this evidence of inflows is just some data error.  Perhaps these countries don’t have their books in order and the numbers they report, or fail to report, don’t jive with reality?  This is possible, but unlikely when the evidence of inflows is in the range of billions of US dollars.  Data discrepancies aside, suppose the data are good and these recorded illicit inflows are legitimate.  Does it make sense to let the amount of illicit inflows be subtracted from the illicit outflows for a net estimate of illicit money moving into or out of a country?

It’s easy to come up with an explanation for why someone in a developing country might want to send money abroad.  Political instability, poor economic performance, and inefficient capital markets in the home country all discourage domestic saving or investment.  Macroeconomic instability might foreshadow a decreasing value of the country’s currency, so residents would want to keep their assets in a foreign, more stable currency, such as the Euro or US dollar.  Investment in foreign assets is an option for developed country residents who want to diversify their portfolio (as if to take advantage of better interest rates than domestic offerings or to minimize risk across their portfolio), but is generally not an option for residents of developing countries due to restrictions on foreign investment.  Moreover, some developing country governments offer large incentives in order to entice foreign investment into their countries for future development, even offering guarantees on the foreign debt, while there are few incentives and few guarantees for domestic investors.  For residents with shady morals, tax evasion is an obvious and well known reason to stash their cash abroad.  Similarly, if a country has capital controls, such as limits on how much money may be exchanged for foreign currency or transferred abroad?as is the case in most developing countries, illicit channels are the only ways to fully skirt these controls.

With these driving motivations for developing country residents to send money out, coupled with incentives to bring money in from abroad through official channels as foreign direct investment, what possible reason could someone in a developing country have to bring money in through illicit channels, under the government radar?  Additionally, once the money is successfully sneaked in, it’s unlikely that the illicit inflows will be declared as income and given over to the government in income taxes.  Nor is it likely that those who bring the money in through illicit channels will be putting the money toward efforts to help develop and stabilize the economy.  Only two uses come to mind.  Neither of them is good for the official economy.  Neither would offset the detrimental effects of the illicit outflows.  Neither suggests that it would be reasonable to let this evidence of inflows wash out any evidence of outflows (as if one flow is good and the other flow is bad).  In fact, both uses encourage me to think that to properly capture the damage done to developing countries by illicit flows one would need to add the two flows together, not let them wash each other out…

Coming soon (tomorrow), the exciting conclusion where everything is revealed!  Stay tuned.

Written by Devon Cartwright-Smith

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