Financial Transparency Coalition

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.

Photograph by Ulrik De Wachter

Yesterday I posed the question of whether it is wise to subtract evidence of illicit inflows from illicit outflows (which are known to hinder developing country economies), as if one would cancel the other out.  If billions of dollars are leaving a developing country through illicit channels and billions of dollars are being brought in through illicit channels, can we say with utter certainty that the country has no problems with illicit money?  I think not.  In fact, I can only think of two enterprises in developing countries that would require the inflow of large sums of cash, and neither offsets the problems created by outflows nor helps the developing country’s economy stabilize and grow.

The first use of the money brought into a developing country under the government radar, through illicit channels, is to finance activity in the underground economy.  Do you need to buy a fancy car but do not want to leave a paper trail and pay a small fortune in sales tax?  Easy: get it from the black market and pay cash.  Like copious quantities of drugs?  Better have lots of cash on hand.  (They don’t take plastic…I’m told.)  Are you a drug lord in need of a massive hacienda to impress your friends and wow your enemies?  I bet you can find some contractors to build it, and they probably would have no problem being directly compensated with fat stacks of tax-free cash.  A study by Global Financial Integrity finds, tucked away in the appendix at the back, an average of US$30 billion was secreted into Russia from 2002-2006 through trade misinvoicing.  Since I cannot personally measure the shadow economy in Russia, I can only point to the numerous suggestions I’ve found that Russia’s black market has flourished.  Money makes the black market move all over the world.  The entire drug trade is financed and run by cash transactions.  Money opens doors and persuades good but poor people to turn a blind eye when they know they shouldn’t.  Excessive flows of money (bribes) encourage systems of corruption that undermine a struggling country’s ability to stabilize itself and grow.  Underground flows of cash finance terrorism and war.  Illicit funds brought into developed countries through hidden channels and fed into the underground economy are not used for the good of the people, and they do not offset the problem of illicit outflows.

The second use involves the hawala money transfer system.  The hawala system is run by a network of hawala brokers, or hawaladars, in separate countries all over the world.  Transferring money between countries is as simple as giving an amount of money to a hawaladar, A, in country A, Mr. A calling his counterpart in country B and telling Mr. B that this amount of money (converted into local currency) is owed to you, or to whoever is arranged to receive the transfer in country B (such as a family member or henchman).  The hawaladars in both countries settle up the debt at a later time.  This system is entirely based on trust between the hawaladars, which is why it’s common for hawaladars to use family members in foreign countries as their counterparts.

Consider the following illustration.  Suppose there’s a man in the U.S. named Raj who wants to send $100 home to his family in India.  He can use the local bank to transfer the money, for a fee of $20, and the money will arrive in the Indian bank in a week or so, ready to be picked up.  Or he can go to a nearby U.S.-based hawala broker and for a transaction fee of, say, $5, have an Indian hawaladar provide his family the $100 (in rupees, of course) the next day.  Some hawaladars in developing countries will even deliver the funds to the family, a door-to-door courtesy that no bank offers.

Here’s where the illicit inflows comes in.  Suppose Raj wanted to transfer $50,000 between countries.  If his local hawaladar calls his Indian counterpart to arrange to have $50,000 worth of cash available in Indian rupees, that Indian hawaladar better have the rupees available or he is going to lose his business.  If he doesn’t have the cash handy the U.S. hawaladar will find someone else and may never call again.  Hawaladars must have large amounts of cash readily available at all times.  Since the whole system is based on the belief that debts can be settled later and that transactions with the counterparts will be completed quickly and without fuss, and since this whole system operates under the radar, hawaladars rely on illicit inflows to keep their business afloat.

There is some evidence that hawaladars do most of their transactions through the mispricing of trade.  Hawala brokers are often businessmen with a legitimate business.  Their foreign-country contact may also be a businessman or may be a member of a tiered network of hawaladars, many of whom may also run a business.  To settle debts, to provide sources of cash, and to keep up notions of trust between parties, hawala partners who engage in international trade in their normal business routine can misprice trade invoices to conceal money transfers.  The same study by Global Financial Integrity also finds that an average of US$17 billion was funneled into the UAE through trade misinvoicing, from 2002-2006—an estimate consistent with the claim (page 3): “The United Arab Emirates, especially Dubai, are believed to handle the largest volume of [hawala] transactions…”  Hawaladars in Dubai need to provide for billions of USD worth of transactions and the evidence is clear that the manipulation of trade misinvoices is a preferred avenue for providing adequate cash flows into the UAE.

Since the money floating around in the hawala system exists outside of the official system, the government cannot generate revenue by subjecting these transactions to taxes.  Money brought into a developing country to finance the hawala system undermines the formal financial system and reduces government income.  Thus, even if the illicit flows models identify net inflows, rather than outflows, it is foolish to let evidence of illicit inflows wash out the estimates of illicit outflows.   To more accurately gauge the problem developing countries face from illicit flows, it may be better to add the two estimates together.  Then we may see a more realistic estimate of how much illicit money is enabling illegal activities and undermining development efforts.