The Difficulty of Addressing Governance Issues Underlying Illicit Financial Flows

February 18th, 2010

A recent study at Global Financial Integrity (GFI) found that illicit financial flows from developing countries (henceforth emerging markets), which grew around 18 percent per annum since 2002 swelled up to  US$1 trillion in 2006. While the lack of prudent macroeconomic policies, political instability, and governance issues are major drivers of illicit flows, a subsequent study at GFI found that banking secrecy and  lack of regulatory oversight  facilitated the absorption of illicit flows in mainly Western financial institutions. Curtailing illicit flows must therefore involve both emerging market as well as developed countries to address the factors responsible for the generation and absorption of illicit funds.

Here we discuss the difficulty of addressing complex governance issues underlying the generation of illicit flows. We start by recognizing that the accurate measurement of  complex  governance issues  through indicators is fraught with difficulties. This came to light in the course of GFI’s study. For instance, we noticed that illicit financial flows from many emerging markets were increasing even though their World Bank governance indicators were actually improving. As we discovered, this was not necessarily an anomaly—the Bank indicators were mainly focused on public sector governance while illicit financial flows are typically generated and driven by the private sector. The preponderance of the private sector in driving illicit flows can be illustrated by the fact that if corrupt government officials stash bribes abroad, they act in their private, and not official, capacity. Hence, public sector governance in some emerging markets could be improving even as their private sector governance deteriorates thereby generating illicit flows through, say, trade mispricing.

Measurement issues aside, international financial institutions have run into serious problems in dealing with governance issues through the use of conditionality in their lending programs. Take, for example, the International Monetary Fund (IMF) which typically attaches two types of conditionality on the use of its financial resources by emerging market countries.  Thus, while quantitative performance criteria (e.g., reduction of the budget deficit, accumulation of foreign exchange reserves) attached to the loans are designed to ensure that the loans are repaid in a timely manner, structural conditionality such as improvements in specific governance-related measures seek to complement quantitative benchmarks in reducing the risks of borrower default. The overall objective of conditionality is justified given that the IMF is a monetary institution whose raison d’être is the provision of short-term balance of payments assistance. However, there are a number of problems with the way conditionality has actually worked in practice.

The importance of conditionality in IMF lending began to grow in the 1970s as members’ quotas, the basis for lending, increasingly lagged the significant growth in world trade and capital flows. Both quantitative performance criteria as well as structural conditionality became stiffer as the use of Fund credit increased as a proportion of the member’s quota. By the end of the 1980s, multilateral aid agencies such as the IMF and the World Bank started to consider how governance issues could be considered as part of structural conditionality on the premise that improvements in governance could elicit a supply-side response and improve aid effectiveness. However, relatively little attention was paid to key issues—does the Bank and the Fund have the mandate, the staff resources, and the competence to design and monitor governance-related conditionality which would need to cover a bewildering range of complex issues related to both the public and private sectors?

The IMF decided to “streamline” conditionality following several studies which found that the proliferation of conditionality on borrowers had become burdensome. Several studies found that the burden of conditionality in terms of the cost of monitoring and implementation was quite heavy, particularly for Sub-Saharan Africa and Central Asia where trained staff resources are scarce and institutions are weak. The question arose—how effective was conditionality in the attainment of stated objectives? Internal IMF studies showed that the proliferation of conditionality in Fund programs led to increasing non-compliance. Senior World Bank officials such as Joseph Stiglitz and Paul Collier noted that the penalties imposed lacked moral legitimacy, that the punishment was excessive relative to the crime, and that conditionality often failed to meet its objective due to a lack of “ownership” whereby governments were convinced that compliance was in the national interest rather than merely required by outsiders.

As a result and also due to the sensitivities involved, there have been relatively few Fund programs involving structural conditionality on governance-related issues. In recognition of the complexities of the issues involved, the IMF’s guidelines on conditionality typically allow members to seek waivers on quantitative performance criterion or structural conditionality, if they are able to demonstrate to the Fund’s satisfaction that nonobservance of the conditionality will not jeopardize program implementation. In fact, the IMF has seldom, if ever, withheld disbursement of funds because a structural conditionality on governance-related issues was not met. A large part of the reason is that a structural conditionality involving a narrowly defined governance issue is seldom critical to program implementation in the sense that noncompliance would not allow the authorities to meet the quantitative benchmarks set under the program.

There are other limits to the applicability of conditionality, whether governance-related or not. Obviously, the conditionality leverage can only be used when a member approaches a multilateral lending agency for a loan. But there are many emerging markets with serious governance issues which have no need or, even, qualification for such financing. Hence, governance continues to be a serious issue in many emerging markets in spite of the best efforts of international lending institutions. Given the significant increase in illicit financial flows from emerging markets and the need to ensure greater effectiveness of external aid at a time of unprecedented budgetary pressures in donor countries, the time is ripe for multilateral agencies to adopt a comprehensive approach to improving governance in emerging markets. That, however, is a separate subject matter.

Written by Dev Kar

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