Financial Transparency Coalition

Last week, Global Financial Integrity released its annual country-specific report on the drivers and dynamics of illicit financial flows. This year, GFI examined Mexico. GFI defines illicit financial flows as “cross-border movement of money that is illegally earned, transferred, or utilized… [Generally involving] the transfer of money earned through illegal activities.” These activities can include corruption, transactions involving contraband goods, criminal activities, and tax evasion.

The report’s author, Dev Kar, estimates illicit financial flows as the sum of two components.[1] One of these components is a measure of trade mispricing. Using IMF statistics, Kar compares Mexico’s recorded imports to what the world says it exported to Mexico; and then he compares Mexico’s recorded exports against world imports from Mexico.

In a perfect world these numbers would line up. But they don’t for two reasons. The first is trade mispricing. Trade mispricing occurs when a company or an individual shifts wealth between countries, using either export under-invoicing or import over-invoicing. Suppose a Mexican furniture manufacturer, who wants to send money abroad illegally, is importing $100 worth of timber from the United States.  Instead of paying $100, the furniture company reports and pays $200.  The company’s U.S.trading partner takes $100 for the furniture, reports the $100 on its own invoice, and shifts the extra $100 to a secret Delaware bank account (and maybe keeps an extra few dollars as a transaction fee).  Now the furniture company has shifted the $100 to the United States without Mexico’s knowledge. But the $100 discrepancy is also reflected in the difference between what the United States says it exported to Mexico and what Mexico reports it imported from the United States.

The second reason these numbers don’t line up—and this is not to be overlooked—there statistical errors associated with compiling such large datasets. Even in the absence of any trade mispricing, it is unlikely Mexico’s recorded imports from the world would match perfectly with the world’s recorded exports toMexico, and vice versa.

Using the normalized estimates, Kar’s study finds illicit financial flows averaged $18.7 billion per year between 1970 and 2010. Of this total, $15.3 billion per year—or 82%—is attributable to trade mispricing.

Kar does not net out “reversals” or illicit inflows from his estimates. This diverges from more traditional models, where economists do subract illicit inflows from illicit outflows, resulting in a lower “net” estimate of capital flight. But this gives a skewed picture. Illicit outflows, because they are illegal by definition, are not supplementing the domestic economy in the same way an illicit outflow is detracting from it. Moreover, as Kar notes, “The traditional method of estimating illicit flows…seriously understates the adverse impact of illicit flows on poverty alleviation and economic development in developing countries.”

While the example I used above about the Mexican furniture company illustrates a way Mexicans can use trade mispricing to send money abroad, Mexicans are able to use the practice to bring money in as illicit inflows. Theoretically one could argue this offsets the outflow of funds. In reality, these inflows are often the proceeds of the drug trade or of money laundering.

As it would turn out, it recent years criminals in Mexico regularly use trade-based mechanisms, including trade mispricing, to launder money and skirt their government’s tight financial rules. This often occurs when drug trafficking organizations want to repatriate their earnings from drug sales overseas. For example, a Mexican front company can ship furniture to the United States and, by over-invoicing the goods, can include in the invoice enough for both the merchandise and laundered funds. The buyer on the other side, who’s holding the illicit cash, remits the payment for the furniture and sends the funds to the Mexican company’s account, which now enter the banking system as a formal, legal transaction.

This method skirts the warning flags provided by most laws and regulations. It would be recorded as an illicit inflow of cash (a “reversal”) and in a traditional model of illicit financial flows it “offsets” the equal amount in outflows. This, quite frankly, is completely nonsensical. Why should laundered money offset the damage of tax evasion?

With this report, GFI has put forward a number of policy recommendations for addressing trade mispricing in Mexico. The reasons the Mexican government should heed their advice are not limited to loss of funds—the implications of trade mispricing, and illicit financial flows generally, range from money laundering to the drug trade; from tax evasion to corruption. This is not just a question of loss of resources—although that would be bad enough—but rather a question that reaches into economic stability and national security.