Financial Transparency Coalition

This post is the first in a three-part series on policy solutions to confront trade mispricing from Mexico and the War on Drugs. It is adapted, with permission, from this feature article originally published by Policy Matters Journal.

In July of last year, the U.S. Department of Justice discovered that the banking giant HSBC “willfully failed” to apply money laundering controls to $881 million in drug trafficking proceeds, including those from two major Mexican drug cartels. Specifically, HSBC’s policies allowed high risk and suspicious account holders to open HSBC bank accounts in Mexico. A Senate Subcommittee on Investigations report condemns the actions of HSBC’s U.S. affiliate and provides details on its Mexican affiliate’s deficiencies, which included “a dysfunctional monitoring system; bankers who resisted closing accounts despite evidence of suspicious activity; and high profile clients involved in drug trafficking.”

It is no coincidence that HSBC’s sister company in Mexico posed a significant money laundering risk to HSBC’s U.S. affiliates. The border between Mexico and the United States has a long and storied history of transfers of illicit goods and money, and in recent decades has been a major conduit for the transfer of illegal narcotics from the South to the North. The illegal drug trade is a significant source of illicit funds that Mexican cartels launder across the American border.

In the United States, the War on Drugs has focused mainly on stemming the demand in the North and stifling the supply from the South. This effort has largely failed because the demand for illegal drugs is so large that narcotics dealers are willing to take significant risks to enter the North American drug market. A more effective method for fighting the War on Drugs would make it difficult for the cartels to hide or use the monetary proceeds from selling narcotics, thus making it unprofitable for them to do so. It is important, therefore, to gain a better understanding of the severity of money laundering and trade mispricing from Mexico, Mexico’s current policy solutions, and other policy alternatives that could curtail the problem.

The scale of illicit financial flows from Mexico is immense. Researchers at Global Financial Integrity (GFI) have chronicled a forty-year history of IFFs crossing the Mexican border. They found the outflow of illicit capital from Mexico increased sharply between the 1970s and 2009. These outflows ranged from around US$1 billion in 1970 to US$68.5 billion in 2010, with a peak in 2007 of US$91 billion. Another report released by GFI finds that from 2000 to 2009, Mexico experienced the third highest amount of illicit financial flows of any developing nation in the world, behind only Russia and China.

According to GFI, Mexican criminals’ preferred method of transferring money abroad is trade mispricing. Though it remains one of the lesser-known forms of money laundering, there is little new or innovative about trade mispricing. It is also one of the most common methods for laundering money internationally. In Mexico, trade mispricing constitutes over eighty percent of IFFs.

In part, the prevalence of trade mispricing from Mexico may be the result of free trade agreements. NAFTA, and other free trade agreements, have removed the tax incentives for governments to more closely monitor the corresponding invoices of imports and exports, reducing the likelihood that border authorities will catch the entities that mis-invoice their trades. In other words, before international rules like NAFTA largely removed import and export tariffs, customs officials had a strong incentive to examine the invoices accompanying particular shipments to ensure that the proper amount of taxes were being paid at the point of entry or departure. As part of this examination, officials ensured the shipments matched the invoices, essentially ensuring no trade mispricing had taken place. Once NAFTA removed these levies, the incentive for customs officials to closely monitor invoices disappeared with them.

The results of this change in incentives are apparent in the macroeconomic data. Global Financial Integrity has shown that the level of IFFs in general and trade mispricing in particular rose considerably after NAFTA. Specifically:

For the period as a whole [1970-2010], we find that increased trade also resulted in increased trade mispricing … [T]rade mispricing and trade openness have been increasing in lock-step over the entire period studied. Under NAFTA, the slope of the trade openness time trend line increases substantially, along with the average volume of [trade mispricing].

In other words, NAFTA provided a clear jump in the legitimate trade between Mexico and the United States. However, as that trade went up, so did the level of trade mispricing.

Mexico may find itself increasingly exposed to these problems in the future as the nation signs more free trade agreements. In fact, Mexico is one of the most aggressive signers of free trade agreements in the world, signing twelve such agreements involving forty-four countries around the world. It is also currently in negotiations to become part of the Trans-Pacific Partnership, which will greatly increase the number of countries with which Mexico will have a free trade agreement. These developments may allow illicit actors to more easily trade misprice goods with a wider variety of countries worldwide.

Will Gray is a graduate student at the George Mason University’s School of Public Policy.

This article was edited by Ann Hollingshead and Jonathan Peterson.