Tag: Trade

Hidden in Plain Sight: Illicit Financial Flows

The importance of Illicit Financial Flows (IFFs) in the context of economic development has slowly come to grasp people’s attention. The World Bank defines IFFs as “money illegally earned, transferred, or used that crosses borders.” Since 2006, the Global Financial Integrity (GFI), a Washington, DC-based think tank, has done extensive research on IFFs. Their studies emphasize that the developing world lost $7.8 trillion in IFFs between 2004-2013—whereby $1.1 trillion was lost in 2013 alone. Studies have shown there is a strong correlation between IFFs and higher levels of poverty and economic inequality. The United Nations just passed its first resolution on combatting IFFs, as it is pertinent to achieving the Sustainable Development Goals. This article explores further how IFFs occur, their role in keeping economies from developing—especially in the African continent, and some suggestions to tackle them.

Illicit financial flows are often mistaken as capital flight. This assumption is false because capital flight could be entirely licit. We can group the IFFs in three categories: commercial activities, which account for 65% of IFFs; criminal activities, estimated to be about 30%; and corruption, amounting to around 5%. Trade mis-invoicing is the most common way illicit funds leave developing nations, averaging 83.4%. Trade mis-invoicing means moving money illicitly across borders by misreporting the value of a commercial transaction on an invoice that is submitted to customs. It is carried out by under-invoicing exports and over-invoicing imports. Under-invoicing the value of exports means writing the price of a good as being less than the price actually paid, in order to show reduced profits and then pay less in taxes. Once the good is exported, it will be sold at full price and the excess money will be put in an offshore account. Over-invoicing the value of imports is when the price of a good is listed as being higher than the seller actually intends to charge the client. The excess money is deposited in the importer’s offshore bank account. There is the misconception that IFFs are largely due to corruption when in fact they account only for 5%, as mentioned above. With invoice manipulation of prices, there is no need for bribing anymore.

Another scheme used in IFFs is misreporting the quality or quantity of the traded products and services. According to a report by the United Nations Economic Commission for Africa and the African Union Commission, in 2012, Mozambican records showed a total export of 260,385 cubic meters of timber, while Chinese records alone show an import of 450,000 cubic meters of the same timber from Mozambique. Other strategies consist of creating fictitious transactions (which consists of making payments on goods or services that never materialize), transfer mispricing (which involves the manipulation of prices), and profit shifting (which is popular among corporations looking for favorable tax rates).

 

Role of IFFs in Keeping Economies from Developing

Illicit Financial Flows act as a barrier to economies from developing and achieving the UN Sustainable Development Goals. Illicit financial outflows—facilitated by secrecy in the global financial system—are bleeding developing countries dry. UNCTAD emphasizes that developing countries will need $2.5 trillion every year until 2030 to achieve their goals on health, nutrition, education and the rest. But pledged capital inflows are only around $1.2 trillion. Preventing or even reducing IFFs can fill this funding gap. Seven out of the past 10 years, IFFs were greater than Official Development Assistance (ODA) and Foreign Direct Investment (FDI) given to poor nations.

The IMF estimates that developing nations lose $200 billion from tax revenues per year due to IFFs, while OECD countries lose $500 billion. Specifically, the United States (US) loses $100 billion annually. Tackling IFFs is in the interest of the US. Even though both developed and developing countries are victims of IFFs, developing countries suffer greater losses.

When it comes to most significant volume of IFFs, Asia is leading by 38.8% of the developing world over the ten years of this study. However, when IFFs are scaled as a percentage of gross domestic product (GDP), Sub-Saharan Africa tops the list averaging 6.1% of the region’s GDP.

At the Seventh Joint  Annual Meetings of the ECA Conference of African Ministers of Finance, Planning and  Economic  Development  and  African  Union  Conference  of  Ministers of  Economy  and  Finance  in  March  2014  in  Abuja,  Nigeria, a Ministerial Statement was issued, which states that:

“Africa loses $50 billion a year in illicit financial flows. These flows relate principally to commercial transactions, tax evasion, criminal activities (money laundering, and drug, arms and human trafficking), bribery, corruption and abuse of office. Countries that are rich in natural resources and countries with inadequate or non-existent institutional architecture are the most at risk of falling victim to illicit financial flows. These illicit flows have a negative impact on Africa’s development efforts: the most serious consequences are the loss of investment capital and revenue that could have been used to finance development programmes, the undermining of State institutions and a weakening of the rule of law.”

Former South African president Thabo Mbeki stated at a High-Level Panel on IFFs “Africa is a net creditor to the rest of the world.” The amount of IFFs out of Africa were between $854 billion and $1.8 trillion over the period 1970-2008, according to estimates by GFI. There is a campaign to end IFFs, “Stop the Bleeding”, led by Trust Africa Foundation. Mr. Mbeki stressed that Africa can no longer afford to have its resources depleted through IFFs. On the other hand, illicit financial transfers by African elites paint a different picture. It shows that African elites lack confidence in their own economies. Because they have the privilege to go abroad for education and healthcare, they are less likely to invest in their own countries.

Curbing IFFs

When searching the literature on IFFs, the focus seems to be on developing nations, which are the source. However, there is little focus on the destination countries like Switzerland, Ireland, United Kingdom, etc. A paper by GFI titled “The Absorption of Illicit Financial Flows from Developing Countries: 2000-2006”, discusses that there are two types of destinations for money leaving the developing world. These are offshore financial centers and non-offshore developed country banks. The greatest challenge is getting the money back from the destination countries.

The OECD and the Stolen Asset Recovery Initiative (StAR) surveyed frozen assets held by OECD countries and how much of them were returned to the countries of origin . Between 2010 and June 2012, $1.4 billion of corruption-related assets were frozen and only $147 million was returned.

During the Arab Spring, banks and governments froze billions of dollars held by previous leaders along with their associates from Tunisia, Egypt, and Libya. However, following the Arab Spring, only few assets have been returned and the process of recovering stolen assets is very cumbersome. In order to recover stolen assets, there needs to be solid enough proof that these assets were in fact gained through corruption to begin with.

Illicit financial flows is an issue that plagues the developing world. Nations are denied tax revenues that could be geared towards providing necessities, employment, and economic growth. Nations should hold their financial institutions accountable if they participate in tax evasion activities. There is a need for the creation of financial supervision agencies focused on IFFs. Another suggestion would be the development of a global trade-pricing database so that customs officials are not tricked by false prices. Lastly, the Bank of International Settlement should publish data on international banking assets by country of origin and country of destination in order to better comprehend where IFFs are headed.

Written by Mariamawit F. Tadesse

Germany Does Have Unfair Trade Advantages

In one of Donald Trump’s rants, he claimed the reason why there are so many German cars in the U.S. is that their automakers do not behave fairly. The German economy’s prompt response was that “the U.S. just needs to build better cars.” However, this time, probably without even realizing it, Donald Trump was on to something – Germany’s currency setup does give it unfair trade advantages.

While China is commonly accused of currency manipulation to provide cheap exports, the IMF has recently decided the renminbi (RMB) is no longer undervalued and added it in its reserve currency basket, along with other major currencies. However, an IMF analysis of Germany’s currency found “an undervaluation of 5-15 percent” for the Euro in the case of Germany. Thus for Germany, the Euro has a significantly lower value than a solely German currency would have.

Since the Euro was introduced, Germany has become an export powerhouse. This is not because after 2000 the quality of German goods has improved, but rather because as a member of the Eurozone, Germany had the opportunity to boost its exports with policies that allowed it to maintain an undervalued currency.

Germany and France are the largest Eurozone economies. Prior to joining the Eurozone, both countries had modest trade surpluses.

In the above figure we can see how following the implementation of the Euro, the trade balances of Germany and France completely diverged. The French moved to having a persistent trade deficit (importing more than they export), while Germany’s surplus exploded (exporting much more than they import). After a brief decline in the surplus in the immediate aftermath of the crisis, it is now again on the rise.

In the early 2000s Germany undertook several national policies to artificially hold wages down. These measures were seen as a success for Germany globally. By being part of the Eurozone and holding down wages, the Germans could export at extremely competitive prices globally. Had they not been part of the Eurozone, their currency would have appreciated, and they would not have the same advantages.

In the aftermath of the European debt crisis, Germany took a tough stance on struggling debtor countries. Under German leadership, the European Commission imposed draconic austerity measures on countries such as Greece to punish them for spending irresponsibly. Spearheaded by Germany, The EU (along with the IMF) offered a bailout to Greece so that it could pay the German and French banks it owed money to.

This bailout came with strict conditions for the Greek government that was forced to impose harsh austerity. The promise was that if the government cut its spending, the increased market confidence would help the economy recover. As a member of the Eurozone, Greece had very limited monetary policy tools it could use. Currency devaluation was no longer an option, the country was stuck with a currency that was too strong for its economy.

Meanwhile Germany prospered and enjoyed the perks of an undervalued currency. Being able to supply German goods at relatively low prices, Germany’s exports flourished. At the same time, Greeks, and other countries at the periphery of the union, were only left with the choice to face a strong internal devaluation, which meant letting unemployment explode and wages collapse until they become attractive destinations for investment.

Germany consistently broke the rules of the currency area, without ever being punished. When it first broke the deficit limits agreed upon by Eurozone members in 2003, the European Commission turned a blind eye. Germany is often considered to have set an example for other EU nations by practicing sound finance, and having a growing, healthy economy.

Greece, on the other hand is blamed for spending too much on social services, and many of its problems are blamed on being a welfare state. When you compare the actual numbers, however, Greece’s average social spending is much less than that of Germany. Between 1998 and 2005, Greece spent an average of 19 percent of GDP, while Germany spent as much as 26 percent.

To address these vast differences in the trade patterns of the EU nations, the European Commission introduced the so-called “six-pack” in 2011. These regulations introduced procedures to address “Macroeconomic Imbalances.” However, as found in the Commission’s country report “Germany has made limited progress in addressing the 2014 country-specific recommendations.”

Germany’s trade competitiveness comes at the price of making other members of the Eurozone less competitive. This is something that Germany needs to be aware of when responding to the problems other economies are facing. Currently Germany is demanding punishments for countries whose have few policy tools available to stimulate growth as Eurozone members.

However, Germany should keep in mind that the Euro is preventing the currency adjustments that would take away its trade competitiveness. Without a struggling EU periphery, there wouldn’t be a flourishing Germany.