April 30, 2009
This article was originally published by the Indian Express.
Economists use two basic models to estimate illicit financial flows (IFFs), also known as illegal capital flight. According to the first method, if the source of funds (borrowing abroad and foreign direct investment) is higher than recorded use, the excess must have leaked out as unrecorded transactions and are therefore illicit by definition. The second method tracks the over-invoicing of imports and under-invoicing of exports by domestic residents in order to capture their illicit holdings of foreign currency abroad. The Global Financial Integrity (GFI) study estimated that black money to the tune of $22.7-$27.3 billion left India annually during 2002-2006.
That issue, of black money leaving India, and the total stock of slush funds held abroad by Indians, has become a hot-button political issue. Unfortunately, in the political fray a number of commentators have misinterpreted the GFI report and have confused the issues.
One of them simply took the unrecorded BOP part and depicted that figure ($4.6 billion) as the lower end of the range of black money outflows. Clearly, this is incorrect; the GFI range of $22.7-$27.3 billion includes both unrecorded BOP transactions, as well as trade mispricing. Other commentators have taken this range and interpolated them back to 1947 in order to come up with the total stock of slush funds abroad. Such back-of-the-envelope calculations yield a highly dubious figure, given the significant structural changes in both the Indian and world economies since then. The opacity surrounding the operations of offshore financial centres, tax havens, and on-shore banks which hold these illicit assets mean that no one knows what that stock of slush funds is.
A question was raised concerning calculating trade mispricing. As is standard practice, the cost of freight and insurance was explicitly accounted for; the main method of estimating black money outflows through trade mispricing involved the calculation of trade discrepancies using data reported to the IMF by its member countries. In addition, the GFI study also utilised the IPPS system, measuring trade mispricing based on deviations of the traded price against a “world norm”. Estimates obtained through the two completely independent methods were quite close. Another commentator opined that trade reforms in India should have reduced the practice of trade mispricing. Nothing shows that the two are linked. In fact, the decline of import duties may well encourage import over-invoicing, particularly if grassroots corruption and the related desire to accumulate wealth abroad away from the reach of regulatory authorities, are alive and kicking.
Another comment was that economists tend to cherry-pick estimates — including outflows but ignoring inflows of black money. On the contrary, ever since the trade mispricing model was put forward more than 30 years ago, economists have taken account of all signs in estimating capital flight from individual as well as small sample countries. However, according to this “traditional” method, Africa supposedly received $12.3 billion per year in black money inflows during 2002-2006. This is an absurd result (because of Africa’s continued dependence on much smaller external aid) leading us to reject the “wrong sign” method. There is not a single study that validates the nature and significance of illicit inflows; it is possible that economists have therefore seriously understated the issue of black money outflows from developing countries.
For instance we have seldom come across traders bringing in black money through trade mispricing. The monetary impact would have been noticed by the RBI. Hence, our premise was that black money doesn’t just hide — it tends to flow out and away from reach. And once it goes, it hardly ever comes back. Naturally; if tax cheaters and other corrupt individuals have gone to great lengths to shelter their wealth in secrecy, why on earth would they bring it back to the government’s attention?
Note that the best economic models cannot capture all the ways to send money out, a limitation we mention in the report. For instance, a US State Department report estimates that hawala transactions in India range between $13-17 billion annually. If so GFI’s estimates of illicit flows from India are likely understated. Nor can economic models capture a courier’s cross-border transfer of foreign exchange in a suitcase. Thus we placed restrictions on the direction and size of IFFs. Regarding the direction of flows, we ask — does the country show illicit financial outflow (through the balance of payments) in three or more years? The rationale is that a country with illicit financial outflows in three or more years out of five cannot suddenly turn around into a net receiver of black money. That would fly in the face of how black money behaves in life. Regarding the size of outflows, we ask whether a country’s illicit outflows exceed 10 per cent of its exports, a volume that is much larger than what can possibly be attributed to data issues.
As a result of this filtration process, GFI’s estimates are quite conservative. Even so, illicit outflows have now come to outstrip official development assistance by a factor of 10 to 1. The volume of black money outflows from India is only the fifth or sixth highest (depending upon the method of estimation) among developing countries. We argue that if for every dollar in aid ten dollars leaves through the backdoor, it is time that both donor and recipient countries adopt policy measures to address the implications for poverty alleviation. We can expect the outflow of black money from developing countries and its absorption in the world’s shadow financial system to increasingly grab the attention of both the public and the policy makers in the coming years.
The writer is a lead economist at the Global Financial Integrity, Washington DC and a former senior economist at the International Monetary Fund
This article was originally published by the Indian Express.