How Illicit Financial Flows from Developing Countries Reach Offshore Centres

The illegal movement of money or capital from one country to another is termed as illicit financial flows (IFFs). According to Global Financial Integrity (GFI), when funds are illegally earned, transferred and/or utilized, it is termed as illicit financial flow. Capital that is legally earned but illegally transferred, would be considered as illicit financial flow. The movements of funds by drug cartels, criminals and terrorists, trade misinvoicing by businesses and corrupt public officials’ transfer of funds outside the country of origin are some of the items that fall under the definition of illicit financial outflow. Illicit financial flows from developing countries move to offshore financial centers and developed countries.

The report ‘Illicit Financial Flows from Developing Countries: 2002-2011′ by Global Financial Integrity states that illicit financial flows from developing countries was US $946.7 billion in 2011 while the cumulative financial outflow between 2002 and 2011 was US $5.9 trillion. This indicates the possible adverse economic effect that illicit financial flows have on developing countries’ economies. Again, illicit financial flows are increasing; they have increased at an average of more than 10 percent per year between 2002 and 2011, after adjusting for inflation. In 2011, illicit financial flows increased by 13.7 percent from US$832.4 billion in 2010.

According to the report ‘Illicit Financial Flows from Developing Countries: 2002-2011’ by Global Financial Integrity, Asia accounted for 39.6 percent of total illicit financial flows from developing countries. Asia has the largest share of illicit flows among the regions and six of the top fifteen exporters of illicit capital are Asian countries (China, Malaysia, India, Indonesia, Thailand, and the Philippines). Of the other regions, developing Europe consisted of 21.5 percent of total illicit flows, Western Hemisphere 19.6 percent and Middle East and North Africa (MENA) 11.2 percent. Africa has the smallest nominal share of regional illicit flows of 7.7 percent. However, it has the highest average illicit flow to GDP ratio at 5.7 percent. The report states that the MENA region experienced the highest rate in illicit flows over the period studied (31.5 percent per year) followed by Africa (20.2 percent), developing Europe (13.6 percent), Asia (7.5 percent) and Latin America (3.1 percent). While six of the exporters of illicit capital are in Asia, two are in Africa (Nigeria and South Africa), four in Europe (Russia, Belarus, Poland and Serbia), two in the Western Hemisphere (Mexico and Brazil) and one in the MENA region (Iraq).

The major portion of illicit flows consists of trade misinvoicing (80 percent on average) and the rest by balance of payments leakages. Businesses can transfer money out of a country by under-invoicing exports or over-invoicing imports. As misinvoicing is illegal, the resulting financial flow also becomes illicit. According to the report ‘Illicit Financial Flows from Developing Countries: 2002-2011’ by Global Financial Integrity, total illicit financial flows as a percentage of developing country GDP increased from 4.0 percent in 2002 to 4.6 percent in 2006 and, then, declined to 3.7 percent of GDP in 2011. Between 2002 and 2011, the cumulative illicit financial flow from the top fifteen exporters was US $4.2 trillion that represented 70 percent of total illicit financial flow from developing countries. During this period, Mainland China had cumulative illicit financial flows of US$ 1.08 trillion followed by the Russian Federation with US$ 881 billion.

The report finds that there are three common variables that led to export misinvoicing in fifty-five developing countries over the period 2002-2011. The three variables are the state of overall governance in the country, export proceeds surrender requirements (EPSR) and capital account openness; the latter two are regulatory in nature. EPSR requires exporters in developing countries to repatriate foreign currency earned through international trade for domestic currency. The report finds that EPSR motivates exporters to under-invoice their exports and hold foreign currency in offshore bank accounts. Therefore, the introduction and presence of EPSR leads to an increase in illicit financial flows from developing countries. Also, the report finds that the issue of trade misinvoicing increased while the developing countries liberalized their capital account since the 1970s. It seems that capital account liberalization combined with weak governance leads to increased illicit financial flow. Again, there is a positive relationship between corruption and trade misinvoicing; an increase in corruption leads to increases in both export and import misinvoicing.

Another paper by Global Financial Integrity titled. ‘The Absorption of Illicit Financial Flows from Developing Countries: 2002-2006’ researches the destination of illicit financial flows from developing countries. It finds that cash from developing countries flows to two destinations, offshore financial centers and non-offshore developed country banks. However, the cash flow from developing countries is both licit and illicit. When companies are genuinely repatriating profits, the financial flow is licit. The paper mentions that illicit financial flows from developing countries are invested in financial assets like equities, precious metals, arts and real estate. One interesting finding is that absorption is higher than total illicit financial flows. Absorption includes both licit and illicit flows; also, a portion of illicit flows are held in cash as illicit investments are considered riskier, according to the paper. This could possibly explain the reason for absorption outstripping the flow of illicit finance.

According to the IMF definition of offshore centers, these centers held 44.2 percent of private sector deposits from developing countries between 2002 and 2006. The rest 55.8 percent was held by developed country banks. Also, the paper states that offshore financial centers received more illicit financial flows from Asia relative to other regions during this period. 53.1 percent of total illicit flows from Asia flowed to offshore financial centers, which included Ireland and Switzerland. Again, the paper reveals that most illicit flows from developing countries of the Western Hemisphere and Europe were deposited in developed country banks relative to offshore financial centers. Finally, the paper states that 46 to 67 percent of total illicit funds are held by developed country banks on average. The paper concludes that 20 to 72 percent of total illicit flows from developing countries were absorbed into developed country banks between 2003 and 2006.

Illicit financial flows is an issue that plagues developing countries. It denies the developing countries of income, tax revenues, investment capital that could lead to increased employment, economic growth and poverty reduction in these countries. However, regulations do not seem to have any effect in stemming the outflow of illicit capital. On the contrary, they seem to increase the outflow of illicit capital. Concrete steps in making developing countries more attractive investment destinations would reduce illicit financial flows. Improvements in infrastructure, human capital, etc. would certainly help developing countries to reduce illicit financial flows. However, improvements in governance seem to be key in decreasing the outflow of illicit finance and developing countries need to improve their governance before they can see any substantial reduction in illicit financial flows.

It can be counter argued that even if illicit finance remains in developing countries, it would be reinvested only in the black market. As the operation and expansion of the black market does not have any positive contribution on the real economy, illicit finance may not have any significant contribution in the development of the real economy and in employment generation or poverty reduction in developing countries. Then, whether illicit finance remains or outflows from developing countries is irrelevant to these countries as they do not gain in any way from the existence of illicit finance within their borders.

The substantial financial flow that the developed country banks receive may act as a helpful injection to the developed countries’ economies. This injection can help boost the financial markets of the developed market economies and increase investment in these economies. It can lead to increased investment in mining, metals, consumer based industries and other industries. This may lead to higher economic growth and GDP in developed countries. However, there maybe a few possible downsides of financial inflow in developed countries, especially when that inflow is illicit. The illicit financial flows to the developed country banks and potentially to financial assets may create an asset bubble in these countries. An overvaluation of equities may always lead to disturbance in the economies that could always precipitate to a full blown economic crisis.

The illicit financial flows to the developed countries may often be accompanied or followed by people who accumulate the illicit finance. As these people have engaged in bribery and other unlawful activities in developing countries to accumulate their illicit finance, there is always a possibility that they may resume their criminal behaviour once they move to the developed countries. This may possibly increase the crime rates and lead to expansion of black markets in the developed countries. An increase in crime rate or black market is undesirable for all developed countries. Again, allowing the inflow of illicit finance to the developed countries may unwittingly encourage the growth of black mark in the developing countries and, consequently, in the world. It may incentivize unscrupulous people to engage in illicit activities in developing countries and participate in the expansion of black market in developing countries with the explicit objective of moving the illegally earned finance to offshore financial centres and developed countries.

Finally, illicit financial flows may be invested in real estate in the developed countries. This can lead to rapid increases in real estate prices in these countries that may make it difficult for their residents to own residential or commercial properties. Cities in North America like San Francisco, Toronto and Vancouver have experienced substantial increases in real estate prices. The increase in real estate prices have far outstripped the increase in per capita income of local residents in these cities. The same trend is observed for London. Financial inflow from developing countries to real estate has made it almost impossible for the local residents to own residential properties in these cities. This may lead to frustration and disappointment among the local residents of the developed countries. Therefore, financial flows, particularly illicit, to the developed countries may have negative consequences for the developed countries.

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