The Conundrum of Illicit Financial Flows
|The Conundrum of Illicit Financial Flows
By Teshome Abebe
November 14, 2014
In an extraordinary book titled Lying: Moral Choice in Public and Private Life,1 Sissela Bok wrote about truth, deception, white lies, excuses, the justification for lies, lying in a crisis, as well as permissible lies and their consequences. The book was first published in 1978, and I dusted up my old copy to see what new insights, if any, I might glean from it to help explain the rising tide of illicit financial flows. It would have been incomplete, insufficient and a disservice to readers to attempt and explain the phenomenon purely in economic terms alone.
Bok notes that Plato had contemplated the “noble lie”—which is one that would normally cause discord, but offers some benefit to the liar and assists in an orderly society, therefore, potentially beneficial to others. It is often told to maintain law, order and safety, and it is the only kind of lie that is permissible.
Mirroring a utilitarian marginalist approach, Ian King suggested, “Deceive only if you can change behavior in a way worth more than the trust you would lose, were the deception discovered (whether the deception actually is exposed or not).” In this view, lies could achieve good outcomes in some cases (white lies).
What ever the justification, what ever the motive for telling lies, “All lies, defined precisely as the external communication of what one does not hold to be internally true, are categorically sinful and, therefore, ethically impermissible”, (St. Augustine).
Regardless of one’s views on truth or of their professed doctrinal stand, society has absolutely no interest in undermining truth telling. After all, a lie is only advantageous in circumstances where people will believe it, i.e. where a practice of truth telling prevails. As a result, society’s interests are served more by everyone supporting the practice of truth telling so as to make liars the exception—the outliers, so to speak. That explains why in most countries those who commit perjury in a court of law are prosecuted. The judges and the system of justice do not appreciate being cast as looking foolish when the truth is finally discovered.
As a result, truth telling must be seen as our part of doing what is necessary to uphold the practice from which we all benefit. In that sense, I condemn illicit capital flight exactly as I would condemn thievery even though I can at the same time make the argument that both have distributive effects.
How is truth telling related to the topic of my current essay? Well, one factor driving illicit capital flows is misinvoicing. Misinvoicing is really falsifying trade documents, and as such, it is hardly an act of truth telling. It is a form of scam made operational in many different forms by individuals or groups who have an incentive not do their part. These individuals or groups can be called the free riders of society who want others to do their part to maintain a system, while they skip their part.
As Robert K. Fullinwider would say, they “…want to reap the benefits of the system without investing the reciprocal sacrifice of supporting it.” Free riders, indeed! Unfortunately, the more open an economy is, the more likely documents are to be falsified, leading to an ever increasing amount of capital outflow from poor countries whocould ill-afford such theft in the first place. The fact that misinvoicing continues to grow implies that if you engage in world trade, you will soon be asked to falsify documents at some point by some one. And that is very bad for those of us who hold that telling the truth is just our way of doing our part to uphold the practice from which we benefit—truth telling!
Let me first outline some cautionary points with regard to illicit financial flows, followed by a description of what they are. I will then list the factors responsible for financial flows followed by an illustrative comparative data for six African peer countries: Ethiopia, Ghana, Kenya, Nigeria, South Africa and Sudan.
The phenomenon of illicit financial flows is extremely complicated to decipher accurately and precisely. As a result, almost all studies on the subject use estimation techniques that is beyond the scope of this short article. In addition, it is extremely difficult to identify the specific sources of illicit financial flows with some degree of accuracy. Illicit financial flows were thought to be caused by official corruption and economic instability. Recent evidence based on better data illustrates that, while official corruption is one factor, it is not the only important factor. There are other factors, including: crime, corruption, tax evasion, import underinvoicing, import overinvoicing, export underinvoicing, and export overinvoicing.
In most of the factors listed above, the major motive is understood to be evasion of taxes on trade. While real depreciation of exchange rate was found to affect import underpricing, the incentive of tariff evasion has been found to be a major cause for trade misinvoicing in general. Specifically, studies have determined that while the practice of misinvoicing is higher among developing countries than in developed ones, the current account deficit; customs duties; and currency overvaluations contribute as the main factors in import overpricing. Alternatively, export underpricing is influenced by political instability; capital account openness; current account deficit; trade openness; and external indebtedness.2
Furthermore, there is overwhelming evidence that the estimates obtained of illicit financial outflows by most studies are already very conservative figures. That is because they do not include illicit flows as a result of “… the misinvoicing of trade in services (rather than the trade in goods), same-invoice trade mispricing (such as transfer mispricing), hawala transactions, and dealings conducted in bulk cash.” As a consequence, “… much of the proceeds of drug trafficking, human smuggling, and other criminal activities which are often settled in cash are not included in these estimates. It also means that much of abusive transfer pricing conducted between arms of the same multinational corporation are not captured in our figures.”3
A recent detailed study of illicit financial flows from developing countries between 2002-2011 by the highly respected Global Financial Integrity group (GFI) concluded that: “We estimate that illicit financial outflows from the developing world totaled a staggering US$946.7 billion in 2011, with cumulative illicit financial outflows over the decade between 2002 and 2011 of US$5.9 trillion. This gives further evidence to the notion that illicit financial flows are the most devastating economic issue impacting the global South.”
In addition, the study also found that “…a set of three common variables basically drove export misinvoicing in the 55 developing countries over the period 2002-2011. Two are regulatory in nature—export proceeds surrender requirements (EPSR) and capital account openness— and the third is the state of overall governance in the country.”
What is potentially devastating about the nature of illicit financial flows is that they are rising in volume over the period under study, showing the most intense increases over the period between 2008 and 2011. (All data are in millions of dollars.)
A caution: interpreting these data is very tricky given that trade data in almost all developing countries is highly unreliable and at times, inaccurate. The problem of trade data is not confined to developing countries alone, and one must be cautious in how they are deployed and interpreted. Yet, given the fact that these estimated values are highly conservative and do not include the underground economy in all of the countries under study, it is very telling that the issue of illicit financial flows is very serious indeed. As a consequence, governments may have to devote sufficient resources to monitor, or implement better or effective policies that discourage and deter trade misinvoicing.
Using the data presented in Tables 1 through 3, it is evident that illicit financial flows as a result of trade misinvoicing constitute 64% in Ethiopia; 2% in Kenya; 19% in Nigeria; 105% in South Africa; and 34% in Sudan. By way of contrast, that ratio is so negligible in Ghana that it does not appear to be a problem for the republic. This lends support to the assertion by the GFI group that an open economy with the presence of weak governance– perceived or otherwise– can be a prescription for more illicit financial flows.
In the study conducted by the GFI, Ethiopia came in at number 39 (out of 144) from the top in total outflows, outranked in Africa by Nigeria (10); South Africa (13); Egypt (26); Sudan (30); and Cote D’Ivore (37). By contrast, peer country Ghana came in at 92, and Kenya at number 119. Are the Ghanaians and Kenyans more honest or patriotic than their Ethiopian or Nigerian Brethren? Tempted as we might be to readily respond to that question, the limited data would simply not allow us to arrive at that conclusion. We have to look at other pieces of data such as, their governance; alternatives available to them to transmit funds legally; and other relevant societal, political, as well as economic factors. Unsurprisingly, China, the Russian Federation and Mexico took the top three spots in the derby for financial outflows!
Another corroborative study by Boyrie, et al,4 on capital outflows from Africa to the United States concluded that in 2005 alone a total of $4.903b moved out of Africa. This was further disaggregated into $2.432b through high priced imports, and $2.471b through low priced exports.
The same study also found that for the period 2000-5, Ethiopia lost $165,392,709 through high priced imports (import overpricing) from the US; and $13,547,409 through low priced exports (export underpricing) to the US, for a total capital flight of $178,940,118.
Based on their estimates, the authors concluded further that the country moving the most capital to the US through trade misinvoicing was South Africa—with a total of $6.9b. The North African countries of Egypt, Algeria, Morocco, and Tunisia alone moved $6.734b through trade misinvoicing, while the remaining Sub-Saharan countries combined for a total of $13.408b. Given the size of these transfers, it is reasonable to conclude that every one involved on both sides of the transactions stands to benefit from the practice. Apparently, and at least in this case, it is all right to get a little as long as you give a lot!
Given the size of the capital outflows from the developing countries, it is reasonable that we should be concerned. What we should be concerned about is systematic trade misinvoicing which occurs because traders and other entities try to circumvent foreign exchange controls or just simply wish to move their capital across national frontiers illegally.
Underinvoicing of imports, which is done to avoid customs taxes or trade quotas where they exist; export overpricing, which in turn is done to obtain export subsidies, for example, or other subsidies from the government, are all means of obtaining leverage for purposes of, among others, capital flight. Whenever and wherever government agencies lack the capabilities to deal with the complicated issues of misinvoicing, or wherever they are induced to become cooperative, trade misinvoicing may be one of the most fertile avenues for capital flight.
Other illegal activities that help propel capital flight include: money laundering, drug trafficking, contraband smuggling, human trafficking and other illegal and legal underground activities. It is understandable that because of the nature of these sorts of activities, accurate information on capital flight is hard to obtain. As a result, one must rely on reasonable and robust estimates corroborated by alternative studies.
As a final comment, the data reviewed by this author is so consistent over time, across countries and across studies that there appear to be serious problems of illicit outflow of capital from those countries that need it most to those that do not need it as much.
A correct view of capital flows is imperative: the flow of capital in and out of a country is normal especially during periods of high growth and in an open economy. It should be encouraged and enhanced through appropriate policies and control regimes. But when that flow is primarily and dominantly through misinvoicing and other illegal activities, it causes sever harm to the development agenda of a country.
The more open an economy is and the more sustained it’s growth, the more likely also that illicit capital outflow will become a major problem and a drain on national economies. Through sustained naming and shaming; unbending inquiry; doubt and skepticism; doctrinal appeals or those based on the common good; and may be even moral suasion, we have the opportunity to influence egalitarian minded policy makers and individuals to mend this one of the most anti-poor and anti-development practices in the developing world.
Teshome Abebe is professor of Economics and may be reached at: email@example.com
 Sissela Bok, Lying: Moral Choice in Public and Private Life, (Pantheon Books, 1978; Vintage Paperback editions, 1979, 1989, 1999).
 Ila Patnaik, A.S. Gupta, and A. Shah, “Determinants of Trade Misinvoicing”, Working Paper, National Institute of Public Finance and Policy, New Delhi, 2010.
 “Illicit Financial Flows from Developing Countries: 2002-2011”, Global Financial Integrity, December 2013.
Please also see Teshome Abebe, “Ethiopia: Vertical Integration, Government Revenue and Prices: A Theoretical Amplification” Ethiomedia.com, August 12, 2014.
 Maria E, de. Boyrie, J. A. Nelson, S. J. Pok, “Capital Movement Through Trade Misinvoicing: The Case of Africa”, Unpublished Paper.
 For additional reference, please see Teshome Abebe, Africa’s Odious Debts: How Foreign Loans and Capital Flight Bled a Continent, Leonce Ndikumana and James K. Boyce. London: Zed Books, 2011, Book Review, The Journal of Economics, Volume XXXVIII, No. 1, 2012. Pp. 99-102.
I wish to thank Daniel Teferra—UWW, and Zenebe Abebe of Colorado State University for insightful comments on an earlier draft.