Unpacking illicit financial flows, capital flight

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Dr Gift Mugano
In recent months and this week in particular, there have been intensive discussions on externalisation of funds, which has seen Zimbabwe losing billions of dollars from this malpractice. This week’s instalment seeks to unpack externalisation of funds by narrowing around illicit financial flows and capital flight.

What constitutes Illicit Financial Flows and Capital Flight?
Developing countries have registered massive growth in cross-border financial flows in recent years. Most analysts classify these flows into categories of aid, debt, investment, trade, migrant remittances and foreign exchange reserves. As long as these transactions are “fair value”, reported and recorded accurately, the flows are captured in the Balance of Payment (BoP) statistics, are above board or licit (legal).

But this is not the complete picture. Beneath the surface lurks a category of substantial financial flows which has interchangeably been referred to as “illicit financial flows”, “capital flight” or “dirty money flows” or externalisation of funds.

While these terms may be used differently by different experts, all references to them include a number of shared implicit characteristics, which can be broadly listed as:

  • These flows are largely unrecorded (not captured by the BoP and other official statistics);
    These flows are often associated with active attempts to hide origin, destination and true ownership etc. (they seek secrecy);
  • These flows are usually associated with public loss and private gain because no (or little) tax is paid on them or because they may be comprised of bribes paid, constitute domestic wealth permanently put beyond the reach of domestic authorities in the source country, the flows are not part of a ‘fair value’ transaction and would not stand up to public scrutiny if all information about them was disclosed;
  • In most cases, these flows violate some law or the other in their country of origin, movement or use.
  • Sometimes, as when exports are under-priced or when bribes are transferred into offshore accounts, there is no actual cross-border flow of money. However, capital would be lost nonetheless.

What is the scale of the problem?
The global estimate of $539 billion — $829 billion of annual capital flight from developing countries dwarfs the annual aid flow of $104 billion. Country level estimates show that it is not unusual for a developing country to lose as much as 5 percent -10 percent of gross domestic product annually to capital flight.

South Africa, for example, is estimated to have been losing an average of 9,2 per cent of GDP (losing $13 billion in 2000), China 10,2 per cent of GDP (losing $109 billion in 1999), Chile 6,1 per cent of GDP (losing $4,7 billion in 1998) and Indonesia 6,7 per cent of GDP (losing $14 billion in 1997). Russia is estimated to have lost as much as $400 billion between 1990 and 1995 alone to these flows.
Cumulatively, more than $230 billion is believed to have left Nigeria and some 17 sub-Saharan African countries are estimated to have lost in excess of 100 per cent of their respective GDPs since 1970.

AFRODAD estimated that Zimbabwe lost $2,83 billion between 2009-2013, through illicit financial flows, which translates to about US$570,75 million a year. Of this, 97,88 percent (US$2,793 billion) was lost through the mining sector, 0,98 percent fisheries, 0,61 percent, Timber and 0,53 percent in wildlife.

What are the main mechanisms used for capital flight?
The mechanisms most commonly implicated in the flight of capital include:
The mis-invoicing of trade transactions.
This can be done by:

  • Under-invoicing the value of exports from the country from which cash is to be expatriated. The goods are then sold on at full value once exported with the excess amount (constituting flight capital) being paid directly into an offshore account;
  • Over-invoicing the value of imports into the country from which cash is to be expatriated, the excess part of which constitutes capital flight and is deposited in the importer’s offshore bank account;
  • Misreporting the quality or grade of traded products and services to assist value over or under-statement for the reasons noted above;
  • Misreporting quantities to assist value over or under-statement for the reasons noted above;
  • Creating fictitious transactions for which payment is made.

Transfer mis-pricing
This is the manipulation of prices of cross-border transactions between related affiliates of MNCs. The motives and mechanisms are similar to those above.
However, the practice is made easier and is harder to detect as the transactions are now done between related parties — so no outside party is involved.
Evidence has shown that around 60 per cent of trade takes place between subsidiaries of MNCs. As these transactions occur between different parts of the same company, there is ample scope for mis-pricing and, as a result, shifting of profits.

Detecting transfer mis-pricing is complicated within the highly complex international production networks that exist today and where companies use trademarks, brands, logos and a variety of company specific intangible assets. Finding independent benchmark valuations for many of these is highly problematic.

For example, oil companies such as Chevron, Texaco and Caltex are estimated to have avoided US$8,6 billion in taxes by using a novel design of accounting and tax transactions with domestic and foreign governments between 1964 and 2002.
Using mis-priced financial transfers

These are intra-corporate financial transactions — for example, loans from parent to subsidiary company at exaggerated interest rates — to shift profit out of a host country is another way illicitly transferring capital out. Real estate, securities and other forms of financial trade can also be mis-priced to facilitate capital flight and exaggerated payments for intangibles such as goodwill, royalties, franchising rights and use of patents is another channel for the flight of capital.

For example, Microsoft has been accused of siphoning exaggerated payments of royalties to its low tax Irish subsidiary to which it transferred many of its main patents and copyrights.

Unscrupulous wire transfers
These involve a bank or a non-banking financial institution transferring money out of a country illicitly. Wire transfers are of course a legitimate way of moving money between countries, but it is when such transfers violate laws, or are used to avoid taxes or hide ill-gotten wealth that they constitute illicit capital flight. Banks can mis-report the source, destination or ownership of funds to help disguise illicit transactions.
For example, the US General Accounting Office (GAO) determined that private banking personnel at Citibank helped Mr Salinas (the brother of the then Mexican president) transfer US$90-100 million out of Mexico in a manner that ‘effectively disguised the funds’ source and destination, thus breaking the funds’ paper trail’.
Other mechanisms
These include the smuggling of cash and other high value mobile assets. Luxury yachts have been regularly sold and moved across oceans to shift capital from one country to another.
The widow of Sani Abacha, for example, was stopped at Lagos airport, trying to leave with tens of suitcases of stashed cash.
The payment of bribes and corrupt monies offshore
In many instances involves bribes payable to public officials by commercial organisations; there is an element of capital flight involved.
The payment of a bribe always means that the recipient country will not get a fair value on the commercial activity undertaken by the firm paying it and that both tax evasion and capital flight will deprive the country of scarce resources.
For example, tens of millions of dollars of bribes, paid into the offshore accounts of public officials was uncovered when the Elf scandal broke out in the 1990s.

What is the development impact of capital flight?
The sustainable development of a country is only possible if it mobilises and retains sufficient resources domestically.

These resources are needed for spending on social and welfare programmes, and for investment to help increase the stock of productive capital. Capital flight undermines sustainable development by increasing dependence on external resources, such as aid, needed to replace the gap left by the fleeing domestic capital.

Where resources stay within a country, they can be locally consumed or invested to promote economic activity. The escape of such funds depresses economic activity and has a negative impact on long-term growth rates.

The flight of domestic resources abroad undermines the development of an accountable and participative relationship between the state and its citizens. This is reached when citizens’ resources are mobilised to fulfil domestic needs – in other words, citizens pay taxes and then hold their governments to account to ensure that the money is utilised properly towards priorities defined by them.

If a large amount of such wealth is transferred offshore, incentives to participate in the establishment of a just and functioning domestic society diminish significantly.
Much of the capital that flees a country is untaxed, this reduces the tax base by shifting wealth and resources beyond the government’s reach. Thus capital flight depresses both budget revenues, which are needed to finance the provision of essential services such as health and education, and the investments needed to meet the Sustainable Development Goals and the country’s overall development.

It also worsens the distribution of income by shifting the tax burden away from capital and onto less mobile factors, especially labour and consumption.
The infrastructure that facilitates capital flight by allowing vast amounts of capital to flow across borders unchecked and in secret, is also vulnerable to being used by terrorist and criminal networks and thus puts our collective and individual security at great risk.

This infrastructure also makes it easier to engage in corrupt behaviour, especially through the payment of bribes to, and the diversion of funds by, domestic political and business elites. Such funds are usually stashed offshore, protected by secrecy and privacy which makes detection difficult and hence increases the rewards that can be earned by engaging in corrupt behaviour.

Their actions increase within country inequality, reinforce power imbalances, undermine democracy and the rule of law and lead to a deteriorating economic and social situation under which ordinary law-abiding citizens suffer.

Capital flight from developing countries deprives their citizens of a future. The poorest and most vulnerable are those most affected when resources that could otherwise have been used for life-saving and life-sustaining expenditure on basic healthcare and other essential services are illicitly taken out of a country.

In conclusion, one can now appreciate that the Government of Zimbabwe’s fight with externalise is a good one due to the ills to brings about.
However, this is a complicated game which requires pragmatic approach since some who are purported to have externalised funds would not have done so illegally. I will unpack this angle in my next article.
Asante Sana

Dr Mugano is an Author and Expert in Trade and International Finance. He has successfully supervised four Doctorates candidates in the field of Trade and International finance, published over twenty – five articles and book chapters in peer reviewed journals. He is a Research Associate at Nelson Mandela University, Registrar at Zimbabwe Ezekiel Guti University and Director at Africa Economic Development Strategies. Feedback: Cell: +263 772 541 209. Email: gmugano@gmail.com

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