Illicit Financial Flows from Developing Countries: The Absurdity of Traditional Methods of Estimation

Illicit financial inflows and illicit financial outflows must be added together in order to accurately measure the adverse impact of these flows on developing economies, explains Dr. Dev Kar.

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The Alpha, but Whither the Omega, of the Greek Crisis?

Global Financial Integrity Lead Economist Dev Kar examines the role of illicit financial flows (IFFs) in the Greek debt crisis. IFFs cost Greece an estimated US$160 billion over the last decade.

Photograph by Simon Tong

Greece has been in the news a lot lately and as we all know, it has not been good news. By all accounts, the austerity measures being imposed on the population as a condition for bailing Greece out of the financial crisis, is severe. As Walter Mead points out in a recent blog, investors are worried that the Greeks may not stand for them. He rightly notes that ordinary Greeks feel that the rich should pay the costs of the economic crisis and not them. They are right. According to an article in the Washington Post (Is austerity a Greek myth? By David Ignatius, May 3, 2010), Prime Minister Papandreou admits that corruption now robs the Greek economy by US$20-30 billion and “graft” (probably meaning bribery and kickbacks) accounts for some 8-12 percent of GDP. If, as I suspect, the Prime Minister is talking of graft and corruption as separate components, the size of Greece’s underground works out to some 18-21 percent of GDP. The result still falls short of the 25-30 percent of GDP estimated by most economists.

There is no question that Greece is caught between the proverbial rock and a hard place. To understand how the country got there, I shall try to trace the road map with the help of some basic economic data for the decade ending 2009. The first striking thing is that Greece ran a sizable current account deficit that grew from 6.6% of GDP in 2000 to 15.5% of GDP with most of the increase coming in the second half of the decade. A current account deficit basically arises from increases in import costs over export earnings. It is symptomatic of an excess of consumption over income. Greece financed this consumption boom not by drawing down domestic (public and private) savings or gross foreign exchange reserves of the central bank but through the contracting of external debt which swelled from a manageable 73% of GDP in 2000 to close to 160% of GDP by the end of the decade.

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The Difficulty of Addressing Governance Issues Underlying Illicit Financial Flows

A recent study at Global Financial Integrity (GFI) found that illicit financial flows from developing countries (henceforth emerging markets), which grew around 18 percent per annum since 2002 swelled up to US$1 trillion in 2006. While the lack of prudent macroeconomic policies, political instability, and governance issues are major drivers of illicit flows, a subsequent study at GFI found that banking secrecy and lack of regulatory oversight facilitated the absorption of illicit flows in mainly Western financial institutions. Curtailing illicit flows must therefore involve both emerging market as well as developed countries to address the factors responsible for the generation and absorption of illicit funds.

Here we discuss the difficulty of addressing complex governance issues underlying the generation of illicit flows. We start by recognizing that the accurate measurement of complex governance issues through indicators is fraught with difficulties. This came to light in the course of GFI’s study. For instance, we noticed that illicit financial flows from many emerging markets were increasing even though their World Bank governance indicators were actually improving. As we discovered, this was not necessarily an anomaly—the Bank indicators were mainly focused on public sector governance while illicit financial flows are typically generated and driven by the private sector. The preponderance of the private sector in driving illicit flows can be illustrated by the fact that if corrupt government officials stash bribes abroad, they act in their private, and not official, capacity. Hence, public sector governance in some emerging markets could be improving even as their private sector governance deteriorates thereby generating illicit flows through, say, trade mispricing.

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From Monetary to Fiscal Dominance: Implications for Illicit Financial Flows

Most countries in the world are somewhere in-between a bipolar policy extreme characterized by either complete monetary dominance or complete fiscal dominance. Complete monetary dominance (equivalently zero fiscal dominance) is characterized by complete independence of the monetary authority. Under such a situation, any increase in debt (generated by the central bank selling government bonds in the open market) must be followed by increases in the current or future primary surplus (i.e., excess of the current government revenues from all taxes over current government expenditures) by the fiscal authority such that it is able to back the principal and interest payments on the newly issued debt. The other policy-mix extreme is complete fiscal dominance characterized by a monetary authority whose policies have been totally subordinated to the government. All outstanding debt is backed by the monetary authority in the form of current and future seigniorage revenues or that part of revenues accruing to the government through the creation of money (as in quantitative easing). A case of complete fiscal dominance would compel the monetary authority to fully accommodate the fiscal authority whenever a budget deficit is financed with debt. Obviously, the effectiveness of inflation targeting–arising out of the monetary authority’s pursuit of its primary policy objective—is reduced in the presence of fiscal dominance when monetary policy is subordinated to fiscal needs.

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Are Bilateral Trade Statistics Unreliable?

Illicit financial flows exit developing countries through two broad channels—as unrecorded capital flows from a country’s external accounts (captured by the World Bank Residual model) and trade mispricing (captured by the Direction of Trade statistics or DOTS model). GFI’s study Illicit Financial Flows from Developing Countries: 2002-2006 points out that some researchers have questioned the use of the trade mispricing model to capture illicit flows. They argue that data issues underlying the recording of partner country exports and imports introduce enough “noise” so that the trade mispricing model is unable to capture illicit flows. I was therefore not surprised to hear cynical remarks about the quality of bilateral trade statistics at a recent World Bank conference (Understanding the dynamics of the flows of illicit funds from developing countries, September 14-15). Here, I point out the reasons why most economists reject such arguments for not studying trade mispricing as a conduit for illicit financial flows from developing countries.

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