Illicit financial flows (IFFs) have become a high profile issue in recent years. The Sustainable Development Goals include a target (16.4: significantly reduce illicit financial and arms flows, strengthen the recovery and return of stolen assets and combat all forms of organized crime), and the issues has been included in the Addis Ababa Action Agenda and the work of the G20 and the OECD. Donors including NORAD and DFID and multilateral organisations such as the World Bank and African Development Bank are also responding.

Introduction

Large estimates of trade misinvoicing have played a key role in shaping perceptions of the issue. The Washington based NGO Global Financial Integrity (GFI) uses mismatches in official trade data to estimate that trade misinvoicing drains US$800 billion from developing countries annually. Their work also inspired UNECA and the African Union to set up a High Level Panel on Illicit Financial Flows from Africa, which estimated US$50 billion of illicit flows from Africa.{2} Based on these estimates, Thabo Mbeki as chair of the panel argued that ”the bulk of illicit financial flows – 60% and more – derive from the activities of the large commercial companies”, through trade misinvoicing,  with criminal activities such as drug trafficking accounting for about 30%, and corruption less than 10%.

Manipulation of import and export prices is certainly a real phenomenon. In China overpayments of imports have been used to get around the country’s currency controls. In Venezuela scammers use inflated import invoices to buy cheap dollars from the official currency control agency. There have long been concerns that exporters shipping tropical hardwoods from Papua New Guinea may be underdeclaring their value. Networks involved in smuggling people, drugs and arms use Halawa agents to transfer money, and they may settle up between themselves through shipments of licit goods under-charged. However, it is not clear that the influential and widely quoted estimates of trade misinvoicing derived from mismatches in trade statistics help us to understand the reality of illicit economies and networks in practice.

This briefing looks at some of the key problems with these estimates and argues that continuing to use them as such a bright point of light in shaping our understanding could impede, rather than support targeting of effective action in combatting corruption, organized crime, illegal exploitation of natural resources and tax evasion.

Moving away from the lamppost

Illicit flows are, by their nature, difficult to identify and this first generation of estimates have played a critical role in drawing attention to the issue. Difficulties in measurement do not mean that the problem of trade misinvoicing or broader illicit flows should be dismissed, or that the challenges to governance of natural resource revenues should be underestimated. But continuing to circle around the most convenient lamp-post provided by these big numbers is unlikely to lead to fruitful results.

Challenging these estimates is not an argument for no action on illicit flows, nor is it a quest for impossible accuracy, but it is an urgent call for a more realistic conversation that draws in the expertise of revenue authorities, statistical agencies, customs agencies, law enforcement and businesses, as well as experts in natural resource governance and organised crime. There are four areas which are particularly relevant:

1. Understanding domestic realities – Domestic studies are critical to understanding the impact of illicit finance on development. Such research is being undertaken in Kenya, Tanzania, West Africa and South Africa, for example. However, the catalyst for these studies has often been the existing estimates of massive commodity trade misinvoicing. This creates a tension as the evidence that they find may challenge rather than provide confirmation of the received wisdom. Mirror trade statistics may provide one source of data for national studies, but they cannot be viewed as clear evidence of misinvoicing, and studies need to develop findings which are recognisable to practitioners. Enabling learning from across these studies about how to analyse illicit flows on the ground is a crucial step to support international understanding.

2. Measuring international progress – The UN has so far been unable to reach agreement on an SDG indicator on Illicit Flows. The wished-for indicator has been “total value of inward and outward illicit financial flows” – however it is increasingly clear that this indicator does not exist, cannot be calculated and is unlikely to be meaningful given the range of impacts of different types of illicit flow. Individual-country analyses should feed into understanding of where third-countries are acting as getaway vehicles, and how this can best be addressed. Frameworks such as the Financial Secrecy Index developed by the Tax Justice Network, and the development by the EU and the OECD of criteria for identifying non-cooperative jurisdictions are relevant efforts towards exploring the second question, as are ‘mystery shopper’ exercises in testing how easy it is to register anonymous companies.

3. Commodity value chains – It is clear that the extractive sector is prone to leakages, but inflated expectations of massive hidden margins can contribute to policy instability and undermine government accountability. Initiatives such as the Extractive Industry Transparency Initiative and the Natural Resource Governance Institute are doing important work to improve transparency and analysis of extractive revenues at a country level. But there is also potential to advance understanding of illicit flows within global commodity value chains. The G20 has asked the World Customs Organisation to study the issue of IFFs, and their expertise could support such an approach. Industry bodies such as the International Council for Mining and Minerals (ICMM), the oil and gas association for environmental and social issues (IPEICA) and the Swiss Trading & Shipping Association should also contribute to understanding illicit flows risk and provide insight on trading practices and commercial realities.

4. The role of multinational companies – The problem of how to tax global commerce effectively is different from how to find corrupt or stolen money, or fight organised crime. Strengthening administration of tax law so that it is neither weakly enforced, nor capricious and predatory is positive for citizens, businesses and government, and ultimately critical for sustainable development. This suggests a key area of shared interest between multinational companies and others concerned with illicit flows, around the effectiveness of beneficial ownership transparency systems. Blurring the distinction between legal and illegal conduct in relation to tax by combining them into a vaguely defined composite category is not something to do lightly, and certainly not on the basis of a combination of wishful thinking and misunderstanding.

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Comment by Matthew Salomon, Senior Economist, Global Financial Integrity

Broad response

Noting the increased prominence of IFFs on the development agenda in recent years and the role of trade misinvoicing in advancing general understanding of IFFs, the author (Maya Forstater) asks whether a focus on misinvoicing is not too narrow a frame for moving ahead on the IFFs agenda. She concludes that “it is not clear that the influential and widely quoted estimates of trade misinvoicing help us to understand the broader reality of illicit economies and networks in practice.” Further, the author suggests that focusing on misinvoicing is indeed looking under the wrong lamppost in the sense that it is an obstacle to progress: “continuing to allow [misinvoicing estimates] to shape understanding could impede rather than support progress in combatting corruption, organized crime, illegal exploitation of natural resources and tax evasion.”

Without question, focusing solely on misinvoicing as representative of the IFF issue is too narrow a frame – I absolutely agree with the author on this. I’d go further than the author has in this line of argument: the international community should cast as wide a net as possible in approaching a quantitative assessment of the IFFs problem. In fact, there appears to be growing international support to do this. Among a recent gathering of IFF experts at the UN there was “strong support … to keep efforts (to estimate various sources of IFFs) disaggregated and to work on improving measurement for the separate components …”

IFFs are unobservable and will remain so even as the international community makes progress in its attempts to monitor those flows. Basic principles of statistical science argue for broadening the scope of inquiry to include more indicators of illicit activity, even as indicators are uncertain and differ from each other in quality.

Translating the statistical principles into the terms of the exemplum of the man searching for his lost keys: we should be looking under all lampposts. In this context, there are no “wrong” lampposts.

However, while we welcome and support the author’s desire to broaden the scope of inquiry into IFFs, it is not at all clear why pursuing that objective requires her to discredit misinvoicing estimates. The author’s assertion that misinvoicing estimates are impeding progress is not supported in the note and remains, to us, mystifying.

Concerning methodology

While she acknowledges the existence of misinvoicing as a problem, the author also attempts to discredit the methodology used by Global Financial Integrity (GFI) and others (including IMF researchers) in estimating misinvoicing. In this context, she notes: “not all trade misinvoicing shows up as mismatches in the trade data, and conversely, not all mismatches in the trade data are evidence of misinvoicing.” Here the author conflates issues of technique and data limitations in a way that obscures matters.

The basic truth of IFFs in general, and misinvoicing in particular, is this: nothing illicit just “shows up.” IFFs are unobservable and can only be gauged, however crudely, through reasonable inference applied to available data, warts and all. In an ideal situation, we might imagine an available administrative database covering all transactions with sufficient detail to identify the problematic passage of goods through intermediate trade hubs noted by the author as well as a host of other factors that earlier critiques have noted (e.g., temporal, geographic, and commodity aggregation effects, valuation effects). The point is this: even with such an ideal database, misinvoicing would still be unobservable. Even in that case, it would still be necessary to draw reasonable inferences about misinvoicing.   

The data available to researchers are far from ideal. Understanding the limitations of the data used is critical, and recognition of those limitations should pervade both the specific implementation of the partner-trade analysis and the interpretation of the results obtained. For practitioners, there is always room for improvement and necessary analytical adjustments are improvements. Such adjustments might be necessitated, for example, by the discovery of subtle deficiencies in the data for particular countries and commodities. Equally important, reporting practices must be fully transparent and must not misrepresent the findings.

GFI uses a variety of available databases and a variety of methods to draw inferences about misinvoicing. The IMF’s Direction of Trade Statistics (DOTS) are the basis of GFI’s annual estimates of trade misinvoicing for all emerging market and developing countries. The DOTS data are the most comprehensive available in terms of coverage, a fact that makes DOTS attractive for use in GFI’s global estimates. The DOTS data, however, do not provide the commodity-level detail that another, less comprehensive but more detailed, database do provide (e.g., UN COMTRADE). Furthermore, the DOTS data are adjusted when other data are available to increase the accuracy of the estimate to some extent; an example is the adjustment for re-exporting Chinese trade through Hong Kong, an adjustment that’s possible only because Hong Kong has made such data available.

In terms of its annual global estimates, GFI is attempting to provide a rough indication of the overall magnitude of misinvoicing, a measure that, by design, tends to underestimate the overall magnitude. The result that a significant share of total developing country trade is potentially misinvoiced is alarming. Moreover, there are concrete (and relatively inexpensive) steps that developing countries can take to reduce such misinvoicing. No, that will not eliminate all illicit financial flows – but curtailing misinvoicing to some degree is surely a step in the right direction.

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This briefing is prepared for the project “Taxation, Institutions and Participation (TIP): The dynamics of capital flows from Africa”, funded by the Research Council of Norway.

The author would like to thank Alex Erskine, Odd-Helge Fjeldstad, Leonce Ndikumana, Kathy Nicolaou, Volker Nitsch, Vijaya Ramachandaran, Tuesday Reitano, Peter Reuter and Mathew Salomon for comments and insights. Views and conclusions expressed within this CMI Insight are those of the author alone.