Global Financial Integrity


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

Cross-posted from the blog of the Task Force on Financial Integrity and Economic Development.

Capital flight, in its broadest sense, consists of the cross-border transfer of licit as well as illicit capital. The licit component of capital flight basically consists of short-term capital movements initiated by the private sector. This portion of capital flight arises as a result of private investors’ portfolio decisions in response to interest rate differentials, changes in tax policy, expectations of exchange rate depreciation, and other macroeconomic conditions.  In contrast, illegal capital flight or illicit financial flows are intended to disappear from any record in the country of origin, and earnings on the stock of illegal capital outside that country does not normally return. Of late, there has been a transition, from the term illegal capital flight to the term “illicit financial flows” in documents of the United Nations and other multilateral institutions. Illicit money is money that is illegally earned, transferred, or utilized. Somewhere at its origin, movement, or use, the money broke laws and hence it is considered illicit.  There is another reason for the change in terminology. While the term capital flight tends to place the onus of curtailing the problem upon the economic or governance problems in developing countries, illicit financial flows sees the transfer as a two-way street where the poor countries generate the flows while the developed world facilitates their absorption.

The recent Euro zone crisis and media reports on capital flight from Greece and other Club Med countries raise a number of questions on how illicit flows are estimated using economic models. While there is nothing new about the flight of capital from countries that are politically unstable, poorly governed, badly managed, or all three, economists have been quixotic in their approach to estimating these flows. Scores of research papers on capital flight published in prestigious academic journals have this recurrent theme—outward transfers of illicit capital are offset by inward illicit flows. Yet, economists have hardly paid any attention to the “inflows” indicated by traditional models of capital flight. Instead, they have automatically netted out inflows from outflows without asking whether that is warranted.

Research at Global Financial Integrity (GFI) find that the traditional method used by economists to estimate illicit financial flows seriously understate the flows as a result of automatically netting out inflows from outflows. Netting out the two make little sense when flows in both directions are harmful to a country. After all, illicit inflows are also unrecorded and therefore cannot be taxed by the government or utilized for economic development.  Moreover, there are enormous difficulties involved in correctly identifying a genuine return of illicit outflows. The main difficulty is that traditional models of capital flight used by economists, by definition, are incapable of providing any indication of capital flight reversals. While these models only indicate unrecorded flows, the genuine return of capital flight is reflected in higher recorded foreign direct investment and/or recorded inflows of portfolio capital. In contrast, the illicit inflows indicated by conventional models of capital flight benefit no one except a few corrupt individuals which only worsen the already skewed distribution of income that prevail in many developing countries. Finally, research at GFI show that netting out illicit flows distorts both the regional distribution of capital flight and the country rankings of the largest exporters of illicit capital.

The understatement of illicit flows not only hurts the cause of poverty alleviation in developing countries, but donor governments and multilaterals are lulled into believing that external aid is more effective than it really is.  In light of these drawbacks to the traditional method, GFI studies focus on estimating gross illicit flows from developing countries. We argue that only in very few cases can we substantiate the return of flight capital as an increase in recorded FDI or private short-term capital flows following such reform.

The way forward lies in clearly distinguishing two objectives. If the objective is to study the issue of illegal capital flight or illicit financial flows, economists should look only at gross outflows without any attempt to net out “inflows” either in a given year or across a time period. The reason is that the so-called inflows captured by these models, are also unrecorded and therefore cannot be used by the government for any productive purpose. If the objective is to gauge the adverse impact of illicit flows, economists should recognize that illicit flows in both directions are harmful and add them, as flows in both directions drive the growth of the underground economy. GFI studies clearly illustrate the absurdity of netting out illicit inflows from outflows. For instance, although the Club Med countries like Greece and Portugal received massive illicit inflows over the past decade, not one dime from these inflows helped them avoid the financial crisis.

Cross-posted from the blog of the Task Force on Financial Integrity and Economic Development.