Often overlooked, trade misinvoicing puts dent on growth and development

While civil society organizations deplored the failure of the recently drafted Addis Ababa Action Agenda to include the establishment of an intergovernmental body to oversee tax matters, the recognition of the role of illicit financial flows in undermining the economic growth of developing countries in the document was nevertheless a welcome and unprecedented move. “Including illicit flows in the A4 document indicates that the international community now fully recognizes the problem and embraces the idea that it must be addressed in a substantial way,” Tom Cardamone, Global Financial Integrity’s managing director, who was in Addis Ababa, Ethiopia, for the third International Conference on Financing for Development to advocate for specific and measurable targets to curb illicit financial flows, told Devex. “Such an outcome could not have been predicted even two years ago and is a monumental shift in the conventional wisdom on development.” The challenge now, however, is to actually halt the practices that continue to rob developing countries of hundreds of billions a year. While the Addis action agenda’s proposal to redouble efforts to “substantially reduce” illicit financial flows by 2030 includes strengthening national regulation and improving international cooperation, it fails to even mention the largest and perhaps most easily overlooked component of these losses. Over $5 trillion in misinvoicing losses Figures from GFI show that illicit financial flows are mostly made up of costs arising from trade misinvoicing, or the deliberate misreporting of the price or quantity of a commercial transaction on export and import documents. Criminals misinvoice trade for four main reasons: to launder money, to directly evade taxes and customs duties, to claim tax incentives, and to dodge capital controls. In a chapter for a 2012 World Bank publication titled “Draining Development?,” Volker Nitsch, an economist at Technische Universität Darmstadt, Germany, pointed out that there are two sets of problems involving trade misinvoicing figures. First, discrepancies in bilateral trade statistics can arise for reasons unrelated to mispricing. Second, motivations for faking trade invoices are not only limited to transferring capital across borders. Nitsch cited an argument by economist Jagdish Bhagwati, who has studied underinvoicing of imports and capital flight from the least-developed countries: “Whereas it is easy to establish the conditions under which the faking of trade values … will occur, it is in practice extremely difficult to set about determining whether such faking is actually occurring. It is further impossible to find out how much faking is going on.” To address this problem and establish actual figures with which to make comparisons, GFI measures trade misinvoicing between advanced economies and developing countries. Customs administrations in developed countries, GFI argues, are generally “more accountable, transparent, and technically sophisticated” than those in emerging economies. Based on this methodology, the outflows from trade misinvoicing are staggering: From 2003 to 2012, the latest year for which figures on illicit financial flows from GFI are available, more than $5 trillion has been counted as trade misinvoicing outflows. In the same period, developing countries lost a total of $6.6 trillion in total illicit outflows, which comprise illicit hot money outflows and trade misinvoicing losses. But the real amount of total illicit outflows could even be much higher, given that GFI considers its own methodology — which doesn’t include movements of bulk cash, the mispricing of services and many other kinds of money laundering — “highly conservative.” GFI’s data sources don’t reveal whether trade misinvoicing flows are attributable to multinational corporations or locally owned businesses, either, making the task of tracking these losses even more difficult. According to GFI, as developing countries try to process customs transactions quickly to promote trade and economic growth, trade misinvoicing has become a “fairly low-risk” activity for criminals, particularly those who misinvoice their transactions 5 to 10 percent. “Other than a 13 percent drop in 2009, which we attribute to the global financial crisis, and a 7 percent drop in 2012, which we believe is due to incomplete reporting, there has been a large and constant increase in the estimated value of misinvoicing around the globe,” Cardamone said. “For individual countries, there is much fluctuation in the value of misinvoicing during the period studied but I am unaware of any specific policies that have been implemented that have resulted in a significant and permanent decrease in that activity.” The case of Africa Africa, a continent often painted as a large recipient of official development assistance, is a sobering case to look at in exploring the impact of illicit outflows on developing countries. According to GFI data, when all kinds of financial flows, whether legitimate or illicit, are accounted for, it turns out that Africa has actually been a net creditor to the world: The last year that Africa received more revenues than it lost was 1998. A 2014 GFI report funded by Denmark’s Ministry of Foreign Affairs and the Danish International Development Agency studied the impact of trade misinvoicing in Ghana, Kenya, Mozambique, Tanzania and Uganda and found that, while the magnitude and sources of trade misinvoicing varied across countries, issues involving customs invoice review procedures and access to on-the-spot information applied to all. One of the most common reasons trade misinvoicing happens is that customs officials often lack international market data to determine the fair value of imports. Providing customs departments with a real-time trade pricing database that has the global average prices of some 25,000 items, according to Cardamone, can be used to determine if goods about to be shipped have been misinvoiced. “By enabling customs departments to compare the invoice value of a shipping container against average global pricing for the same product, customs officials can identify irregularities, investigate a container and, if necessary, interdict goods before they leave the port,” Cardamone said. “Without a price comparison capability, customs officials are in the dark.” Still, appropriate customs systems are no guarantee that trade misinvoicing won’t happen. For instance, despite the presence of proper customs administration processes, Tanzania has the worst illicit flows to gross domestic product ratio among the five countries studied. Its mining sector, in particular, is the biggest offender, misinvoicing fuel imports to take advantage of import duty exemptions and contributing to around $1.87 billion in losses every year. How can donors help? Despite the investments of development partners in the customs administrations of Ghana, Kenya, Mozambique, Tanzania and Uganda, trade misinvoicing remains rampant, and according to GFI, “in many cases still increasing.” This, however, shouldn’t serve as a signal for donors to steer clear of customs reforms, capacity building and technical assistance projects, but instead be a reminder that interventions need to be complemented by better data for customs officers, according to GFI. While cross-border financial crime has not been a traditional target of ODA — the Development Assistance Committee of the Organization for Economic Cooperation and Development doesn’t even have a category for aid addressing illicit financial flows — the increased attention on illicit financial flows in recent years has pushed donors in helping shape policies to stem the continued drain from developing countries. The United Kingdom, for example, uses aid money from the Department for International Development to finance its own International Corruption Group, which aims to strengthen the capacity of the London Police, the Metropolitan Police and the Crown Prosecution Police in bringing corruption cases involving U.K. citizens and companies active abroad to prosecution. Meanwhile, a project funded by the German Federal Ministry for Economic Cooperation and Development, or BMZ, and implemented by GIZ, Germany’s development agency, has also helped fight organized crime and corruption in the Western Balkans through capacity building for prosecutors and easing cross-border cooperation within the region. GFI itself has recently launched a program to combat trade misinvoicing. Funded by a yearlong $1.7 million grant from the Norwegian Ministry of Foreign Affairs, GFI will work with select developing country governments in tempering trade fraud and increasing the collection of related tax revenue, which could finance development projects. Assisting civil society organizations that push for greater government accountability, supporting multilateral and industry-specific transparency efforts alike, such as the Extractive Industries Transparency Initiative, building relevant capacity in their own agencies, and promoting further research on illicit financial flows are also some ways in which development partners can target their interventions effectively. Check out more insights and analysis for global development leaders like you, and sign up as an Executive Member to receive the information you need for your organization to thrive.