A PROGRAM OF THE CENTER FOR INTERNATIONAL POLICY

Illicit Financial Flows from Africa:

Hidden Resource for Development
Prepared by Dev Kar and Devon Cartwright-Smith1

ABSTRACT
ThispaperpresentsananalysisofthevolumeandpatternofillicitfinancialflowsfromAfricancountriesovera 39-year period from 1970 to 2008. The paper makes a contribution given that existing research on long-term trendsinthepatternofillicitflowsfromAfricancountriesisratherscanty.TheclassificationofAfricancountries usedinthispaperdiffersfromthatintheIMFsWorldEconomicOutlook;here,EgyptandLibya(membersof theAfricanUnion)areincludedunderNorthAfricawhilethegroupofCFAFranccountriesisdistributedalong ageographicalbasis.ThepaperpresentsestimatesofillicitfinancialflowsfromAfricaanditsvariousregionsand economicgroupingsduringthe1970s,1980s,1990s,andthemostrecentnine-yearperiod2000-2008forwhich dataareavailable.Wefindthatillicitflowshavenotonlygrownonadecennialbasis,cumulativelytheyhavecome tofarexceedthecontinentsoutstandingexternaldebtattheendof2008.Thestatisticalanalysisoflong-termtrends bringsoutsomeinterestingregionaldisparitiesinthepatternandgrowthofsuchflows.UtilizingtheWorldBank ResidualmodelandtheIMFDirectionofTradeStatistics,illicitoutflowsfromAfricaacrossthe39-yearperiod areestimatedatUS$854billion.Theauthorspointoutthatdatalimitationsignificantlyunderstatestheproblem. Makingvariousadjustmentstotheestimatesuggeststhatthevolumeofillicitflowsovertheperiod1970to2008 maybeclosertoUS$1.8trillion.WearguethatthisstaggeringlossofcapitalseriouslyhampersAfricaseffortsat povertyalleviationandeconomicdevelopment.

1 DevKar,formerlyaSeniorEconomistattheInternationalMonetaryFund(IMF),isLeadEconomistat GlobalFinancialIntegrity(GFI)attheCenterforInternationalPolicy,WashingtonDC,andDevonCartwrightSmithisanEconomistatGFI.TheauthorsthankRaymondBakerandotherstaffatGFIforhelpfulcomments. ThanksarealsoduetothestaffoftheIMFsStatisticsDepartmentfortheirassistancewithbalanceofpayments data.Anyerrorsthatremainaretheauthorsresponsibility.Theauthorswouldwelcomecomments;citationsshould refertoaWorkingPaperofGlobalFinancialIntegrity,aProgramoftheCenterforInternationalPolicy(CIP).The viewsexpressedhereinarethoseoftheauthorsanddonotnecessarilyreflectthoseofCIPoritsboard.

w w w. g f i p . o r g | 5

I.

Introduction

The problem of illicit flows from Africa deserves serious consideration. As Governor Ndungu (2007) of the CentralBankofKenyanotedinhiskeynoteaddressatapolicyseminarofGovernorsofAfricancentralbanks:

q
The costs of this financial hemorrhage have been significant for African countries. In the short run, massive capital outflows and drainage of national savings have undermined growth by stifling private capital formation. In the medium to long term, delayed investments in support of capital formation and expansion have caused the tax base to remain narrow. Naturally and to the extent that capital flight may encourage external borrowing, debt service payments also increased and further compromised public investment prospects. Furthermore, capital flight has had adverse welfare and distributional consequences on the overwhelming majority of poor in numerous countries in that it heightened income inequality and jeopardized employment prospects. In the majority of countries in the sub-region, unemployment rates have remained exceedingly high in the absence of investment and industrial expansion.

q
ArecentstudyproducedbyGlobalFinancialIntegrity(GFI)estimatesillicitfinancialflowsoutofalldeveloping countriesat$858billionto$1.06trillionayear.Amongdevelopingcountries,Africapresentsthemostanalytical difficulties because countries with inadequate data account for nearly 37 percent of regional GDP.2 One thing is certain: while African countries have had to shoulder a heavy debt burden, a number of researchers such as Ndikumana and Boyce (2008), have shown that sustained illicit outflows have turned the continent into a net creditortotherestoftheworld. SeminalresearchatGFIontheabsorptionofillicitfunds(forthcoming)showthatwhilesomeoftheprivate assetsheldoutsidetheircountriesbydevelopingcountrynationalsmaybelegitimate,thebulkofsuchfundsare certainlynot.ThisisbecauseestimatesofillicitcapitaloutflowsprovidedbyeconomicmodelssuchastheWorld BankResidualmodelandtheTradeMisinvoicingmodel(seeSectionIIforabriefdescription)accountforthebulk ofdepositsreportedbybankstotheBankforInternationalSettlements(BIS)andbyoffshorefinancialcenters. Thepurposeofthispaperisnottoexplainthefactorsthatdriveillicitfinancialflowsortocarryoutaseriesof econometrictestsseekingtodeterminetheirsignificance.Thereisawealthofexistingresearchonthesesubjects. Rather,weanalyzethelong-termevolutionofillicitflowsfromthecontinentanditsvariousregionalandeconomic groupings.Thereby,weshedlightonhowsuchflowshaveaffectedparticulargroupsofcountriesintermsofthesize ofregionaleconomies,populations,andinflowsofofficialdevelopmentassistance.Suchanexercisehasnotbeen carriedoutforAfricancountries.Inpresentingthisdiscussionoflong-termtrendsinregionalillicitflows,wealso pointoutcertaincommonpitfallsindatainterpretation.

2 See,Illicit Financial Flows from Developing Countries: 2002-2006,DevKarandDevonCartwright-Smith, GlobalFinancialIntegrity,December2008,WashingtonDC.

6 | GLOBAL FINANCIAL INTEGRITY

The paper is organized as follows. Section II presents a brief description of the two main economic models usedtoestimateillicitflowstheWorldBankResidualmodelandtheTradeMisinvoicingmodelbasedonthe IMFsDirectionofTradeStatistics.Wethenexplainthemethodologyandtherationaleunderlyingthetreatment ofestimateswithreferencetothetraditionalmethodusedinpaststudies.SectionIIIpresentsadiscussionofthe long-termevolutionofillicitflowsstartingwiththe1970sthroughthe1980s,1990s,andthe9-yearperiod20002008.Thenwedrawoutcertaindominantregionalpatterns,rankingcountriesintermsofthevolumeofoutflows andcomparingtheresultstoarecentstudybyNdikumanaandBoyce(2008).SectionIVpresentsamethodto correctfordatainadequaciesandgapswhichunderstateillicitflowsfromdevelopingcountries.Notethatwedonot accountforillicitflowsgeneratedduetosmuggling,violationsofintellectualpropertyrights,tradeinnarcoticsand othercontrabandgoods,humantrafficking,sextrade,andotherillegalactivitiesastheyareoutsidethescopeofthis study.SectionVdiscussesthedevelopmentimpactofillicitflows.Finally,SectionVIpresentsthemainconclusions ofthepaper. II. Models of Illicit Financial Flows

Illicitmoneyismoneythatisillegallyearned,transferred,orutilized.Ifitbreakslawsinitsorigin,movement,or useitmeritsthelabel. Flightcapitaltakestwoforms.Thelegalcomponentstaysonthebooksoftheentityorindividualmakingthe outwardtransfer.Theillegalcomponentisintendedtodisappearfromrecordsinthecountryfromwhichitcomes. Byfarthegreatestpartofunrecordedflowsareindeedillicit,violatingthenationalcriminalandcivilcodes,taxlaws, customsregulations,VATassessments,exchangecontrolrequirements,orbankingregulationsofthecountriesout ofwhichtheunrecorded/illicitflowsoccur. Therearetwomainchannelsthroughwhichillicitcapital,unrecordedinofficialstatistics,canleaveacountry. TheWorldBankResidualmodelcapturesthefirstchannelthroughwhichillicitcapitalleavesacountrythrough itsexternalaccounts.Thesecondtypeofillicitflows,generatedthroughthemispricingoftradetransactions,is capturedbytheTradeMisinvoicingmodelwhichusesIMFDirectionofTradeStatistics. Specifically,theWorldBankResidualmodelcomparesacountryssourceoffundswithitsrecordeduseoffunds. Sourcesoffundsthecountriesinflowsofcapitalincludeincreasesinnetexternalindebtednessofthepublic sector and the net inflow of foreign direct investment. The net external indebtedness is derived by calculating thechangeinthestockofexternaldebtwhichwasobtainedfromtheWorldBanksGlobalDevelopmentFinance database.Useoffundsincludesfinancingthecurrentaccountdeficitandadditionstocentralbankreserves.Both thesedataseriesalongwithdataonforeigndirectinvestmentwereobtainedfromtheIMFBalanceofPayments database. According to the model, whenever a countrys source of funds exceeds its recorded use of funds, the residualcomprisesunaccounted-for,andhenceillicit,capitaloutflows. Trademisinvoicinghaslongbeenrecognizedasamajorconduitforillicitfinancialflows.Byoverpricingimports andunderpricingexportsoncustomsdocuments,residentscanillegallytransfermoneyabroad.Toestimatetrade misinvoicing,adevelopingcountrysexportstotheworldarecomparedtowhattheworldreportsashavingimported fromthatcountry,afteradjustingforinsuranceandfreight.Additionally,acountrysimportsfromtheworldare comparedtowhattheworldreportsashavingexportedtothatcountry.Discrepanciesinpartner-countrytradedata, afteradjustingforinsuranceandfreight,indicatemisinvoicing.However,notethatthismethodonlycapturesillicit transferoffundabroadthroughcustomsre-invoicing;IMFDirectionofTradeStatisticscannotcapturemispricing thatisconductedonthesamecustomsinvoice(forwhichwemakeanadjustmentinSectionIV).

w w w. g f i p . o r g

| 7