Stemming the bleeding

According to the World Governance Indicators (WGI),a set of statistics which attempt to measure effectiveness and transparency...

Written by Dev Kar | Published:March 2, 2009 12:14 am

According to the World Governance Indicators (WGI),a set of statistics which attempt to measure effectiveness and transparency — and which are compiled,but not endorsed,by the World Bank — corruption in India has declined between 1996,the first year for which indicators are available,and 2007. This is unquestionably a positive development. In spite of this,however,research (in which I was a participant) at the Global Financial Integrity has thrown up troubling results: most notably that illicit financial flows from India were the fifth-highest in the world; China led that list; it was followed by Saudi Arabia,Mexico,and Russia. These flows include the proceeds from both illicit (such as corruption and criminal activities) and licit activities (such as operating a bona fide business). They are troubling in another direction: they feed the underground economy,and rob developing countries such as India of much-needed tax revenues. And even if the moneys are earned legitimately,they don’t stay legal: the funds from a legitimate business become illicit when they are transferred across borders in contravention of applicable foreign exchange and tax regulations.  

According to the GFI study (posted on the website gfip.org),illicit financial outflows from India increased more than five-fold between the year 2002 and the year 2006. On average,the flows were about US $22.7 billion per year; and the increase,in total,was from US $8.3 billion in 2002 to US $44.6 billion in 2006. These estimates were obtained using two methods widely used by economists: one estimating the gap between the source and use of funds and the other involving an analysis of discrepancies in partner country trade data. Outward illicit flows exist whenever a country’s source of funds exceeds its use — or when imports are over-valued and exports under-valued relative to trade reported by partner countries. The wealth generated by the consequent over-invoicing of imports and the under-invoicing of exports is accumulated by residents outside the country where they live.

While these estimates of the outflow of black money from India are substantial,they are,in fact,likely to be less than the actual figures. This is because the methodology used cannot capture all the clandestine channels through which money can be sent abroad. For instance,an Indian resident can acquire foreign currency in exchange for Indian rupees through the services of a “hawaladar”. The trust-based,word-of-mouth nature of hawala-type currency swaps leave no paper trails and are very difficult to estimate using normal methods. Anecdotal evidence suggests that the volume of hawala transactions alone is a multiple of the GFI estimates of illicit financial flows from India.

This raises a question — if India’s governance indicators have been improving,how can illicit financial flows from the country be increasing? This may appear paradoxical,but there is in fact an explanation for this seeming contradiction.    

A closer look at the WGIs show that they focus almost exclusively on public sector governance; only a few survey questions on which the indicators are based touch tangentially upon the complex issue of corporate governance. Consider the recent Satyam Computer scandal which highlights certain weaknesses in India’s corporate regulatory environment. The Satyam episode points to the failure of the audit process to identify the private sector’s manipulation of corporate balance sheets. Moreover,the sheer extent and scale of the fraud at Satyam shows that there are delays in the enforcement of Indian corporate laws in a transparent manner across the board.

The disconnect between public sector governance and illicit financial flows arises because the former does not reflect the state of corporate governance while the latter are driven by the private and not the public sector. Government agencies are not directly involved in such activities although corrupt government officials,acting in their private capacity,can be. Hence,it should not be surprising that a country like India,with improving governance indicators,may still experience increasing outflows of black money.

As long as there is a motivation for the hidden accumulation of wealth out of reach of domestic regulatory agencies and there are secrecy jurisdictions and Western financial institutions happy to take those deposits,illicit capital will continue to stream out of developing countries like India. For these reasons,governments and international institutions need to take a series of well-defined economic,regulatory,reporting and other policy steps in order to stem the cross-border transfer of illicit capital.   

The writer is Lead Economist at the Global Financial Integrity Program,housed at the Centre for International Policy,Washington DC

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