Latest GFI Report: Illicit Capital Flows Through China

The latest from Global Financial Integrity focuses on illicit outflows and inflows revolving around China (excerpt from press release):

Illicit Financial Flows from China and the Role of Trade Misinvoicing

The Chinese economy hemorrhaged US$3.79 trillion in illicit financial outflows from 2000 through 2011, according to a new report [PDF] released today by Global Financial Integrity (GFI), a Washington, DC-based research and advocacy organization. Amidst increased domestic concern over inequality and corruption, GFI’s study raises serious questions about the stability of the Chinese economy merely two weeks before the once-in-a-decade leadership transition…

…The research, conducted by GFI Lead Economist Dev Kar and GFI Economist Sarah Freitas, found that the illegal outflows—the proceeds of crime, corruption, and tax evasion—were largely due to a trade-based money laundering technique known as ‘trade misinvoicing ,’ which accounted for US$3.2 trillion, or 86.2%, of the total outflow of illegal capital over the 11 years studied. The trade misinvoicing figures were provided exclusively to The Economist, and appear in the latest edition of the magazine which hits newsstands tomorrow.

Dr. Kar, a former senior economist at the IMF, and Ms. Freitas discovered a sharp increase in annual illicit financial outflows over the time-span, increasing from US$172.6 billion in 2000 to US$602.9 in 2011. As GFI’s past studies have observed, such massive outflows make China the largest victim of illicit financial outflows worldwide.

While the report focuses purely on Chinese trade, there’s obvious implications for the rest of us connected to the global supply chain. What distinguishes this report from the previous, global-oriented report is that its more tightly aimed at trade mis-pricing, where capital is smuggled in and out of a country via reporting a different value for shipments from its actual selling cost.

A further innovation is the examination of FDI round-tripping, where illicit outflows are redirected back to the host country to take advantage of preferential tax treatment accorded to foreign investment, typically via Hong Kong or the British Virgin Islands. Money laundering, anyone?

There’s also some info on which goods are most likely to be mispriced – nuclear reactors (!), electrical and electronic equipment particularly circuits, and mobile phones (!).

The numbers are staggering, as are the implications – for wealth inequality, for tax evasion and sheltering, for profit and income shifting.

While Malaysia is not in the same class as China, there’s certainly some of the same things going on here – approximately half of the “illicit” outflows from Malaysia come from the same trade mis-pricing channel. Given the MNC domination of the external sector, income shifting and tax sheltering are the most likely motives, and round-tripping less of a concern or a problem.

However, I think the tax implications are real enough, and a good enough reason to tighten rules on transfer pricing, and on customs enforcement.

Technical Notes:

Kar, Dev, and Sarah Freitas, “Illicit Financial Flows from China and the Role of Trade Misinvoicing”, Global Financial Integrity, 2012