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Mexico: Illicit Financial Flows, Macroeconomic Imbalances, and the Underground Economy
A January 2012 Report from Global Financial Integrity
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The report finds that Mexico lost a total of $872 billion in illicit financial flows (or illegal capital flight) over a 41-year period from 1970 to 2010. These illicit financial flows were generally the product of: corruption, bribery and kickbacks, criminal activities, and efforts to shelter wealth from a country's tax authorities.
- Total capital flight represents approximately 5.2 percent of Mexico's GDP over the 41-year period ending in 2010; IIlicit flows peaked in 1995 at 12.7 percent of GDP.
- Average outflows increased sharply in each successive decade; They were $3 billion in the 1970s, $US10.4 billion in the 1980s, $US17.4 billion in the 1990s, and $49.6 billion in the decade ending 2009.
IFF Drivers: The growth of the underground economy and trade mispricing are found to be significant drivers of Mexico's illicit financial flows. In fact, illicit flows and the underground economy are found to drive each other, creating a feedback loop. (12)
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About the Author
Dev Kar, formerly a Senior Economist at the International Monetary Fund (IMF), is Lead Economist at Global Financial Integrity (GFI). The author would like to thank Sarah Freitas, Economist at GFI, for running the models in E-Views and in STATA and for contributing the box articles. She also provided guidance on data sources and collection to Daniel Robinson, a staff intern at GFI. Thanks are also due to Raymond Baker, Tom Cardamone, Heather Lowe, Lauren Pickett and other staff at GFI and CIP for helpful comments and to Krishen Mehta, a member of GFI's Board, for helpful comments on the policy section. Any errors that remain are the author's responsibility.
There is a stable relationship between the volume of illicit outflows and the onset and aftermath of Mexico's macroeconomic crises during the 41-year period. With reference to the six crises studied, illicit outflows increased in the crisis year compared to the two years preceding the crisis. (4)
Furthermore, illicit flows through trade mispricing rose sharply after NAFTA came into being. (47) The following chart shows this acceleration:
The cross-border holdings of bank deposits reported to the Bank for International Settlements (BIS) show that the United States, offshore financial centers or tax havens in the Caribbean, and tax havens in Europe, are the three top destinations for Mexican private sector deposits. These deposits consist of both licit and illicit funds. However, due to a lack of data on withdrawals and incomplete reporting by financial institutions it is not possible to determine the destinations of illicit financial flows only. (41)
It is clear that almost three-quarters of total illicit flows over the period 1970-2010 were generated through trade mispricing (Appendix Table 6). Moreover, model simulations indicate that increasing trade openness since 1994 when NAFTA was implemented led to more trade mispricing. This would strongly suggest that policy should be focused on curtailing trade mispricing. The report recommends three policy measures to reduce trade mispricing:
- require risk-based price profiling; (49)
- require a legally binding declaration of traders between exporters and importers; (51) and
- undertake additional measures to curb abusive tranfer pricing. (51)
In addition to policy action to curtail trade mispricing, the report recommends four additional policy actions to reduce illicit capital flight from Mexico:
- expand double tax avoidance agreements; (53)
- require automatic cross-border exchange of tax information on personal and business accounts; (54)
- pursue macreconomic stability; (56)
- improve overall governance in order to reduce the propensity to pay bribes and kickbacks; (57) and
- take steps to reign in the role of offshore financial centers (OFCs) and banks; (59)
About Illicit Financial Flows
The term, illicit financial flows, pertains to the cross-border movement of money that is illegally earned, transferred, or utilized. Illicit financial flows generally involve the transfer of money earned through illegal activities such as corruption, transactions involving contraband goods, criminal activities, and efforts to shelter wealth from a country's tax authorities.
Dev Kar, the author of the report, utilized the World Bank Residual Model (CED) and a trade mispricing model based on IMF Direction of Trade statistics.
The World Bank Residual Model tracks illicit outflows by measuring differences in a country's recorded source of funds relative to its use of funds. According to this method, illicit outflows exist when a country's recorded source of funds exceeds its recorded use of funds.
The trade mispricing model compares a country's recorded imports to what the world says it exported to that country; similarly, the country's recorded exports are compared against world imports from that country. Import values are adjusted for the cost of freight and insurance before they are compared to exports. GFI's estimates of trade mispricing are based on the gross excluding reversals (GER) method which tracks illicit outflows as a result of export under-invoicing and import over-invoicing.
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