Illicit transfer of funds and the rate of investment

It is perplexing why the perception of the business community regarding the quantum of investment is different from the information provided by the government. Leading figures of the business community in industry, trade and finance seem to agree that business investment has become moribund during the last few years. But government statistics record a sustained healthy increase in the rate of investment. The Finance Minister is also upbeat about it, and provided data on investment in his last budget speech to highlight government business-friendliness.

Another government statistic difficult to understand is why the economic growth rate should be falling with a rising investment rate. A convenient explanation is that the incremental capital output ratio has risen, and another is that investment figures, especially public investment, are overstated. It is expected that some capital deepening should occur with economic progress, and overstating investment figures, especially public investment figures, is frequently alleged and reported. However, there is a nagging suspicion that these might not be the entire story. The recently published report Illicit Financial Flows from Developing Countries: 2004-2013 by Global Financial Integrity Report 2015 (GFI) contains some disturbing information which provides a clue to another possible reason why the investment rate of Bangladesh may appear greater than what it actually is.

GFI divulged that among the 146 developing countries for which it had data on illicit outflow of funds, Bangladesh secured the 23rd position in terms of both 2013 outflow and cumulative outflow of the five year period 2009-13.  A staggering amount of US$9.7 billion was siphoned off from Bangladesh in 2013 alone, and during 2009-13 the average outflow per year was $6.9 billion. Between 2004 and 2013 the total amount transferred overseas illegally was $55.9 billion. These transfers amounted to 5.6 percent of the GDP produced by the economy during this 10-year period. In other words, the benefits of much of the annual increments in GDP that the people of the country had achieved through their blood and toil did not accrue to them; these are now safely parked overseas, out of the reach of the legal institutions of the country.

That some money was illegally transferred overseas every year was never in doubt, but few suspected the massive scale of the transfer (GFI cautions the readers that these figures are most likely underestimates of the true scale). The foreign debt accumulated by the country since its birth till 2013 did not reach even half of this (10-year) illegally transferred amount, and the amount of foreign aid we had received in 2013 was much less than one-third of the amount siphoned off overseas (Bangladesh Economic Review 2015).  The stock of international reserves of the nation was only about a third of the reserves of foreign exchange held by a handful of illicit transactors. The total stock of foreign direct investment at the end of 2013 was only 89 percent of the illicit outflow in that year alone, and the inflow of FDI was only about 15 percent of the illicit outflow.  These numbers give some indication of the mammoth size of the leakages of resources from the country.

The mechanisms of illicit transfer of large sums of money are not well understood. Hundi has been used for transfer of funds for ages; but it may not be a convenient or safe vehicle for transfer of large sums in the modern world. If so, the illicit transfer of funds in all likelihood used the formal banking channels for taking money out of the country. Banking experts could perhaps throw some light on the complexities of such transfers. The Global Financial Integrity Report does give a good indication of how the funds might have been transferred. According to its research, 83.4 per cent of the total illicit transfer of $7.8 trillion from the developing world during the 10-year period 2004-13 was done through 'fraudulent misinvoicing of trade transactions'. This must mean trading (export and import) enterprises in both developing and developed world were deeply involved in this illicit act and colluded with one another. It is known that multinational companies frequently resort to misinvoicing among its own subsidiaries or associated companies in order to reduce tax burden, avoid local restrictions or simply transfer funds. Since international invoicing is done through internationally accepted banks, the illicit transactions have been most likely routed through them.

For the purposes of this write-up it is important to recognise that these funds had to be earned by the country before it could be transferred, whether legally or otherwise. So these must be part of the nation's actual gross domestic product (GDP).  The national accounts statisticians estimate GDP by various methods including what is called 'the expenditure approach'. This involves adding up consumption spending, C, investment spending (or gross fixed capital formation and change in inventories), I, and export earnings, X, and then subtracting import payments, Z, from the sum; thus GDP=C+I+X-Z.

If the mechanisms of illicit transfer of funds from Bangladesh are similar to the way it is done worldwide, that is, through trade misinvoicing, then nearly $8 billion of the $9.7 billion transferred in 2013 should have been transferred through over- or under-invoicing of import and export items. The actual amount transferred through this mechanism is estimated by GFI to be $8.4 billion. There is thus little difference between Bangladesh and the rest of the developing world in respect of the mechanism of transfer.

Suppose a trading house in Bangladesh imports wheat. The value shown in the invoice is $200 million, but the market value of the imported wheat is actually only $100 million. The invoiced amount will go into the national accounts as consumer good import of $200 million, but only half of it will be reflected in total consumer spending assuming that domestic market values are determined by actual world prices, and are not affected by over-invoicing. Hence, consumer import will be inflated in national accounts by $100 million. If the trader had imported machinery instead, the national accounts would have inflated investment import by $100 million, which would not have been reflected in the actual investment spending.  In estimating GDP the statisticians will be subtracting $200 million for the import instead of $100 million. Hence, over-invoicing will artificially reduce the recorded GDP by $100 million.

If an enterprise exports a commodity worth $200 million, but the invoice value is shown as $100 million, the national accounts statisticians will record export of $100 million only. Export in the national accounts will be less than what is actually produced and exported. Noting the definition of GDP above, under-invoicing of export has exactly the same impact on the magnitude of official GDP as over-invoicing of import; both reduce GDP by the amount of such misinvoicing. Hence, if our trade account underreported net export by $8.4 billion, our GDP was also at the same time underestimated by $8.4 billion. (Here we are ignoring indirect effects such as that of changes in the exchange rates, price effects and wastes associated with illicit activities. Usually primary effects are not fully offset by secondary effects.) However, BBS added a statistical discrepancy amount of $1.3 billion (to C+I+X-Z) to arrive at the final GDP figure. Assuming that the entire discrepancy was due to misinvoicing, the estimated GDP was underestimated by $7.1 billion.

The GDP of Bangladesh in 2013 was officially recorded as $150 billion (World Bank). Without misinvoicing the GDP would have been $157.1 billion according to the assumptions above.  The total investment amounted to $43 billion or 28.4 per cent of the official GDP. If there were no misinvoicing the rate of investment would have been 26.9 per cent of GDP. Thus the rate of investment was inflated by 1.5 per cent due to misinvoicing. Throughout the period 2005-2013 for which we have data of all the relevant variables, there was a minimum overstatement of investment ratio by nearly 1 per cent; it shot up to over 1.6 per cent during the last year of the caretaker government rule (2007-08). It fell to less than 1 per cent in 2011 as political uncertainties subsided to some extent, but rose sharply again to 1.5 per cent during the political turbulence of 2013. It would seem that political uncertainties encourage large increases in illicit outflows of funds. Another thing to note is that between 2011 and 2013, the investment as a ratio of official GDP increased by nearly 1 per cent, but as a ratio of actual GDP it increased by less than half a percentage point.

There is good reason to believe that investment goods are over-invoiced more than other goods. The former usually have very low import duties on them, while the other goods are taxed at a higher rate. There is thus less incentive to over-invoice non-investment goods. Since a large part of the imported investment goods is imported directly by the manufacturers, the over-invoiced value is likely to be shown by them in their accounts. Assuming that all imported investment goods are brought in by the manufacturers, over-invoicing in this case will not affect GDP. But since the amount of over-invoicing raises investment by the same amount, the investment-GDP ratio will be considerably higher than what it would have been in the absence of any over-invoicing.  Under-invoicing of export reduces GDP, but does not affect consumption or investment estimates. Therefore, under-invoicing will also raise the investment ratio.

The government will of course go by its official data and highlight the recorded level that shows an increase in investment. But the business community is more likely to base their estimates or perceptions on their first-hand knowledge and experience of their environment. Hence, the conclusions of the two groups may differ.

The over- and under-invoicing phenomena throw some light on the reasons for the difference of opinions about investment climate and actual investment between the government and business leaders. It should be mentioned that the numbers presented above are not definitive, but only indicative. But what they do suggest is that fiddling with facts or malpractices can sometimes give rise to consequences that are neither foreseen nor easily understood. A thorough research is needed to arrive at definitive and actionable conclusions. Interested researchers have no option but to approach foreign entities for funds since neither the government nor the business community is likely to fund such a research. The latter should look into the mirror before bringing allegations of evils of foreign funding for research.

Table 1: GDP, investment and Illicit outflow of funds

[blockquote cite="Source: World Bank and Global Financial Integrity"]

	2005	2006	2007	2008	2009	2010	2011	2012	2013
GDP at market prices (million US$)	69,443	71,819	79,612	91,631	102,478	115,279	128,638	133,356	149,990
Trade misinvoicing    (miliion US$)	3,494	2,734	3,342	6,126	5,430	5,008	4,750	6,546	8,355
Illicit outflow of funds (miliion US$)	4,262	3,378	4,098	6,443	6,127	5,409	5,921	7,225	9,666
Illicit outflow of funds (%GDP)	6.14	4.70	5.15	7.03	5.98	4.69	4.60	5.42	6.44
Gross capital formation (US$)	17,937	18,776	20,841	24,009	26,855	30,257	35,274	37,689	42,582
Gross capital formation (% of official GDP)	25.83	26.14	26.18	26.20	26.21	26.25	27.42	28.26	28.39
Gross capital formation (% of actual GDP)	24.59	25.19	25.12	24.56	24.89	25.15	26.44	26.94	26.89

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