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The Financial Crimes That Are Destroying The Economy Of The Developing World

For every dollar of aid that flows into developing economies, many more leave through complex networks of shell companies, false invoices, and tax havens. What would happen if all that money stayed in these struggling economies?

Let’s say I’m a South Africa-based factory owner and you’re a solar panel salesperson from New York City. I want some solar panels to make my factory more self-sufficient, and we agree I’ll pay you $1 million for them. But I ask you a favor: Could you invoice me for $1.2 million and then deposit the extra $200,000 that I just gave you into another company’s bank account in New York City. You’re eager to close a big sale, so we agree to the deal.

You might know false invoicing is illegal, you might not, but it’s very unlikely either of us gets caught anyway. What you don’t know is that I actually made most of that $1,200,000 from my side business, smuggling poached elephant ivory to China; the money I’m about to wire into your bank account comes from my Canary Islands bank account where I send all my business earnings to minimize tax obligations; and I’m going to use that $200,000 to purchase stolen art from a broker in midtown Manhattan so I can decorate my future retirement home in the Seychelles, where another company I control anonymously just purchased some beachfront property.

Each year, roughly $1 trillion moves out of developing countries through a tangled network of anonymous shell companies, tax havens, and trade mispricing techniques like our invoice example, according to Global Financial Integrity (GFI), a Washington, D.C.-based research organization that studies these so-called illicit financial flows and their beneficiaries. That’s $10 in illicit financial outflows for every $1 of foreign aid flowing in.

GFI and its allies support greater financial transparency as the antidote to illicit financial flows. "While regulation can require a lot of work on the part of government regulators, transparency requires minimal work by comparison," says Clark Gascoigne, GFI communications director. "Supreme Court Justice Louis Brandeis famously wrote that 'sunlight is said to be the best of disinfectants.'"

A little transparency can go a long way, for example, when it comes to shell companies like in the example above that are used to buy stolen art or to purchase land anonymously.

Around 2 million corporations and LLCs are registered annually in the U.S. alone. The vast majority of those companies do great things like creating jobs and wealth and in more and more cases some form of social good. But a tiny percentage of shell companies slip through the cracks each year, allowing poachers, corrupt dictators, small arms dealers, terrorists, drug traffickers, and human traffickers to conduct illicit business as easily as any Fortune 500 company.

On May 24, 2012, a U.S. Senate Foreign Relations Committee hearing weighed-in on a recently re-introduced bill that if passed would allow law enforcement and tax authorities easier access to the information needed to determine which companies registered in any U.S. state are legitimate and which are shell companies for criminals. Forty-one nonprofits and business groups signed an open letter to the Senate and House in support of the reform. It’s just one of many ways to reduce opportunities to do harm while increasing opportunities to do good.

"In the 21st century, a world of ubiquitous cheap information, it should be possible to close down the space for illicit financial flows by establishing mechanisms for data sharing," says Owen Barder, senior fellow and Europe director at the Center for Global Development. "We have the opportunity now to change the rules of the game so that international financial flows benefit, rather than impoverish, the majority of people round the world."

The extent of benefits to developing countries from reducing illicit financial flows isn’t yet known, but the potential is huge. "[Save the Children’s Head of Research] Alex Cobham recently documented that if Zambia were selling its copper at world market prices, instead of laundering it through Switzerland to take the profits off-shore, Zambia’s GDP would be 50% higher," says Barder.

"The issue is getting nothing like the attention it deserves," Barder adds. "There are no academics researching the poverty impact of illicit financial flows. NGOs deserve credit for raising the issue, but it needs to be underpinned by more rigorous and comprehensive research."

Of course cynics may be inclined to think if some loopholes close then criminals will just find another way around. That’s no excuse, says Gascoigne.

"Transparency makes it hard to find new loopholes. While regulations can often be twisted and circumvented by innovative accountants and attorneys, transparency mechanisms are much harder to circumvent," he asserts. "Moreover, we know what loopholes currently exist, and we know how to address them. If we close these loopholes and new loopholes arise in the future, we can address them in turn. But that is no excuse for ignoring the problems in front of us today."

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  • Guest

    Sorry, but the sub-head is very misleading - as is the article - in its use of the term "foreign aid". Typically, this phrase is used to describe development assistance provided by industrialized countries to developing countries. Foreign aid may come in the form of grants or loans, but foreign direct investment and business transactions are not normally referred to as "aid". Are you confusing terms or are investment and business dealings in developing countries now considered "aid"?

    The financial crimes that are destroying the developing world are more simple than the complex laundering and tax-avoidance schemes described in the article (though making it more difficult for anyone to illegally launder or shift money into overseas tax havens would be beneficial). Simple theft of public funds, nepotism, and other forms of corruption cost many countries - developed and developing - billions of dollars a year. A lot of these funds are not shifted overseas, such is the brazenness of the political and financial elites. Laundering the money is as simple as investing in land or privatized industries often in plain site for citizens and activists to see.

    It is going to take a lot more than cracking down on illicit financial transactions to combat the abuses of high-powered politicians and businesspeople worldwide.

  • Oscar

    Dear Sir,

    Thank you for reading and for your comment. To your first question, about aid versus foreign direct investment, I believe you are making a link when there is only a comparison. I am not saying foreign direct investment and international business transactions are now considered a form of aid; I am saying that amount of money taken from developing countries through illicit financial channels is equal to ten times the amount of all foreign aid to developing countries.

    I also encourage you to look more into the work of Global Financial Integrity or the Task Force on Financial Integrity & Economic Development, as you may be underestimating the extent to which public theft of any kind relies on cheap, opaque, global mechanisms for storing and transferring money.

    And lastly, you are right that it will take a lot more than cracking down on illicit financial transactions to combat the abuse of public office. The point above is that the benefits of such a crackdown are possibly underestimated to a massive extent, and the efforts behind it are definitely under-resourced in terms of information and political will.

    Best wishes and thanks again for reading,
    Oscar Abello (author of the article)

  • Medicalquack

     Time to fix some math and hold financial software quants accountable to ensure we get both "accurate" results along with the "desired" results...two should be the same but as we have seen, its not...

    It's getting harder with algorithms today to function properly and Facebook IPO showed that and now look at the mess we have.  BATS did it better when theirs went rogue..shut it down and fix as you will get a second chance.  Facebook was the "ultimate" Attack of the Killer Algorithms" and nobody is immune, whether it's intentional or unintentional with design.  Aglos for profit are starting to the hit the walls for sure and we need accountability.  Perhaps banks should be a little more attention to what their in house quants are doing?