How to Assess Commodity-trade Related Illicit Financial Flows?

by Prof. Gilles Carbonnier and Dr. Rahul Mehrotra

This article originally appeared in L’Agefi Commodities, Special Edition, April, 2019:
https://stsa.swiss/news/stsa-news/commodities-2019-magazine

Developing countries are expected to mobilise greater domestic resources to pay for the Sustainable Development Goals. In this context, illicit financial flows (IFFs) have become a critical development policy issue, in particular for commodity-exporting countries. IFFs are broadly understood as cross-border flows of financial capital which are earned, transferred and/or utilised in contravention of existing laws (illegal activities) or through normatively wrongful acts that may still be technically lawful, if unregulated (illicit activities). Resource-rich developing countries are particularly concerned about the erosion of their tax base due to commodity trade-related IFFs through trade mispricing and abusive transfer pricing, since they generate a significant share of public revenues from the production and sales of commodities. Therefore, curbing IFFs and promoting fair and effective taxation of the natural resource sector is critically important to mobilise domestic revenues and reduce dependence on foreign aid.

In late-2017, we launched an international research project comprising of economics, legal, and political science experts as part of the Swiss Programme for Research on Global Issues for Development (R4D.ch). Motivated by the Sustainable Development Goals 16.4.1 (curb IFFs) and 17.1 (strengthen domestic resource mobilization), our economics research aims to estimate the actual magnitude of IFFs, while the legal and political science research aims to identify and rigorously analyze the regulatory loopholes and governance challenges driving this global phenomenon. The project aims to provide empirical clarity and evidence-based policy recommendations to countries involved in the commodity value chain, initially focusing on Ghana and Laos as exporters, and Switzerland and United Kingdom as trading hub. Our project consortium consists of The Graduate Institute (Geneva), Center for Development and Environment (University of Bern), NADEL – Center for Development and Cooperation (ETH Zurich), as well as the University of Ghana (Accra, Ghana) and National Institute of Economic Research (Vientiane Capital, Laos).

During the first stage of our research, we analysed the limitations in applying existing empirical methods to credibly estimate IFFs since they rely on asymmetries in bilateral trade-partners’ aggregate exports and imports. Our research identified a number of data and methodological limitations associated with missing and/or misclassified Customs data from exporters, transit trade activities by trading firms, and use of intermediate shipping, storage and marketing hubs which complicate this analysis. To advance the empirical research on IFFs beyond these limited methods and data sources, we are developing more sophisticated approaches which rely on highly disaggregated trade data to estimate abnormal pricing in exports and imports of individual commodities, i.e. the magnitude of trade valued outside an assumed arm’s length price range based on free-market prices from commodity exchanges or defined statistically using the central tendency of the observed price distribution. For example: we compare the observed pricing patterns of gold and copper exports and imports to the benchmark commodity exchange prices from the London Bullion Market Association and London Metals Exchange, respectively. However, the validity of this methodology relies on incorporating a sophisticated understanding of each commodity being analysed, specifically in the selection of free-market reference prices and the magnitude of normal price variation due to product quality or purity and transportation costs. This implies an important need for on-going dialogue between academic researchers and industry experts, as well as collaborations with stakeholders in other commodity exporting and trading hubs to facilitate rigorous analysis to inform evidence-based policymaking.

This research will inform a number of ongoing national and international policy initiatives aimed at curbing IFFs in commodity exporting countries and trading hubs, while helping resource-rich developing countries implement regulatory reforms and capacity-building to improve natural resource governance and strengthen domestic resource mobilization. A selection of these initiatives include tax and customs capacity-building, specifically relating to commodity valuation systems and improved statistical infrastructure, as well as regulatory reforms relating to transfer pricing rules and tax transparency initiatives.