Illicit financial flows (IFFs) accruing from commodity trade mispricing tend to erode the tax base of resource-rich, developing countries, while also contributing to regulatory and financial risks for major trading and financial hubs. To date, there is however a lack of robust evidence to analyze the magnitude and channels for trade-based IFFs. In their new research paper, Prof. Gilles Carbonnier and Dr. Rahul Mehrotra present a novel empirical approach which combines price-filter analysis methods with in-depth commodity market research. Applying this approach to Switzerland – one of the world’s largest financial and trading centers for commodity trading firms and ancillary services – they discuss the available evidence on the magnitude of abnormally priced commodity imports. Based on legal rules for transfer pricing and customs valuation, the research compares transaction-level import prices to an arm’s length price range representing fair market value, defined using contemporaneous benchmark prices from commodity exchanges as adjusted for product and market-specific factors. Abnormally undervalued imports indicate financial inflows in Switzerland while abnormally overvalued imports are interpreted as outflows. In cases where heterogeneous commodities are traded without reference to a specific market benchmark, the arm’s length price range is defined using the interquartile range of observed prices calculated at the country-year level. Finally, the researchers contrast these estimates with commonly used estimates of trade mispricing based on asymmetries in aggregate, mirror trade statistics.

Their main findings are as follows:

First, in the case of gold, this research finds a significant magnitude of abnormally under-valued unwrought gold dore imports: equaling CHF 21.7 billion between 2012-17, or 4.5% of total imports, this represents an economically significant risk of illicit financial flows. The data show that Mongolia, South Africa and Burkina Faso rank among the main source countries of abnormally undervalued gold imports in Switzerland.

For soft commodities, the analysis finds small magnitudes of abnormally under-valued cocoa imports (CHF 44.7 million or 5% of total value) and coffee imports (CHF 128.9 million or 3% of total value), using interquartile range price filter methods. Ghana and Ecuador are among the major trading partners whose cocoa exports demonstrate the highest magnitudes of abnormal pricing. Meanwhile for coffee, Brazil, Colombia, Ethiopia, Guatemala and India feature as the main exporters of abnormally priced imports in Switzerland.

Finally, the mirror trade analysis highlights large discrepancies between recorded Swiss imports and reported exports by trading partners, which can be attributed in part to the so-called entrepot-trade effect and the high level of merchanting activities by Swiss trading firms.

The authors underscore an urgent need to improve commodity trade data-recording standards and reconsideration of fiscal incentives in the industry. They identify the following implications for policymakers:

1. Upgrade Customs’ statistical infrastructure to increase transparency: Two of the most significant risks for trade-based IFFs, i.e. trade mispricing and transfer mispricing, remain hidden due to a lack of adequate statistical infrastructure, even in the case of an advanced trading hub like Switzerland. High-value precious metals, like gold, are more prone to be a conduit for trade-based IFFs. However, the product classification system used by national trade and customs administrations for precious metals remains highly aggregated and lacks transparency regarding important valuation criteria like purity and presence of other precious metals in alloy form. Similarly for soft commodities, Customs data still does not record the sub-varieties included in each export or import transaction.
2. Reconsider unintended consequences of tax incentives offered by trading hubs: These tax incentives usually take the form of exemptions on importing and trading valuable products. For instance, Switzerland’s Value Added Tax rules exempt gold products, including coin, bars, and especially unprocessed, semi-manufactured and scrap gold, from taxation. Furthermore, any alloy containing two or more percent by weight of gold constitutes the legal definition of gold. Similarly, Singapore exempts investment grade precious metals from its Goods and Services Tax regime with the aim of raising Singapore’s share in the global precious metals market. Such fiscal incentives can combine with the lack of transparency in trade statistics to increase IFF risks in trading hubs.
3. Leverage new technologies to improve international trade governance: A number of innovative technologies hold the potential to transform international trade in the coming years. Blockchain and blockchain-based distributed ledger technologies can have tremendous impact on the global trade supply chain by improving transparency for critical high value products. Similarly, artificial intelligence and machine learning-based platforms combined with FinTech services can help optimize trade shipping routes, reduce transaction and logistics costs, and improve fraud detection. If their potential is harnessed through focused research and development by resource-rich countries and trading hubs, these technologies offer a vital opportunity to improve existing trade governance systems by making the trade value chains more transparent, efficient and robust to IFF-related practices.

Access full research paper here: Carbonnier, G. & Mehrotra, R. (2019). Abnormal Pricing in International Commodity Trade: Empirical Evidence from Switzerland. R4D-IFF Working Paper Series, R4D-IFF-WP01-2019.

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