Reverse capital flight to Pakistan: analysis of evidence.
Mahmood, Zafar
Capital flight from Pakistan has remained one of the major concerns
of policy makers, mainly because of the nature of private capital
outflows; that is, whereas private citizens hold a large amount of
foreign assets, die country's burden of foreign debt continues to
grow. Capital flight over and above normal levels raises serious
concerns. Capital flight induces foreign donors to demand repatriation
of private capital held abroad in return for their support. Previous
studies have largely ignored the fact that illegal capital flow is a two
way phenomenon. Private citizens' foreign capital is brought into
the country when time is opportune. Using the measure of trade
misinvoicing, this paper finds that between 1972 and 2013 the (net)
reverse capital flight in Pakistan was of the order of about $30
billion. To explain this phenomenon, the paper examines die evolution of
Pakistan's exchange and trade control regimes in four phases. It is
found that reversed capital flight increased during liberal regimes when
both current and capital accounts were liberalised, meaning that in the
absence of strong regulatory bodies, private citizens could manipulate
trade and exchange laws. The paper offers some specific policy
recommendations to restrict cross-border movement of capital through
illegal channels.
JEL Classification: F21, F32, H26
1. INTRODUCTION
Capital flight from Pakistan has been one of the main concerts for
planners and policy-makers. Their worries come from the
"paradoxical" nature of private capital outflows: private
citizens hold large foreign assets while the country is in crisis
burdened under growing foreign debt. Any abnormal capital flight when
the position of foreign exchange reserves is unstable raises serious
concerns for national welfare loss. (1) Evidence on capital flight often
induces foreign donors to impose conditions for repatriation of private
capital held abroad.
The impetus for capital flight from a country represents a demand
for foreign exchange that arises due to portfolio reasons, excessive
taxation, expectations of a major exchange rate realignment,
macroeconomic (large fiscal and current account deficit) and political
instability, and, of course, various foreign pull factors. Illegal
outflow of capital is often channelled through remittances transferred
by such means as Hundi/Hawala system, export under-invoicing, import
over-invoicing, and smuggling of precious metals, antiques, etc.
Interestingly, illegal (unrecorded) capital flow is a two-way
phenomenon. The capital held abroad by private citizens is brought into
the country at opportune times. Policy-makers have only recently taken
notice of this problem and decided to reverse capital flight that might
be taking place through workers' remittances. Reverse capital
flight takes place when imports are under-invoiced and exports are
over-invoiced. What are the reasons for reverse capital flight? The
answer is three-fold. First, it helps whitening the black money that
earlier flew from the country. Second, it facilitates evasion of taxes
on imports, and realises superfluous rebates and refunds on exports.
Third, it assists in the circumvention of non-tariff measures (NTMs) on
imports.
Given the nature of trade misinvoicing in Pakistan, it is
permitting the two way movement of illegal capital. In this situation an
adjustment of unrecorded private capital flows (arising from short-term
capital movements or on payments flows that do not show directly in the
recorded statistics) with capital flows arising from trade misinvoicing
becomes essential to have a complete account of illegal capital flows in
Pakistan.
Previous studies [Khan (1993) and Sarmad and Mahmood (1993)] focus
only on the problem of capital flight from Pakistan, while Mahmood and
Nazli (1999), covering the period 1972 to 1994, find evidence of reverse
capital flight to Pakistan but stop short of analysing the phenomenon
due to changes in trade and exchange control regimes. (2) The present
paper shows that private citizens' motives in evading trade taxes
and circumventing trade controls are to build foreign assets in
Pakistan. Thus, net reverse capital flight is indeed taking place
instead of net capital flight from the country.
Why does reverse capital flight take place? This is mainly because
most of the reverse capital ends up in the informal part of the economy,
where the owners of illegal capital easily avoid domestic taxes. Owners
of this capital under-invoice import of goods with high customs duties
to bring back their illegal capital. For this purpose, they use their
foreign based capital or foreign exchange bought through Hundi/Hawala
companies. To further hide their illegal capital from the radar of
domestic tax authorities, they invest the capital, brought home in the
guise of imported goods, in the informal sector. Interestingly, this
happens despite the fact that owners of illegal capital can easily bring
back the capital by remitting through the formal banking channels. This
is so because by bringing back the illegal capital through
under-invoiced imports they are not only able to evade import taxes but
can also keep the illegal capital hidden from authorities by investing
it in the informal sector.
Concomitantly, Section 111(4) of the Income Tax Ordinance, 2001,
provides immunity from probe to foreign remittances coming through
formal banking channels. This in effect encourages money laundering and
round-tripping. It works like a permanent amnesty scheme to bring back
capital residing outside the country. Since no questions are asked about
the source of capital and no taxes are imposed, reverse capital inflow
through remittances is mostly used in the formal economy or kept in
foreign currency accounts. One reason for the recent surge in
remittances, largely believed to be the reverse capital, is the adoption
of stringent money laundering laws and regulations by the international
community.
The paper covers the period 1972 to 2013. During this period
Pakistan passed through different exchange rate regimes including fixed
exchange rate, managed floating exchange rate, multiple exchange rate,
dirty float and flexible exchange rate. On the trade policy front,
during this period Pakistan implemented various reform programmes, in
particular the drastic cut in tariff rates and NTMs, and incentives for
export promotion. Moreover, Pakistan allowed full convertibility on the
current account along with partial convertibility on the capital
account. (3) It would be useful to analyse the illicit capital flows by
using the latest available data, in terms of the link between capital
flight and shifts in exchange rate and trade policy regimes.
The rest of the paper is divided into seven sections. Section 2
provides an overview of exchange rate and trade regimes in Pakistan.
Section 3 discusses the methodology to identify and measure the size of
trade misinvoicing. The approaches to estimate capital flight are
discussed in Section 4. Section 5 provides the adjustment mechanism of
illegal capital flows with trade misinvoicing. Section 6 reports data
and data sources. Estimates of illicit capital flows and discussion on
the findings are reported in Section 7. Finally, Section 8 concludes the
paper and offers some policy recommendations.
2. EXCHANGE RATE AND TRADE REGIMES
To explain the trends in illicit capital flows, it would be useful
to demarcate in an analytically meaningful manner the evolution of
Pakistan's exchange and trade control regimes. In this context, we
delineate four phases:
2.1. Phase I (1972-1981): Fixed Exchange Rate Regime and Partial
Lifting of Trade Controls
During this phase, Pakistan maintained the fixed exchange rate
policy. On 11th May 1972, the Pakistani currency was devalued by 56
percent, which was appreciated by 11 percent in February 1973 soon after
the US dollar was devalued by 10 percent. The exchange rate fixed in
1973 was maintained upto 7th January 1982. Upon devaluation of the
currency, the trade control system was overhauled on the lines
recommended by the International Monetary Fund (IMF). The export bonus
scheme that introduced a multiple exchange rate system throughout the
1960s was abolished, tariffs were reduced on intermediate and capital
goods, and the degree of cascading in the tariff structure was lowered.
With the exception of tax rebates and export financing, all export
subsidies were withdrawn. Instead, export duties were introduced on a
number of intermediate inputs to promote high value added industries.
These were eliminated subsequently, however. In addition to these policy
measures, the import licensing system was simplified; all the
permissible imports were placed either on the "Free List" or
the "Tied List". During this phase both current and capital
accounts remained substantially restricted.
The impact of these liberalisation measures on the economy was
short lived due to rising domestic inflation. The rupee once again
became overvalued, especially after the appreciation of the US dollar to
which the currency was pegged. Instead of devaluation of the rupee, the
government preferred to use export subsidies and quantitative
restrictions on imports to manage the trade balance. Licensing
procedures were tightened again. Differential import duty rates were
imposed for commercial and industrial users. All of these measures
further increased the anti-export bias in government policies.
2.2. Phase II (1982-1998): Managed Floating Exchange Rate and
Liberalisation Initiatives
The government fine-tuned the overvaluation of the currency by
adopting the managed floating exchange rate on 8th January 1982 and
linking the currency to a basket of 16 currencies of its major trading
partners. The value of the currency started declining after the adoption
of the new exchange rate regime. Since 1991, some new measures to reform
the exchange and payments system were introduced that included: (i)
resident Pakistanis were allowed to maintain foreign currency accounts
like non-residents to attract funds held abroad by private citizens,
legally or illegally; (ii) restrictions on holding foreign currency and
on foreign exchange allowances for travel were removed; and (iii) rules
governing private sector's foreign borrowing were liberalised,
especially where no government guarantee was required. In addition, a
host of other restrictions on foreign payments were removed (e.g., for
the purpose of education, royalty payment, foreign advertisement, and
professional institutions' membership).
During this phase the import tariff structure was significantly
rationalised: maximum tariff rate declined from 350 percent in 1982 to
45 percent in 1998. Import licensing was eliminated with the exception
of a small number of items remaining on the negative and restricted
lists; these were further reduced gradually. Non-tariff barriers were
reduced except for security, health, religious and reciprocity reasons.
Some new export promotion measures were also introduced such as: (i)
streamlining of schemes of duty-drawbacks, bonded warehousing and export
credit; (ii) garment units in export processing zones were allowed to
buy textile export quotas from the Pakistani market; (iii) foreign
companies were allowed to export goods; and (iv) improvements were made
in the institutional arrangements for quality control, marketing and
training of skilled manpower.
In 1994, full convertibility of Pak-Rupee was introduced for
current account transactions as part of the trade liberalisation
programme, while a cautious approach was adopted for the convertibility
of the capital account. The central bank implemented partial
convertibility of the capital account by allowing foreign exchange
companies to operate in Pakistan and the corporate sector to obtain
foreign equity. Pak-Rupee was also made fully convertible for some
capital account transactions, e.g., foreign portfolio investment in the
country. Aside from allowing 100 percent foreign equity participation,
no restrictions were in place on the repatriation of capital, profits,
royalty, etc.
2.3. Phase III (July 1998-July 2000): Multiple Exchange Rate and
Dirty Float Regimes
This phase was marked with political instability in the country and
economic sanctions by western countries against the nuclear test by
Pakistan. The government froze the foreign currency accounts in order to
preserve its official foreign exchange reserves. These steps eroded the
confidence of the private sector. Whatever gains had been made on the
current and capital accounts through liberalisation in the earlier
periods were virtually reversed. To counter the crisis, government
adopted the system of multiple exchange rates consisting of an official
rate (pegged to US dollar), a floating inter-bank rate (FIBR), and a
composite rate (combining official and F113R rates). On May 1999,
Pakistan adopted the system of dirty floating exchange rate and the
currency was pegged to the US dollar by removing the multiple exchange
rate system. The exchange rate was then defended within narrow bands
(margins) till July 2000.
Despite economic and political difficulties, Pakistan resisted the
protectionist pressure from domestic interest groups and continued with
market-based reforms, including a more liberal policy for imports and
foreign investment. Besides, the maximum tariff rate came down to 30
percent from 45 percent in 1998. The scope of export prohibitions was
reduced and export subsidies were linked with export-performance.
2.4. Phase IV (July 2000-2013): Flexible Exchange Rate Regime and
Trade Liberalisation
Since 20th July 2000, Pakistan has been following a flexible
exchange rate regime. Nevertheless, the de jure exchange rate
arrangement is managed float without fixing predetermined paths for the
exchange rate. The central bank's interventions are limited to
moderating and preventing excessive fluctuations in the exchange rate.
The central bank intervenes in the market using the US dollar. Foreign
exchange controls and restrictions are now minimal. Current account
transactions are now unrestricted except for occasionally imposed limits
on advance payments for some imports. Foreign investors can now freely
bring in and take out their capital, profits, dividends, royalties, etc.
IMF (2010) classifies Pakistan's exchange rate regime as a de facto
conventional peg to the US dollar within a narrow band.
Pakistan has reduced tariff rates across the board. Between 2003
and 2007, the maximum tariff rate was 25 percent. However, due to rising
trade deficit, the maximum tariff was raised to 35 percent in 2008. In
the 2012-2013 budget, the government reduced maximum tariff rate to 30
percent and simplified the tariff structure by reducing the number of
tariff slabs from 8 to 7. Quantitative restrictions and other direct
state interventions relating to trade have been drastically reduced.
Ordinary customs duties are now the primary trade policy instrument
along with some NTMs that range from price controls to exchange and
finance controls, quantity controls, and monopolistic and technical
measures. Many of the statutory regulatory orders (SROs) providing
discretionary exemptions to firms and industries are still in force
making the trade regime more complicated.
The government has introduced the Strategic Trade Policy Framework
(2009-2012). It includes measures such as: financing of export firms at
fixed interests for a short to medium term, creation of a fund to hedge
markup rate hikes, provision of insurance cover for visiting buyers,
facilitation of export firms in foreign markets, arranging warehousing
facilities abroad, providing support for compliance certification,
compensating inland freight charges, funding technology, skills and
management upgradation for value added products, supporting brand
promotion and compliance with safety standards, clustering development,
reducing cost of doing business, etc.
3. TRADE MISINVOICENC
An importer is tempted to under-invoice imports if import duties
and rents on quantitatively restricted imports are higher than the
premium on the exchange rate in the open (or black) market that he has
to purchase to pay foreign sellers in full. When there are no foreign
exchange controls but trade barriers do exist, then clearly there is an
incentive to under-invoice imports [Mahmood (1997)]. There is, however,
some risk attached both to under-invoicing of imports and engaging in
illegal foreign exchange transactions. Thus, under-invoicing will not
occur unless the difference between import tariff equivalent and premium
on foreign exchange in the open market is greater than the evaluated
risk factor of being caught by law enforcing agencies [Bhagwati (1964)].
The importer who practices under invoicing brings capital to the country
(the reverse capital flight) and draws benefit from this transaction. It
is quite likely that if this perceived benefit is added to the saving of
import duties due to import under-invoicing then the above differential
further rises. Capital is brought into the country but by by-passing
official foreign exchange reserves.
One can also explain over-invoicing of imports that takes place
simultaneously. This is used to take capital out of the country. In this
case, the importer is willing to pay higher customs duties to take out
its capital, normally the 'black money', outside the country
to safe havens, to whiten it at a later date. With the resultant higher
average import tax earning rate it transmits false signals about the
trade policy being more protectionist or restrictive whereas in fact it
is not.
Likewise, under-invoicing of exports is practised to take black
money outside the country. By under-invoicing, the exporter is willing
to surrender the benefit of export subsidy if it is available or avoid
export tax if there is any. This practice deprives the government of
foreign exchange earnings.
Some exporters also resort to export over-invoicing to
illegitimately benefit from export subsidies and to make reverse capital
flight possible to whiten the black money taken out of the country at
some earlier date. If the exporters do not have black money outside the
country then they buy it from the Hundi/Hawala
("correspondent") exchange companies based in foreign
countries. In this case exporters compare the differential between the
subsidy rate and the perceived benefit from reverse capital with the
premium on foreign exchange paid on capital purchased from the
Hundi/Hawala traders in the open market; if the differential is greater
than the evaluated risk factor of being caught, then the exporter will
over-invoice. In this case government receives additional foreign
exchange earnings but loses on account of extra export subsidies it pays
for over-invoiced exports.
4. ILLICIT CAPITAL MOVEMENTS
Two approaches to measure illicit capital movements are available
in the literature: direct and indirect. The direct approach uses
information obtained from the balance of payments accounts. This
approach identifies capital flight as short-term capital outflows, and
considers it as a response of private citizens to investment risks in
the country. Usually, these funds promptly respond to political or
financial crisis and expectations about more restrictions on capital
account or devaluation of the home currency.
Cuddington (1986) using the direct approach, defines capital flight
as a short-term (speculative) reaction of private investors to
macroeconomic instabilities or other policy-induced investment risks.
(4) This is why the Cuddington approach focuses only on the acquisition
of short-term foreign assets by private non-bank investors, and errors
and omissions instead of the private sector's total acquisition of
external claims. (5) Cuddington chooses only the short-term foreign
assets because they presumably respond quickly to changes in expected
profitability or shift in risks. Cuddington thus defines capital flight
([KF.sub.CUD]) as:
[KF.sub.CUD] = -NEO - NAC ... (1)
where, NEO stands for net errors and omissions; and
NAC for net acquisition of non-bank private short-term capital.
The direct measure of capital flight is not free from criticism as
it does not take other than short-term capital flows into account
because long-term foreign financial assets are close substitutes for
short-term assets due to the existence of very active secondary markets
in long-term financial assets. On the other hand, errors and omissions
include unrecorded flows or statistical discrepancies. In view of this
criticism, indirect approaches to capital flight are also suggested.
Indirect approaches include the World Bank's (1985) and that
of Morgan (1986). In these approaches, capital flight is considered as a
residual of increase in external debt, net foreign direct investment,
foreign exchange reserves and the current account deficit. Here, the
idea is that the first two inflows finance the latter two outflows. If
the first two sources of funds cannot finance the latter two uses of
funds then the difference would indicate occurence of capital flight.
The World Bank approach considers increases in external debt and
net foreign direct investment as capital inflows to the country, and
deducts from these inflows the sum of current account deficit and
increase in official reserves. This difference is taken as a claim on
foreign assets by private individuals. In other words, this approach
assumes that if the capital inflows do not finance the current account
deficit or official reserve accumulation (i.e., the recorded use of
foreign funds), it leaves the country in the form of capital flight. The
World Bank definition of capital flight ([KF.sub.WB]) can be expressed
as follows:
KFWB = CED + NFDI + CAB + COR ... (2)
where,
CAB is Current account balance,
COR is Changes in official reserves,
CED is Changes in external debt, and
NFDl is Net foreign direct investment.
The Morgan definition (6) works out foreign capital inflows on the
lines of the World Bank definition. In this approach inflows are used to
finance the current account deficit, increase in official reserves and
increase in the net foreign assets held by commercial banks. Thus, the
Morgan definition of capital flight (KFM()R) can be written
as:
[KF.sub.MOR] = CED + NFDI + CAB + COR + NAFA ... (3)
where, NAFA is Net acquisition of foreign assets by commercial
banks.
5. ADJUSTMENT OF CAPITAL FLIGHT WITH TRADE MISINVOICING
Trade and foreign exchange restrictions and lax enforcement of
controls create incentives for trade misinvoicing in such a way that it
can result in both way movement of private capital, i.e., capital flight
from the country and/or reverse capital flight to the country.
Interestingly, the difference in trade statistics of the reporting
country and its trading partners often helps to identify this problem.
Using the partner country data technique, (7) we adjust the capital
flight estimates derived from three approaches with estimates of trade
misinvoicing in the following way:
[KFM.sub.WB] = [KF.sub.WB] + MI
[KFM.sub.MOR] = [KF.sub.MOR] + MI
[KFM.sub.CUD] = [KF.sub.CUD] + MI
where,
[KFM.sub.WB] is Capital flight estimates adjusted for trade
misinvoicing using the World Bank approach.
[KFM.sub.MOR] is Capital flight estimates adjusted for trade
misinvoicing using the Morgan approach.
[KFM.sub.CUD] is Capital flight estimates adjusted for trade
misinvoicing using the Cuddington approach.
MI = [MI.sub.X] + [MI.sub.m], = Misinvoicing in total trade.
[MI.sub.X] = [M.sub.icp] - [X.sub.pic] * Ad = Misinvoicing of
exports.
If [MI.sub.X] < 0 then exports over-invoicing is taking place
from the country.
If [MI.sub.X] > 0 then exports under-invoicing is taking place
from the country.
[MI.sub.m] = [M.sub.pic] - [X.sub.icp] * Ad = Misinvoicing of
imports.
If [MI.sub.m] > 0 then imports over-invoicing is taking place in
the country.
If [MI.sub.m] < 0 then imports under-invoicing is taking place
in the country.
[M.sub.icp] = Imports of industrial countries from Pakistan (cif).
[X.sub.pic] = Exports of Pakistan to industrial countries (Job).
[M.sub.pic] = Imports of Pakistan from industrial countries (cif).
[X.sub.icp] = Exports of industrial countries to Pakistan (fob).
Ad = Adjustment factor defined as cif-fob ratio.
6. DATA
We adopt here the sign convention used in the balance of payments
accounts. The data used here are for the period 1972-2009. The data
definitions and sources used are as following:
(1) Changes in external debt. World Bank: World Debt Tables.
(2) Net foreign direct investment. IMF: Balance of Payments. Line
3..XA.
(3) Current account surplus. IMF: Balance of Payments. Line A..C4.
(4) Changes in official reserves. IMF: Balance of Payments. Line
2..X4.
(5) Errors and omissions. IMF: Balance of Payments. Line A..X4.
(6) Non-bank private short-term capital. IMF: Balance of Payments.
Line 8..2X4.
(7) Net acquisition of foreign assets by banks. Figures are
multiplied by -1 for consistency with the balance of payments sign
convention. IMF: International Financial Statistics. Line 7ad.
(8) Trade data for Pakistan and industrial countries IMF: Direction
of Trade.
(9) cif-fob factor. IMF: International Financial Statistics.
(10) Before 1982, values in items 1-6 were reported in terms of
Special Drawing Rights (SDRs). These values are converted into US
dollars by using the average SDR/dollar exchange rate reported in IMF:
International Financial Statistics, Line sb.
7. ESTIMATES OF CAPITAL FLIGHT
How large is the size of illicit capital flows in Pakistan? Between
1972 and 2013, Pakistan received (net) illicit capital inflow (or
reverse capital flight) of about $30 billion. (8) Accumulated reverse
capital flight represents 50.5 percent of the total outstanding external
debt and 13 percent of the GDP in 2013. Such a large size of reverse
capital flight negates the widespread and exaggerated impression about
the net capital flight from the country.
In illicit capital flow activities individuals with varied
behaviours and interests are involved. Their motive essentially is to
circumvent economic policies to draw maximum benefit for themselves. As
economic policies change from time to time to meet developmental
objectives of the economy, so does illicit capital movement in intensity
and direction. The preceding analysis shows that illicit capital flow is
an area which successive governments in Pakistan have not been able to
contain.
Table 1 shows that on average in all periods, the Pakistani traders
over-invoiced exports and under-invoiced imports to bring illicit
capital to the country. More specifically, Table 1 reveals that in the
first phase (1972-1981) exports were under-invoiced by an average of
$28.43 million per annum. It shows the clear motive to lake capital out
of the country. This is the period when capital account restrictions
were the harshest. Exports of intermediate inputs were restricted by
using export duties. Thus, exporters not only circumvented capital
controls but also export restrictions with connivance of the Customs
staff. In the same phase, however, imports were under-invoiced by
$277.48 million per annum. In this case, the clear motive was to bring
illicit capital back to the country and evade high import duties. On the
net basis, during the first phase there was a reverse capital flight of
$249.10 million per annum through trade misinvoicing.
In all the remaining three phases, Table 1 shows that there was
over-invoicing of exports and under-invoicing of imports. Consequently,
in the period when managed floating exchange rate or flexible exchange
rate policies were in force, the country received a net inflow of
illicit capital through the balance of payments account. The highest
average per annum export over-invoicing was recorded during the third
phase (1998-2000). This period was marked with depletion of foreign
exchange reserves, economic sanctions imposed by the Western countries,
freezing of foreign currency accounts, use of multiple exchange rates
and later, adoption of the dirty floating exchange rate, and use of
export-performance linked export subsidies. At the time when government
was looking for financial resources, exporters deprived the country by
obtaining extra subsidy on account of over-invoiced exports.
Nonetheless, government was satisfied as the over-invoiced earnings on
exports raised its foreign exchange reserves. (9)
The highest under-invoicing of imports was recorded during the
second phase (1982-1998), when by and large tariffs and NTBs were very
high, so there was an incentive for importers to circumvent trade policy
restrictions and indulge in import under-invoicing activities and
bringing home illicit capital (Table 1). The fourth phase (2000-2013)
also recorded very high levels of average per annum import
under-invoicing. During this period, tariff rates were not very high but
still high enough to entice importers to resort to such activities.
Although, NTBs declined during this period but NTMs increased owing to
corruption and bad governance. On the net basis, the overall illicit
capital inflow was the highest during the second phase followed by the
fourth phase. Total trade misinvoicing estimates show that relatively
lower trade restrictions and liberalisation of current and capital
accounts, especially in the fourth phase, could not stop illicit capital
movement. This implies that implicit trade and capital accounts
restrictions remained widespread, which enticed people to defy them to
draw benefits. The pertinent question is how this large illicit capital
inflow was financed. The answer is through Hundi/Hawala, a channel that
is used to finance trade misinvoicing. In addition, illicit capital that
was taken out of the country at some earlier date became a major source
of reverse capital flight at a later date.
Table 2 reports estimates of capital flight that are un-adjusted
for trade misinvoicing using the three approaches discussed earlier: the
World Bank, Morgan and Cuddington's. Estimates using these
approaches are not very consistent with each other; thus, it is
difficult to arrive at any consensual conclusion. Whereas the Morgan and
Cuddington estimates are consistent with each other in the first three
phases, they are inconsistent with each other in the fourth phase.
The World Bank estimates show that there was a net capital flight
from Pakistan in the first three phases, while both Morgan and
Cuddington approaches show net inflow of illicit capital (Table 2). In
the fourth phase, estimates based on the World Bank and Cuddington
approaches show reverse capital flight while the Morgan approach shows a
net capital flight from the country; this is mainly because of large
acquisition of foreign assets by commercial banks, a component this
approach includes in addition to the components of the World Bank
approach (see Equations 2 and 3). Arguably, acquisition of foreign
assets by commercial banks is not capital flight, so the Morgan
estimates should be used with some care. On the whole, for all periods
unadjusted estimates for the World Bank and Morgan definitions show net
capital flight from Pakistan, while the Cuddington approach shows
reverse capital flight.
Although, we could not arrive at some consensus using estimates of
capital flight that are un-adjusted for trade misinvoicing, yet the
adjusted estimates of capital flight are congruous in all approaches in
all phases except for Morgan in the fourth phase (Table 3). The World
Bank approach shows that with the change in exchange rate regime and
trade liberalisation, the size of reverse capital flight has increased.
A similar result can be noticed for the Cuddington approach. This
pattern has emerged due to a fall in cost of illicit capital flow
transactions owing to both trade and capital accounts'
liberalisation, especially as the regulatory bodies are weak in
implementing the rules and regulations. All in all, Table 3 reveals that
Pakistani private citizens have been bringing huge amounts of illicit
capital every year since 1972.
So far we have discussed the trends in illicit capital movement
across borders. We can gain more insights if we use the estimates to
find out the importance of illicit capital flows in terms of GDP and
foreign exchange earnings. The ratio of reverse capital (light to GDP
(10), for example, can be considered as the investment going into the
underground economy. The ratio of reverse capital flight to foreign
exchange earnings indicates the significance of illicit capital inflow
vis a vis official capital inflows.
Using the World Bank approach, the estimates of reverse capital
flight to GDP show the highest ratio in the second phase (1982-1998),
followed by the third phase, the first phase and the fourth phase (Table
4). What these estimates signify? On average, they are about 1.5 percent
of the annual GDP. If we recap the happenings in the second phase, it
may be noticed that during this period Pakistan launched a programme of
economic liberalisation, privatisation and denationalisation, the
structural adjustment programme with donors' support, a shift in
the exchange rate regime from fixed to a managed float, policy of
whitening of domestic black capital and the illegal capital residing
abroad and permission for opening of foreign currency accounts to
residents. With these major policy changes, when the cost of transaction
of capital flows declined, it became easy for private citizens to bring
back their capital held abroad. To avoid any legal actions at a later
date by the government, most of this capital was brought into the
country through illegal channels instead of legal channels.
The ratio of reverse capital flight to foreign exchange earnings
was the highest in the third phase (Table 4). This was the time period
when the country followed multiple exchange rate policy, freezing of
foreign currency accounts as a result of decline in foreign exchange
earnings including remittances and export earnings. Consequently, in
this period of uncertainty private citizens proportionately brought home
more capital through illegal channels.
8. CONCLUSION AND POLICY RECOMMENDATIONS
The findings of this paper refute the general assertion that
providing external funds to countries like Pakistan could be futile if
they lead to capital flight. Contrary to this claim, this paper shows
that reverse capital flight takes place on net basis all the time. These
illicit inflows complement the resources received by the country in the
form of foreign loans, foreign investment and the country's own
foreign exchange earnings. Of course, illicit capital is largely
invested in the underground part of the economy. The underground part of
the economy, including the real estate sector, is out of the tax net.
Industries in Pakistan prefer to under-report their true installed
capacity by under-invoicing their plant and machinery and hence
under-report the actual size of the establishment. This practice
ultimately helps industries to also evade taxes on their sales, purchase
of domestic inputs and income.
Capital flight exacerbates problems in the domestic economy
including unfavourable investment climate. By implication, a healthy
state and conducive economic environment should be instituted in the
event of reverse capital flight. The paper finds evidence of large
volume of reverse capital flight to Pakistan. Does this mean that
everything on the economic front is very well in the country? Perhaps
not! As noted earlier, the way business in commercial markets and real
estate sector is flourishing and expanding, one is tempted to conclude
that the situation is favourable for absorbing reverse capital flight.
An important finding is that the reverse capital flight increased
during the period of trade and exchange liberalisation. This indicates
that in the absence of strong regulatory bodies, liberalised trade and
exchange regimes allowed private citizens to manipulate trade and
exchange laws.
Tax evasion and avoidance have been the key sources of illicit
movement of capital across borders in Pakistan. Improving tax
administration and effective enforcement of trade laws can control to
and fro movements of illicit capital. The following specific measures
are suggested to restrict the cross-border movement of capital through
illegal channels:
(1) Money obtained through corruption and tax avoidance/evasion is
the main source of illicit funds that are illegally transferred across
borders. There is therefore a dire need to introduce governance reforms
to control rampant corruption in the country, which undercuts lawful
activities in the country.
(2) Illicit capital movements are largely due to lax enforcement of
capital and trade controls by regulatory bodies. This provides high
premium to private citizens if they circumvent trade and foreign
exchange controls and misuse trade incentives. An effective
implementation of trade and exchange controls is, therefore, expected to
discourage illicit movement of capital. In this context, it would be
very rewarding if customs administration is improved, tariff structure
is simplified by making it more uniform, and appointing pre-shipment
inspection companies with good reputation.
(3) To control Hundi/Hawala (correspondent) businesses, their
related individuals or entities be traced by banking authorities who are
holding large sums of funds to settle laundered money in Pakistan.
Government's Remittance Initiative has made a little dent in this
system but this menace is still going on at a large scale.
(4) A policy support that discourages undervaluation of capital in
the country would make under-invoicing of imports of plants and
machinery less attractive. For example, a policy of accelerated
depreciation allowance to attract investment might offset
under-invoicing of imports of capital goods and other goods.
(5) For domestic capital that is residing illegally abroad,
arrangements may be made with other countries about prompt sharing of
information concerning private citizens' bank accounts and
trade-related transactions to and from Pakistan. Moreover, the
international community must be reminded of its responsibilities of not
allowing its jurisdiction for movement of illicit capital to and from
Pakistan by using international forums.
(6) As most of the reverse capital flight ends up in the informal
part of the economy, there is an urgent need to bring this part of the
economy under the tax net to resolve the problem of illicit capital
movement. But this raises a pertinent question; is Pakistan's
taxation system so unfair and punitive that capital owners prefer to
invest in the informal sector? To be fair with the tax authorities, it
seems that it is not a question of paying some tax, but no tax at all!
Thus, a culture of tax compliance needs to be created, but this calls
for an active role of the decision-makers.
(7) Use of trade misinvoicing (i.e., the trade account) to move
capital in and out of the country indicates that the capital account in
the de facto realm is not fully convertible although in the de jure area
the system seems to be fully convertible. This dichotomy needs to be
eliminated by taking appropriate and effective measures.
(8) Last but not least, sound macroeconomic environment and
policies in the country should be able to prevent cross-border movement
of illicit capital.
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Capital Movements. Economia Internazionale 52:1, 79-90.
Mahmood, Z. and M. Azhar (2001) On Overinvoicing of Exports in
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Mahmood, Z. and R. Mahmood (1993) Underinvoicing of Imports: A Case
Study of Pakistan. The Pakistan Development Review 32:4, 1141-1155.
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Zafar Mahmood <
[email protected]> is Professor of Economics,
School of Social Sciences and Humanities, National University of
Sciences and Technology, Islamabad.
(1) Interestingly, whereas capital flight activates idle capital,
it also deteriorates income distribution in the country. Moreover, it
deprives the government of lax revenues and foreign exchange earnings
via workers' remittances that are leaked to fund both way movement
of illegal capital.
(2) It is important to note that with trade liberalisation, in the
absence of effective regulatory institutions, opportunities to
misinvoice trade increases, which accommodate two ways illegal capital
flows. It may be noticed that the arrest of some owners of the foreign
exchange companies in 2008 corroborate the view that the central
bank's policy on capital account liberalisation is not implemented
in letters and spirit, and thus other means, including trade account,
are being utilised to illegally transfer capital across borders.
(3) The very fact that trade misinvoicing takes place in Pakistan,
to move capital in and out of the country', explains that the
capital account de facto is not fully convertible. Thus, those who wish
to take their money out or bring in get indulged into trade misinvoicing
activities because of certain controls that are still in place on the
movement of capital.
(4) Also see, Eggerstedt, Hall, and Wijnbergen (1993).
(5) It may be noted that 'errors and omissions' usually
consist of both unrecorded short-term and longterm capital; therefore,
estimates based on Cuddington's definition are not purely
short-term. Moreover, capital flight cannot be restricted to short-term
assets only, because the long-term foreign bonds are now considered as
close substitute to short-term assets as there is very little loss of
liquidity associated with acquisition of longterm assets in the
secondary capital market.
(6) The definitions of capital flight by the World Bank and Morgan
consider total accumulation of foreign assets short-term and long-term
(both reported and unreported).
(7) In this technique, cif import values of the country are
compared with cif-fob adjusted export values of the partner country to
find 'paverse' discrepancies in trade statistics [see,
Bhagwati (1964); Bhagwati, Krueger, and Wibukswasdi (1974); Gulati
(1987); Mahmood and Mahtnood (1993); Mahmood (1997) and Mahmood and
Azhar (2001)].
(8) It needs to be underlined here that since workers'
remittances through official channels are also partly used to reverse
the capital flight, the above figure is, somewhat, an understatement of
the true size of the reverse capital Might. In the FY2005-06 Pakistan
received $4.6 billion, which rose to $13.92 billion in FY2012-13-a
3-times rise in remittances.
(9) It may be noted that in the absence of export over-invoicing,
remittances that were to be used to over-invoice exports may come
through legal channels thus raising the official foreign exchange
reserves.
(10) Different studies estimate that the size of the underground
economy in Pakistan is about the same as that of the formal economy, See
for instance, Kemal and Qasim (2012).
Table 1
Trade Misinvoicing (Average Per Annum, US Dollar in Million)
Period/Phase Exports Imports Total Trade
I: 1972-1981 28.43 -277.48 -249.10
II: 1982-1998 -161.52 -769.62 -931.14
III: 1998-2000 -443.35 -160.10 -603.46
IV: 2000-2013 -166.38 -557.97 -724.35
Total Period -138.48 -548.66 -687.14
Source: Author's estimates.
Table 2
Un-adjusted Capital Flight (Average Per Annum, US Dollar in Million)
Period/Phase World Bank Morgan Cuddington
I: 1972-1981 16.9 -6.3 -29.00
II: 1982-1998 39.71 -357.71 -121.53
III: 1998-2000 89 -227.67 -461.33
IV: 2000-2013 -57.46 2216.00 -43.46
Total Period 8.47 511.47 -100.12
Source: Author's estimates.
Table 3
Adjusted Capital Flight (Average Per Annum, US Dollars in Million)
Period/Phase World Bank Morgan Cuddington
I: 1972-1981 -232.15 -255.35 -278.05
II: 1982-1998 -891.44 -1288.85 -1052.67
III: 1998-2000 -514.45 -831.12 -1064.79
IV: 2000-2013 -781.81 1492.57 -767.81
Total Period -678.67 -175.67 -787.25
Source: Author's estimates.
Table 4
Significance of Adjusted Illicit Capital Flows for Pakistan (Annual
Average; Percent)
Period/Phase Capital Flight as a
Percentage of GDP
World Bank Morgan Cuddington
I: 1972-1981 -1.259 -1.460 -1.721
II: 1982-1998 -1.932 -2.650 -2.395
III: 1998-2000 -1.856 -1.540 -1.513
IV: 2000-2013 -0.499 1.063 -0.821
Total Period -1.357 -1.277 -1.722
Period/Phase Capital Flight as a Percentage
of Foreign Exchange Earnings
World Bank Morgan Cuddington
I: 1972-1981 -8.415 -10.410 -14.950
II: 1982-1998 -9.531 -13.115 -11.969
III: 1998-2000 -1.0561 -9.254 -8.785
IV: 2000-2013 -2.512 4.756 -4.234
Total Period -7.369 -7.089 -10.241
Source: Author's estimates.
