Capital flight

Not all money that leaves a country in a hurry is criminal money.

Capital flight is what the workbook calls it when companies and individuals shift money from one country to another for two reasons: to diversify risk, and to protect their wealth against the impact of financial or political crises. A family that expects its currency to collapse, or its government to change the rules, moves money out.

The funds involved are usually legitimately earned. That single word is what separates capital flight from trade-based money laundering, which moves the proceeds of crime.

The trouble is that the trick used can be the same. Where a country restricts how much money may leave, the studies the workbook cites find one common technique for getting around it: over-invoice imports, or under-invoice exports. The goods are real. The prices on the paper are not.

So a bank can see the same red flag for two very different motives. Telling them apart is the point of the concept.

The definition (Chapter 8, section 8.6.1(b)). Companies and individuals shift money from one country to another to diversify risk and protect their wealth against the impact of financial or political crises.

The technique (same section). Several of the studies the workbook draws on show that a common technique used to circumvent currency restrictions is to over-invoice imports or under-invoice exports.

Why those two and not the other two? Put the workbook's two invoicing directions from section 8.6.2(a) beside them:

Both push value outward. That is why those are the two the workbook names for capital flight.

The three neighbours in section 8.6.1, in the workbook's own order:

1. (a) Tax avoidance and evasion — differing tax rates give corporations an incentive to shift taxable income from jurisdictions with relatively high tax rates to those with relatively low rates, to minimise income tax.
2. (b) Capital flight — risk diversification and protection against financial or political crises.
3. (c) Trade-based money laundering — unlike tax avoidance and capital flight, which usually involve the transfer of legitimately earned funds across borders, capital movements relating to money laundering involve the proceeds of crime, which are more difficult to track.

Why the three are taught together. All three abuse the international trade system, and section 8.6.1 is headed Abuse of the International Trade System. Academic attention, the workbook says, has focused on money laundering and on these related activities, which is why the same detection work serves all three: studies analysing whether reported import and export prices reflect fair market values, and statistical techniques to detect discrepancies in the information on shipping documents.

No figure for capital flight. The workbook gives none — no threshold, no estimate of volume, no percentage. The trade-volume figures nearby in the chapter (global merchandise trade above US$9 trillion a year, services a further US$2 trillion) describe the trade system as a whole, not capital flight, and should not be offered as one.

Illustrative amounts. The technique, the directions and the definition are the workbook's.

Suppose a country restricts outward remittances, and a business there wants USD 300,000 held abroad instead.

Route 1 — over-invoice an import. It imports machine parts whose fair market price is USD 50 a unit and buys 10,000 units.

• Fair market value = 10,000 x USD 50 = USD 500,000
• The friendly overseas supplier invoices USD 80 a unit = 10,000 x 80 = USD 800,000
• The importer remits USD 800,000 for goods worth USD 500,000
• Value left abroad = 800,000 - 500,000 = USD 300,000

Every rupee that leaves does so as a lawful payment for a lawful import. The remittance passes the currency restriction because, on paper, it is the price of goods.

Route 2 — under-invoice an export. The same business exports the same parts, fair market value USD 500,000, and invoices USD 20 a unit.

• Invoice value = 10,000 x 20 = USD 200,000 repatriated
• Value transferred to the overseas importer = 500,000 - 200,000 = USD 300,000

Same result, opposite direction of trade: USD 300,000 never comes home.

What a GIFT IFSC banking unit sees. Financing Route 1, it sees a unit price of USD 80 against a market price it knows to be about USD 50 — a gap of (80 - 50) / 50 = 60% — with no difference in specification in the documents. That is the price discrepancy the workbook's statistical detection methods look for.

And here is the exam point. The 60% gap looks identical whether the money is a family's lifetime savings fleeing a currency crisis or a narcotics network's takings. The document check cannot tell them apart. Only the source of the funds can: legitimately earned means capital flight, proceeds of crime means trade-based money laundering. The bank's obligation is the same either way — investigate, and if it has reasonable grounds to suspect proceeds of crime, file a suspicious transaction report.

Chapter 8 (Financial Action Task Force and Its Recommendations on AML and CFT), section 8.6.1(b), is capital flight; 8.6.1(a) is tax avoidance and evasion and 8.6.1(c) is trade-based money laundering, and the three are written to be contrasted. Section 8.6.2(a) supplies the invoicing directions the technique relies on.

The chapter's own sample question asks it almost word for word: when companies shift money from one country to another to diversify risk and protect their wealth against the impact of financial or political crises, what is the process better known as? The answer is Capital Flight, with tax avoidance and evasion, trade-based money laundering and anti money laundering offered as distractors. Expect also the difference question: capital flight and tax avoidance usually move legitimately earned funds; TBML moves proceeds of crime.

• Capital flight usually involves legitimately earned funds. That is the discriminator against trade-based money laundering, and the workbook states it in those words.
• The motive is risk diversification and protection against financial or political crises — not tax. Shifting taxable income from high-tax to low-tax jurisdictions is the separate item, tax avoidance and evasion, at 8.6.1(a).
• The two named devices are over-invoicing imports and under-invoicing exports. Reverse either one and the value moves the wrong way. Under-invoicing an import and over-invoicing an export both bring value in.
• It is not itself money laundering. Moving legitimate money abroad may breach exchange control, but the PMLA needs a scheduled offence and proceeds of crime.
• The workbook gives no figure for capital flight. The US$9 trillion and US$2 trillion figures in the same chapter are global merchandise and services trade, not capital flight — and the workbook itself is quoting an older FATF study for them.
• The same red flag serves both. A price far from fair market value is evidence of misinvoicing, not of its motive. Do not answer "capital flight, so no report needed".