Trade misinvoicing as a channel for capital account openness

A recent literature has explored the effectiveness of capital
controls (Klein,
2012, Yothin,
Noy and Zheng, 2012, Patnaik
and Shah, 2012). In a recent paper on trade flows, we find that
unofficial capital flows through the channel of trade misinvoicing
are an additional mechanism through which the effectiveness of
capital controls is eroded.

Trade misinvoicing

In the 1970s and 80s, when the literature first identified capital
flight through trade misinvoicing, many countries had significant
restrictions on trade. Aizenman (2004) showed that in countries that
have capital account restrictions, greater trade integration creates
greater opportunities to shift capital through trade misinvoicing.

In a recent paper (Patnaik,
Sen Gupta and Shah, 2012), we find that de jure capital
account restrictions are correlated with higher levels of trade
misinvoicing. After controlling for factors such as macroeconomic
stability, corruption, currency overvaluation, and political
instability, the openness of the capital account influences trade
misinvoicing. For each increase in the Chinn-Ito index of de
jure capital controls by 0.1, export misinvoicing goes up by 0.8
to 1.3 percent of exports. On the landing page above, we have
released the full dataset so as to facilitate replication and
downstream research.

Based on this evidence, trade misinvoicing should be viewed as a
channel for de facto capital account openness. Over the
1980–2005 period, the average extent of misinvoicing-induced capital
flows in developing countries works out to roughly 7.6 percent of
GDP. This is a substantial number when compared with the objectives of
macroeconomic policy.

Traditional and new explanations

The traditional literature on trade misinvoicing has focused on two
broad motivations for misinvoicing. First, it emphasised high customs
duties. When firms face high rates of customs duties, or VAT on
imports, they have an incentive to understate the true value of
imports. Second, misinvoicing was viewed as a method for achieving
capital flight, which was, in turn, motivated by fears of
expropriation alongside unsound economic policy and political
instability.

An overvalued exchange rate, and high inflation, gives expectations
of depreciation in the near future and stimulates capital
flight. Research on the determinants of the large outflows of capital
from Latin American countries in 1980s and Asian economies in late
1990s has identified explanatory variables such as macroeconomic
instability, large budget deficits, low growth rates and the spread
between foreign and domestic interest rates. These factors, as well as
others such as corruption, political freedom, and accountability were
significant in explaining capital flight from sub Saharan Africa.

By the logic of this traditional literature, when countries like
India and China achieved high GDP growth and cut customs duties
sharply, the motivation for misinvoicing should have subsided. We find
that by and large, such a decline in misinvoicing is not
visible. Hence, we pursue a new explanation: that misinvoicing is a
tool for evading capital controls.

Conventional estimates are likely to understate the phenomenon

The magnitude of trade misinvoicing is conventionally estimated by
juxtaposing trade data from the importing and the exporting country. A
firm interested in moving capital out of a country would underinvoice
its exports, thus bringing reduced foreign exchange into the
country. Similarly, overinvoicing of imports would allow the domestic
importer to gain access to greater foreign exchange than
required. Both these mechanisms leave domestic firms in control of
hard currency assets overseas. Underinvoicing of imports, on the other
hand, can result from an attempt to evade taxes on imports including
customs duties and the Value Added Tax (VAT) on imports. These
calculations are likely to understate the scale of misinvoicing on the
current account for three reasons:

1. The overall misinvoicing of imports that is computed using
   macroeconomic data reflects a certain cancelling out between some
   firms who are engaged in underinvoicing of imports and other firms who
   are engaged in overinvoicing of imports. Similar considerations apply
   with misinvoicing of exports. To the extent that firms have
   heterogeneous goals, the measured misinvoicing is likely to understate
   the true scale of gross capital flows being achieved through
   misinvoicing in an economy.

2. Services trade offers substantial opportunities for misinvoicing given
   the lack of market benchmark prices for many services such as
   customised software. Many elements of services trade
   are not in conventional trade databases.

3. Intra-MNC trade offers opportunities for misinvoicing that would
   not be captured in our methodology. When the importer and the exporter are one
   firm, there will be no discrepancy in the data, even if the value of a
   product is overstated or understated.

For these three reasons, conventional trade misinvoicing measures
may understate the true extent of misinvoicing.

Conclusion and implications

The evidence on misinvoicing suggests that studies on the
effectiveness of capital controls should also take into account
unofficial flows through the trade account as these may be further
eroding the effectiveness of capital controls. For example, there is
interest in the extent of capital flight from China. While capital
flight through official channels can be observed directly on the
capital account of the balance of payments, significant capital flight
might take place through the current account. Since the trade account
for China is large, it provides a channel for capital movements. The
discussion on whether there is capital flight from China cannot be
settled without an analysis of its trade account.

It is sometimes argued that developing countries should open the
trade account but not the capital account. This evidence suggests that
once trade openness is achieved, a substantial element of de
facto capital openness follows.