## Thursday, December 20, 2012

### 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.

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.

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.

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