Column : Watch out for capital flows via trade

Dec 20 2012, 20:46 IST
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SummaryAfter India achieved high growth & cut customs duties, motivation for misinvoicing should have subsided. That’s not visible.

In the recent discussion on capital flight from China, the country’s State Administration of Foreign Exchange denied the speculation that there was capital outflow. While capital flight through official channels can be observed directly on the capital account of the balance of payments, when capital flows on the capital account are restricted, flight may 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.

In the 1970s and 1980s, when the literature identified capital flight through trade misinvoicing, countries had significant restrictions on trade. Even then, misinvocing offered a serious channel for capital flows. It was found that in countries that have capital account restrictions, greater trade integration creates greater opportunities to shift capital through trade misinvoicing.

Trade misinvoicing only captures flows through merchandise trade. Services, and the difficulties of assessing the price of, say, a client-specific software, by a customs officer, offer further channels for misinvoicing, and are not accounted for in the trade data. Even beyond this, not all movement of capital through mispriced trade results in a difference between export and import values. For example, a form of trade mispricing that facilitates movement of capital or profits across borders is transfer pricing by multinational corporations. Such mispricing does not result in any discrepancy between the import and the export values. Trade misinvoicing thus underestimates the extent of capital flows that can take place through the current account. The accompanying table shows that flows on account of misinvoicing are as significant as net capital flows to a country.

In a recent paper, my co-authors and I found out that capital controls in countries with large trade flows are correlated with high levels of trade misinvoicing. After controlling for factors such as macroeconomic stability, corruption, currency overvaluation, and political instability, the openness of the capital account still has a significant role to play in determining trade misinvoicing. Trade misinvoincing should be viewed as a channel for de facto capital account openness. During 1980 to 2005, the average extent of misinvoicing induced capital flows in developing countries was of the amounted to around 38% of official flows, and 7.6% of GDP.

The magnitude of trade misinvoicing is conventionally estimated by juxtaposing trade data from the importing and the exporting country. A firm interested

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