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Black money abroad? It's returning via FDI, P-Notes!

Last updated on: February 11, 2011 17:54 IST

Black money abroad? It's returning via FDI, P-Notes!

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N Chandra Mohan

The recent expos of Swiss bank account holders has rekindled a controversy regarding the amount of illegal money stashed abroad by Indians.

Political leaders have been demanding these funds be returned and even distributed to the poor.

Amazing sums like $1.4 trillion have been bandied about, even though it is well-recognised that the exact numbers are difficult to come by. 

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Image: It is alleged that $1.4 trillion is stashed abroad
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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Those who receive kickbacks from corruption deals or launder their money abroad are most unlikely to inform the Reserve Bank of India of their intentions.

Since capital flight has been the norm in India till recently, the popular perception is that this haemorrhage continues on a growing scale even in an era of reform.

According to an International Monetary Fund report a decade ago, $20-$30 billion, or $1-2 billion every year, might have leaked out of the country during 1971-86.

This number was taken from a 1990 study on capital flight and trade misinvoicing by Meenakshi Rishi and James Boyce.

Rishi later updated these estimates, which indicated that $88 billion, or $3 billion every year, in 1997 dollars left the country from 1971 to 1997.

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Image: It is said that $88 billion left India from 1971 to 1997
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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More recently, Global Financial Integrity, a programme of the US-based Centre for International Policy, put out a couple of reports authored by Dev Kar* that placed illicit outflows from India at $213 billion or $2,891 million in 2005 dollars from 1948 to 2008, the bulk of which fled the country after the 1991 economic reforms.

Real illicit outflows gathered momentum between 1991 and 2008 when their growth accelerated to 16.4 per cent a year against 9.1 per cent from 1948-1990.

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Image: Real illicit outflows gathered momentum between 1991 and 2008
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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The Rishi-Boyce method is basically a residual measure and similar to what World Bank does to estimate capital flight. If the source of funds (change in external debt and net foreign direct investments) exceeds recorded uses like financing the current account deficit or adding to forex reserves, it flees the country as capital flight.

Illicit inflows exist when the recorded use of funds exceeds the source. This residual measure, then, is adjusted for the net effect of trade misinvoicing, notably, export underinvoicing and import overinvoicing.

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Image: Illicit inflows exist when the recorded use of funds exceeds the source
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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The underinvoicing of exports occurs when an invoice that understates actual receipts is given to the authorities when forex earnings are to be converted to rupees.

The remaining forex earnings are parked abroad. Similarly, when the invoice overstates imports. But there can be inflows when exports are overinvoiced and imports underinvoiced.

The net effect of misinvoicing, thus, must be considered. As Kar seeks to derive gross illicit outflows, periods of misinvoicing with the wrong sign are set to zero. So, too, are inward flows when sources of funds fall short of uses.

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Image: Net effect of misinvoicing must be considered
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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However, not all outflows are illicit. Former RBI governor Y V Reddy argued 14 years ago that abnormal outflows can also be legal, although some researchers prefer to term only illegal outflows as capital flight.

This phenomenon can also be viewed in three ways: gross capital flight, reverse capital flight and net capital flight. Much like outflows, there can be inflows.

In fact, the size of capital inflows and outflows sloshing through India's balance of payments is as much as 103.5 per cent of GDP. The difference between gross and reverse flight is net capital flight.

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Image: Not all outflows are illicit
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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Net capital flight is perhaps more of a reality since India's laws and the policy environment have changed since 1991. The incentives for stashing funds abroad illegally have steadily diminished since then. Direct and indirect taxes, including tariffs, have came down and the exchange rate is more realistic.

India is also one of the world's fastest-growing economies.

With current account convertibility and liberalised trade, the financing requirements for the illegal import of items like gold have also come down from earlier times when smuggling was rampant.

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Image: Incentive to stash money abroad has dropped
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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What left the country earlier, thus, is now returning home as a two-way process. If around $3 billion in 1997 dollars left the country every year from 1971 to 1997, there were net inflows amounting to $3.6 billion a year from 1991 to 1997 according to the numbers if the the Rishi-Boyce method is used.

Between 1998 and 2008, net inflows trickled down to $5 million a year in 2005 dollars.

As noted earlier, Kar's methodology is somewhat different in normalising illicit inflows and shows gross illicit outflows of $1.3 billion in 2005 dollars from 1998 to 2008.

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Image: Between 1998 and 2008, net inflows fell to $5 million
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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There is suggestive evidence that rich domestic residents who salted their funds abroad are bringing back their money in the form of portfolio investments through participatory notes (P Notes) - it is a derivative instrument for which the ultimate beneficiary is not known.

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Image: Rich Indians are bringing back money in form of P Notes
Photographs: Reuters
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Black money abroad? It's returning via FDI, P-Notes!

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It's believed that domestic residents with funds abroad are also bringing back their money as foreign direct investment. The returning flight is also fuelling a real estate boom all over the country.

Nevertheless, the perception persists of a stock of funds held abroad in Switzerland and elsewhere waiting to be brought back by a pro-active government.

*a)The Drivers and Dynamics of Illicit Financial Flows from India:1948-2008, November 2010 and b) Illicit Financial Flows from Developing Countries: 2000-2009, Update with a Focus on Asia, January 2011 (co-author Karly Curcio).


Image: Returning flight is fuelling realty boom
Photographs: Reuters
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