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Capital Flight: To and From Pakistan.

Byline: Dr Zafar Mahmood - Email:

Capital flight from Pakistan has always received attention from policy-makers and concerned citizens. The worries come from the "paradoxical" nature of capital outflows; that is, the private citizens hold large sums of foreign assets overseas while the country is facing a crisis like situation due to the heavy burden of foreign debt. Given insufficient level of foreign exchange reserves in the country, illicit capital outflow is a cause for serious concern for the country. Evidence of the capital flight (officially unrecorded private capital outflow) from the country often induces foreign donors, in return for their support for foreign debt reduction policies, to impose harsh conditionalities for repatriation of the private capital held by its citizens abroad.

Unrecorded private capital movement is a two way phenomenon. Unrecorded private capital outflow often represents a demand for illegal foreign exchange, which takes place due to portfolio reasons (i.e., people want to invest overseas due to uncertainty in the country), excessive taxation in the country (or alternatively people want to avoid taxes), money obtained from bribery, kickbacks and organized crime, exchange rate overvaluation with the expectation of major exchange rate realignment (for example, depreciation of the currency), large fiscal deficit, high inflation, financial repression resulting into negative real interest rates, weak banking supervision, poor corporate governance, fear of government default on debt, and political instability. All of these are the so-called push factors that compel private citizens to take their capital outside the country.

There are also the so-called pull factors that induce people to take their capital abroad to safe havens created by developed countries. These factors include better economic opportunities, low or no taxes, purchase of property, tourism, etc.

The modus operandi of capital flight from Pakistan generally includes the following: capital flight is primarily fed through "leaked" remittances of Pakistani expatriate workers who transfer their foreign savings through Hundi/Hawala system, under-invoicing of exports, over-invoicing of imports, export through the baggage of overseas travellers, and transfer of capital through precious metals, antiques, etc. More specifically, due to stringent restrictions on capital account (i.e., non-convertibility of capital account) of the balance of payments as private residents cannot transfer their money to foreign countries through official channels, they transfer their capital in the guise of trade transactions.

At the same time, reverse capital flight to the country takes place through under-invoicing of imports, over-invoicing of exports, and smuggling of goods. Reverse capital flight takes place to evade import duties and benefit from export rebates. Similarly, it enables importers to circumvent quantitative restrictions on imports.

Given the nature of trade mis-invoicing, both way movement of capital is possible. It may be noted that by under-invoicing the actual exports, the extent of the amount that is under-invoiced is kept outside the country by exporters. On the other hand, when imports are over-invoiced as compared to the actual value of imports, importers open a Letter of Credit (LC) for the amount which is over-invoiced and receive foreign exchange from the Central bank equal to the stated amount but when they bring imported goods to the country the actual value of imports is much less and thus keep the difference outside the country. Likewise, one can explain the under-invoicing of imports and over-invoicing of exports that reverse the capital flight. It needs to be underscored that in all these activities customs staff is fully involved.

Interestingly, contrary to the general perception about capital flight from Pakistan, when we take into account both way capital movements on account of trade mis-invoicing in addition to Hundi/Hawala system related capital flight, the evidence suggests that the motives to build up foreign assets in Pakistan has actually been outweighed by the motivation to evade trade taxes and circumvent trade controls. Hence, a reverse capital flight (net inflow) of unrecorded private capital instead of capital flight is taking place in Pakistan. The question is where this capital is invested? The answer is that it is invested in the underground part of the Pakistan economy or it is invested in the real estate. The underground (informal) sector of Pakistan is unregistered and is outside the tax net and so is the real estate.

How big are these flows? There is a paucity of the latest data. Nonetheless, between 1972 and 2003, mainly due to trade misinvoicing Pakistan has been a net recipient of unrecorded private capital (i.e., reverse capital flight) of about $13 billion. Thus, these findings undermine the exaggerated impression about capital flight from Pakistan.

Capital flight leads to disappearance of wealth from the country and is accompanied by a depreciation of the Pakistan rupee, which in turn lower the nominal value of remaining public and private assets in the country. Illicit capital flows disappear from the records of the country and earning of these flow in foreign country generally do not return to the home country. The Pakistan rupee appreciates when reverse capital flight takes place.

Pakistan has adopted trade liberalization policies to promote efficiency and expand exports. But in the absence of effective regulatory bodies, deregulation and trade liberalization has accelerated capital flight. Deregulation means less control and hence it becomes easy to misuse the legal channels. Whereas trade liberalization means lower tariffs so when importers over-invoice to take money outside the country they have to pay lower import duties. In other words, the cost of capital flight goes down in the aftermath of trade liberalization that results into bigger magnitude of capital flight.

As noted above, capital flight is not uni-directional. The capital/assets held abroad by the Pakistani citizens are brought into the country at opportune time that inflates the prices of the real estate and stocks/shares. With trade liberalization policies adopted by the country and the policy of the government 'No Questions' to the source of (foreign) capital, the capital enters the country in the guise of foreign direct investment, but of course this foreign investment enters through official channels.

I offer the following suggestions to control the officially unrecorded movement of capital that encourages illegal activities in the country:

* There is a strong relationship between illicit flows and deteriorating income distribution that ultimately has adverse implications for poverty. Thus, by controlling capital flight from the country reduction in poverty can be achieved.

* Good governance reforms must be introduced to control corruption which is the main source of illicit funds.

* Pakistan needs to join hands with other developing countries to persuade developed countries for their decisive efforts to eliminate secrecy havens from their territories.

* Expand tax base and improve tax collection to curtail capital flight.

* Control trade misinvoicing by appointing credible pre-shipment agencies.

* Sign agreements with other countries about sharing information on personnel and business accounts.

* Take measures to bring underground part of the economy into the fold of formal economy.

* Illicit capital flows take place largely due to weak enforcement of controls, which provides high premium to private citizens if they defy trade and exchange restrictions and misuse trade incentives, therefore, an effective implementation of trade and exchange liberalization policies by establishing effective regulatory body is expected to discourage people to use illegal channels for capital movements.

* A build up of foreign exchange reserves, low rate of inflation and stability of the Pak currency are essential factors to prevent capital flight from the country.

Dr Zafar Mahmood

The writer is HEC Foreign Professor and presently on the faculty of Pakistan Institute of Development Economics (PIDE), Islamabad.
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Geographic Code:9PAKI
Date:May 31, 2011
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