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GTAP Resource #959

"Preferential Trade, Mis-invoicing and Capital Flight"
by Biswas, Dr. Amit Kumar

The dependence of less developed countries (LDCs) on protectionary policies and exchange controls to manage their balance of payments (BoPs) and scarce capital reserves are widespread and phenomenal. Presence and persistence of regulatory control on trade and payments induces exporters and importers to undertake illegal transactions. Such actions in turn lead to black market for scarce foreign exchange as well as capital flight.
With this backdrop let us shift our focus to analyze a situation where an economy has experienced a certain amount of trade reform through lowering of the tariff rate and a somewhat floated domestic currency. Zero or low tariff rate reduces the incentive for an importer to under-invoice and given a certain amount of BMP he may even go for over-invoicing. A minimal amount of under-voicing or even a positive amount of over-voicing by the importers is likely to reduce the demand component in the black-market for foreign exchange. The exporters on the other hand may still continue with their under-invoicing practices if they think that they would gain given a small magnitude of BMP and small punishment costs in the event of mis-reporting. Thus there may be continuing supplies of illegal foreign exchange with a reduced demand for it. With capital control still in place, which forbids the domestic investors from investing aboard which are more lucrative destination, huge amount of unauthorized foreign exchange may cross the border illegally. Usually capital flight is an illegal conversion of financial assets from the national currency to assets in a more stable currency in response to or in anticipation of heightened financial risk.
The purpose of this paper is to examine how changes in trade policy affects capital flight. This paper builds up a three-country preferential – non-preferential trade model where, ceteris paribus, trade channels are demarcated in the sense that low or zero tariff prevails in the preferential trade channel while higher tariff is exercised in the non-preferential trade cannel. Initially we would experience that the preferential trade channel is prone to capital flight and non-preferential trade channel is conducive for illegal transactions in foreign exchange in the local market. Given these initial outcomes, we would proceed to examine the behavior of the BMP through the changes in the demand and supply components in the illegal foreign exchange market. Finally we would further examine the process of occurrence of capital flight and the operation of parallel foreign exchange market in the changed circumstances where BMP is determined endogenously within the model. In this general equilibrium framework, we demonstrate that the initial surge in capital flight through preferential trade channel and increased transaction in illegal foreign exchange market through preferential trade channel would likely to be partly taken care of once we allow changes in the BMP through transaction in illegal foreign exchange market demand and supply components. We also apply the results of our theoretical model to Mexico’s preferential non-preferential trade channels to justify the validity of our model.

Resource Details (Export Citation) GTAP Keywords
Category: 2002 Conference Paper
Status: Published
By/In: Presented at the 5th Annual Conference on Global Economic Analysis, Taipei, Taiwan
Date: 2002
Created: Biswas, D. (4/3/2002)
Updated: Bacou, M. (4/3/2002)
Visits: 2,809
- Preferential trading arrangements
- Domestic policy analysis

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