Trade Mispricing from Mexico: Policy Solutions to Confront the War on Drugs
By Will Gray
In July of last year, the U.S. Department of Justice discovered that the banking giant HSBC “willfully failed” to apply money laundering controls to $881 million in drug trafficking proceeds, including those from two major Mexican drug cartels. Specifically, HSBC’s policies allowed high risk and suspicious account holders to open HSBC bank accounts in Mexico. A Senate Subcommittee on Investigations report condemns the actions of HSBC’s United States affiliate and provides details on its Mexican affiliate’s deficiencies, which included “a dysfunctional monitoring system; bankers who resisted closing accounts despite evidence of suspicious activity; and high profile clients involved in drug trafficking.”[i]
It is no coincidence that HSBC’s sister company in Mexico posed a significant money laundering risk to HSBC’s United States affiliates. The border between Mexico and the United States has a long and storied history of transfers of illicit goods and money, and in recent decades has been a major conduit for the transfer of illegal narcotics from the south to the north. The illegal drug trade is a significant source of illicit funds that Mexican cartels launder across the American border. Before these nations signed the North American Free Trade Agreement (NAFTA), they had much stricter control of goods and money traveling over the border. Since its passage, however, cartels have found it easier to transfer money across the border, which has facilitated their continued distribution of drugs throughout the Americas.
In the United States, the War on Drugs has focused mainly on stemming the demand in the north and stifling the supply from the south. This effort has largely failed because the demand for illegal drugs is so large that narcotics dealers are willing to take significant risks to enter the North American drug market. A more effective method for fighting the War on Drugs would make it difficult for the cartels to hide or use the monetary proceeds from selling narcotics, thus making it unprofitable for them to do so. It is important, therefore, to gain a better understanding of the severity of money laundering and trade mispricing from Mexico, Mexico’s current policy solutions, and other policy alternatives that could curtail the problem.
Illicit Financial Flows & Mexico
While there is significant overlap between the two, illicit financial flows and money laundering pose two distinct problems for policymakers. Illicit financial flows occur when money is illegally transferred across national borders for the purpose of concealing its existence from government authorities. The illegal transfer of wealth can be part of a money laundering scheme (explained below) or for other purposes, such as tax evasion by otherwise legitimate individuals or companies.
Money laundering occurs when a person or group of people attempt to hide the illicit origin of the proceeds of a crime in order to use the money for legitimate purposes, such as business investments or commercial purchases. Money laundering schemes vary widely both in scale and complexity, and may or may not employ illicit financial flows.
While these phenomena pose separate problems, in an increasingly globalized world, the employment of illicit financial flows to facilitate money laundering schemes has become easier and more effective. As early as 1997, the U.S. government was openly discussing this connection. In that year, a report published by the Office of National Drug Control Policy noted that “[t]he worldwide phenomenon known as globalization cannot be divorced from the illicit activity of money laundering.”[ii]
The connection between illicit financial flows and money laundering also exists in Mexico, where drug smuggling organizations are exerting increasing control over their supply chain. Drugs and money flow between Mexico and a wide variety of countries, including production centers in South America and retail markets in the United States and elsewhere.
The scale of illicit financial flows from Mexico is immense. Researchers at Global Financial Integrity (GFI) have chronicled a forty-year history of IFFs crossing the Mexican border. They found the outflow of illicit capital from Mexico increased sharply between the 1970s and 2009. These outflows ranged from around US$1 billion in 1970 to US$68.5 billion in 2010, with a peak in 2007 of US$91 billion. Another report released by GFI finds that from 2000 to 2009, Mexico experienced the third highest amount of illicit financial flows of any developing nation in the world, behind only Russia and China.[iii]
According to GFI, Mexican criminals’ preferred method of transferring money abroad is trade mispricing. Though it remains one of the lesser-known forms of money laundering, there is little new or innovative about trade mispricing. It is also one of the most common methods for laundering money internationally. In Mexico, trade mispricing constitutes over eighty percent of IFFs.[iv]
Trade mispricing occurs when an entity secretly transfers wealth from one country to another by either import over-invoicing or export under-invoicing. Ann Hollingshead provides this explanation on the Financial Transparency Coalition’s blog:
Suppose a Mexican furniture manufacturer, who wants to send money abroad illegally, is importing $100 worth of timber from the United States. Instead of paying $100, the furniture company reports and pays $200. The company’s U.S. trading partner takes $100 for the furniture, reports the $100 on its own invoice, and shifts the extra $100 to a secret Delaware bank account (and maybe keeps an extra few dollars as a transaction fee). Now the furniture company has shifted the $100 to the United States without Mexico’s knowledge.[v]
In part, the prevalence of trade mispricing from Mexico may be the result of free trade agreements. Free trade agreements, including NAFTA, have removed the tax incentives for governments to more closely monitor the corresponding invoices of imports and exports, reducing the likelihood that border authorities will catch the entities that mis-invoice their trades. In other words, before international rules like NAFTA largely removed import and export tariffs, customs officials had a strong incentive to examine the invoices accompanying particular shipments to ensure that the proper amount of taxes were being paid at the point of entry or departure. As part of this examination, officials ensured the shipments matched the invoices, essentially ensuring no trade mispricing had taken place. Once NAFTA removed these levies, the incentive for customs officials to closely monitor invoices disappeared with them.
The results of this change in incentives are apparent in the macroeconomic data. Global Financial Integrity has shown that the level of IFFs in general and trade mispricing in particular rose considerably after NAFTA. Specifically:
For the period as a whole [1970-2010], we find that increased trade also resulted in increased trade mispricing … [T]rade mispricing and trade openness have been increasing in lock-step over the entire period studied. Under NAFTA, the slope of the trade openness time trend line increases substantially, along with the average volume of [trade mispricing].[vi]
In other words, NAFTA provided a clear jump in the legitimate trade between Mexico and the United States. However, as that trade went up, so did the level of trade mispricing.
Mexico may find itself increasingly exposed to these problems in the future as the nation signs more free trade agreements. In fact, Mexico is one of the most aggressive signers of free trade agreements in the world, signing twelve such agreements involving forty-four countries around the world. It is also currently in negotiations to become part of the Trans-Pacific Partnership, which will greatly increase the number of countries with which Mexico will have a free trade agreement. These developments may allow illicit actors to more easily trade misprice goods with a wider variety of countries worldwide.
Mexico’s Current Policy Solutions
The HSBC money laundering controversy garnered significant media attention in Mexico and the United States. In response to these and other challenges, Mexico’s legislature passed a new anti-money laundering law in October of 2012, titled “The Federal Law for the Prevention and Identification of Operations with Resources from Illicit Proceeds.” Specifically, the law:
Even in the areas of Mexico where the government can and does exert enough controls to make the laws effective, this particular law falls short of addressing some of Mexico’s fundamental vulnerabilities. Given that illicit money is transmitted out of Mexico primarily by trade mispricing, such schemes can employ the cross-border trade of nearly any good or service. Yet this law only concentrates on a few specific goods and services (the so-called “vulnerable activities”). This approach leaves Mexican lawmakers exposed to a hopeless cycle of playing whack-a-mole with myriad goods and services that criminals can use to hide their money.
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It is no coincidence that HSBC’s sister company in Mexico posed a significant money laundering risk to HSBC’s United States affiliates. The border between Mexico and the United States has a long and storied history of transfers of illicit goods and money, and in recent decades has been a major conduit for the transfer of illegal narcotics from the south to the north. The illegal drug trade is a significant source of illicit funds that Mexican cartels launder across the American border. Before these nations signed the North American Free Trade Agreement (NAFTA), they had much stricter control of goods and money traveling over the border. Since its passage, however, cartels have found it easier to transfer money across the border, which has facilitated their continued distribution of drugs throughout the Americas.
In the United States, the War on Drugs has focused mainly on stemming the demand in the north and stifling the supply from the south. This effort has largely failed because the demand for illegal drugs is so large that narcotics dealers are willing to take significant risks to enter the North American drug market. A more effective method for fighting the War on Drugs would make it difficult for the cartels to hide or use the monetary proceeds from selling narcotics, thus making it unprofitable for them to do so. It is important, therefore, to gain a better understanding of the severity of money laundering and trade mispricing from Mexico, Mexico’s current policy solutions, and other policy alternatives that could curtail the problem.
Illicit Financial Flows & Mexico
While there is significant overlap between the two, illicit financial flows and money laundering pose two distinct problems for policymakers. Illicit financial flows occur when money is illegally transferred across national borders for the purpose of concealing its existence from government authorities. The illegal transfer of wealth can be part of a money laundering scheme (explained below) or for other purposes, such as tax evasion by otherwise legitimate individuals or companies.
Money laundering occurs when a person or group of people attempt to hide the illicit origin of the proceeds of a crime in order to use the money for legitimate purposes, such as business investments or commercial purchases. Money laundering schemes vary widely both in scale and complexity, and may or may not employ illicit financial flows.
While these phenomena pose separate problems, in an increasingly globalized world, the employment of illicit financial flows to facilitate money laundering schemes has become easier and more effective. As early as 1997, the U.S. government was openly discussing this connection. In that year, a report published by the Office of National Drug Control Policy noted that “[t]he worldwide phenomenon known as globalization cannot be divorced from the illicit activity of money laundering.”[ii]
The connection between illicit financial flows and money laundering also exists in Mexico, where drug smuggling organizations are exerting increasing control over their supply chain. Drugs and money flow between Mexico and a wide variety of countries, including production centers in South America and retail markets in the United States and elsewhere.
The scale of illicit financial flows from Mexico is immense. Researchers at Global Financial Integrity (GFI) have chronicled a forty-year history of IFFs crossing the Mexican border. They found the outflow of illicit capital from Mexico increased sharply between the 1970s and 2009. These outflows ranged from around US$1 billion in 1970 to US$68.5 billion in 2010, with a peak in 2007 of US$91 billion. Another report released by GFI finds that from 2000 to 2009, Mexico experienced the third highest amount of illicit financial flows of any developing nation in the world, behind only Russia and China.[iii]
According to GFI, Mexican criminals’ preferred method of transferring money abroad is trade mispricing. Though it remains one of the lesser-known forms of money laundering, there is little new or innovative about trade mispricing. It is also one of the most common methods for laundering money internationally. In Mexico, trade mispricing constitutes over eighty percent of IFFs.[iv]
Trade mispricing occurs when an entity secretly transfers wealth from one country to another by either import over-invoicing or export under-invoicing. Ann Hollingshead provides this explanation on the Financial Transparency Coalition’s blog:
Suppose a Mexican furniture manufacturer, who wants to send money abroad illegally, is importing $100 worth of timber from the United States. Instead of paying $100, the furniture company reports and pays $200. The company’s U.S. trading partner takes $100 for the furniture, reports the $100 on its own invoice, and shifts the extra $100 to a secret Delaware bank account (and maybe keeps an extra few dollars as a transaction fee). Now the furniture company has shifted the $100 to the United States without Mexico’s knowledge.[v]
In part, the prevalence of trade mispricing from Mexico may be the result of free trade agreements. Free trade agreements, including NAFTA, have removed the tax incentives for governments to more closely monitor the corresponding invoices of imports and exports, reducing the likelihood that border authorities will catch the entities that mis-invoice their trades. In other words, before international rules like NAFTA largely removed import and export tariffs, customs officials had a strong incentive to examine the invoices accompanying particular shipments to ensure that the proper amount of taxes were being paid at the point of entry or departure. As part of this examination, officials ensured the shipments matched the invoices, essentially ensuring no trade mispricing had taken place. Once NAFTA removed these levies, the incentive for customs officials to closely monitor invoices disappeared with them.
The results of this change in incentives are apparent in the macroeconomic data. Global Financial Integrity has shown that the level of IFFs in general and trade mispricing in particular rose considerably after NAFTA. Specifically:
For the period as a whole [1970-2010], we find that increased trade also resulted in increased trade mispricing … [T]rade mispricing and trade openness have been increasing in lock-step over the entire period studied. Under NAFTA, the slope of the trade openness time trend line increases substantially, along with the average volume of [trade mispricing].[vi]
In other words, NAFTA provided a clear jump in the legitimate trade between Mexico and the United States. However, as that trade went up, so did the level of trade mispricing.
Mexico may find itself increasingly exposed to these problems in the future as the nation signs more free trade agreements. In fact, Mexico is one of the most aggressive signers of free trade agreements in the world, signing twelve such agreements involving forty-four countries around the world. It is also currently in negotiations to become part of the Trans-Pacific Partnership, which will greatly increase the number of countries with which Mexico will have a free trade agreement. These developments may allow illicit actors to more easily trade misprice goods with a wider variety of countries worldwide.
Mexico’s Current Policy Solutions
The HSBC money laundering controversy garnered significant media attention in Mexico and the United States. In response to these and other challenges, Mexico’s legislature passed a new anti-money laundering law in October of 2012, titled “The Federal Law for the Prevention and Identification of Operations with Resources from Illicit Proceeds.” Specifically, the law:
- Creates a new financial investigation unit that will answer to the Mexican Attorney General and will assist with investigations
- Bans the use of cash or precious metals, jewels, and other items as payment for certain transactions such as real estate transactions or the purchase of cars, boats, planes, and other luxury goods;
- Provides a list of “vulnerable activities,” which include gambling, the issuance of loans, various services related to the real estate sector, and trading of jewelry, precious metals, watches, precious stones, and artwork, among other activities. Each transaction within these vulnerable activities, depending on its value, must be reported to the Ministry of Finance; and
- Requires that any entity engaging in these vulnerable activities carry a number of extra responsibilities, including stricter “Know-Your-Customer” rules and keeping all records on such clients for at least five years, on an ongoing basis.
Even in the areas of Mexico where the government can and does exert enough controls to make the laws effective, this particular law falls short of addressing some of Mexico’s fundamental vulnerabilities. Given that illicit money is transmitted out of Mexico primarily by trade mispricing, such schemes can employ the cross-border trade of nearly any good or service. Yet this law only concentrates on a few specific goods and services (the so-called “vulnerable activities”). This approach leaves Mexican lawmakers exposed to a hopeless cycle of playing whack-a-mole with myriad goods and services that criminals can use to hide their money.
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