Mexico’s Underground Economy and Illicit Money Outflows

Yesterday Global Financial Integrity released a new report, “Mexico: Illicit Financial Flows, Macroeconomic Imbalances, and the Underground Economy,” which provides an in-depth look at flows of illicit money from Mexico. The study finds that nearly $1 trillion in illicit capital left Mexico from 1970-2010, averaging about $50 billion a year this past decade. Illicit outflows have increased over time – in 1970 only $3 billion of illicit money left the country per year – and experienced particularly large upswings during macroeconomic crises. These flows decreased by more than 50 percent as a share of exports, though this is largely because exports overall increased dramatically as Mexico transformed from a relatively closed to open economy.

The report’s most interesting finding is that this illicit capital is not necessarily or mostly drug money. Instead it comes from Mexico’s large underground economy. In these markets the goods being traded are not necessarily in and of themselves illegal. What’s illegal is the under-the-table way that they are bought or sold. The report finds that the vast majority (80 percent) of the money leaving Mexico does so through a method called “trade mispricing.” This is when a company either undervalues exports or overvalues imports, and agrees with its trading partner (for many this is the same entity or owner) to transfer the balance to a bank account abroad. Just as when a restaurant doing cash business fakes the number of customers it receives to avoid paying taxes, companies doctor their trade records to allow money to flow out of a country untaxed.

In Mexico’s case, economic liberalization in the 1990s had the unintended effect of promoting this type of capital flight. The explosion of trade around NAFTA provided exporters and importers more opportunities than ever to manipulate the rules of the game.

Dealing with this challenge means tackling the informal economy, which both drives and is driven by illicit outflows. Mexico’s regulatory institutions need to catch up to the high volume of trade in the post-NAFTA era, strengthening auditing practices and tax authorities along the way. Another way of chipping away at the underground economy is to shrink the number of people working in it, by creating more formal sector jobs. This is good for workers, who get better social protections in the formal economy, and for businesses, which can get loans and other services needed to grow and expand. More formal sector enterprises will also generate much-needed tax revenue in Mexico (the country with the lowest rate of tax collection in the OECD and among the lowest in Latin America). These extra public funds will pay for more public schools, better roads and stronger police forces, benefiting Mexican society in the long run.

The United States also has a role to play in helping Mexico combat money laundering. As the number one destination of illicit funds from Mexico, U.S. banks could make it a lot harder to move money north by improving transparency and reporting more regularly on private deposits. Getting banks to do their part will require deeper cooperation between the United States and Mexico, with tougher rules and regulations on both sides of the border.