draining development.pdf - Khazar University

Governance and Illicit Flows 51lying political settlement of the producing country. The indirect negativeeffects are likely to far outweigh any positive direct effect. It would bequite consistent with our definition to describe the financial flows associatedwith these sectors as illicit.Financial outflows with positive or neutral effects. We discuss in passingabove a number of examples in which financial outflows do not have anet negative effect if both direct and indirect effects are accounted for. Insome cases, this can involve making difficult judgments that are specificto the context. For instance, in the presence of significant market failuresfacing investors, it may sometimes be useful not to enforce restrictionson capital flight too excessively. In textbook models, developing countrieslack capital and, therefore, capital should flow in if policies areundistorted. In reality, the productivity in developing countries is so lowthat most investments are not profitable, and temporary incentives areneeded to attract investments (Khan 2009). It is possible that some ofthese incentives have to be made available in other jurisdictions to becredibly secure from expropriation. In these contexts, the strict enforcementof restrictions on financial flows may reduce the degree of freedomstates have in constructing credible incentives for investors taking risksin technology absorption and learning.For example, a significant part of the foreign direct investments inIndia in the 1980s and 1990s came from jurisdictions such as Mauritius.A plausible interpretation is that much of this was Indian domestic capitalgoing through Mauritius to come back for reinvestment in India. Oneside of this flow was clearly a hidden financial outflow, the other a transparentinflow in the form of foreign direct investment. As a result, thedeveloping country may not be a net capital loser, and, indeed, the incentivesprovided through this arrangement may make new productiveinvestment possible in areas where investment may not otherwise havetaken place. As in the case of odious debt, recycling is also only one sideof a two-way flow and is generally assumed to be driven by tax and regulatoryarbitrage and to be harmful for society (for example, see Kant1998, 2002; Schneider 2003b, 2003c). However, in the case of countrieswith low productivity and missing tacit knowledge, the rents captured inthis way may, in some situations, serve to make investments more attractiveand thereby increase net investments. The direct effect may be to