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:
- 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.
This law addresses a number of issues in Mexico’s previous money laundering legal regime, but enforcement remains a significant problem for Mexican authorities. This is particularly true in the northern border areas, where the Mexican government struggles to assert control of security, let alone sophisticated financial controls.
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.
Impediments to Controlling Illicit Financial Flows
Mexican responses to, and efforts to fight against, problems associated with money laundering and IFFs continue to fall far short of the necessary steps to control the problem. There are numerous reasons for this, but they boil down to one basic point: given the size of demand for drugs in the United States and the profitability of that trade, Mexico does not itself have sufficient capacity to prevent criminal organizations from conducting and profiting from their smuggling activities.
Mexico and the United States could make it more difficult for criminals to enjoy the proceeds of illegal activities. Yet these nations have not taken these necessary steps in large part because anti-money laundering policies do not affect only drug dealers and smugglers. They affect a wide range of individuals, some of whom are wealthy and engage in completely legitimate business activities. These individuals do not want to see the enactment of more powerful anti-IFF laws any more than the drug smugglers do, and have effective means of lobbying legislators.
Other observers have noted another possible reason that the Mexican government has not taken a more assertive stance against the drug cartels:
From Mexico’s point of view, interrupting the flow of drugs to the United States is not clearly in the national interest or in that of the economic elite… Certainly, [drug] money could corrupt the Mexican state, but it also behaves as money does. It is accumulated and invested, where it generates wealth and jobs.[i]
In other words, from a purely economic perspective, some policymakers may see narcotics trafficking as a net-benefit that transfers wealth from the United States to Mexico. Any benefit to the economy, even if the source is masked behind a veil of legitimate business transactions, provides politicians with a short-term win they can bring to their voters. By contrast, strong and effective anti-IFF policies may not provide the kind of instant impact that politicians often want in order to demonstrate their leadership to voters.
We should not overlook this impediment. If narcotics were not so profitable for the drug cartels, they would not have the resources to wage war against each other, nor would they bother engaging in the risk of smuggling the drugs in the first place. While anti-IFF policies may not often garner attention from the press or voters, they can make a substantial impact on the War on Drugs, which would likely resonate with voters on both sides of the border.
Proposed Policy Solutions
Much of the analysis of IFFs and the U.S.-Mexico narcotics issue focuses on the incentives driving illicit actors. The literature has not directed sufficient focus on the incentives driving government and law enforcement officials on both sides of the border. However, as the discussion on free trade agreements and IFFs makes clear, until policy changes are made in both countries to change incentives faced by governments, illicit actors will continue to successfully employ trade mispricing as their method of choice to launder their money.
Reform in both the United States and Mexico should concentrate on two areas of the government: the respective tax and customs authorities. One reform that would help curb trade mispricing would be an information-sharing mechanism for tax authorities in the U.S. and Mexico to communicate suspicious cross-border transactions, specifically those involving the purchase and sale of goods and services across the border. The primary goal of this communication would be to ensure that the same information is being reported to each authority regarding the same transaction. This would also require greater communication between tax authorities and customs authorities, who themselves help monitor invoicing.
Another possible reform involves taking greater measures to ensure that border and customs agents on both sides of the border inspect more closely the invoices of each shipment crossing the border. If they inspect a shipment and the amount of goods on the invoice does not match the amount of goods in the shipment itself, they need both the power to question that disparity and the incentive to find it. Some of this could be achieved with greater education of customs officials so that they understand trade mispricing in practice and how and why we need to fight it.
A third reform, which the Financial Transparency Coalition has advocated, would curtail trade mispricing by altering the incentives for the trade partners themselves. Under this proposal, parties selling goods or services across borders would sign a statement in the invoice certifying that no trade mispricing has taken place in the transaction. As Raymond Baker, Director of Global Financial Integrity, has pointed out, “some exporters and importers will readily violate such a clause. But there are not many multinational corporations that will run such transactions through their tax planning departments for the prohibited tax manipulations and then ask their people to sign a statement saying they did no such thing.”[ii]
These are not impossible reforms and they would go a long way toward curbing money laundered across the U.S.-Mexico border. Once the profits from the drug trade become more difficult to keep and use, the incentive to engage in the drug trade will also dry up. This provides the United States and Mexico with a clear path toward winning not just a simple victory in the War on Drugs, but a victory that can change the very dynamic of the war.
 Senate Permanent Subcommittee on Investigations, U.S. Vulnerabilities to Money Laundering, Drugs, and Terrorist Financing: HSBC Case History. (Washington, D.C.: United States Senate, 2012).
 Office of National Drug Control Policy, US/Mexico bi-national drug threat assessment, (Washington, D.C.: Executive Office of the President of the United States, 1997).
 D. Kar & S. Freitas, Illicit Financial Flows from Developing Countries Overthe Decade Ending 2009, (Washington, DC: Global Financial Integrity, 2011).
 D. Kar, Mexico: Illicit Financial Flows, Macroeconomic Imbalances, and the Underground Economy. (Washington, D.C.: Global Financial Integrity, 2012).
 A. Hollingshead, Trade Mispricing And Mexico: A Problem In Both Directions, Financial Task Force, http://www.financialtaskforce.org/2012/02/01/trade-mispricing-and-mexico-a-problem-in-both-directions/ (Accessed May 3, 2013).
 Kar, Mexico: Illicit Financial Flows
 G. Friedman, Mexico and the Failed State Revisited, Stratfor Geopolitical Intelligence, http://www.stratfor.com/weekly/20100405_mexico_and_failed_state_revisited (Accessed May 3, 2013).
 R. Baker, “Plundering a Continent,” Association of Concerned Africa Scholars (2012), http://concernedafricascholars.org/bulletin/issue87/baker/.
A.L. Callegari, Lavado de dinero: blanqueo de capitales: una perspectiva entre los derechos mexicano, espanol y brasileno. (Mexico, 2010).
M. Camacho, Fenomeno de lavado de dinero en Mexico: causas, efectos y propuestas para reforzar su combate. (Ciudad de Mexico: Facultad de Derecho UNAM, 2008).
J.G. Castaneda, Ex Mex: From Migrants to Immigrants. (New York: The New Press, 2007).
J. Madinger, Money Laundering: A Guide for Criminal Investigators (Third Edition). (Boca Raton, Florida: CRC Press – Taylor & Francis Group, 2012).
M. Naim, Illicit: How Smugglers, Traffickers, and Copycats are Hijacking the Global Economy. (New York: Anchor Books, a division of Random House, Inc., 2005).
Farhana Hossain and Xaquín G.V. (2011, September 11). The Reach of Mexico’s Drug Cartels, The New York Times, http://www.nytimes.com/interactive/2009/03/22/us/BORDER.html (Accessed May 3, 2013)
S. O’Neil, Trade-Based Money Laundering in Mexico, Latintelligence, http://www.shannononeil.com/blog/trade-based-money-laundering-in-mexico/ (Accessed May 3, 2013).
J. Preston & S. Dillon, Openning Mexico: The Making of a Democracy, (New York: Farrar, Straus and Giroux, 2004).
Alert Global Media, Report on the money laundering laws and regulations in Mexico, (Miami, FL: Alert Global Media, 1997).
Senate Permanent Subcommittee on Investigations. U.S. Vulnerabilities to Money Laundering, Drugs, and Terrorist Financing: HSBC Case History. (Washington, D.C.: United States Senate, 2012).
Stratfor Geopolitical Intelligence, Evolving U.S.-Mexico Relations and Obama’s Visit, http://www.stratfor.com/analysis/evolving-us-mexico-relations-and-obamas-visit (Accessed May 3, 2013).