- Mohammed El Qorchi, Samuel Maimbo, and John Wilson
- Published Date:
- August 2003
Historically, IFT systems are relatively commonplace. Despite the different terminology ascribed to IFT systems—fei-ch’ien (China), hui kuan (Hong Kong), hundi (India), hawala (Middle East), padala (Philippines), and phei kwan (Thailand)—they developed to provide monetary facilitation of trade between distant regions at a time when conventional banking instruments were either absent or weak. Over time, the operational features of speed, low cost, cultural convenience, versatility, and potential anonymity led to their use for various legal and illegal remittance purposes.
Informal hawala systems have typically thrived in jurisdictions where the formal banking sector is either absent or weak, or where significant distortions exist in payment systems as well as foreign exchange and other financial markets. Generally, except for cases where the purpose of using the informal sector is of an illegal or criminal nature, the growth of informal funds transfer systems seems to be negatively correlated with the level of development and liberalization of the formal financial sector. The study found that these systems are more likely to be prevalent in jurisdictions where the formal banking sector is either virtually absent or not functioning, as is sometimes the case in conflict-torn countries, or does not provide a reliable, cost-effective, and convenient mechanism for the transfer of funds. Where these conditions exist in recipient countries, the system can be used particularly for migrant labor remittances as well as humanitarian, emergency, and relief aid. The attraction to the informal funds transfer systems is also likely to be heightened in countries where inefficient banking institutions operate in an environment of financial policies that include foreign exchange controls.
Illegitimate use of the informal hawala system could occur regardless of the level of development of the financial sector. In cases where the intent of the user is of an illegal or criminal nature, the use of informal financial systems will occur irrespective of the level of financial sector development in the country. While both the formal and informal financial sectors are vulnerable to abuse, the potential anonymity that the system offers the users renders it susceptible to smuggling activities; capital control circumvention; customs, excise, and income tax evasion; money laundering; and terrorist financing operations. These crimes are not new and law enforcement agencies have long been concerned about informal financial mechanisms. For financial sector regulators, however, legislation against financial crimes is a relatively recent phenomenon. In drafting new international standards against financial crimes—registration, licensing, reporting, and record-keeping requirements—financial authorities also need to consider the settlement process between hawala operators and the economic and regulatory implications of hawala-type systems.
The nature of the settlement process of hawala transfers has implications for economic and regulatory policies. Developing appropriate responses to IFT systems requires a clear understanding of both the remittance and settlement mechanisms. Essentially, the accounting details of these informal transactions are similar to those of other international payments, including ones that go through the banking system. Like the informal hawala system, banks do not necessarily move physical cash between branches or correspondent banks when effecting transfers. The main difference between hawala and formal institutions is that the subsequent settlement of hawala accounts usually remains outside formal operating channels that are regulated by national authorities.
Because informal hawala transactions are unrecorded in national accounts and other statistics, the data available to policymakers do not offer a comprehensive and accurate description of the economic and monetary situation of a country and are likely to limit the effectiveness of their policies. A hawala transaction is a balance of payments transaction, not because “money is sent” across borders or there is any recorded purchase or sale of foreign exchange, but because the transaction is intrinsically linked to changes in international assets and liabilities. However, while hawala and other IFT transactions are conceptually part of national BOP accounts, accurate compilation is almost impossible. Nevertheless, even though national authorities are unable to directly maintain records of informal financial transfers, the indirect effects of these transactions on monetary aggregates and operations, as well as on the balance of payments, should be taken into consideration. The system reduces the amount of statistical information available to policymakers on the level of economic activity in the country.
IFT systems have fiscal implications for both remitting and recipient countries. First, hawala operators are typically not taxed. The revenue collection structures required for informal financial business do not exist. Second, the business activities of IFT users are also likely to evade direct and indirect taxation. Third, since the settlement of accounts between hawala operators may include underinvoicing and smuggling of goods and services, the government may also incur losses in its customs and excise duty revenue.
IFT transactions cannot be reliably quantified since accessible records are scarcely available for statistical or BOP purposes. Despite this limitation, certain considerations can be made of the dimensions of IFT transactions, and there are some approaches to quantification that can give indicative results. While these results are rough simulations, they indicate that the monetary and fiscal implications of IFT systems remain significant.
Current regulatory and supervisory practices vary between hawala-recipient and hawala-remitting countries. Overall, the study found distinct differences between the recipient and remitting countries’ regulatory and supervisory responses toward the informal hawala system. In recipient countries, concerns over foreign exchange management, capital movements, the quality of the formal financial sector, and the level of political stability have been important influences on the regulatory attitude toward the system. However, hawala-remitting countries generally have fairly liberal foreign exchange policies and developed financial sectors. In these countries, the regulatory and supervisory interest primarily stems from concerns about their potential criminal abuse.
Emerging approaches to international standards need to sufficiently take into account specific domestic circumstances. In the wake of the recently heightened concerns that money launderers and terrorist groups use IFT systems, the number of national and international regulatory initiatives to license or regulate their activities has increased. A number of countries have decided that the potential anonymity characterizing these systems presents risks of money laundering, terrorist financing, and other law enforcement concerns, which preclude a policy of benign neglect. This said, the paper cautions against the application of emerging international standards without due regard to specific domestic circumstances. Developing international regulatory and supervisory standards for informal funds transfer systems is a complex process. Differences in the stages of economic development, in general, and the financial sector, in particular, imply that national regulators need to give careful consideration to country-specific circumstances and national legal systems.
Regulators must bear in mind that prescribing regulations alone will not ensure compliance. Regulations are not a panacea for possible abuse of the IFT systems. Specifically, regulators need to possess the appropriate supervisory capacity to enforce the regulations. Also, they must bear in mind that experience shows that restrictive methods will not drive out all businesses involved in unlicensed financial transfer activity from the market. The informal banking system cannot be completely eliminated by means of criminal proceedings and prohibition orders. Policymakers should acknowledge the existence of practical reasons, from the customer’s point of view, to resort to these methods rather than formal banks for international payment purposes. As long as such reasons exist, the hawala and other IFT systems will continue to exist.
For purposes of long-term financial sector development, addressing the potential risks of financial abuse and criminal activity requires a two-pronged approach. In the majority of countries where IFT systems exist alongside a functioning conventional banking sector, it is recommended that hawala dealers be registered. In these systems, additional efforts should be made to improve the level of transparency by bringing them closer to the formal financial sector without altering their specific nature. Simultaneously, the regulatory response must address the weaknesses that may exist in the formal sector. The formal and informal financial systems benefit from their mutual deficiencies and each tends to expand when the condition of the other is impaired. High transaction costs; long delays in effecting money remittances; exchange controls; and overly bureaucratic policies and procedures for simple money transfers in the formal system are major incentives for the existence of the informal financial system. To face the challenge, the formal sector should tackle its deficiencies and enhance its competitiveness. In conflict-torn countries with no functioning banking system, imposing requirements beyond basic registration may not be feasible because of the lack of supervisory capacity.
Clearly, the development of various informal funds transfer systems over many years and across many countries points to the important role that these systems can play in the absence of a robust and efficient formal financial sector. However, risks of misuse exist considering the informal nature of these systems, particularly anonymity and lack of records. The ability of the formal financial sector to respond to the legitimate market demand for hawala-type transactions, coupled with prudent regulatory policies for hawala operators, requires sound and sustainable macroeconomic policies, a well-developed payments system, and a healthy financial sector. Notwithstanding the progress apparently made by the formal sector in expanding its activity at the expense of informal activity, these gains are not definitive and can easily be reversed. Poorly functioning financial systems or just the deterioration in financial or macroeconomic conditions could pave the way for greater recourse to informal payment systems. A setback in financial and exchange liberalization or the rise in the exchange spread between official and parallel market exchanges can always induce a greater reliance on IFT activity.