Capital controls linked Frauds in International Trade

Punjab national bank fraud involves international trade where goods and capital move in and out of country. While the goods move physically, the capital moves (or at times doesn't) through various electronic arrangement between banks. The aim of this post is to enumerate various frauds that have been noticed in this area, and which are linked in some ways to capital controls that India maintains. They wouldn't have occurred but for the myriad capital controls placed on our economy while keeping an open current account. When goods can move free, and capital cannot, one can become a mule for the other. Other than capital controls, money laundering may also be the motive in few of them.

Frauds in international trade

Anyway, here are the common modus operandi of some popular frauds

1. Under or Over Invoicing of Exports/Imports - The 90s fraud

This was a common method of evading capital controls and to gain wrongful incentives under various government support programs for exports. The value of goods mentioned on the invoices are manipulated towards nefarious ends. The exports are over-invoiced in order to get hawala money into the country or to get higher amount of drawback or incentives which are based on percentage value of exports. The imports are under-invoiced to avoid customs duty. The import of goods are rarely over invoiced.
The above mode has become extinct to a large extent after services trade picked up. The under/over-invoicing of services is far easier to carry out and the possibility of detection is harder. Therefore when it comes to goods, the over invoicing prevails only to get incentives under government of India schemes and the under-invoicing of imports prevails to save customs duty. With the risk management systems getting robust, this method might slowly die a natural death.

2. Raising cheap loans abroad - the Nirav Modi way

Based on the undertaking of a local bank, loans can be raised abroad. Over years, Government of India has relaxed the rules for raising capital abroad. However, it still is an area where only established big players can enter.  It is not easy to raise money abroad unless backed by a strong corporate presence and good past record. A Tata or an Infosys may raise foreign capital abroad, but a Gitanjali (for all its star studdedness) might struggle. This is where the local bank undertakings/guarantees come in. The local banks usually need collateral, and if this can somehow be bypassed by showing fake assets or corruption, a con job may be pulled. This is how the current PNB scam has taken place. PNB had given the required letter of undertaking though electronic means (SWIFT) and rolled it over after the due period. With each cycle, the interest costs added up, leading to ballooning of the amount. While the total amount involved may indeed by around 11000 crore rupees, I believe that if one accounts for the goods in transit, the loss should not be more than one or two cycles of goods being traded. That should ideally be around one sixth of the amount being projected at the maximum. Even this amount comes to around Rs 2000 crore which would be a stiff loss.

[On a side note, the interest rate differential (between LIBOR+ and INR interest rate) makes it attractive to raise loans in foreign currency. While the inflation differential should adjust the exchange rates in the market commensurately, thus wiping out interest differential gains in the long run, it doesn't appear to wane the appetite of foreign currency loan takers. A deeper look may be needed to uncover the reasons.]

3. Round tripping of precious goods (Gold, diamonds etc) 

Round tripping of precious metals and gems is an easy way to achieve two things. One, to transfer money in and out of country at minimal cost, and second, to raise cheap loans linked to exports credit.
Usually gold of 24 carat purity is the metal of choice. Gold bars of 24 carats are imported against an advance license by DGFT, which allows the gold bars to be brought in without payment of customs duty, and after doing minimal value addition through melting, gold coins of 24 carats (or crude gold jewelry of 24 carats) are exported out. The exported jewelry/coins are melted back into bars at the foreign location, usually by a related party, and is sent back as fresh consignment of gold bars. The entire cycle can be completed within 3 to 10 days, but the export credit can be rolled over the period of around 120 days. The banks give credit for the entire term of 120 days, usually at lower prime lending rates for exporters, and this loan can be easily used by the exporter to lend in the market at higher interest rates. Many gold exporters have made a fortune by raising such cheap loans and rolling it over while the gold consignments round trip multiple times a year between a tax free country (like Dubai) and India. The foreign trade policy in fact allowed this to happen. The loophole was thoroughly exploited till last year when the proverbial thing hit the fan with some people achieving turnover of Rs 40000 crores a year. It has been made a little difficult now with the coins exports of 24 carat being disallowed under advance license scheme. 

A similar modus operandi can be (and were) set up for round tripping of diamonds in the name of diamond cutting and polishing. 

4. Fake Services exports 

Not many government agencies know what goes on within the services sector, especially in the IT and ITeS areas. The nature of the business cannot be penetrated easily by untrained. This makes it easy for the operators here.
For trading across borders in this area, the IT service firms raise an invoice in the name of firms abroad, which is endorsed by an official from Department of Electronics (DoE) on a form known as SOFTEX and the money is realized into the banks against this form. The RBI gets the realization report from the Banks through their EDPMS and this aggregated data is used as services trade statistics. There is at present no other (or better) services statistics in India. While some services such as transport, erection and maintenance etc leave physical trail, IT services are a black box. Most IT services are provided online, and payment is received against it through normal banking channels (or parked abroad if need be through under invoicing). IT being a vast area, it is difficult to assess the exact value of the services provided. While rough indications such as manpower required, man hours engaged, size of firm etc., may be used to determine the value of software services provided, it is still an inexact science as the underlying value of service is a function of intellectual property and skills involved. Therefore the DoE officer who assesses  the invoices for accuracy is in a precarious position. Going by the market intelligence, it appears that SOFTEX forms gets endorsed blindly without any penetrating verification. This makes the fake IT services invoicing a heaven for hawala operators. If you want to get a million dollars into India, the easy thing to do is to bill a service exports for that much. Once the money is in, deep bookkeeping practices may be used to cover up any profits and taxes. Ditto for imports of IT services. Services firms can also be opened and closed at will.
This modus operandi might also wane with cyrpto technologies kicking in. 

Endnote

Other than these, there are Hawala operators who try to find ways to launder the money internationally through methods such as opening shell companies at tax havens and coming back through equity participation routes. As technology progresses, newer methods will evolve, right from complex mechanisms of  crypto-currencies to simple startup capital appreciation scams. It's a cat and mouse game between investigating agencies and those who wish to break the rules. The solution is to strengthen institutional mechanisms (e.g better central bank oversight, better technology and software integration) to counter such frauds and speedier judicial process to bring the culprits to book.