Settlement Procedures

Returning to the prototype hawala remittance discussed earlier, there are numerous means by which outstanding positions can be settled. Below, we briefly outline some commonly used methods, such as simple reverse informal hawala transactions, bilateral and multilateral financial settlements, bilateral and multilateral trade, smuggling, purchase of international services, and other international asset transactions including capital flight. We also consider the possibility of more complex settlement procedures involving higher level intermediaries in the financing chain. Although the settlement aspect of informal hawala transactions is elusive, there are various possible designs, and some observations can be made about the mechanisms. Detailed accounting steps involved in the principal settlement mechanisms can be found in Appendix I.

Simple reverse transaction. The most obvious form of settlement for hawala accounts would seem to be simple “reverse hawala,” that is, a remittance or payment going in the opposite direction (see Appendix Table A1.1). While it is possible, the likelihood of account balancing through a “reverse hawala” is still fairly small, not only because of the low probability that hawala remittances from country B to country A would pass through the same hawaladars but also, more important, because aggregate remittance flows are highly asymmetrical among countries. Some countries, such as those with large numbers of migrant workers, are natural net sources of remittances; countries that are sources of emigration are natural net recipients of such remittances. Thus, the GCC countries, Europe, and even the United States will have large outflows of private transfers, while South Asian and some Latin American countries will probably have substantial net inflows. It would, therefore, seem mathematically difficult for a significant fraction of hawala activity to be “settled” through simple or bilateral reverse transactions.

Complex reverse transaction. Hawaladars could use more complicated reverse informal hawala transactions for settlement purposes. In a country subject to exchange or capital controls, HB could receive local currency from an individual interested in having funds abroad (country C). If the initial transaction is not settled, HB might ask HA for assistance. HA would recommend another hawaladar in country C (HC), either because they are correspondents or because an open position between them had remained unsettled from an earlier transaction. Alternatively, HA can instruct HC to make funds available to any beneficiary in country C. In other cases, HB would deal directly with HC and instruct HA to settle the transaction, which would also clear the initial position. Complex or multilateral reverse transactions assume the existence of a large network of hawaladars across countries.

Bilateral financial settlement. Conceptually, the simplest manner of settling a hawala transaction is for HA to make payment directly to HB, or into HB’s bank account (see Appendix Table A1.2). In this way, HA’s and HB’s balance sheets are restored to the status quo ante and accounts are squared. This kind of settlement may well take place on occasion, but probably not in HB’s home country account. Bilateral financial settlement through HB’s home country account implies an explicit foreign exchange transaction such as the purchase by HA of HB’s local currency counterpart to the hawala amount, or an absence of restrictions in country B on residents’ holding of foreign currency accounts. In such a case, HA could simply deposit to HB’s credit the foreign currency amount received from the initial customer.

Multilateral financial settlement. The absence of constraints permitting simple financial settlements is, however, an unlikely configuration for countries that are hawala recipients, so settlements in this form will probably not transpire, at least in the variant just described. A more likely scenario might be bilateral financial settlement using third country accounts. That is, HA can settle his obligation to HB with a deposit to some account maintained by HB in country C, which is presumed to be a country, like A, that accepts convertible currency transactions. Obviously, this kind of settlement entails a form of capital export/capital flight on the part of HB, who now acquires a foreign-currency-denominated balance outside country B, as recompense for a payment made in his local currency on instructions received from HA. Since no actual foreign exchange transaction (purchase/sale) has taken place in this sequence of events, the underlying exchange rate remains implicit in the relationship between the hawala remittance and the settlement amounts. “Financial settlement” in a third country illustrates (1) how connected international transactions can take place in circuitous fashion and (2) the possible connection of the hawala channel to “capital flight” in recipient countries with exchange controls.

Bilateral trade. An obvious possible use of HB’s balances in a foreign bank, if settled with HA, might be to finance imports to country B (see Appendix Table A1.3). Another possibility would be for HA to pay the costs of these goods. Again, there are various possibilities. In essence, HA clears his obligation to HB by exporting goods to HB, and the latter satisfies his claim by accepting goods rather than cash. The simplest variant of settlement via trade would be the export of goods from country A to country B. This can be envisioned as a trade flow directly between HA and HB (who may also be in the import-export business), or, more generally, it can be envisioned as trade between third parties in countries A and B, that is, individuals/groups to whom the original hawaladars have transferred their bilateral claims and obligations.

Multilateral trade. With this consideration, the potential complexity and variety of “hawala settlement” comes into even sharper perspective. It is also possible to write plausible scenarios in which exports originate from a third country. Thus, the settlement counterparty to a hawala remittance (or various transactions) from the Middle East to a South Asian country could well be exports to that country from Europe that are paid for by the hawaladar in the Middle East. A second scenario might involve exports from a third country to a location that is not country B, that is, HB has transferred his claim to an associate in another country. This seems likely when HB has a liability to a hawaladar who is located in that other country. Cases like these, obviously, will entail a chain of transactions in which the original informal remittance is likely to be totally invisible.

Misstatement of trade values. A related type of trade settlement would not be outright smuggling but over- or underinvoicing of exports and imports. This would have a similar, if slower, effect in “reimbursing” hawaladar claimants for sums advanced to recipients of remittances. Here the potential complication is not concealing imports entirely, but rather letting them be recorded at an understated value. In the case of undervaluation, of course, the importer in country B may also benefit from reduced tariff payments, a factor that in theory can also be taken into account between HB and HA as they work out such transactions.

Smuggling. In considering “trade settlement” of hawala, the possibility of smuggling into country B looms as another variant. After a typical hawala remittance, HB would be “entitled” to a quantity of merchandise, which is equivalent to the value of the hawala payment made, at the implicit exchange rate. A traditional answer to this problem has been the smuggling of merchandise into country B, which “clears the books” without the complication of declaring the trade flow or associated payments. The classic, often-cited instance of smuggling as the “settlement counterpart” to hawala is the gold trade, say, between the GCC countries and South Asia. Given the labor/migrant relations between South Asia and the GCC countries, the predominant remittance flows, the currency rules, the popular desire for gold, combined with India’s (since discarded) longtime ban on private gold imports, it is hardly surprising that gold smuggling across the Indian Ocean was a busy activity that fit into the hawala context as a natural clearing and settlement mechanism.

International services. Another acknowledged form of clearing/settlement for informal hawala transactions is the provision of travel or other international services to HB or other residents of country B, financed by HA or associated consolidators (see Appendix Table A1.4). In effect, residents of country B who want to travel or purchase services abroad, for medical or educational purposes, for example, but who might be constrained by foreign exchange rationing imposed by the authorities, may have an option to “purchase” these services with local currency from HB or local consolidators. As explained above, reverse hawala is a well-suited channel to conduct these transactions. HB himself is the potential consumer of international services, and this transaction is paid for by HA, which liquidates both accounts.²¹

International investment transactions and capital flight. This is similar to HB acquiring a foreign bank deposit, but with a wider menu (see Appendix Table A1.5). In such a case, HB or his financial correspondent could acquire other foreign assets (financial paper such as bonds or stocks, real estate, and the like) in exchange for a claim on HA. HA, for his part, would likely purchase the desired assets in the name of HB or HB’s associate, so as to liquidate the liability. In this scenario, HA’s liability is discharged, and HB remains with external financial or real assets over a broad range. In technical terms, HB’s external claim on HA is exchanged for a foreign asset of another kind. The procedure described here might well be used in countries where the acquisition of foreign assets is forbidden or restricted to specific types or amounts in an effort to “conserve” foreign exchange or reserve the stock of foreign exchange for sanctioned, official uses. The settlement will indeed offer an interesting channel for entities looking to “flee” the domestic currency and acquire external foreign currency assets. Once again, in the chain of transactions discussed here, none of the transactors have carried out an open purchase or sale of foreign exchange, but they have operated in separate currencies using an implicit exchange rate between them. From the moment of the initial remittance, at least two of the participants, HA and HB, have assumed international financial positions without going through the official sector. This is unlikely to be a problem for HA, but HB or his client has from the start acquired a cross-border asset, his claim on HA, merely by paying out local currency funds to a beneficiary of the remitter.

Higher level intermediaries. As implied by the potential complexities of the arrangements, settlement of informal remittances is likely to go beyond direct bilateral deals and may well involve several hawaladars located in different countries. It is also plausible that there are higher levels of financial consolidation in the hawala chain, that is, a smaller number of players who each take larger positions than the original intermediaries, HA and HB. Hawaladars who have wide networks and conduct substantial transactions can play this role, as can individuals or entities not engaged in hawala at all. However, neither on-site discussions nor the literature revealed any specific instances where individuals or groups admitted to being consolidators.

Balance of Payments

As illustrated earlier, the accounting and mechanics of the informal hawala system and transfers through other IFT channels are, in many ways, similar to transfers made through banks, exchange-houses, and other entities in the formal sector of the economy. All such transfers are, in theory, part of the balance of payments (BOP) accounts, whether or not “money is actually moved” or a foreign exchange purchase or sale takes place, because the remittance itself is intrinsically paired with an international capital flow that provides the financing. That is, considering the prototype hawala remittance as a whole, the action of the remitter to “send funds” across borders to a beneficiary is enabled by the willingness and ability of at least two hawaladars to finance this transaction by changing their cross-border asset and liability positions. The hawaladar on the remitter’s side receives payment and assumes a cross-border liability, with the agent on the receiving side making payment in exchange for a cross-border asset.

In simple balance of payments terms, the action of making a hawala remittance gives rise, at least in concept, to the following BOP entries for the two countries involved, of which there are a number of components (see Figure 5.1).

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Balance of Payments Entries in Remitting and Recipient Countries

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The transfer is a debit for the remitting country, offset—indeed, financed—by an increase in liabilities (credit) of the remitter, and the converse obtains for the receiving country. “Net” effects for both countries are zero. Three aspects of this example are useful to keep in mind for understanding the BOP context of such transactions.

First, a hawala remittance is indeed a BOP 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 that are the financing counterpart. Thus, a seemingly domestic payment, such as paying cash from one U.K. resident to another, may generate other, cross-border transactions that are all part of a set of BOP flows. If these transactions could be measured and compiled into each country’s BOP accounts, they would be visible.

Second, it is intuitively clear that none of the four components of this prototype informal sector transaction is likely to be measured or captured in the BOP accounts of either country involved. The individuals or entities involved are not part of any “reporting universe” that files information with the relevant authorities. This means not only that IFT transactions are not reflected in national BOP accounts but also that they probably will not contribute to errors and omissions, so there is not even an indication that something is missing or badly measured. As suggested by the above discussion, nonzero errors and omission values depend crucially on partial measurement of connected international transactions. In a compact example such as this one, if all the components of the sequence are beyond measurement, there is no trace of errors or omissions at all.²²

Third, cash movements across borders play no role in hawala remittances nor do they, indeed, in most international remittances.²³ Nothing in the sequence of the hawala transfer, or most of the settlement variants, causes physical cash to move across borders. What “moves” are asset and liability positions, that is, bookkeeping entries of the hawaladar participants and related parties. Indeed, the hawala payments flow—from a remitter to HA (in, say, dollars) and from HB to a recipient (in local currency)—is typically domestic, not cross-border. Of course, if HA clears the liability by paying the cash collected in this transaction into HB’s account in some banking system, the currency may find its way back to some other venue, or to the United States, but it is not destined for South Asia. This point is worth bearing in mind because in some countries, notably Pakistan, purchases of cash dollars in the black or parallel market by the authorities are counted as part of hawala remittances in compiling net inward transfers in the balance of payments statistics. In fact, such currency is not part of hawala remittances, and only a fraction of the total is likely to be a part of “current transfers” in a technical sense.²⁴

Therefore, the main point to be made with regard to the balance of payments context is that while hawala and other IFT transactions are conceptually a part of national BOP accounts, accurate compilation is highly unlikely. Published BOP accounts probably contain little numerical—and certainly no identifiable—traces of hawala, and, thus, no empirical handle can be grasped to quantify or explore the dimensions and forms of these kinds of transactions.²⁵ Any attempt at quantification (such as the one we make below) must be based on indirect measurement and heavy use of prior information or parameters in whatever model may be used.

Macroeconomic Implications

Monetary and exchange policy formulation. Because IFT transactions are not reflected in official statistics, the remittance of funds from one country to another is not recorded as an increase in the recipient country’s foreign assets or in the remitting country’s liabilities. While, on the one hand, the direct impact on the policy options of IFT systems is not obvious, however, its indirect impact on monetary and exchange rate policy choices can be significant. The size of the informal financial sector can grow considerably if the distortions between the official and parallel exchange rate are significant. On the other hand, large-scale hawala or other IFT transactions could exacerbate these distortions by diverting foreign currency away from the banking system and further widening the exchange spread. Such developments could influence the formulation and effectiveness of exchange rate policy. The flight of foreign currency outside the formal banking sector could also lead monetary authorities to change the course of monetary policy. They could, for instance, encourage banks to offer attractive interest rates on both domestic and foreign currency deposits with a view to reducing the amounts of domestic and foreign currency kept outside the banking sector.

Composition of broad money. Because there is no physical movement of cash during informal hawala transactions, only value changes hands; broad money remains unaltered. The beneficiary receives funds in local currency from the hawaladar contact in the recipient country. If the funds come from the hawaladar’s cash balances, the direct effect of the transfer of the funds between the concerned parties on broad money is therefore nil. The structure of a monetary survey suggests that almost nothing in hawala remittances or other IFT systems has significant effect on the components of overall national banking assets and liabilities. However, the composition of broad money in a recipient country may be affected by informal hawala transactions. This outcome is related to the cash nature of these transactions. The pool of cash available to hawala in recipient countries (HB) is supplied by individuals or groups in these countries that provide local currency to receive funds from abroad. The monetary effect of these informal transactions, in comparison with official transfers, would be reflected in a decline in deposit accounts (possibly savings and time deposits) in favor of an increase of cash in circulation.²⁶ Since beneficiaries of remittances are usually in low-income categories and rarely have bank accounts, and considering that those interested in using hawala channel transactions for accumulating assets abroad are usually in higher income groups, these transactions would have an impact on the composition of broad money. The adverse impact of the informal hawala system on the banking sector and the related development of a cash economy could increase the instability of demand for money, limit financial intermediation, and affect monetary transmission mechanisms, restraining thereby the efficiency of monetary policy. The flourishing of a cash economy and the related leakage of money away from the banking system could also constrain the availability of bank resources and push up interest rates in the economy, as banks attempt to attract deposits by offering higher interest rates. The impact on interest rates is likely to be aggravated if the loss of government revenue from hawala-related activities significantly exacerbates the fiscal situation and requires the government to resort to monetary and bank financing.

Private consumption patterns. Remittances, in general, either through the formal or the informal system are reflected in private consumption. Even though some expatriate workers send funds home for investment purposes, such as in real estate, it is generally agreed that remittances are overwhelmingly aimed at covering the basic needs of families in home countries. Hawala transactions initiated from countries with exchange and capital controls tend to reinforce this consumption pattern, since the indirect transfer of funds in the recipient country from wealthy groups to relatives of expatriate blue collar workers through hawaladars tends to favor consumption spending over savings. The wealthy groups may use their savings accounts to provide funds in local currency and in cash to local hawaladars, who would subsequently funnel them to beneficiaries with high propensity to consume.

Foreign exchange operations. In economies structurally in need of foreign currency, the loss of foreign exchange in the formal banking system related to the use of IFT systems has contributed to a “virtual” parallel exchange market where foreign exchange can easily be accessed. Even though the supply of foreign exchange through the IFTs disappears from the official market, the informal supply still finances imports of goods and services and thereby responds at least partially to a potential demand for foreign currency that would otherwise have been expressed in the official market. In some countries, such as Pakistan, the shortage of foreign exchange in the official market has required central banks to purchase foreign exchange from the black markets. Such a move indirectly influences the level and composition of broad money. Purchases from the parallel market entail a “recycling” of foreign currency into the formal sector through increases in central bank foreign assets, but foreign currency would be supplied by foreign correspondents of money changers or other intermediaries.

Fiscal policy. Because they generally operate outside the formal banking system activity and do not pay any taxes, the IFT systems have fiscal implications for both remitting and receiving countries. Moreover, like any underground economic activity, IFT systems also entail a loss of business for the financial sector and thereby reduce government income.

The loss of government revenue occurs in two ways: first, through loss of direct taxes in the form of income and other business taxes. The income and profits of hawaladars are unrecorded and likely to escape taxation. Second, hawaladars do not pay indirect taxes such as VAT and other service taxes. The hawala business of fund transfers is not subject to other kinds of taxes, like the formal sector, such as registration fees, and so on. Under the assumption that the informal hawala system tends to favor basic consumption, government revenue may incur further loss because taxes on these goods are usually lower. However, this possible loss is not just related to IFT systems because transfers through the formal sector would have the same effect. In some cases, government efforts to encourage remittances through formal channels are accompanied by tax exemption or subsidies, which would also affect fiscal balances.

As mentioned earlier, reverse transactions may be intertwined with undeclared domestic and international activities. Related transactions used for settlements, such as smuggling, and under- and overinvoicing in domestic as well as in international transactions, evade tax systems or increase spending (subsidies). By facilitating bogus or irregular import and export transactions, the IFT system can indirectly have a deleterious impact on the government in the form of lower tax receipts from imports and expropriation of export subsidies. The loss of government income is not directly related to IFTs, but it is inherent in part of smuggling or tax evasion activities. In domestic markets, underinvoicing the value of real estate transactions or any other transaction conducted in the real or financial markets with a view to exporting funds abroad facilitates tax fraud and evasion. The informal nature of the informal hawala system, through reverse transactions, offers a discreet medium to those eager to send their wealth overseas without leaving detectable tracks. It offers a reliable medium that allows capital flight to safe havens and investment abroad without declaring the generated income to tax administration. By providing financing to unrecorded imports, the system indirectly favors the circulation of goods and facilitates import of smuggled goods—such as electronics, gold, and diamonds—contributing, therefore, to the expansion of informal economic activities that avoid tax payments.

Information and economic data. As an underground activity, IFT systems reduce the information available to policymakers, particularly central banks, and limit significantly the meaning of economic data by underestimating the factors that affect economic aggregates, including national accounts. In this regard, they constrain the capacity of economic authorities to have a truthful picture of the status of, and the changes in, economic activity; project its trends; and devise appropriate economic policy responses. This handicap may adversely affect policymaking in all economic areas, especially monetary and fiscal policies.

Quantitative Dimensions

Estimation constraints. It is intuitively clear that IFT transactions cannot be reliably quantified. It would be extremely difficult, if not impossible, to make accurate estimates of either balance sheet or turnover figures in the “money bazaars” or informal activities in general. These difficulties are compounded by the questionable legal status of foreign exchange dealings; the high proportion of smuggling in total foreign trade;²⁷ and the general lack of available records, especially for statistical or balance of payments purposes. This holds true for both the “remitting” and, especially, the “receiving” sides of the transactions. As discussed earlier, on the receiving side these transactions are sometimes associated with capital flight motivations and can involve contravention of exchange control regulations, so there is little incentive to keep or make records available.

Approaches to quantification. The limited literature²⁸ on international transfers and workers’ remittances, which recognizes that economic factors—such as black market exchange rates—influence transfer mechanism choices, uses standard data sources and does not actually attempt to quantify amounts sent through informal channels.²⁹ A few studies have tried to measure informal hawala transactions empirically, mainly through interviews with market participants.³⁰ Against this background, certain discussions can illustrate the possible dimensions of hawala and refer to some approaches to quantification that can give indicative results. Though conjectural, a few bases on which an effort can be made include

• the ethnic connection and “common knowledge” about the culture or characteristics of populations or countries with a hawala tradition;

• the number, or share, of a country’s nationals who are residents or working as expatriates elsewhere, since this will be an important factor in the scale of private remittances;

• the relative inability of banks and other institutions to quickly deliver funds, and the high cost of remittances through sanctioned channels; and

• the existence of an active parallel exchange market. The larger the divergence from the “official” exchange rate, the higher the incentive for all participants to divert their transactions into the informal market. Where parallel markets exist, there has generally been some available measure of the exchange rate divergences, or “black market premium.”

Most of these factors are not easily quantifiable, except in a very rough way. Even good data on the “number of emigrants” from potential recipient countries are generally lacking. What is usually available is a version of international transfers through sanctioned channels and some measure of exchange market conditions, such as official versus private rates.³¹ Details of the model specification, steps in the simulation procedure, and the results of the model are given in Appendix II.