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Could the war in Ukraine encourage Western leaders to finally deal with shadow finance?

by Johnny Flentø

'I say to the Russian oligarchs and the corrupt leaders who bilked billions of dollars off this violent regime: no more… We are coming for your ill-begotten gains.'
-Joe Biden at the 1 March 2022, State of the Union Address

One way that Western sanctions on Russia are supposed to work is by pressuring influential Russian business leaders to oppose Putin’s foreign policy actions. Russian oligarchs have kept vast sums of wealth and financial assets in Western financial systems and now Western leaders have moved to leverage this basic fact to pressure Russia into greater compliance with international norms by, for example, seizing the luxury yachts of Russia’s economic elite.

But there are several hurdles to enforcement of Western sanctions designed to target Russia’s oligarchy. Many of these hurdles are related to a long-established global financial architecture that includes secrecy jurisdictions, offshore tax havens, shell corporations, and the other financial and legal institutions that enable large-scale illicit financial flows. This architecture includes also major centres in the West — such as Zurich, the City of London, South Dakota, and Delaware — and offshore jurisdictions in the Western orbit — such as the Cayman Islands or the British Virgin Islands. Russia’s economic elite, much like their counterparts anywhere in the world, have used these centres to park and hide assets out of reach.

This will make enforcement of sanctions more difficult. But it might also provide the impetus for Western leaders to take less tepid steps towards greater financial transparency and regulation of the more shadowy corners of global finance.

The wealth of Russia’s oligarchs

When the Soviet Union imploded, a few individuals siphoned vast amounts of Russia’s public assets and wealth to private companies. Subsequently large sums were transferred abroad, including to tax havens. Western banks, lawyers, and accountants assisted willingly and made good business from these transactions.

The post-Soviet government began its economic reform with a privatization programme. This privatization programme allowed Russian businessmen to acquire stock in previously state-run firms at very low prices. When Yeltsin’s administration needed finance for the 1996 elections, it designed a scheme to borrow money from these new oligarchs against security in shares of Russia’s most valuable firms. The scheme worked and Yeltsin was re-elected. But, when the Russian government defaulted on these loans, the oligarchs obtained controlling stakes in many of Russia’s most profitable companies — including steel, mining, shipping, gas, and oil.

For decades since, Russian money has flowed to Western economies and Western leaders were at ease with these financial flows. The huge sums helped stimulate OECD economies, not least the real estate market in London but also, for example, steel mills in Denmark and shipyards in France. Russian money also enabled generous contributions to political parties, such as the conservative party in the United Kingdom.

The pledge for sustainable development

The world has agreed on the Sustainable Development Goals, including SDG 16, which aims to reduce illicit financial flows (16.4). According to the UN, illicit flows comprise financial flows that are illicit in their origin, transfer, or (intended) use, including tax evasion.

Much of the flows linked to Russian oligarchs fits this definition. Efforts to track and freeze these assets should be encouraged, not just because of the war, but because of their illicit nature.

A key engine behind inequality

Much economic research is done to estimate the volume of illicit flows and hidden assets, for example. A rather conservative estimate is that around 10% of the world’s GDP is held in tax havens and secrecy jurisdictions. Although we are talking of large amounts in absolute terms, the Russian oligarchs account for only a fraction of this wealth proportionally.  

Any new momentum to crack down on illicit flows, created by the war in Ukraine and efforts to freeze Russian money out of the Western system, could also be used to go after all the dirty money hiding in secrecy jurisdictions.

As long as there are financial havens to hide wealth, some people and companies will use it. This is clearly demonstrated in the Panama and the Pandora Papers  which have shown just how pervasive these practices are. It is not just oligarchs and drug lords that hide their wealth, but known and loved companies, performing artists, and politicians.

What needs to be done?

The key tools to start eliminating or at least drastically reduce illicit financial flows and hidden wealth are country-by-country reporting on taxes and ownership transparency — including mandatory disclosure of beneficial ownership in real estate, trusts, companies, and corporations. 

The UK needs to deal with the legal regimes they helped set up some 50 years ago, in jurisdictions like the Cayman Islands and the British Virgin Islands, which are some of the largest financial havens in the world. Secondly, the UK has a challenge in its real estate register, which allows secret ownership through cascade-like ownership structures, making especially London a magnet for real estate buyers keen to hide their money.

In the US, South Dakota allows billionaires to establish dynasty trusts in so-called ownership limbo, allowing wealth to be held outside the reach of tax authorities for generations. The state of Delaware accommodates and protects anonymous ownership of limited liability companies, with no obligation to disclose who the real beneficial owners are.   

The same tools that can help curb illicit financial flows and bring the world closer to achieving the objectives of SDG 16 are also useful to governments that rely on sanctions for international security. Country-by-country reporting and greater ownership transparency make compliance with and the enforcement of these types of sanctions easier. 

Johnny Flentø is an adviser at the Institute of Economics, Development Economics Research Group (DERG), at Copenhagen University. He is a co-author of an upcoming WIDER Working Paper on illicit financial flows.

The views expressed in this piece are those of the author(s), and do not necessarily reflect the views of the Institute or the United Nations University, nor the programme/project donors.

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