(EST PUB DATE) COLOMBIA'S GROWING UNDERGROUND ECONOMY: ERODING ECONOMIC PROSPECTS AND STATE CAPACITY

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• Publication Date: March 1, 2001

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Screfl
Report
Office of Transnational Issues
DI Colombia Working Group
Colombia's Growing Underground
Economy: Eroding Economic Prospects
and State Capacity
A Research Paper
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March 2001
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Intelligence Report
Report
Office of Transnational Issues
� DI Colombia Working Group
Colombia's Growing Underground
Economy: Eroding Economic Prospects
and State Capacity
A Research Paper
This paper was prepared by the Office of Transnational
Issues and the DI Colombia Working Group. Comments
and queries are welcome and may be directed to the Chief,
Strategic Assessments Group, OTI, on
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Colombia's Growing Underground
Economy: Eroding Economic Prospects
and State Capacity
Key Findings
The underground economy in Colombia�a complex web of semi-legal and
illegal activities not counted in government statistics�is growing, eroding
economic prospects and state capacity.
Colombia's underground economy dramatically expanded
between 1993 and 1999 and may total nearly 60 percent of GDP:
� Of the three major components of the underground economy, a substantial
informal economy is longstanding but growing in scope and vitality
because of the formal economy's woes in recent years, spendthrift
governments, and stifling regulations.
� The drug economy is increasing because of an explosion of illicit crops
since the mid-1990s; Colombia has become the world's top producer and
trafficker of cocaine. In areas where the drug industry is concentrated, it
skews local prices, wages, credit, and investment.
� The insurgent economy is growing more menacing as Colombia's illegal
armed groups step up their involvement in the drug industry and gain
influence throughout the country by means of extortion, kidnapping, and
enforcement of guerrilla "laws." It has become parallel to�or a replace-
ment of�the formal economy, especially in the safehaven (despeje) of the
Revolutionary Armed Forces of Colombia (FARC) and in remote areas of
the south and east. Doing business with the insurgents is becoming an
economic alternative for some rural Colombians as the formal economy
falters�a vicious cycle that bolsters guerrilla rhetoric about the failings
of the "neoliberal" model.
The underground economy provides jobs and a means around excessive
redtape but, on balance, erodes economic prospects and state capacity. It
deprives workers and firms of legal security, reduces government tax
revenue, and fuels corruption and violence that discourage private invest-
ment and undermine institutions.
Bogota has made piecemeal progress in tackling the underground economy,
Policy steps in
the past two years reveal the government is moving down a slippery slope, as
Andres Pastrana's administration overcorrects to address unintended
consequences of earlier reform attempts. Colombian
authorities should continue to rein in government spending�freeing up
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ing out waste and corru tion
a num er or government P011C1S are
inadvertently encouraging further growth of the underground economy:
� Government borrowing to cover a large fiscal deficit is crowding out the
private sector. Bogota's imposition of a politically expedient and easy-to-
collect financial transactions tax has been counterproductive�the widely
disliked measure is causing increased tax evasion as checks are endorsed
multiple times rather than cashed.
� The lack of clear, stable "rules of the game" discourages investment and
adherence to government regulations. Tax evasion is significant, and
collection has hovered at some 11 percent of GDP despite seven tax
reforms in the last 10 years.
Colombia is unlikely to make substantial progress in the
next two to five years in reversing the underground economy, which is
deeply entrenched and requires a substantial commitment to comprehen-
sive, long-term solutions. in 2000
that the country requires sustained GDP growth greater than 4 percent per
year to begin sufficient job creation to reduce the size of the underground
economy:
� However, without major innovations and policy reforms, a sweeping
peace agreement, and a dramatic improvement in the security situation,
local and foreign analysts stress that Colombia�having escaped the fate
of the rest of the region in the 1980s�may be entering its own lost
decade
Looking ahead, a growing underground economy in Colombia will
adversely affect the formal economy and government effectiveness along
the border with neighboring countries, especially Ecuador, Panama, and
Venezuela. It will preclude a resurgence in private investment and
contribute to instability; the drug and insurgent economies in particular are
likely to bring increased violence and security problems:
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� Growth of the world-leading counterfeiting industry will cause problems
for already-dollarized Ecuador and El Salvador and other Central
American countries considering dollarization.
In the short-term the Pastrana government may not have many choices, but
over the long term a new policy regime�combined with progress toward a
peace settlement�could begin a virtuous cycle:
� Phasing out of the financial transactions tax and other improvements
in the tax system would help, as would steps to spur new private-sector
lending to small businesses and farmers switching to licit crops. Efforts to
reduce the underground economy by reducing transactions costs are likely
to be relatively effective.
� Bogota also can tackle the underground economy by improving govern-
ment capacity and will continue to look for technical assistance from
the United States, other developed countries, and international financial
institutions. This could include help with programs to combat corruption,
modernize tax and customs authorities and sten then the government's
supervisory and regulatory agencies
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Contents
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Key Findings
ill
Scope Note
ix
Introduction: Tangled Web of Activities Weave Underground Economy
1
Definition
Establishing the Trend: Underground Economy Outstripping Formal
1
Economy's Growth
Formal Economy, Historically Strong
1
Underground Economy Picking Up Steam
2
Examination of Underground Economy Components
3
The Informal Economy: Growing Refuge as the
Formal Economy Struggles
3
The Drug Economy: Booming but No Redeeming Features
6
The Insurgent Economy: Rising Menace
10
Rolling Back the Underground Economy Demands Comprehensive
12
Solution
Growing the Formal Economy
13
Combating Contraband and Corruption
13
Promoting Alternative Development
13
Hitting the Insurgents in the Pocketbook
15
Reaching Out
16
Outlook: Underground Economy Will Spread, Resist Quick Fixes
16
Implications: Undermining Economic Stability and Institutional Capacity
17
Appendixes
A.
21
B. Estimating the Size of Colombia's Drug Economy
23
Tables
1. Underground Economy Links to the Formal Economy
2
2. Key Bureaucratic Obstacles in the Formal Economy
5
3. Underg ound Economy Clouds Balance of Payments
6
4. The Economics of Geography: Insurgents' Influence Greatest
11
Where Population, Production Least
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Scope Not This paper is the culmination of a six-month program of research and analysis
on the underground economy in Colombia.
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Colombia's Growing
Underground Economy:
Eroding Economic Prospects
and State Capacity
Introduction: Tangled Web of Activities Weave
Underground Economy
The underground economy in Colombia�a complex
mesh of semi-legal and illegal activities not counted in
government statistics�is growing, eroding economic
prospects and state capacity. There are many causes of
the underground economy, from demand for drugs to
burdensome government regulations, and an equally
wide range of solutions. A number of these solutions
dovetail with Plan Colombia programs, such as alter-
native development to wean coca farmers off illegal
crops, but more are needed. US assistance will help,
but only Bogota can be responsible for the paramount
task of improving Colombia's business and security
environment.
Definition
Formal or official economic data reflect economic
activity captured in government statistics, such as
GDP and employment. Significant economic activity
is not counted by the government, however, because
many economic actors wish to hide their activities.
There are many definitions of what constitutes this
underground economy; some researchers focus on
uncounted legal activity, such as barter or underreport-
ing of legally acquired income, and others focus on
illegal activities. In this paper we accept a broad defi-
nition, identifying the following loosely defined com-
ponents of Colombia's underground economy:
� The informal economy encompasses activities that
are basically legal but not reported to the govern-
ment because of an unwillingnP-ss to comply with
government regulations or an explicit desire to hide
income or assets from the government. This includes
everything from sidewalk vendors to large corpora-
tions underreporting (legally acquired)
taxable income.
� The drug economy encompasses all facets of the
narcotics industry, from cultivation to processing,
from trafficking to money laundering.
1
� The insurgent economy encompasses the activities
of Colombia's illegal armed actors, the two major
insurgent groups and their paramilitary adversaries.
This paper focuses particularly on the most powerful
group, the Revolutionary Armed Forces of
Colombia (FARC), but similar analysis applies to
the National Liberation Army (ELN) and the United
Self-Defense Groups of Colombia (AUC), an
umbrella organization formed to confront the
guerrillas. The insurgent economy has paralleled�
and indeed contributed to�the growth of these
groups.
These components frequently overlap with each other
and the formal economy. Smugglers laundering
drug money deposit their proceeds in honest banks;
insurgents use revenue from their increasing involve-
ment in the drug trade to buy legitimate provisions�
the combinations are endless. As a result, the whole
underground economy is less than the sum of its many
parts. (C NF)
Establishing the Trend: Underground Economy
Outstripping Formal Economy's Growth
Formal Economy, Historically Strong
For most of the past half century, Colombia's formal
economy was one of the strongest performers in Latin
America. The economy averaged 4.7-percent growth
from 1950 to 1995, enduring high violence and
periodic economic downturns elsewhere throughout
the region. Colombia even managed to weather the
Latin American debt crisis in the 1980s and avoid
default, largely because of sound economic manage-
ment. During most of the 1990s, Colombia was
one of three countries in Latin America to hold an
investment-grade rating from leading international
ratings agencies. The economy began to weaken in the
latter half of the 1990s, however, and collapsed in
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Table 1
Underground Economy Links to the Formal Economy
There is a constant, fluid overlap between the underground and fornal economies. Experts caution about draw-
ing sharp distinctions but agree that there are a few sectors where interactions are concentrated. A common
feature is the use of cash�the preferred medium of exchange for underground activities�rather than checks
and other financial instruments
Sector
Comment
Commerce
Retailing of contraband allows traffickers to launder drug money. Some contraband products are counterfeit,
controlled, or illegal; some are legitimate. Many buyers and sellers are otherwise law-abiding citizens
and firms.
Real Estate
Land and buildings are popular assets for those who wish to invest ill-gotten wealth with little hassle, but the
overall economic climate�including interest rates and property demand�can make such investments
speculative. The use and management of these properties may support numerous legitimate and illegitimate
activities.
Financial System
Persons involved in underground economy transactions commingle licit and illicit currency in bank deposits.
Rules on the size of deposits may be circumvented by "smurfing," and rules on the origin of deposits may be
circumvented by corruption. Small and rural institutions are more likely to have suspect accounts. Traffickers
and insurgents may steal financial information from banks to facilitate kidnappings and extortion of their
clients.
Currency Exchange
As typified by the Black Market Peso Exchange, the exchange of dollars and pesos allows funds from under-
ground activities to enter and leave the formal economy. Once fueled by government currency controls, the
market now feeds off drug profits; many law-abiding citizens and firms take advantage of the cheap dollars.
' Smurfing is defined as structuring, i.e., a money laundering
placement technique in which the launderer divides large case
deposits into smaller amounts and attempts thereby to avoid
currency transaction reporting requirements
1998-99 as a host of negative local factors converged
with spillover from the global financial crisis�for
example, skyrocketing interest rates and plummeting
oil prices. Currently, more than half of the population
continues to live below the poverty line�defined as
earning $50 per month-
Underground Economy Picking Up Steam
The underground economy in Colombia has
grown steadily since the mid-1970s with only two
reversals�during 1984-86 and 1991-93 �
The most dra-
matic expansion in underground activities took place
between 1993 and 1999, a measured increase
in the ratio of unofficial to official income from
23 percent to 58 percent.' The rise in 1997-99
reflects a particularly noteworthy shift: Colombia's
underground economy is growing in scope and
vitality.
Growth of the underground economy has not been
clearly cyclical or countercyclical in relation to
' Experts emphasize that all measurements of underground activity
are imprecise and prone to measurement error. Nevertheless, the
relative size of Colombia's undeigiound economy is roughly
similar to those in other countries in the region.
underground economies in Latin America ranged trom 2 to
60 percent of formal GDP.
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"�Seem&
� Formal
economy
(GDP)
Figure 1
Colombia: Underground Economy Growing
Elation $ (nominal)
120
100
80
60
40
0 1977 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99
changes in the GDP. This reflects the complex interre-
lationship between the formal economy and the under-
ground economy, as well as among various
components of the underground economy:
� A decrease in the formal economy reduces legal
income that could be spent or invested in under-
ground activities and vice versa.
� On the other hand, growth in the formal economy�
often fostered by market-friendly rules and regula-
tions�may draw people out from the shadows to
obtain greater access to credit and other benefits.
Our assumption and the view of experts we have
consulted is that, over the long run, growth and
health of the formal economy is critical to reducing
Colombia's underground economy
3
Underground
economy
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Examination of Underground Economy
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several years in the components of Colombia's under-
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In general terms, the "informal"
economy is largest, but all three have significant
impacts.
The Informal Economy: Growing Refuge as the
Formal Economy Struggles
The informal economy has existed throughout
Colombia's history, beginning with smuggling in the
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colonial era as Colombians tried to avoid Spanish
tariffs. Smuggling�of both imports and exports,
everything from refrigerators to exotic animals�
remains the main industry in some parts of the
country. Free trade zones are notoriously exploited
for contraband purposes;2 various sources estimate
total Colombian contraband trade at $3-5 billion per
year. There are three main reasons for the strong
allure of contraband trade, from both the supply and
the demand side:
� Prices for contraband are as much as 50-percent less
than those for comparable legal merchandise,
with much of the discount resulting from cheap
currency�largely from illicit transactions�avail-
able in the Black Market Peso Exchange.3The
BMPE began in the 1950s, as smugglers traded
black-market US dollars to avoid regulations and
taxes, and has thrived as drug traffickers learned to
use it for money laundering.
� Some consumers readily evade taxes and tariffs to
obtain a bargain, even if the quality of goods is low
and there are no warranties. In recent years, various
sources have estimated that 80 percent of cigarettes
sold in Colombia�and similar percentages of
liquor, electronics, and appliances�were contra-
band. A thriving black market in gasoline, run by
"gasoline cartels," has emerged as Colombia has
gradually let the domestic cost rise to reflect global
oil prices.
� Contraband has quasi-legal status in some parts of
Colombia and is rarely prosecuted,
. Enforcement is complicated by a host
of factors, including
and weak controls on incoming
cargo.
� Free trade zones known as smuggling havens that have an impact
on the Colombian economy include the Colon FTZ in Panama,
Maicao in La Guajira Department, and San Andres, an island in the
Caribbean that was Colombia's first F17, facif tatin smu ling
markets known locally as "San Andresitos."
3 The allure of low prices is powerful and puts contra an in direct
competition with Colombia's legal imports which averaged some
$12 billion per year from 1998 to 2000.
'Secret,
The formal economy's dismal performance in recent
years, which culminated at the end of the 1990s with
Colombia's worst ever recession, accordingly has
boosted the informal economy. The rise is seen
dramatically in the labor market; official unemploy-
ment skyrocketed from 12 percent in 1997�and an
average of some 10 percent during 1990-97�to 20
percent in 2000, forcing many people to eke out a
living any way they can. According to a government
estimate based on household surveys, 60 percent of
those employed in June 2000 worked in the informal
sector, as compared with 55 percent in 1998.
A poor business environment, the result of short-
sighted government policies, also has played a major
role in fueling the informal economy. As the cost
of complying with regulations rises, the informal
economy becomes more attractive relative to the
benefits of staying in the formal economy. An array of
regulations, profligate government spending�espe-
cially during Ernesto Samper's administration�and
successive efforts to squeeze more taxes from a dwin-
dling tax base put a stranglehold on the private sector
and made Colombia one of the least competitive coun-
tries in the world in terms of investment and growth
potential
Government bond issuance to cover a large fiscal
deficit�especially pronounced at the end of the
1990s�is crowding out private borrowing
the government's imposition of a
politically expedient and easy-to-collect financial
transactions tax in November 1998 has been counter-
productive. The widely disliked tax is causing
increased tax evasion and financial distortions; checks
are endorsed multiple times rather than cashed, for
example.
The lack of clear, stable "rules of the game" discour-
ages investment and adherence to regulations. Tax
evasion by both individuals and firms is significant�
some estimates say 40-percent evasion rates are
common�and collection has hovered at about
11 percent of GDP, despite seven tax reforms in the
last 10 years.
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Table 2
Key Bureaucratic Obstacles in the Formal Economy
Colombia reveals a host of impedi-
ments to efficient business operations. Many of these present not only a drag on businesses in the formal sector
but also in total provide compelling evidence of the disincentives for informal enterprises to join the formal
economy.
Complaint
Comment
Suggested Remedy
Excessive paperwork
Corruption and ineffective judicial
system
Top concern of over half the respondents;
Customs and Tax authority and Food
Supervisory Agency most criticized.
Embezzlement the top mentioned item;
discourages respect for the law; places
law-abiding companies at a disadvantage.
Minimize regulatory changes when
personnel in these agencies change; accept
food registrations accepted by other countries;
control final product rather than inputs.
Standardize punishments and upgrade enforce-
ment; focus on debt collection mechanisms and
intellectual property protection.
Poor infrastructure Poor road systems and inadequate ports place
onerous transportation costs.
Improve Cali-Buenaventura road; revise or
drop the minimum rate system.
Credit problems
Credit is scarce and expensive.
Enhance government incentives to private
investors and banks.
Labor force rigidity
Excessive costs involved in dismissals mean
workers with seniority have little incentive to
be productive; high payroll taxes discourage
new job creation.
Make working hours more flexible; drop
obligation to pay fixed salary; drop requirement
to pay triple time for Sunday work�especially
in textiles.
Physical security problems
Distribution trucks attacked and goods resold at Revive regional railroads.
lower prices, often in poor condition; constant
roadblocks and strikes.
The burgeoning public sector has been a catalyst for
inefficiency and corruption, the cost of which local
analysts estimate at some 3 percent of GDP per year.
Despite Colombia's "apertura," or opening to trade
and investment in the early 1990s, the public sector
has grown from 29 percent of GDP in the 1980s to 34
percent in 1999, leading to extra redtape and increased
opportunities for bribes. Revealing the poor
productivity of government spending
he average rate of return
on private capital for 1950-95 was 12 percent, as
compared with 1 percent for public capital.
attributes Colombia's large informal economy to the
dominance of self-interest over public good and an
inability to solve problems collectively. Reflecting the
propensity to bend the rules, Colombia consistently
ranks as one of the most corrupt countries in the
5
world,
Impact. The informal economy has numerous
positive characteristics, as Peruvian economist
Hernando de Soto emphasized in his groundbreaking
book, The Other Path, in 1986. It is a welcome "shock
absorber" during recession and an outlet for persons
and firms that lack the will or capacity to compete in
the formal economy. It provides a venue for individu-
alism and a way around the thicket of
government regulations.
On the other hand, the informal economy provides
little in the way of labor standards, property rights, or
contract enforcement�legitimate economic actors
would prefer access to these benefits, were the cost of
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Table 3
Underground Economy Clouds Balance of Payments
By changing trade and investment patterns, the underground economy has a range of impacts on Colombia's
official balance of payments. The effects peaked during the early 1990s, a period of high drug-related inflows.
In 2000�with repatriation of drug proceeds flat, the formal economy struggling, and the government cracking
down on contraband�the effects were less pronounced.
Account
2000 Balance'
(Billion US $)
Comment
Exports
13.0 Official data underestimate actual export revenue because drug exports are not recorded.
Currency appreciation caused by drug revenue inflows decreases legal exports (they are
less competitive).
Imports
10.8 Official data underestimate actual imports because purchases of contraband are not
recorded. Currency appreciation caused by large drug revenue inflows increases legal
imports (they are more affordable).
Trade
2.2 The net effect of unrecorded exports and imports is uncertain. Currency appreciation caused
by large dollar drug revenue inflows reduces the official trade and current account balance.
Capital
0.9 Traffickers make substantial portfolio and direct investments in Colombia or overseas,
depending on the state of the economy, law enforcement, and other factors. Some invest-
ments are recorded but not linked directly to traffickers�the Cayman Islands are a leading
source of foreign direct investment�while many are off the books.
Reserves
9.0 Large dollar drug revenue flows may offset or worsen a deficit in the official current
account, leading to a rise or fall in foreign exchange reserves and thus complicating the
government's ability to conduct exchange rate and monetary policy.
participation in the formal economy not so high. It
also undermines the formal economy by:
� Inhibiting the local production of goods, such as
tobacco and textiles, and, for products that
Colombia does not produce, driving legitimate
importers out of business. In both cases, smuggling
lowers le2itimate employment-
� Depriving the government of significant tariff,
income, and value-added tax revenue, thereby feeding
a vicious cycle of higher deficits, harsher austerity
measures, and flight from the formal economy.
� Distorting official economic statistics. Because
unemployment, income, and other data may not
� 7'77-77777 �
be reliable or accurately reflect the true situation,
government economic policies may be misguided.
The Drug Economy: Booming but No Redeeming
Features
The drug economy, which began in the early 1970s
with marijuana production and trafficking and
exploded with cocaine processing and trafficking in
the 1980s, continues to grow and mutate:4
� The 1990s witnessed dramatically increased cultiva-
tion of both coca and opium poppy, the raw materials
for cocaine and heroin, respectively�much of the
coca surge reflects a shift in cultivation away from
4 Coca, marijuana, and similar substances have been present
throughout Colombia's history�albeit much less pervasive than in
Peru and Bolivia�but the export-oriented drug economy has
existed only for the last 30 years or so.
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Figure 2
Colombia: Coca Cultivation Exploding
1995
Source: CIA.
96 97
98 99 2000
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Peru and Bolivia. At the
same time, the BMPE
whom it was confiscated. Tax amnesties have
evolved into a progressively larger and more sophisti-
permitted traffickers to legitimize their ill-gotten
cated mechanism for changing drug profits from US
wealth, while encouraging future tax evasion.
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dollars into Colombian pesos.
The cocaine industry has exhibited particular dyna-
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� The demise of the large Medellin and Cali cartels of
the 1980s and 1990s led to more numerous, less
mism, far outpacing the formal economy, with coca
cultivation increasing from 50,900 hectares in 1995
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vertically integrated trafficking organizations.
Colombia's armed groups have increased their ties
to 136,200 hectares in 2000,
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-about 3 percent of Colombia's 4 million
to the industry, in part to fill the big cartels' vacuum.
hectares devoted to crops.
Some of the smaller "boutique" cartels are run by
illicit crops in 1999 repre-
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savvy, US-educated Colombian businessmen,
sented about 9 percent of Colombia's farming GDP
and about 1.3 percent of the country's total GDP.
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while not condoning the activity, reflect that institu-
The government has undertaken some policies that are
tion's acknowledgement of the drug economy as an
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neutral, if not friendly, toward the illegal narcotics
important part of the nation's economy. Along with
the rise in cultivation of illicit crops, Colombia has
industry, n the 1980s,
the Central Bank's exchange rate policies facilitated the
conversion of drug dollars into pesos. The courts have a
continued to process and traffic most of the region's
cocaine; the latter activities are where almost all of the
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poor record on completing asset forfeiture cases, some-
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times returning seized property to traffickers from
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drug economy's value added lies. The Colombian
Government is not attempting to include either
element in formal GDP, acknowledging the inherent
difficulty in doing so and the opprobrium attached to
the enormous amount of money involved.
Potential cocaine HC1 production in Colombia�
depending on variables such as crop yields and
processing ratios�increased from 230 metric tons in
1995 to 580 metric tons in 2000.
traffickers could net some $4 billion per
year�almost 5 percent of GDP�from wholesaling
cocaine and heroin, althou h only half this amount may
be repatriated to Colombia
Various studies estimate that the relative amount of
repatriated drug revenue has fallen from peaks in the
late 1980s and has remained fairly constant in recent
years:
� A government study in September concluded that
net revenue from overseas sale of cocaine shipped
from Colombia was roughly 3 percent of GDP.5
The study estimated that the gross revenue from ply-
ing this cocaine on the streets of the United States
and other consumer countries was about $46 billion,
indicating that only a small fraction of the industry's
earnings return to Colombia�the lion's share goes
to wholesalers and retailers abroad, whose markup
at successive parts of the distribution chain is
substantial.
� Reasons for reduced drug export earnings include
the government crackdown on contraband and
other forms of money laundering and reduced
investment opportunities in Colombia because of
the formal economy's dismal performance in recent
years.
Impact. Like the informal economy, the drug econ-
omy has some positive aspects. It creates jobs and a
wide net of support businesses throughout the country.
The drug economy, especially during the boom years
5 Colombia's leading legal export is oil, which from 1998 to 2000
earned an average of $3.5 billion, or some 30 percent of total legal
export revenue
of the late 1980s and early 1990s, has had a significant
influence on the national economy:
� Repatriated drug profits allowed traffickers to amass
substantial investments, particularly construction
projects in Medellin and Cali, and holdings of rural
property�traffickers own some 3 percent of the
national territory,
They probably have not infiltrated large
legitimate conglomerates,
but
do own and control productive enterprises through-
out the country, especially in areas where the drug
industry is concentrated.
� Large drug money inflows boosted Colombia's
foreign exchange reserves and kindled an apprecia-
tion of the peso in the early 1990s. This was a
double-edged sword, however, as the strong peso
contributed to a deterioration in the country's trade
balance. Reduced inflows toward the end of the
decade fueled a collapse in construction and real
estate�in the last three years real estate prices have
dropped up to 70 percent�and worsened the peso's
plunge during the global financial crisis.
On balance, the drug economy has had a negative
impact on the formal economy�in contrast to what
some researchers once maintained�because of the
crushing weight of its perverse effects. These include
rampant corruption and violence, the distortion of
local markets, the weakening of institutions, and the
tearing of the country's social fabric:
� Drug money has corrupted members of the country's
political, judicial, and economic elite; it has been a
key factor behind Colombia's dubious distinction as
one of the most violent countries in the world, with a
per capita murder rate eight times that of the United
States. the
country's economy has performed worse in the
cocaine era than it did in previous years.
� In places where the drug industry is concentrated, it
skews local prices, wages, and investment. In coca
8
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Figure 3
Colombia: Coca and Opium Poppy Growing Areas, 2000
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boom towns, wages are high but prices are exorbi-
tant�$0.50 for one egg, for example�and migrant
workers often squander their pay. Cocaine base is
used for barter, and some locals rely on traffickers
for credit. The drug industry drives out legitimate
business; some rural areas have lost self-sufficiency
in food production, and in Putumayo
Department said that 80 percent of his town's
economy depends on coca cultivation.
The need to repatriate drug profits has given a strong
impetus to the contraband industry, which is a
highly effective means of money laundering
at least half of incoming
laundered narcotics revenue enters Colombia in the
form of contraband goods. The need to invest drug
profits has undermined critical agricultural reform
efforts because traffickers have little interest in
making productive use of their agricultural land
holdings.
The Insurgent Economy: Rising Menace
The newest and most sinister component of the under-
ground economy, the insurgent economy has in some
ways matched the rise of the drug trade. Indeed, the
FARC's rise in territorial influence and numbers�
from 900 combatants at the start of the 1980s to
9,000-12,000 today�parallels its increasing involve-
ment in narcotics. Until the late 1990s, the FARC's
involvement in the cocaine industry was largely
limited to taxing illicit crop cultivation, drug
processing, and airstrip use. However,
some FARC
leaders and fronts are assuming a more prominent role
in cocaine production and trafficking to augment the
group's income:
The FARC may earn at least $150 million
annually�about half their total income�from
drug-related activities, but such estimates are rough
The FARC and the second leading insurgent group, the
ELN, are expanding their nondrug revenue sources as
well.
the FARC may earn an additional $150 million annu-
ally from extortion, cattle rustling, financial crimes
such as bank robbery, and kidnapping:6
� The extortion rackets focus on the mining, oil,
commercial, agricultural, and transportation sectors
as well as multinational corporations. In 2000 the
FARC announced a so-called peace tax that legal-
ized, in insurgent eyes, the extortion of wealthy
individuals and firms. Calculation of FARC revenue
is complicated by the group's tendency to extort
services in kind, not cash.
� The guerrillas often stRal rather than extort, with
highway tollbooths and rural banks being frequent
targets. The insurgents themselves do not use the
formal banking system as much as traffickers and
tend to spend the bulk of their revenue in their areas
of influence, many of the
organized groups involved in Colombia's counter-
feiting industry, the world's leading supplier of fake
US currency, originate from areas controlled by
insurgents.
� The booming kidnapping industry, for which the
insurgents bear most of the responsibility, has set
successive records in recent years�topping 3,700
victims in 2000, three times the number of victims
in 1995
As the insurgents have progressively increased their
revenue, so have they increased their economic
influence in various parts of the country. Despite
widespread rejection of guerrilla tactics and abuses,
6 Even rough estimates suggest that the FARC's revenue�perhaps
some $300 million per year�may rival that of some of Colombia's
leading corporations. The other illegal armed groups gamer signifi-
cant sums as well. he
ELN may earn about $150 million per year, mostly from kidnap-
ping and extortion; the AUC may earn about $80 million per year,
mostly from the drug trade and voluntary contributions.
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Table 4
The Economics of Geography: Insurgents'
Influence Greatest Where Population,
Production Least
Colombia's three largest cities�Bogota, Medellin, and
Cali�and their surrounding departments (the equiva-
lent of US states) account for about half of the coun-
try's population and production; 19 of the other 32
departments account for most of the remainder Ten
departments in the guerrilla-infested south and east
are vast yet sparsely populated areas that generate
little legitimate, recorded economic activity.
Area Share of Colombia's...
Bogota, Medellin,
Cali, and surround-
ing departments
Nineteen depart-
ments in north
and west
Ten departments in
south and east
Population
Percent
GDP
Land
43
58
10
52
37
33
5
5
57
Colombian society has not mobilized against the
illegal armed groups. Indeed, the lack of effective
response has contributed to the insurgents' eco-
nomic, political, and military ascent. The Pastrana
administration has been particularly reluctant to
antagonize the FARC because of concern that
making serious demands on FARC behavior would
cause the group to break off the already slow-moving
peace process.
Impact. The insurgent economy brings some short-
term benefits to local communities�for example,
from guerrilla subsidies in the form of salaries, clinics,
and road building�but it primarily benefits the
insurgents and their war efforts. As compared with
some drug traffickers, who often make benign or even
productive investments in luxury goods, real estate,
and commercial establishments, the insurgents spend
11
a considerable portion of their proceeds on weapons
and war material.
Nevertheless, the insurgent economy has an even
more disproportionate and pernicious impact than
does the drug economy. Predatory and parasitic
actions directly weaken the formal economy by
raising costs and reducing profits, which are progres-
sively more damaging in a globalized world�
Colombia is steadily losing ground to its emerging
market peers that are not wracked by high levels of
violence. The insurgents' increasing kidnappings,
extortion, and terrorist attacks on infrastructure have
become one of the largest obstacles to sustained
economic growth in Colombia.
Bogota says that the economic cost of the insurgency�
including loss of life, property damage from sabotage,
and reduced production and investment�is 3 to 4
percent of GDP per year. The deteriorating security
situation was a major factor in Colombia's losing its
investment-grade rating in 1999, and some US firms
have considered leaving the country.
Attacks on multinationals have caused those companies
significant losses, reducing royalties used to fund
health, education, and infrastructure projects. A rash of
bombings of the Caiio Lim6n-Covefias oil pipeline
between July and September 2000 forced a US oil firm
to cancel some export shipments, which cost Colombia
more than $120 million in lost revenue. Insurgents
attacked the pipeline a record 98 times in 2000
Rising physical and economic insecurity has
helped fuel an exodus of middle- and upper-class
Colombians, many of whom have relocated to the
United States. from 1996 to
2000, more than 1 million people�out of a total
population of some 40 million�left the country;
almost 300,000 departed last year alone.
The insurgent economy is becoming an alternative
for poor Colombians as the formal economy weak-
ens�a vicious cycle that bolsters insurgent rhetoric
about the failings of the "neoliberal" economic
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model, insurgents
make loans to small and medium-sized businesses
that cannot get credit in the formal economy because
banks are struggling with weak balance sheets, high
taxes, and burdensome regulations. Indeed, local
financial institutions complain that they must
compete in a socialist framework, while the insur-
gents operate without bureaucratic constraints:
� Creditor rights are poorly defined for formal-
economy banks, which even have to subsidize
government programs designed to help debtors.
In contrast, insurgents' enforcement power is
unlimited. The insurgents can exploit their loan port-
folio through extortion of debtors or outright expro-
priation.
� Guerrilla investments in the legal economy, such as
banks and stores, facilitate money laundering while
creating intelligence and support networks.
the FARC is
also using its loan business as a recruitment tool.
the FARC is
intentionally overpaying for supplies to cultivate a
following among the local population and gain
economic influence in the border areas of Panama
and Ecuador.
Rolling Back the Underground Economy Demands
Comprehensive Solution
Reversing the underground economy requires a variety
of solutions, ranging from steps that boost the formal
economy to steps that directly attack the informal, drug,
and insurgent economies. Moreover, these solutions
must be integrated because of the overlapping, and
mutually reinforcing, nature of the underground
12
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