Illicit Financial Flows from China and the Role of Trade Misinvoicing

7/31/2019 Illicit Financial Flows from China and the Role of Trade Misinvoicing

1/26Illicit Financial Flows from China and the Role of Trade Misinvoicing 1

Illicit Financial Flows from China and the

Role of Trade Misinvoicing

Dev Kar and Sarah FreitasOctober 2012


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3/26Illicit Financial Flows from China and the Role of Trade Misinvoicing

Illicit Financial Flows from ChinaAnd the Role of Trade Misinvoicing

Dev Kar and Sarah Freitas

1

October 2012

1Dev Kar, a former Senior Economist at the Internaonal Monetary Fund is Lead Economist at Global Financial Integrity, a DC-based

research and advocacy group. Sarah Freitas is an Economist at GFI. The author would like to take Raymond Baker, Clark Gascoigne,

E.J. Fagan and other sta at GFI and CIP for their insight and assistance. Any errors that remain are the authors responsibility.


4/26Global Financial Integrityii


5/26Illicit Financial Flows from China and the Role of Trade Misinvoicing ii

Contents

Executive Summary iii

I Illicit Financial Flows from China and Implications 1

i Introduction 1

ii The Serious Implications of Illicit Flows 2

iii Summary of Methodology 4 iv. DevelopmentsinTotalIllicitOutows 4

a Table 1 China: Illicit Financial Flows and Trade Openness, 2000-2011 5

v Developments in Trade Misinvoicing 5

a Table 2 Commodity Misinvoicing between China and Hong Kong, 2007-2011 7

II External Assets of China in Tax Havens and Banks 9

a Table 3 China, Hong Kong: Inward FDI Positions, 2009-2010 9

b Table 4 China, Hong Kong: Outward FDI Positions, 2009-2010 9

c Table 5 China, Mainland: Inward FDI Positions, 2009-2010 9

d Table 6 China, Mainland: Derived Outward FDI Positions, 2009-2010 9

e Table 7 China, Hong Kong: Outward Portfolio Investment Positions, 2009-2010 9f Chart 1 Round-Tripping Among the Troika 11

g.Table8.EstimatedFlowsofIllicitCapitalinOshoreCenters 12

h.Table9.EstimatedTotalFlowsofLicitCapitalinOshoreCenters 12

i. Table10.EstimatedTotalFlowsofLicitandIllicitCapitalinOshoreCenters 12

j. Table11.OshoreFinancialServicesbyCenter,2006. 12

References 14


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Executive Summary

Section I

Overtheperiod2000to2011,cumulativeillicitnancialowsfromChinatotaledamassiveUS$3.79trillion,ifone

were to exclude the countrys intra-regional trade with Hong Kong and Macao We found that if adjustments for such

tradewerenotmade,theresultingoutowsduetotrademisinvoicingweresignicantlyunderstatedduetotradedata

distortions.Thesharpriseinillicitoutows,fromUS$172.6billionin2000toUS$602.9in2011,impliedanincreaseof

about7.2percentperyearinination-adjustedterms,whichwasjustbelowthe10.2percentaveragerateofeconomic

growth

Whileourestimatesarebasedongrossoutows,theydonotdiermuchfromthenetofillicitinowsfromoutowsa

methodology with which we disagree with because there is no such thing as net crime Nevertheless, even if illicit

inowsarenettedfromillicitoutows,ChinastillsuerednetillicitoutowsofUS$3.75trillionoverthisperiod.Oneof

theadverseeectsofillicitowsfromChinahasbeenaworseningofthecountrysincomeinequalityastherichget

richerthroughtaxevasion(whichcomprisesbyfarthemajorportionofsuchoutows)andthroughusingtheworlds

shadownancialsystemtoshelterandmultiplytheirillicitwealth.

MisinvoicedtradebetweenChinesecompaniesandtheUnitedStatesincreasedfromUS$48.8billionin2000to

US$59.0billionin2011.ThevolumeoftrademisinvoicingbetweenmainlandChinaandtheUnitedStatesroseto

US$72.0billionbeforethenancialcrisisof2008,buthasdeclinedsincethen,probablyasaresultoflowergrowthin

bilateral trade between the countries

ThecommoditygroupingsmostsusceptibletotrademisinvoicingincludeUNCommodityTradeStatisticsDatabase

(COMTRADE)group84(nuclearreactors,boilers,machinery,etc.)andgroup85,(electricalandelectronicequipment),

withthesub-groupforelectroniccircuits(HSCode854231)showingthelargestcumulativeillicitoutows(US$84.1

billion).Trademisinvoicingrelatedtothesub-groupformobilephones(HSCode851712)increasedatthefastestpace

from 2007-2011 This is consistent with previous studies at GFI which indicate that the more specialized a product, the

easier it is to misinvoice

Section II

AsignicantpartoftheillicitoutowsfromChinaround-tripbacktothecountryasrecordedforeigndirectinvestment

(FDI).Suchround-trippedFDIisgivenpreferentialtreatmentvis--visdomesticcapitalsuchastaxconcessions,

governmentguaranteeofloansextendedbyforeigncorporationstodomesticrms,landandotherfacilitiesat

concessional rates, etc

However,alotoflicitmoneyalsoleavesChinaasFDIinplaceslikeHongKongandtheBritishVirginIslands(BVI),only

to then be laundered into another entity and reinvested in China as FDI from Hong Kong or the BVI It is a complex

money laundering scheme used in order to take advantage of favorable regulations for FDI and to allow high net worth

individuals(HNWIs)tosecretlyaccumulatewealthincontraventionofgovernmentregulationsandoversight.


7/26Illicit Financial Flows from China and the Role of Trade Misinvoicing v

Mainland China and Hong Kong are the largest foreign direct investors in each others economy, with the BVI serving as

the 2nd biggest foreign direct investor in both mainland China and Hong Kong, and BVI serving as the largest recipient

ofFDIfromHongKong.Indeed,itappearsthatwhiletheBVIinvestedamassive$213.7billioninmainlandChinain

2010, nearly all reciprocal investment in the BVI from the Chinese mainland was routed through Hong Kong The BVI

hasapopulationofabout28,000andaGDPofonlyaroundUS$1.1billion,soitishardtoseehowitcanundertake

suchmassiveFDIoutowsunlessfundswereroutedbackinviaHongKong,and/orsubsidizedbyillicitfunds.

OftheroughlyUS$2.83trillionthatowedillicitlyoutofChinafrom2005-2011,US$595.8billionwoundupascashdepositsornancialassets(suchasstocks,bonds,mutualfunds,andderivatives)intaxhavens.Onaverage,roughly

52.4percentofinvestmentsthatowedintotaxhavensfromChinaduring2005-2011wereillicitwhile47.6percentwere

licit


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I. Illicit Financial Flows from China and their Implications

(i) Introduction

Illicitnancialowsorillegalcapitalightinvolvemoneythatisillegallyearned,transferred,orutilized.Whilethefunds

could be earned through bribery, kickbacks, or other illicit activities, they may well be earned through legitimate means

It is the transfer in contravention of capital controls or the nonpayment of applicable taxes that renders the funds illicit

The methods used by economists to estimate the volume of illicit funds leaving a country make no attempt to link

illicitowswiththenatureofthesourceofcapital,whetherlicitorillicit.Infact,thereisnomethodthatcanapportion

totalillicitowsintotaxevasion,criminalproceeds,orcorruption.Thesurveymethod,whichreliesontheopinionsof

government regulatory agencies, private corporations, and others, can shed some light on the relative importance of

theseowsinaglobalcontext.Suchsurveyresultsindicatethatglobally,taxevasionbyhigh-net-worth-individuals

(HNWIs)andcorporationscomprisebyfarthelargestcomponent(around65percent)ofcross-borderillicitowsfrom

developingcountries,followedbytheproceedsofcrime(30percent)andcorruption(5percent).1

ResearchatGlobalFinancialIntegrity(GFI),aWashingtonDC-basedresearchandadvocacygroup,showsthat

outowsofillicitcapitalfromdevelopingcountrieshavebeenagrowingproblemoverthepastdecade.Inordertoassesstheimpactofillicitowsoneconomicdevelopmentandpovertyalleviation,GFIpublishesregularannual

updatesofthevolumeandpatternofoutowsfromdevelopingcountriesandregions.Inaddition,countrycasestudies

atGFIallowanin-depthanalysisofthedriversanddynamicsunderlyingsuchoutows.

According to the latest annual report, developingcountrieslostbetweenUS$775billionandUS$903billionin2009,

downfromthepreviousreportsestimateofUS$1.26toUS$1.44trillionin2008.2Themainreasonforthefalloinillicit

outowsin2009wasduetotheeconomicdownturn,whichreducedforeigndirectinvestments,newloans,andtrading

volumes In fact, the IMFs World Economic Outlooknoted that the 2009 decline in export and import volumes were the

sharpestsincetheSeptember2001attacks.Nevertheless,GFIndsthatillicitoutowsfromthedevelopingworldhave

increasedbyatleast10.2percentperannumoverthedecadeinination-adjustedterms.

Whatdrivesoutowsofillicitcapitalfromacountry?GFIstudies show that cross-border transfers of illicit capital are

propelledbythreemaintypesofdriversmacroeconomic,structural,andgovernance-related.InChinascase,large

andgrowingcurrentaccountsurplusesleadtocapitaloutows,someofwhichmaywellbelicitcapitalight(such

asprivatesectorhotmoneyoutows).Highandrisinginationcouldalsocontributetoillegalcapitalight,assuming

owners do not wish to see the real value of their holdings decline over time The widely held perception that the Yuan

isunder-valued(becauseofthetradesurpluses)mayfeedintoexpectationsofexchangeraterevaluationinthefuture

whichcouldleadtospeculativeinowsandround-trippedcapital(seeSectionIIforadiscussionofround-tripping).

Structural factors for China include non-inclusive growth, as a result of which there are a larger number of high networthindividuals(HNWIs)whochoosetosheltertheirburgeoningwealthabroad.Anotherstructuralfactorisincreasing

tradeopenness(exportsandimportsofgoodsandservicesaspercentofGDP),whichprovidesmoreopportunitiesto

traders to misinvoice trade as the customs administration struggles to keep pace with rising trade volumes Governance

1Baker, Raymond W. (2005). Capitalisms Achilles Heel: Dirty Money and How to Renew the Free-Market System, John Wiley & Sons,

Inc.2Kar, Dev and Sarah Freitas (2011). Illicit Financial Flows From Developing Countries Over the Decade Ending 2009, Global Financial

Integrity, Washington DC.


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factorsincludecorruptionandweakregulatorysystemswhicharereectedinanexpandingundergroundeconomy

relativetoocialGDP.Theundergroundeconomybothdrivesandisdrivenbyillicitows.

(ii) The Serious Implications of Illicit Flows

IllicitnancialowsaremainlygeneratedandtransferredbyChineseresidentswhoareconnectedtothecountrys

globalizedeconomy.Theproceedsoftaxevasion,prot-shifting,bribery,kickbacks,trademisinvoicing,incomeon

unreported external assets, and tax breaks on round-tripped illicit funds all accrue to those who are thus connected

Totheextentthatthegovernmentfailstocollectapplicabletaxes,themiddle-andlow-incomegroupssuertheconsequences.

Tax revenue collection continues to be a persistent challenge in China Revenue performance of the general

government(denedascentralplusstateandlocalgovernments)steadilyimprovedfrom13.8percentofGDPin2000

to 223 percent of GDP in 2011 However, Chinas revenue falls short of the G-7 group of major advanced economies,

which average 360 percent of GDP per annum and lags behind emerging and developing countries average revenue

collection of 266 percent of GDP3EventhoughChinahasmadesignicantprogressinstrengtheningsocialsafety

nets,theIMFnotesthatitwilllikelyrequiremoreresourcesoverthemedium-termtobroadenthecoverageofthe

systemonasustainablebasis.TheChinesegovernmentcannotfailtocollectsucienttaxrevenuestomeetits

ambitious spending promises given that its expenditures on the social safety net account for just 57 percent of GDP

Economies at comparable levels of development spend, on average, more than twice as much4

Apartfromthefactthatrampanttaxevasionlikelytobethelargestcomponentofillicitoutowshavereduced

taxrevenues,thelossofcapitalhasdirectlycontributedtoaworseningofChinasincomeinequality.Aroundthelate

1970s, when the process of economic transition from a closed to an open market system started in China, the country

had a relatively egalitarian society Since then, Chinas income distribution has become increasingly skewed, with

theGinicoecienttheinternationalstandardformeasuringincomeinequalityinacountryrisingfrom.31in1981

to 47 in 20085Therisinginequalityisalsotakingatollonaveragehouseholdconsumption,whichdeclinedbyover

10 percentage points of GDP since the early 1980s6 Indeed, increasingincomeinequalityremainsthesoftunderbellyof Chinas impressive rise in the world economy and presents a serious challenge for maintaining social and political

stability.Thatincomeinequalityisasensitiveissueisbornebythefactthatthegovernmenthasnotreleasedocial

dataontheGinicoecientsince2000.Ocialsaredoubtlessawarethatdataonhouseholdincome,whichare

obtainedthroughgovernment-sponsoredsurveys,areunlikelytoreectforeignholdingsofillicitassetsbyhighnet-

worth individuals, thereby understating the already bad news regarding income distribution

(iii) Summary of Methodology

Economistshaveestimatedcapitalightfromdevelopingcountriesinseveralways.Amongthese,theWorldBank

Residual measure adjusted for trade misinvoicing has come to be well-established since its formulation in 1985

Essentially, the method captures net unrecordedcapitalowswhicharescaledupordown(i.e.,adjusted)as

3Tax to GDP raos are based on World Economic Outlook Database, IMF, April 17, 2012 (link: hp://www.imf.org/external/ns/

cs.aspx?id=28).4Peoples Republic of China: Sta Report for the 2012 Arcle IV Consultaon (2012), IMF Country Report No. 12/195, Box 10.5Ravallion, Marn and Shaohua Chen (2007). Chinas (Uneven) Progress Against Poverty, Journal of Development Economics, 82(1):

1-42.6Aziz, Jahangir and Li Cui (2007). Explaining Chinas Low Consumpon: The Neglected Role of Household Income, IMF Working Paper,

WP/07/181, Internaonal Monetary Fund.



indicated by the deliberate misrepresentation of exports and imports declared in customs invoices Of course, the

resultingcapitalowsarisingfromsuchfraudulentcustomsdeclarationsarealsounrecorded.Itisassumedthatsuch

unrecorded transfers of capital involve illicit funds because there is no reason why transfers of legitimate capital should

gounrecorded.Forreasonsnotedbelow,GFIstudiesonlyconsidergrossillicitoutows.

The World Bank residual measure captures the gap between a countrys recorded source of funds and its use of

thosefunds.Therearetwomainsourcesoffundsforacountrynewexternaldebtcontractedandnetinowsof

foreigndirectinvestments.Therearealsotwousesoffunds,namelynancingthecurrentaccountdecit(whichisessentiallytheshortfallofexportsoverimports)andadditiontoreserveassets.Ifsourceoffundsexceedsuseof

funds,unrecordedorillicitcapitalmusthavebeentransferredfromthecountry.Unrecordedcapitalleakagesthrough

the balance of payments tend to capture bribery, kickbacks, and proceeds from other forms of corruption In case

recorded use exceeds recorded source of funds, the country must have received illicit capital which are not netted out

ofoutowsforreasonsnotedbelow.

Twotypesofinvoice-faking,ormisinvoicing,requireadjustingtheoutowsfromtheWorldBankresidualfora

comprehensiveestimateoftotalillicitoutows:exportunder-invoicingandimportover-invoicing.Exportunder-

invoicingimpliesanunderstatementofacountrysreportedexportsvis--viswhatpartnercountriesreportashaving

imported from that country Import over-invoicing indicates an overstatement of imports by a reporting country relative

topartnercountriesdeclarationofexports.Themethodologyusedtoestimateillicitowsduetotrademisinvoicing

isbasedontheGrossExcludingReversals(GER)methodwhichdoesnotnetoutillicitinowsfromoutows.

Furthermore, we use the IMFs DirectionofTradeStatistics(DOTS)whichcapturesreportingcountriestradewiththe

world; trade discrepancies are derived by adjusting imports for an insurance and freight factor of 10 percent This is

calledimportsfree-on-board(f.o.b.)whichiscomparedwithexportsf.o.b.7 Trade misinvoicing allows the clandestine

acquisitionofforeignassetsandfacilitatesmoneylaunderingandtaxevasion.

Asnoted,economiststypicallynetoutnancialowsintheWorldBankResidualmeasureandthetrademisinvoicing

measure In doing so, their methodology is consistent with the treatment ofrecorded, orlicit,capitalowsinthebalanceofpayments.However,theuseofthenetmethodinthemeasurementofillicitnancialowsisawedfor

severalreasons.First,wemustdistinguishbetweennetrecordedowsinthebalanceofpaymentandnetillicitows.

Anetmeasureofcapitalowsasrecordedinthebalanceofpaymentsisavalidconceptasitrepresentsanetgainor

lossofcapital.Ontheotherhand,anetmeasureofillicitowsmakeslittlesensebecausetheowsareillicitinboth

directions.Afterall,thereisnosuchconceptasnetcrime.Infact,netillicitinowsdonotrepresentanetbenetto

acountryinthesensethatnetcapitalinowsrecordedinthebalanceofpaymentsdo.Second,likeillicitoutows,

illicitinowsarealsounrecorded.Howcouldagovernmenttaxcapitalthatisunrecordedoruseitforanyproductive

purposes?Infact,illicitinowsaremorelikelytodriveundergroundeconomicactivitiesthantheyaretoboostthe

productivecapacityoftheocialeconomy.Hence,intreatingillicitinowsasiftheywerebenecialtoacountry,the

nettingoutmethodseriouslyunderstatetheadverseimpactofsuchowsoneconomicdevelopmentandpoverty

alleviation

Economists have long acknowledged that trade mispricing is an important conduit for the cross-border transfer of

illicit capital8.Theirstudieshavecorroboratedthefactthatforeignassetscanbeacquiredthroughexportunder-

7See the 2010 publicaon of the IMF Direcon of Trade Stascs Yearbook for details on a c.i.f. factor of 10%.8Bhagwa (1964). On the Under-invoicing of Imports, Bullen of the Oxford University Instute of Economics and Stascs; Nayak

(1977), Illegal Transacon in External Trade and Payments in India: An Empirical Study, Economic and Polical Weekly; Gula (1987),



invoicingandimportover-invoicing.Incidentally,themanipulationoftradeinvoicesalsooccursintheUnitedStates

among other industrial countries9Trademispricingaccountsforabout54percentofcumulativeillicitowsfrom

developingcountriesovertheperiod2000-2009,althoughtheshareintotaloutowshasdeclinedsince2004.Over

the decade ending 2009, unrecorded leakages through the balance of payments have been increasing relative to trade

misinvoicingon average, the balance of payments component account for 491 percent of cumulative transfers of illicit

capital while the trade misinvoicing component account for 509 percent

(iv) Developments in Total Illicit OutfowsEstimatesofillegalcapitalightorillicitnancialowsfromChinatendtovarybyamuchwidermarginthantheydo

for most other countries The main reason why they do so relates to intra China-Hong Kong trade For one, China-

HongKongtradeposesdicultiesinidentifyingoriginofexportsanddestinationofimportsthatarerecordedby

their partner countries For example, if Chinas exports to other countries that pass through Hong-Kong are recorded

by those countries as originating from the latter while China records those exports as originating from the Mainland,

then total Chinese Mainland exports to the world would be overstated relative to world imports from Mainland China

(implyingillicitinowsduetoexportover-invoicing).AstherearenoestimatesofhowmuchtradebetweenChinaand

Hong Kong is destined for domestic consumption and how much is merely passing through as re-exports, economists

haveestimatedillegalcapitalightfromChinabybothincludingandexcludingHongKongandMacaofromthetrade

misinvoicing calculations10 We shall therefore present both estimates here

Thereasonsforfocusingonoutowshavebeendiscussedabove.Apartfromtheadjustmentsduetointra-regional

trade,estimatesofillicitowsfromChinaalsovaryduetothecoverageofconduitsresponsibleforsuchows.For

example,somestudiesdonotincludeoutowsduetotrademisinvoicing.Socarehastobeexercisedincomparing

variousestimatesofillicitowsfromChinatoensurethattheunderlyingmethodologiesareroughlycomparable.

BasedonGFIsgrossoutowsmethodologyandexcluding Hong Kong and Macao from world and Chinese trade, trade

misinvoicing-adjustedgrossillicitoutowsfromChinaincreasedfromUS$172.6billionin2000toUS$602.9billionin

2011, a 72 percent real rate of growth per annum, which is slightly below the 102 percent average annual growth rateofGDPoverthisperiod(Table1).11WhileillicitoutowshavedeclinedinrelationtoGDPfrom14.4percentin2000to

8.3percentin2011,therateofoutowshasacceleratedfrom10.4percentinthepre-crisisperiodto13.9percentper

annumsincethen.Table1showsthatcumulatedillegalcapitalightfromChinaaccordingtotheTraditionalNet

measureamountedtoUS$3.75trillioncomparedtoUS$3.79trillionusingGFIsgrossoutowsmethod.

Illicitoutowsthatexceed10percentoftheworldssecondlargestGDPareindeedworrisome.Indeed,ifoutows

continue to ratchet upwards, adverse repercussions on social and political stability cannot be ruled out According to

a report in the Chinese media, more than half of Chinese millionaires seem intent on leaving the country12 The myriad

A Note on Trade Misinvoicing, from the book Capital Flight and Third World Debt; Ndikumana and Boyce (2001), Is Africa a net

Creditor? New Esmates of Capital Flight from Severely Indebted Sub-Saharan African Countries, 1970-96, Journal of Development

Studies; Ndikumana and Boyce (2008), New Esmates of Capital Flight from Sub-Saharan African Countries: Linkages with External

Borrowing and Policy Opons, Polical Economy Research Instute, University of Massachuses Amherst, Working Paper.9See, for example, Simon Pak and John Zdanowicz (2002), An Esmate of 2001 Lost U.S. federal Income Tax Revenues Due to Over-

invoiced imports and Under-invoiced exports.10Capital Flight and Capital Controls in Developing Countries, Gerald Epstein, Editor (2002).11Specically, the trade adjustment involves reducing (i) world imports by Hong Kong and Macaos imports from China (ii) world ex-

ports by Hong Kong and Macaos exports to China. Similarly, Chinas exports to and imports from the world are respecvely reduced

by Chinas exports to and imports from Hong Kong and Macao.12Zhang, Jianping, Ma Wenhui, and Tian Shuai (2012). The fears that are driving the ight of the rich, China Daily.



reasonsnotedrangefrompersonalandeconomicinsecuritytoinadequatesafeguardsforpersonalpropertyand

deteriorating environmental and medical conditions As China Daily notes, any large-scale emigration of Chinese

millionaires could sap the power of the middle class and fuel social instability

If no adjustments for intra Chinese regional trade are made,thenestimatesofillicitoutowsgrowat1percentper

annum in real terms over this period, a much slower pace of growth than is derived by correcting for intra-regional

trade.Whileunadjustedoutowsalsoincreaseinnominalterms,theyundergoasteadydeclineintermsofGDPfrom

131 percent in 2000 to just 44 percent in 2011

There are several indications that a scenario without adjusting for intra-Chinese regional trade is likely to be

unrealistic.Forone,therateofgrowthofillicitoutows(1percentperannum)fallsfarshortofrealeconomicgrowth

(10.2percentperannum)withoutowsactuallydeclininginrealtermsintheperiodbeforethecrisis.Thisisoverlyoptimistic given that World Bank governance indicators related to control of corruption, political stability and absence

ofviolence,ruleoflaw,andothermeasuresshowasignicantdeteriorationovertheperiod1996-2010.Forthis

reason,wedonotpresentaseparatetableshowingdevelopmentsinillicitoutowsthatdoesnotadjustforintra-

regional Chinese trade

(v) Developments in Trade Misinvoicing

The deliberate misinvoicing of exports and imports comprise by far the major channel for the transfer of illicit capital

fromChina,althoughthesharehastendedtouctuateovertheperiod2000-2011.Inthepre-crisisperiod2000-2007,

theshareoftrademisinvoicingintotaloutowswasaround87percentonaveragewhileintheperiodsincethen,

thesharehascomedowntoabout85percent.ArecentstudyattheIMFconcludesthatwhiletheeectivenessof

customs in addressing evasion may be better in India than in China, the latter appears to be catching up over time13

GiventhattheUnitedStatesisChinaslargesttradingpartner,thequestionaboutmisinvoicinginvolvingtrade

between the two countries naturally arises However, it should be noted that we cannot make adjustments for intra-

ChinaregionaltradewhenestimatingmisinvoicinginvolvingChina-U.S.trade.Thereasonisthatwecannotnet

13Mishra, Prachi, Arvind Subramanian, and Pea Topalova (2007). Policies, Enforcement, and Customs Evasion: Evidence from India,

IMF Working Paper.



outHongKongandMacaosexportstoandimportsfromtheUnitedStatesfromU.S.-Chinatradedataandneither

can we net out Chinas exports to and imports from Hong-Kong and Macao out of Chinese exports to and imports

fromtheUnitedStates.ToadjusttrademisinvoicingbetweenChinaandtheUnitedStatesforintra-Chinesetrade,

we would need to have an accurate estimate of the proportion of trade between mainland China and Hong Kong that

continuesontotheUnitedStates(andvise-versa).Errorsinestimatingtradeabsorbeddomesticallyversusthosethat

are re-exported would lead to large distortions in trade data discrepancies Between 2000 and 2011, based on the no

adjustmentmethod,misinvoicingbyChinesecompaniestradingwiththeUnitedStatesincreasedfromUS$48.8billion

toUS$59.0billion.Infact,thevolumeoftrademisinvoicingbetweenmainlandChinaandtheUnitedStateshasbeenincreasing steadily throughout the pre-crisis period 2007-2011 but have declined since then possibly as a result of lowe

growthinChina-U.S.trade.Thelowervolumeofmisinvoicingmayalsoberelatedtotighterregulatoryoversightbythe

UnitedStatescustoms.

Some studies have found that trade misinvoicing occurs in order to take advantage of particular incentives and to avoid

highertaxes.Forexample,FismanandWei(2004)quantiedtheimpactofimporttarisontaxevasionusingdataon

trade between China and Hong Kong14 Based on data on 1,600 groupings of imported goods at the 6-digit HS level,

theyfoundthataonepercentagepointincreaseinthesumofthetariandVATonimportsledtoatwotothreepercen

increaseinevasion.OtherstudiesonChinahavefoundthatrmsseektoreduceexportunder-invoicingwhentax

rebatesarehighifthetaxincentivesonthermsround-trippedFDIislargerthantheexportsubsidiesforegoneasa

result of under-invoicing15 The under-invoicing is used to shift illicit capital abroad (to places such as Hong Kong and

theBritishVirginIslands)whiletheround-trippingasFDIisusedtolaundertheillicitassetsinordertotakeadvantageof

taxbreaksandincentivesontheill-gottenwealth.AccordingtoFunget.al.,Chinesermssystematicallyunderreport

exportstoHongKongeventhoughtheexportrebatesdoosetsomeoftheincentivestodoso.

14Fisman, Raymond and Shang-Jin Wei (2004). Tax Rates and Tax Evasion: Evidence from Missing Imports in China, Journal of Poli-

cal Economy, Vol. 112, No. 2, pp. 471-500.15Fung, Hung-Gay, Jot Yau, and Gaiyan Zhang (2010). Reported Trade Figure Discrepancy, Regulatory Arbitrage, and Round-tripping:

Evidence from the China-Hong Kong Trade Data, University of Missouri, St. Louis, unpublished.



TheGERmethodologycanalsobeappliedtotradeatthecommoditylevel.TheUnitedNationsCOMTRADEprovides

exportandimportdataclassiedbythesix-digitHarmonizedCommodityDescriptionandCodingSystem(HS)andby

partnercountry.Dataarecategorizedfromgeneraltospecic,withthemostgeneralcommoditygroupingslistedas

two-digitcodesandthemostspeciccommoditygroupingslistedassix-digitcodes.

Wechoseeightgroupings(2-digitHScodes85,99,39,84,74,90,71and89)ofChinasimportsfromandexports

toHongKongwiththelargesttradevalue.Withintheseeightgroupings,1,151morespeciccommoditygroupings

wereanalyzedatthesix-digitlevel.Thetencommoditieswiththehighestcumulativegrossoutowsduetotrade

misinvoicing from 2007 to 2011 are shown in Table 2 above

Thecommoditygroupingofelectroniccircuits(HSCode854231)hasthelargestcumulativeillicitoutowsdueto

exportunder-invoicing(US$77.6billion)andimportover-invoicing(US$6.5billion),whichaccountfornearly20percent

of total misinvoicing involving the top ten commodity groupings However, trade misinvoicing involving commodity

groupHS851712(mobilephones,etc.)hasincreasedatthefastestpaceovertheperiod2007to2011,commensurate

withincreasingtradeinmobilephones.ThisisconsistentwiththendinginGFIscasestudyonMexicothattrade

misinvoicing tends to increase with increasing trading volumes

There is a reason why the largest volume of trade misinvoicing involves two main commodity groupings--group 84

(Nuclearreactors,boilers,machinery,etc)andgroup85,Electrical,electronicequipment.First,themorespecialized

a product, the easier it is to misinvoice because an inspector would need specialized knowledge in order to judge

whether the product is under- or over-valued Also, most of these commodities are often declared as parts and

accessoriesofmachinesorsomesuchnon-specicdescription.Thisallowstraderstohidetheactualmarketprice



oftheproductgiventhedicultyforcustomsunitvaluecheckstoagpriceoutliers.Theaggregationofpricefor

heterogeneous commodities presents a technical challenge because it makes no sense to price commodity groups that

are apples and oranges

Thedataanalyzedabovealsohasseverallimitations.First,misinvoicingwithincommodity-specictradecannotbe

comparedwiththeguresonChinasaggregatetrademisinvoicing.Theaggregategureshavebeenadjustedfortrade

withHongKongbyremovingtheentityfromourclosedsystemofcountries.However,asFung,Yau,andZhang(2010)

point out, trade misinvoicing between China and Hong Kong will not be systematically biased at the commodity level,

becausere-exportsandre-importshavebeenlteredoutofouranalysis.Second,theUNCOMTRADEDisclaimer

also makes it clear that there may be some statistical error between reporter and partner country trade statistics due

tovariousfactorsincludingvaluation(importsCIF,exportsFOB),dierencesininclusions/exclusionsofparticular

commodities, and timing Third, the estimates of export under-invoicing and import over-invoicing above assume that

China and Hong Kong are in a closed system of two countries Thus simultaneous collusion cannot exist; export under-

invoicing(importover-invoicing,respectively)fromChinatoHongKongisamirrorstatisticofimportover-invoicing

(exportunder-invoicing,respectively)fromHongKongtoChina.Inotherwords,wecannotassumethattradersinHong

Kong are trying to over-invoice importsat the same time that their counterparts in China are trying to under-invoice

exports

IllicitnancialowsfromChina,whetherestimatedonanetorgrossoutowsbasis,aremassiveaccordingtoseveral

economists.Suchoutowsadverselyimpactthecollectionofgovernmentrevenuesandworsenthedistribution

ofincome.Chinaneedsmoreeectivecollectionoftaxesinordertonanceitsexpandingsocialexpenditure

commitments The matter is urgent given that the countrys rapidly aging population is expected to generate additional

scalpressures.Itisthereforeimperativethattheauthoritiestakestrongmeasurestocurtailthegenerationand

cross-bordertransmissionofillicitcapital.Suchmeasuresshouldcoverallthreetypesofdriversofillicitows

macroeconomic, structural, and governance-related



II. External Assets of China in Tax Havens and Banks

As noted above, there is considerable evidence that the cross-border transfer of illicit capital from China into tax havens

and developed country banks take place mainly through the deliberate misinvoicing of trade Case studies on China

showthatasignicantportionofillicitoutowsre-entersChinaasFDIinacircularprocessknownasround-tripping.16

16Hung-Gay Fung, Jot Yau, and Gaiyan Zhang (2010), Reported Trade Figure Discrepancy, Regulatory Arbitrage, and Round-tripping:

Evidence from the China-Hong Kong Trade Data, University of Missouri, St. Louis, working paper. See also, Eswar Prasad and Shang-

Jin Wei (2006), Understanding the Structure of Cross-border Capital Flows: The Case of China, paper presented at the Columbia

University Conference, China at Crossroads: FX and Capital Markets Policies for the Coming Decade.



Whiletheoutowsareunrecordedorillicit,round-trippedFDIarelicitbecausetheyarerecordedinthebalanceof

paymentsandreportedtotheIMF(seeTables3-6).Indeed,theround-trippingprocesscanbelookeduponasan

elaborate money-laundering exercise

Totheextentthatsuchround-trippedcapitalcompriseasignicantandgrowingportionoftotalFDIintoChina,the

countrysuersadoubleloss.First,itfailedtogeneratetheinitialcapitallegitimatelyandtoinvesttheproceeds

productively(reectingonthecountrysweakgovernanceandregulatoryoversight).Second,thecountryalsolost

revenues in providing subsidies and tax rebates to what essentially are elaborate money laundering mechanisms

entailingthereturnofillicitcapitalmasqueradingaslegitimateFDI.Itisclearwhobenetsandwholosesfrom

suchnancialshenanigans.WewillshowthattheowofFDIfromtaxhavenslikeHongKongandtheBritishVirgin

Islands(BVI)intoChinaissomassivethattheyareunlikelytobesustainediftheywerenotnancedbyasteady

infusionofequallymassiveinvestmentsofillicit(andlicit)fundsbyChinese HNWIs and private corporations in those

jurisdictions

ItiswellknownthatChina,inaneorttoattractforeigndirectinvestmentandportfoliocapital,hasadoptedinvestor-

friendly policies such as tax concessions, government guarantee of loans extended by foreign corporations to domestic

rms,breaksonthetaxratesapplicableonrepatriatedprots,easingofFDIregulations,etc.Whiletheseregulations

havefacilitatedmassiveinowsoflicitforeigncapital,theyhavebyraisingthereturnonforeignrelativetodomestic

capitalalsocreatedtheincentivesforbothlicitandillicitcapitalight.AsSicular(1998)notes,Suchprovisionshave

apparentlybeeneectiveincreatinghigherreturnstoforeigncapital,asthereisevidencethattheycauseChinese

investorstomovemoneyoshoreandthenbringitbackintothecountrydisguisedasforeigninvestment.17 Other

incentivesforcapitalightarethelimitedrangeofdomesticnancialinstruments,theadditionalriskofconscation

associated with illicit funds, and the still-felt insecurities related to ownership of private assets He also notes that

Chineseinvestorsareincreasinglydiversifyingthroughbothvisibleandhiddenchannelsintooshoreinvestments.

The Sicular study is somewhat dated Moreover, Siculars hypotheses were not backed up by hard data on Chinese

assetsinoshorecentersordataonFDIowsbetweenChinaandthosejurisdictions.TheIMFsrelativelyrecent

initiatives,namelythecoordinateddirectinvestmentsurveys(CDIS)andthecoordinatedportfolioinvestmentsurveys(CPIS),allowresearcherstotracethemovementofthesemajorcapitalowsbysourceanddestinationcountries.

Whilethisisalarge-scaledatacompilationexerciseandisquitecomplicatedtoputtogether,researchishamperedby

the fact that CDIS and CPIS data are only available for 2009 and 2010 Many countries including China have not yet

reported such data to the IMF Nevertheless, there is some evidence based on the limited data that the Chinese round-

tripping investment trends that Sicular mentioned are continuing

Howdoesround-trippingwork?AccordingtotheIMFCDISManual,fundsmovefroma business enterprise in the

host or source economy to another enterprise in a routing economy, only to have them come back to the original or

another enterprise in the host economy According to the IMF, the enterprise receiving the funds in the routing economy

has little or no business operations of its own An example of round-tripping would involve a domestic investment by a

ChineseenterprisedisguisedasFDIgoingtoasubsidiaryinaroutingeconomy(typicallyinanoshorecentersuchas

HongKongorBVI).Theprocesscanbedepictedasfollows:

17Sicular, Terry (1998). Capital Flight and Foreign Investment: Two Tales from China and Russia, World Economy, Vol. 21, Issue 5, pp.

589-602.



Chart 1. Round-Tripping among the Troika

The CDIS Manual recommends that host countries record round-tripped funds in conformity with the guidelines

applicableforFDItransactionsandpositions.Theserecorded(licit)fundswouldthereforeappearasoutwardFDIfrom

the host country to the routing economy, and as inward direct investment from the routing economy to the host country

Analogously, the routing economy should record the funds received from the host country as inward FDI and as

outwarddirectinvestmentforthereturnofthesefundstothehosteconomy.However,thedatarequiredtoanalyzethe

round-tripping process is not complete as China does not report outward FDI, let alone those into routing economies

suchasHongKongandBVI.TheseneedtobederivedbasedontheinwardFDIpositionsoftheseoshorecentersvis-

-visthehostcountry,China.ButheretootherearedatagapsastheBVIalsodoesnotdirectlyreportCDISdatatothe

IMF(theBVIisanoverseasterritoryoftheUnitedKingdomandisnotamemberoftheIMF).

AnexampleoftheowoffundsdepictedinChart1involvesacompanyinthehosteconomy(China)whichinvests

intoasubsidiaryintheroutingeconomy(BVI)foron-wardFDIinanothercompanybackinthehosteconomy.Thisis

depictedbythearrowsshowingtheowsbetweenChinaandtheBVI.Ontheotherhand,round-trippingcanalsobe

viewed from the perspective of the routing economy whereby a company in BVI receives FDI from a parent company in

China, the host economy, which then reinvests these funds in another company in China

Table3showsthatforeigndirectinvestmentsfromChinaintoHongKongincreasedfromUS$312.3billionin2009to

US$366.5billionin2010,representingrespectively36.9and37.6percentoftotalFDIintothatoshorecenterwhile

Table5showsthatChinareceivedUS$553.7billionandUS$710.9billionfromHongKonginthoseyears.Thus,China

andHongKongarethelargestforeigndirectinvestorsineachotherseconomy(Table3and6).TheBVIplaysasimilar

role in the round-tripping of FDI except that Chinas FDI into BVI seems to be routed through Hong Kong We can

seethatBVIsFDIintomainlandChinaincreasedfromUS$187.2billionin2009toUS$213.7billionin2010.Giventhat

BVI is a British Overseas Territory located in the Caribbean with a population of about 28,000 and a GDP of around

US$1.1billion,itishardtoseehowitcanundertakesuchmassiveFDIoutowsunlessfundswereroutedbackinvia

Hong Kong18 Sure enough, according to Table 3, the BVI is the second largest recipient of FDI from Hong Kong, which

increasedfromUS$288.7billionin2009toUS$324.3billionin2010.ThefactthatFDIfromHongKongintoChina

(Table5)increasedfromUS$553.7billionin2009toUS$710.9billionin2010(comparedtojustUS$63.5billionfromthe

UnitedStatesin2010)wouldleadonetobelievethattheonlywaysuchmassivecapitalcouldhaveround-trippedback

toChinafromHongKongandBVIwouldbeifequallymassiveillicitoutowsfromChinaweretonancetheminthers

place.Otherwise,itisinconceivablethatBVIandHongKong(withamuchsmallerGDPthantheUnitedStates)could

18Central Intelligence Agency (2012), World Factbook. (reference link: hps://www.cia.gov/library/publicaons/the-world-factbook/

geos/vi.html).



havemarshaledthenecessarynancialwherewithaltocarryoutFDIonthatscaleyearafteryear.MassiveFDIoutows

fromHongKongtoBVI(Table4)outstripthoseintoChinainboth2009and2010;in2010,FDIinowsfromHongKong

intoBVIamountedtoUS$356.7billion,wellinexcessofUS$327.6billionintomainlandChina.

Portfolioinvestments(Table7)intoChinafromHongKong,whichincreasedfromUS$152.4billionin2009toUS$190.7

billionin2010,aremuchsmallerbutbynomeansinsignicant.Interestingly,theCaymanIslandsattractedmore

portfolio capital from Hong Kong than did mainland China, an astonishing fact in itself Bermuda attracted more

portfoliocapitalfromHongKongthandidanyoftheindustrialcountriesincludingtheUnitedStates.Perhaps,thecloserscrutinybymoreeectiveregulatorsinadvancedcountriesmakesportfolioinvestmentswithillicitfundsmore

dicult,accountingforthebulkofsuchfundstoowtotaxhavenslikeBermudaandtheCaymanIslands.

Consideringreported(orlicit)dataonly,Chart1showsthatamassiveamountofFDIisswirlingbetweentheChina-

HongKong-BVItroika.Forexample,in2010,ifwegoclockwisestartingfromChina,US$366.5billionowedoutto

HongKongwhichinvestedUS$356.7billioninBVIwhichinturninvestedUS$213.7billionbackintoChinaaccounting

forUS$936.9billioncirculatingasFDIamongthetroika.Inthatsameyear,ifwegocounter-clockwise,BVIinvested

US$324.3billioninHongKongwhichinvestedUS$710.9billioninChina.Evenifreporteddatadoesnotshowthatthe

latterinvestedbackinBVI,theamountincirculationamongthetroikatotalslightlymorethanUS$1trillion.



It is possible to derive some rough estimates of licit and illicit assets held in tax havens GFIs study on absorption

foundthatbetween24-44percentoftotalillicitoutowsfromdevelopingcountriesarestashedintaxhavens,

dependinguponwhetheroneusesthenarrowerBISdenitionorthebroaderIMFdenitionofsuchjurisdictions.The

IMFsbroaderdenitionclassiesSwitzerlandandIrelandasoshorecenters.19Weestimateillicitandlicitowsintotax

havensusingtheIMFdenition,asfollows.

Cashdepositsare10%oftotalows(basedonCapGeminiworldwealthportfolioholdings)whileothernancialassets

makeup37.9percentoftotalassetsintaxhavens(basedonholdingsinHongKong).Thebalanceisinvestedinnon-nancialassetssuchasrealestate,preciousmetals,etc.Forexample,accordingtoTable8,totalillicitoutowsfrom

Chinain2011wasUS$602.9billionoutofwhichUS$60.3billionwasdepositedascashandUS$228.3billioninother

nancialassets(suchasstocks,bonds,mutualfunds,derivatives);44percentoftheUS$288.6billionheldascashand

othernancialassetsorUS$127.0billioninillicitassetsowintotaxhavens(seeTable8fordetailsonprivatesector

illicitowsintotaxhavens).

Regardingtheestimationoflicitows,westartwithtotal(publicandprivate)internationalinvestmentposition(IIP)

assetsreportedbyChinatotheIMFofUS$4.7trillionin2011thatareheldworldwide(inbanksandtaxhavens)(see

Table9).NotethatIIPsarestockguresnotows.Fromthistotal,wetakeoutociallyheldreserveassetsofUS$3.2

trillion in order to derive private sector asset holdings There could be other publicly held assets in IIP assets, but these

are impossible to identify as the IIP system does not show assets held by sector To that extent, the 2011 estimate of

privatesectorIIPassetsofUS$1.46trillionmaybesomewhatoverstated.Now,outofthis,ifweassumethatsome44

percentareheldintaxhavens,thentheamountheldtotalsUS$643.4billion.Thisproportionmaybeoverstatedaslicit

owsintotaxhavensarelikelytobelowerthanillicitows.Inanycase,thisisastockgureandachangeinthestock

gureisourbestestimateofaowgiventhatwedonothaveinformationonwithdrawals.

Table10estimatestheproportionoflicitandillicitinvestmentowsbasedonthesebroadassumptions.Onaverage,

52.4percentofinvestmentsthatowedintotaxhavensduring2005-2011wereillicitwhile47.6percentwerelicit.These

estimatesvarysignicantlyfromyeartoyeardependinguponanumberoffactorssuchasthegenerationofillicitcapital, regulatory changes, investor preference, extent of illicit funds generated and transferred, risk appetite, etc

Theproblemofillicitowscannotbesolvedbysimplyfocusingondomesticpolicymeasuresthatneedtobetakenby

developingcountriessuchasChina.Theworldsshadownancialsystem,whichfacilitatestheabsorptionofillicitows

must also be subject to greater regulatory oversight so that the system is held to higher standards of transparency

and accountability regarding transactions and operations A whole host of policy measures is necessary to make the

absorptionofillicitassetsmoredicultrangingfromgreatertransparencywithregardtothereportingofdataand

informationtotherequirementthatnancialinstitutionscollectinformationonbenecialownershipofcorporations,

foundationsandtrusts,therequirementofcountry-by-countryreportingbymultinationalsontheirtransactionsand

operations, and the automatic exchange of tax information between sovereign nations and tax havens

19Kar, Dev, Devon Cartwright-Smith, and Ann Hollingshead (2010). The Absorpon of Illicit Financial Flows from Developing Countries:

2002-2006, Global Financial Integrity, Washington DC.



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