A River of Illicit Money Flows Out of China

New report says nearly US$4 trillion disappeared – 10 percent of GDP

An astonishing US$3.97 trillion in illicit funds left China between 2000 and 2011, according to a report released Friday by the Washington, DC-based Global Financial Integrity, a research and advocacy group.

As much as 10 percent of China’s annual gross domestic product may be disappearing out of the country in illicit funds flight, says the 15-page report, titled Illicit Financial Flows from China and the Role of Trade Misinvoicing.

The capital flight is hidden in opaque stratagems on the part of businessmen and corrupt officials to attempt to make sure governments don’t catch them. Consequently the report relies on what amount to the best guesses of government regulatory agencies, private corporations, and others.

“Such survey results indicate that globally, tax evasion by high-net-worth-individuals and corporations comprise by far the largest component (around 65 percent) of cross-border illicit flows from developing countries, followed by the proceeds of crime (30 percent) and corruption (5 percent),” the report notes.

Trade misinvoicing – described as the illegal trade of legal goods – is held responsible for outflows amounting to US$172 billion in 2000, rising to US$602.9 billion in 2011, an increase of about 7.2 percent annually, according to the report, written by Dev Kar, a former senior economist at the International Monetary Fund, and Sarah Freitas, a Global Financial Integrity group economist.

“One of the adverse effects of illicit flows from China has been a worsening of the country’s income inequality as the rich get richer through tax evasion (which comprises by far the major portion of such outflows) and through using the world’s shadow financial system to shelter and multiply their illicit wealth,” the report adds.

Nearly US$600 billion of the illicit flows ended up as cash deposits or financial assets such as stocks, bonds, mutual funds and derivatives in the British Virgin Islands, the Caymans and other tax havens. An uncertain amount of that is then “roundtripped” back in what the report describes as a “complex money-laundering scheme used in order to take advantage of favorable regulations for FDI and to allow high net worth individuals to secretly accumulate wealth in contravention of government regulations and oversight.

Most of the money is routed through Hong Kong, making the territory, with about 7 million people, the world’s third-largest recipient of foreign direct investment, at more than US$80 billion in 2011, a leap from US$52 billion in 2009. Such round-tripped FDI is given preferential treatment vis-à-vis domestic capital such as tax concessions, government guarantee of loans extended by foreign corporations to domestic firms, land and other facilities at concessional rates, etc, the report notes.

To give some idea of the magnitude of these cash flows, the report notes, “For example, in 2010, if we go clockwise starting from China, US$366.5 billion flowed out to Hong Kong which invested US$356.7 billion in the BVI which in turn invested US$213.7 billion back into China, accounting for US$936.9 billion circulating as FDI among the troika. In that same year, if we go counter-clockwise, BVI invested US$324.3 billion in Hong Kong which invested US$710.9 billion in China. Even if reported data does not show that the latter invested back in BVI, the amount in circulation among the troika total slightly more than US$1 trillion.”

Hong Kong’s position as recipient of direct foreign investment is the largest in Asia after China itself and far ahead of its Asian rival, Singapore, at just over US$60 billion according to the United Nations Commission on Trade and Development’s World Development Report 2012. It is the region’s biggest source of capital outflows as the money is reinvested back in to China after having been legitimized via its voyage through the territory.

Some of that money does move out of those BVI and Caymans accounts into businesses overseas, raising hope that Asia might play a role in pulling the Eurozone out of its continuing economic crisis. But probably the preponderance is rolled into the property markets of Canada, the United States, Singapore and to some extent Europe. With the US slowly emerging from its five-year-old real property meltdown, some realtors in New York are studying Mandarin, according to a recent New York Times article, to be more receptive to Chinese buyers.

The real property consultants Colliers International estimate that Chinese mainlanders constitute 20 to 40 percent of foreign investors in London, Toronto, Vancouver and Singapore. One enterprising developer in Spain built a new project with Chinese-style buildings including a courtyard, pavilion, ponds and supposedly checked out by a feng-shui expert to make sure the wind and water aspects were in line.

Mis-invoiced trade between Chinese companies and the United States increased from US$48.8 billion in 2000 to US$59.0 billion in 2011, the report says. The commodity groupings most susceptible to trade misinvoicing include UN Commodity Trade Statistics Database group 84 – nuclear reactors, boilers, machinery, etc. – and group 85, consisting of electrical and electronic equipment, with the sub-group for electronic circuits showing the largest cumulative illicit outflows (US$84.1 billion). Trade misinvoicing related to the sub-group for mobile phones increased at the fastest pace from 2007-2011.

Mainland China and Hong Kong are the largest foreign direct investors in each other’s economy, with the BVI serving as the second-biggest foreign direct investor in both mainland China and Hong Kong. The BVI also serves as the largest recipient of FDI from Hong Kong.

“Indeed, the report continues, “it appears that while the BVI invested a massive US$213.7 billion in mainland China in 2010, nearly all reciprocal investment in the BVI from the Chinese mainland was routed through Hong Kong. The BVI has a population of about 28,000 and a GDP of only around US$1.1 billion, so it is hard to see how it can undertake such massive FDI outflows unless funds were routed back in via Hong Kong, and/or subsidized by illicit funds.”

On average, roughly 52.4 percent of investments that flowed into tax havens were illicit financial flows or illegal capital flight involving money that is illegally earned, transferred, or utilized. While the funds 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.

Outflows of illicit capital from developing countries overall have been a growing problem over the past decade. According to the latest annual report, developing countries lost between US$775 billion and US$903 billion in 2009, down from the previous report’s estimate of US$1.26 to US$1.44 trillion in 2008. The main reason for the 2009 falloff was due to the economic downturn, which reduced foreign direct investments, new loans, and trading volumes.

Global Financial Integrity studies show that cross-border transfers of illicit capital are propelled by three main types of drivers—macroeconomic, structural, and governance-related. In China’s case, large and growing current account surpluses lead to capital outflows, some of which may well be licit capital flight (such as private sector hot money outflows). High and rising inflation could also contribute to illegal capital flight, assuming owners do not wish to see the real value of their holdings decline over time.

“The widely held perception that the yuan is undervalued because of the trade surpluses may feed into expectations of exchange rate revaluation in the future which could lead to speculative inflows and round-tripped capital,” the report continues. “Structural factors for China include non-inclusive growth, as a result of which there are a larger number of tax havens from China during 2005-2011 were illicit while 47.6 percent were licit.’

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