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Yanchun Liu, Matthew Kemper, Patrick Magrath, and Craig Glesze,“China’s Global Trade Balance Discrepancy: Hong Kong Entrepôt Effects and Roundtripping Chinese Capital,” September 12, 2008
A. Purpose of this Study
The U.S.-China Security Review Commission and the United States Congress, commissioned the Trade Lawyers Advisory Group (“TLAG”) -- specifically, members CRG Consulting Texas, Inc. (“CRG-Texas”) and Georgetown Economic Services LLC (“GES”) – to undertake a comprehensive study of the persistent and growing discrepancy in the trade balance data of the People’s Republic of China (“China,” the “Mainland,” or the “PRC”) and the data reported monthly by trade partner governments. The purpose of this study is to examine the role of Hong Kong in the various explanations of the statistical discrepancies that readily emerge when one compares official Chinese trade data with those of its trading partners.
Today, many international scholars and researchers are of the view that China’s entrepôt trade through Hong Kong is to the largest factor responsible for the widening Chinese trade balance discrepancy. The distortion becomes apparent after one examines China’s official trade statistics in light of the corresponding “mirror” trade data compiled by its partner nations. In other words, a comparison of export statistics recorded by the Chinese customs authority and the corresponding import data published by China’s trading partner countries reveals a significant and widening inconsistency over the past several years. Chinese export values, as recorded by Mainland authorities, are significantly lower than Chinese import values as reported by China’s trading partners. Similarly, Chinese exports values, as reported by Mainland authorities, are significantly higher than values of exports to China as published by China’s partner countries.
Consequently, China's balance of trade (consistently in surplus), as determined by official Chinese government statistics, is substantially lower than the global trade surplus as reported by its trading partners. Specifically, based on the Global Trade Information Services database— World Trade Atlas (“GTIS,” “GTA” or “WTA”), China’s trade-in-goods surplus that was reported by 41 major trading partner countries (accounting for approximately 97 percent of total China trade) was US$554.2 billion in 2007. By contrast, Chinese trade surplus with the same 41 trading partner countries, as reported by China, was only US$234.8 billion during the same year – a US$319.4 billion discrepancy. Furthermore, this discrepancy has been trending upward during the period from 1999 to 2007, increasing in eight of the past nine years. The discrepancy has ranged from a low of US$90.8 billion in 1999 to a high of US$319.4 billion in 2007, thus more than tripling over the period.
The reconciliation of this growing data discrepancy is essential for policymakers worldwide – not only to determine China’s true global trade surplus, but also to understand the unique role that Hong Kong has played with regard to China’s overall economic strategy. Therefore, the primary objective of this study is (i) to scrutinize the unique relationship between
the Mainland and Hong Kong, and (ii) to attempt to explain the statistical discrepancies that distort China’s official trade data.
The initial hypothesis that our team sought to prove or disprove was that China’s entrepôt re-export trade through Hong Kong – that is, China’s indirect export and import trade undertaken through the former British territory – constitutes the major trade factor that accounts for the statistical discrepancy and distortion summarized above. To test this hypothesis, we first analyzed various economic studies that had examined this issue during the past 25 years together with the underlying data, and determined that not all of the data discrepancies could be explained by each of those individual studies. We then carefully reviewed all of the relevant legal modifications, including international treaties and conventions that China and Hong Kong have enacted and ratified during the past decade, to try to identify additional explanations for the discrepancy.
Next, we collected our own data through an internationally-recognized source (e.g., Global Trade Information Services) and conducted our own field studies with U.S., Chinese, and Hong Kong customs officials in the U.S., Hong Kong, Beijing, China, and Qinhuangdao City, China. With regard to China’s entrepôt trade through Hong Kong, we obtained ontemporaneous estimates of Hong Kong re-export “middlemen” markups and applied such markups to the most
recently available data to reconcile in part China’s reported trade statistics. Finally, we performed our own independent statistical analyses.
Based on these multiple criteria, our team rejected the Hong Kong re-export trade hypothesis as the only major explanation accounting for the growing trade data inconsistency highlighted above. The compelling factor supporting our conclusion is that China’s indirect export and import trade through Hong Kong represented only 18 percent of China’s aggregate multilateral trade with the 41 trading partner countries in 2007, a significant decrease from the 60 percent figure that prevailed approximately two decades ago. It is noteworthy that the 18 percent is calculated using China’s total trade volume reported by 41 trading partner countries. Along the same calculation basis, the proportion of Hong Kong re-export trade to China’s total trade with its trading partner countries had seen a gradual decrease, from 36 percent in 1999 to around 19 percent in 2006. In other words, even though the China-Hong Kong entrepôt effect is still responsible for a share of the statistical discrepancy at issue, that factor cannot by itself constitute an exclusive reason for the data discrepancies, based on contemporaneous Chinese trade flows. Furthermore, the recent appreciation of the Chinese currency, the renminbi, the rise of material costs, and increase in labor costs due to passage of the new labor law on January 1, 2008, all have serious negative impacts on Hong Kong middleman companies’ business with the Mainland.
For these reasons it is likely that Hong Kong’s role in the Chinese trade surplus discrepancy may continue to decline in the future.
B. Round-trip Capital—An Under-emphasized Cause of Chinese Trade Balance Discrepancy
Although China’s entrepôt trade through the former British colony has decreased substantially during the past 20 years, the statistical discrepancy explained above has been steadily increasing during this same period. As a result, our team had to search for alternative hypotheses to identify and explain the real cause or causes underlying the data problem. Based on our integrated analysis of China’s current-account and capital-account transactions, we hypothesize that a phenomenon referred to as “round-tripping” is principally responsible for the bulk of the trade data incompatibilities highlighted above.
“Round-tripping” is a trade-tax-investment strategy whereby Chinese enterprises undervalue exports or artificially overvalue imports, in order to move Chinese capital across the Mainland border through current-account transactions. Specifically, Chinese enterprises export domestic capital from the Mainland to related-party enterprises situated outside China in offshore tax havens, such as Hong Kong, pursuant to non-arm’s length transfer-pricing transactions that are designed to circumvent Chinese capital controls. The exported Chinese domestic capital is then recycled abroad and returns to the Mainland in the form of foreign investment, and as such, receives a lower tax rate on profits.
Three economic and legal elements should be in place to encourage round-tripping. First, investors from a tax jurisdiction such as China must have access to a foreign tax haven through which they can establish related-party companies with which to engage in non-arm’s length transfer-pricing transactions. Second, the primary tax jurisdiction must have trade and investment barriers that significantly impede and discriminate against domestic investment. Third, the primary
jurisdiction must have on the books tax or other incentives that discriminate in favor of foreign investment. The China-Hong Kong relationship satisfies all of these elements.
Even though Hong Kong is not a de jure tax haven, international practitioners universally consider the former British colony to constitute a de facto tax haven for the following reasons: (i) its relatively low corporate income-tax rate of only 17.5 percent; (ii) the taxation of only Hong Kong-source income; (iii) an extremely tax-friendly territorial principle that is flexibly applied to rather loose and relaxed residency and income-sourcing criteria; (iv) the notable absence of taxes on such traditional income items as capital gains, dividends, and retained earnings; and (v) statutory provisions that allow taxpayers to carry forward losses indefinitely. Significantly, despite the People’s Republic of China’s sovereignty over the island, Hong Kong does not even form part of the customs or tax territories of the PRC. Rather, Hong Kong constitutes a separate “foreign customs territory,” as well as a distinct “foreign fiscal territory,” situated within China’s national geographic territory.
Under the “One Country, Two Systems” legal-and-economic framework, Hong Kong becomes an ideal destination for Mainland investments, governed by the series of Mainland-Hong Kong bilateral treaties. The Mainland has imposed a strict foreign currency control policy, which results in significant obstacles to the free flow of capital across the border of China. On the other hand, local governments in China have a strong incentive for soliciting foreign direct investments
and have issued a set of favorable policies for these foreign investments (e.g., reduced corporate tax rate for foreign invested enterprises). It is noteworthy that effective as of January 1, 2008, the new corporate taxation law of the Mainland eliminates the gap between the domestic and foreign corporate tax rates. Therefore, the adjacent geographical location of Hong Kong, the particular institutional setting of the Mainland on foreign investment, and the Mainland’s foreign currency
exchange controls provide an ideal environment for round-tripping capital. One bit of evidence is the relatively high and stable proportion of Chinese FDI that originates in Hong Kong: from 1999 to 2006, Hong Kong investments had accounted for at least 33% of China’s total FDI.
In the practice of round-tripping, Mainland enterprises export Chinese capital through current-account transactions that artificially inflate the value of imported components sourced from affiliated enterprises located in offshore tax havens, such as Hong Kong. As explained above, the second economic and legal element that facilitates round-tripping practices comprises trade and investment barriers that actively impede and discriminate against domestic investment in the primary tax jurisdiction. China’s capital controls, inadequate protection of private property, and overall lack of domestic bank credit constitute such restrictive impediments.
Yet, to ensure that private Chinese domestic invested enterprises and foreign invested enterprises (“FIEs”) operating on the Mainland receive adequate financial credit and resources to prosper and expand under such circumstances, Chinese authorities can simply direct such entrepreneurs to Hong Kong, one of the world’s leading international financial centers, a ready offshore source for needed financial credit and capital. In fact, the recently-ratified Hong Kong- China bilateral free-trade agreement and bilateral tax convention mentioned above actively encourage Chinese domestic and FIE investors to obtain financing in the Chinese Special Administrative Region (“SAR”). As Beijing’s seventh Special Economic Zone (“SEZ”) on a de facto basis, Hong Kong plays the indispensable role of the Mainland’s offshore international financial and banking magnet.
C. Empirical Findings and General Conclusions
By virtue of the integrated statistical reconciliation process carried out in this study that performs all pertinent trade data adjustments, including that for Chinese round-tripping activities, we are able to draw the following general conclusions concerning the China-Hong Kong entrepôt effect and its overall impact on the PRC’s global merchandise trade surplus. In 2007, the individual causes underlying the growing statistical discrepancy that distorts official Chinese trade data break down as follows: (i) China-Hong Kong entrepôt effect – that is, Hong Kong’s re-export trade and middleman markups; (ii) divergent customs standards used internationally to value exports and imports; (iii) “phantom” Chinese exports-imports; (iv) round-tripping of Chinese capital recycled abroad in foreign tax havens (e.g., Hong Kong) that subsequently returns to the mainland disguised as foreign investment (of which Hong Kong comprised 36% of total FDI in 2006); (v) smuggling; and (vi) residual discrepancy due to other factors such as statistical errors and omissions, servicing trade, timing of imports and exports, etc.
The Sino round-tripping practices and capital-flight activities carried out through Hong Kong comprise a major factor that not only contributes to divergent private savings and investment levels in the Mainland and the rest of the world, but also is a major facto in the understated current-account surplus.
The trade data and capital-flow discrepancies evaluated in this study have implications that run deeper than simple statistical errors and omissions. China’s entrepôt trade, roundtripping practices, and capital-flight activities -- a great majority of which are carried out through Hong Kong -- have contributed to negative trade consequences in the rest of the world, including in the United States, by masking the effects of the PRC’s mercantilist trade policies.
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