China's $3.8 Trillion Hemorrhage

As we covered yesterday, China is starting to hemorrhage money.

How much?

Over the past decade, about $3.8 trillion has left China illicitly. The trend, if you’ll recall yesterday’s discussion, is accelerating. Somewhere around $50 billion per month is flooding out of China.

Today I want to cover the final ramifications of this monetary hemorrhage, and why it matters to your investments and your wealth…

At the individual level, what’s a Chinese saver to do? Over the past decade, the Chinese have sought wealth preservation, if not investment returns, in China’s stock market, as well as in Chinese property markets. These ideas worked out well for some Chinese investors, but not for others. Plus, as I mentioned yesterday, the Chinese buy gold — lots of it.

In addition to investing in Chinese assets — stocks, property, gold, etc. — there’s long been anecdotal evidence of Chinese moving funds offshore in shady ways, as illustrated by the Vancouver story about suitcases full of cash. In other times and other places, I’ve heard similar stories of Chinese suitcase money: in Russia, across the Middle East, in Africa and South America.

There’s an old saying in the field of statistics that “The plural form of the word anecdote is data.” And recently, a number of investigators have gained access to much more hard data about how much Chinese money has moved overseas. The amount of money is huge, to the point of shocking.

When it comes to funds that have moved away from China — and the fate of the individual owners is something else entirely — we’re dealing with what The Economist magazine recently called a form of “voluntary exile.”

The bottom line is that large numbers of Chinese are moving money offshore, by hook or by crook. According to Hurun Report — a Shanghai-based service that caters to a very upscale clientele — the average wealthy Chinese (defined as having a net worth over 10 million yuan, or about $1.6 million) holds 19% of his assets overseas.

Meanwhile, per Hurun, 85% of wealthy Chinese plan to send their children to school outside China, while 44% have plans to emigrate at some point in their life. In and of itself, that’s hardly a ringing endorsement for the future livability of China.

Also, according to a report issued Oct. 25, 2012, by the Washington, D.C.-based Global Financial Integrity (GFI) group, almost $3.8 trillion (yes, trillion!) illegally exited the Chinese economy between 2000 and the end of 2011. About $602 billion left China in just 2011, so the trend is accelerating.

Indeed, if about $50 billion per month ($602 billion divided by 12 months) left China in 2011, it’s no wonder that, for the past year, we’ve seen market-moving reports that China’s economy is slowing down. Perhaps China’s economy isn’t so much “slowing down,” in many respects, as it’s decapitalizing due to illicit outflows.

Naked Officials and Hot Money

What’s the source of these illicit funds? According to GFI, some of the proceeds are outright ill-gotten lucre from bribes to officials, or raw government corruption. Chinese Internet bloggers have coined a term for modestly paid officials who move their families, and/or large piles of assets, abroad: “naked officials.”

Other capital that flees China may be money that was earned initially through legitimate business means. However, these funds then moved out of China in defiance of law, regulation and other capital controls, usually hand in hand with evasion of applicable taxes. It’s often called “hot money,” a term that originated in Hong Kong.

Right away, this hot money puts other entities at a competitive disadvantage, especially Western companies that must go to extreme lengths to obey tax and banking laws on an international scale.

For example, one big headache for every international U.S. business and bank manager is complying with the U.S. Foreign Corrupt Practices Act (FCPA). Noncompliance with FCPA can bring severe corporate and personal penalties on any company subject to U.S. jurisdiction.

Now consider the difficulty a Western business might have in competing with a Chinese business. The Western business has to conduct itself transparently, while obeying a long list of home-country laws and regulations. Meanwhile, the Chinese business has access to cheap and hot money and operates under a business plan that’s based on nominal underpricing of goods and services, made up with accounting shenanigans.

Evading “Normal” Export Channels

Let’s look at some examples. Consider the rare-earth (RE) business, which concerns a set of exotic elements crucial to modern industry — electronics, magnetics, optics, the auto sector and more. The RE biz is about 95% controlled by China at the source.

Over the years, I’ve heard stories from reputable Western buyers about procuring raw RE supplies — of Chinese origin — in places like Thailand and Myanmar. The RE materials come in poorly labeled bags of product (I’ve actually seen examples!) and are hauled in rickety trucks through uncontrolled mountain passes down from China. It’s hardly a “normal” export channel.

I’ve also heard reports of Chinese sellers mislabeling RE elements as, say, a low grade of steel scrap. The scrap gets exported to, say, Japan or Korea, using bills of lading that dramatically understate the value of material. Then the “scrap” buyer pays a second bill for the RE elements using a wire transfer to a numbered bank account somewhere far from China. Again, it’s hardly a “normal” export channel.

The GFI report highlights other shady export practices — far beyond what happens with RE elements — that serve to hide the true cost and/or price of products moving through otherwise legitimate export channels. That is, GFI identified chronic levels of “mis-invoicing” of Chinese exports to the U.S., ranging from $49 billion in 2000 to $59 billion in 2011.

Specifically, Chinese companies are known to cook the books in a way that understates export value out of China versus income from sales at the destination. The “missing” funds pass through any number of tax havens, where there’s no physical value added but where business secrecy is sufficient for markups and profit skimming.

According to GFI, Chinese products most susceptible to trade mis-invoicing include power equipment (even nuclear reactors), boilers, machinery, electrical and electronic equipment and electronic circuits — think of all those “Made in China” products that fill the shelves of Wal-Mart, Target, Best Buy and other stores. GFI identified $84 billion of such mis-invoicing in just 2007–2011.

Big Money Offshore

Along the way, GFI located almost $596 billion of cash deposits and/or financial assets (such as stocks, bonds, mutual funds and derivatives) that landed in tax haven jurisdictions from 2005–2011.

According to GFI, just the British Virgin Islands — with a population of 28,000 — accounted for over $213 billion in officially reported investment in China in 2010. One might say that the British Virgin Islands glow at night from all that Chinese hot money.

The situation with the British Virgin Islands illustrates another point. Some of that hot money actually goes back into China disguised as “foreign” investment, despite being owned by Chinese nationals, with the value-added originally generated in China.

Thus, this hot money isn’t really “new” investment. Instead, we’re just looking at a very roundabout, economically inefficient way for Chinese business owners to recover a return on their original investments. It’s a strange way to grow an economy.

Meanwhile, rampant capital outflow from China greases wheels within a shadow global financial system. Not to paint with too broad of a brush, but it’s accurate to say that illicit funds have been found in proximity with all manner of improper and illegal activities. These include crimes like drug running, human trafficking, arms smuggling, trade in contraband (such as “blood diamonds”) or stolen goods (high-end cars, for example), environmentally damaging land use and much else.

Ticking Time Bomb

In the GFI report, the authors state that there are “serious questions about the stability of the Chinese economy.” Furthermore, per the report, “If outflows continue to ratchet upward, adverse repercussions on social and political stability cannot be ruled out.”

In other words, the massive, illicit capital outflows from China contribute to a growing sense of economic inequality, as well as pervasive corruption. The principal author of the GFI report, Dev Kar, formerly of the International Monetary Fund (IMF), opined that “The Chinese economy is a ticking time bomb. The social, political and economic order is not sustainable in the long run given such massive illicit outflows.”

The Chinese system is “not sustainable”? Now, that’s a problem.

That’s all for now. Thanks for reading.

Byron King