Did China Really Lose $3.75 Trillion in Illicit Financial Flows?

A recent report from the think tank Global Financial Integrity (GFI) identifies China as the largest source of illicit financial flows in the developing world. The report, Illicit Financial Flows from China and the Role of Trade Misinvoicing, identifies $3.75 trillion in illicit outflows during between 2000 and 2011.

The possibility of trillions of dollars in illegal capital flight is certainly worrying. The report’s release generated newspaper headlines such as “China ‘top source’ of World’s Tainted Money,” “Spectre of Capital Flight Slows China FX Reform Drive,” “Capital Outflows: The Flight of the Renminbi,” and “$4 Trillion in Dirty Money Should Worry Us All.”

Has China actually been experiencing catastrophic levels of capital flight over the past decade? The GFI report indicates that China has seen annual outflows equivalent to a staggering 11.1 percent of GDP. If this is true, all other examples of emerging market capital flight pale in significance. In fact, another GFI report attributes 47percent of all illicit financial flows from developing countries between 2001 and 2010 to China.

These illicit flows are calculated through two methods, the World Bank Residual Method and the Gross Excluding Reversals Method. The World Bank Residual Method looks at discrepancies in the balance of payments, attributing differences between the uses and sources of funds to capital flight.  The Gross Excluding Reversals Method estimates illicit capital flows due to trade misinvoicing, differences between exporting and importing country reported trade flows. In the case of China, trade misinvoicing accounts for the vast majority of illicit capital outflows, 86.2 percent.

The process by which trade misinvoicing facilitates capital flight is relatively simple. For example, a Chinese firm sells $100 million of goods to an American firm, but declares to Chinese authorities that the price is only half of that—$50 million. It will then repatriate the declared amount—$50 million—back to China through normal channels. The undeclared amount is kept in an offshore bank account controlled by a subsidiary. The end result is that $50 million evaded China’s capital account restrictions and left the country, i.e., capital flight.

To identify those flows, the GFI report uses the IMF Direction of Trade Statistics. The IMF numbers show that world imports of Chinese goods are significantly larger than declared Chinese exports. China’s reported imports are also larger than world exports to China. These two discrepancies combine to form the total amount of illicit capital flow through trade misinvoicing.

Identifying illicit flows is an important and useful task, but there are two major flaws in GFI report methodology. First, we find that the estimate of illicit outflows is vastly overstated: Our correction of the data reduces the estimated amount of illicit outflows by 75 percent. Second, the significance of the remaining flows is greatly exaggerated.

Let us start with the amounts. This discrepancy between home country and receiving country trade data is not a new finding. In the case of China, trade economists identified this problem more than 15 years ago. This discrepancy is relevant for both research purposes (any empirical economist will tell you that inconsistent data is at the source of many nightmares) and for policy reasons: When the bilateral trade balance between China and the US became a hot political issue, it was highly problematic that China and US official estimates were differing by half.

The main explanation is not false invoicing, but the role of Hong Kong in Chinese trade.  As is well known, Hong Kong acts as an intermediary for a large part of Chinese exporters. Hong Kong’s traders have played the role of middlemen since the opening of China to the world—identifying countries and companies to sell the goods, pricing them, etc. Even if it has decreased over the last decade, the significance of Hong Kong as a channel for Chinese trade should not be understated: Reexports of Chinese goods to the rest of the world through Hong Kong represented around 12 percent of Chinese total exports in the mid-2000s, down from 60 percent in 1992.

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