A closer examination of China’s star FDI figures reveals a large amount of capital going out of the country and returning under a different guise, says Louise de Rosario.

China has been the star in attracting FDI since the late 1990s, capturing $40bn-$50bn a year of global capital. For many years, it was the largest recipient of FDI among developing countries. Last year, it set another milestone – it surpassed the US to be the world’s favourite FDI destination for the first time, thanks to a stunning FDI inflow of $52.7bn. The Chinese government, excited by the surprise achievement despite a global recession, now talks of doubling the figure to $100bn in a few years’ time.

Many investors share the optimism, rushing into new business sectors liberalised by China’s accession to the World Trade Organisation (WTO). Almost every month, there is an announcement of a multinational establishing or expanding its business in what is described as the “Workshop of the World”.

Misleading picture

Look closer, though, and the China picture may be less rosy. In the past few years, more economists have questioned China’s FDI figures. They say that the country has overstated its FDI figures by one-quarter to one-third, amounting to $12bn-$16bn less a year. They say this is due to “round tripping”, whereby capital that originates from China goes through another country, often an offshore tax haven, before re-entering the country as “foreign” investment. Such money could be from state and private-owned mainland firms, Chinese individuals or China-based Hong Kong, Taiwan and foreign firms recycling earnings from their mainland operations. Their overseas vehicles are typically holding companies that hold no operating assets, except their mainland-registered ventures.

Hong Kong is the most popular stop for such outflow, followed by the three financial havens of British Virgin Islands, Cayman Islands and Bermuda. In 2002, Hong Kong accounted for $19.2bn of China’s $52bn in utilised FDI. Virgin Islands was the second largest source of FDI in China, with $6.15bn. The two other Caribbean havens were also high on China’s FDI list.

Motivation

There are political, taxation and other commercial reasons for such a merry-go-round of China-originated money. Some are legitimate, others clandestine. Multinationals, for example, have been using offshore financial havens for years to protect and to maximise profits from their mainland investments.

“Offshore tax havens have always been favourite locations for special-purpose vehicles used for investing in China. This is perfectly normal practice. I don’t see the pattern changing,” says Edward Epstein, representative of the Shanghai-based US law firm Altheimer & Gray.

What is not normal, though, is the unusually large volume of unrecorded capital in and out of China, which distorts its FDI figures. In 1993, Peter Harrold and Rajiv Lall of World Bank estimated that round-tripping accounted for 25% of China’s FDI in 1992, the year in which utilised FDI almost tripled to $11.3bn. That was when a China fever swept through the world following patriarch leader Deng Xiaoping’s call for faster and bolder reforms.

In a mid-2002 presentation, Guy Pfeffermann, an economist at World Bank-affiliated International Finance Corporation (IFC), said that if round-tripping of capital was taken into consideration, China’s net FDI inflows should be around $20bn, not the official $40bn for 1999 and 2000.

One conclusion the Washington-based economist drew from his revised figures was that a rival FDI destination, India, did better than was generally recognised. With the adjusted figures, FDI was 2% of China’s GDP and 1.7% of India’s.

That is “not a huge difference,” he says in an interview. “The point of my presentation is to put things in a realistic perspective. India felt it was not anywhere close to China [in terms of attracting FDI]. Many would-be investors of India, too, have been discouraged by its FDI record when compared with that of China and said ‘why bother?’”

Round-tripping

Economists at Singapore’s ministry of trade and industry stated in a report released in late 2002 that round-tripping of capital originating from China “is likely to have increased since 1992”. Dr Friedrich Wu and other economists at the ministry’s economic division wrote: “FDI flows to China are not as large as official figures show because a significant percentage of it – 25% or higher – consists of ‘round-tripping’ of funds that originate from mainland commercial entities.”

Such new interpretation of China’s FDI figures has lifted the morale of its Asian neighbours that felt they had lost much FDI to the giant. The Hindu wrote in June 7, 2002, that Mr Pfeffermann’s comparison of China and India was “a strong jolt” to those who extolled China’s success in securing the “much-ballyhooed $40bn-$45bn” of FDI in 2000.

The Association of Southeast Asian Nations (Asean) also has less to worry about, wrote the Singaporean economists. “Our analysis has shown that China has not made gains in FDI from the major developed countries at the expense of Asean-5,” they wrote.

They and other foreign analysts often cite one set of data as evidence of China’s round-tripping: the volume of the country’s net capital outflow matches that of the increase in FDI inflows from Hong Kong, British Virgin Islands, Cayman Islands and Bermuda. China’s unrecorded capital flows, placed under the item of ”errors and omissions” in the balance of payments, had risen from a net positive outflow of $12bn in 2000. “This was in tandem with FDI inflows from Hong Kong and the (Caribbean) tax havens, which had correspondingly grown from $960m to $21bn,” the Singapore report said.

There and back again

The first step in round-tripping is to get the money out of China. There are many established channels to do this, despite the government’s continuing tight control on foreign exchange. The most common way is to overstate the value of exports and understate that of imports, a practice known as transfer pricing. Multinationals have traditionally used this method among their extensive network of companies worldwide to minimise tax liabilities in different markets, including China. Mainland and overseas Chinese firms have also learned to do this.

In southern China, where Hong Kong and Taiwanese firms are concentrated, such offshore payment has become widespread and increasingly sophisticated. There are professional money brokers, underground cashiers and so-called cell-phone banks that will respond promptly to requests for cash with just a phone call. Tens of millions of dollars circulate in the China-Hong Kong-Taiwan triangle without official supervision and often without physical transfers of cash.

Mainland Chinese have other ways to beat the system. Chinese individuals are now allowed to bring more foreign exchange out of China for travel and study purposes, and many are using their spouses and children to park their money offshore. The amount they carry each time is not substantial but it adds up over time. The Beijing-based magazine New Finance describes this activity as “house moving by a mouse, a bit at a time”.

The first destination of such capital is usually Hong Kong, whose companies China still regards as “foreign” and provides with special treatment. The money may then re-enter China, go to the Caribbean islands or elsewhere in the world, through the city’s efficient financial system and business network.

There are no figures for the money trail but the stock of China’s direct investment in Hong Kong holds a clue. At end-2001, China was the largest FDI investor in the territory, with $1112bn of investment – one-third of the territory’s total FDI. For as little as a few hundred dollars, such mainland investments could easily set up an offshore shell and assume a new identity before returning to China as “foreign capital”.

It is not surprising, therefore, to find that 200,031 of China’s 389,549 foreign-funded enterprises at end-2001 originated from the city, according to the government of Hong Kong Special Administrative Region (SAR).

As capital parked in Hong Kong made its way back to China, it was reflected partly in the territory’s FDI numbers in China. In most years, the city is the leading China investor, racking up half of the national total. At end-2001, Hong Kong had an accumulative $187bn of China’s utilised FDI – almost half the total. Hong Kong and China have become so integrated economically that it is difficult to distinguish what is mainland or indigenous local Hong Kong capital.

However, the Caribbean havens have caught up in recent years, at the expense of Hong Kong. In 1997, FDI flows from of Virgin Islands, Cayman Islands and Bermuda accounted for 4.36% of China’ s total FDI utilised. In 2001, their share rose to 17.8%. During the same period, Hong Kong’s share decreased from 40% to 34.2%.

Like Hong Kong, the Caribbean havens provide tax exemptions on dividends and offshore earnings, confidentiality, fast and easy procedures for setting up a company and an established legal system. But, unlike Hong Kong, they are not part of China and are perceived to be politically more independent than the SAR.

Offshore vehicles

Companies that specialise in helping China-designated investors to set up offshore vehicles maintain that Hong Kong is still an attractive haven despite the change of flag. Sven Koehler, principal consultant at Hong Kong-based E M Associates, says Hong Kong is still ahead of other offshore havens because it is a bilingual city using English and Chinese, is close to China and does not tax offshore income.

A typical offshore structure that his firm arranges for his clients consists of a parent firm, a Hong Kong company registered in an offshore jurisdiction and a mainland operation. “With such a structure, if you make a mistake in China, it will be the offshore company that will be hit, not the parent. It is usually good to have a buffer,” says Mr Koehler.

What are the advantages for recycling mainland-originated money through a web of companies offshore? The biggest pay-off is the tax concessions that China grants to foreign firms, which are subject to a corporate tax rate of 15%, half the 33% imposed on domestic Chinese firms. Foreign enterprises also enjoy two years of tax holidays after turning profitable and another tax reduction of 50% for the subsequent three years.

“China is the only major country that offers such generous tax concessions to foreign investors. It is much more profitable to have a foreign flag than a Chinese one for a mainland-based factory,” says IFC’s Mr Pfeffermann.

Under the WTO accord, China is supposed to end such preferential treatment of foreign companies but analysts say this is not going to happen soon. “There is no constituency in the Chinese government pushing for the changes. And [if there are tax changes] what are you going to do with existing contracts? Are you going to grandfather them, do you change the tax breaks and what about industries?” says Jonathan Anderson, executive director of Asia Pacific investment research at Goldman Sachs in Hong Kong.

Another reason for using an offshore shell to hold a China investment is to bypass the mainland’s maze of regulations and restrictions on foreign investment. Three groups of China-based operations know the game well: private Chinese firms, high-tech start-ups and venture capitalists.

Route to listing

Private Chinese firms have a problem getting listed in the domestic stock market, which favours state-owned enterprises, so they go overseas for funding. To do so, they set up a shell company offshore to control their mainland assets and then list the shell abroad. Many private Chinese firms have been listed in Hong Kong’s second-board Growth Enterprise Market in this way. The funds they raise are then sent back to China as “foreign capital” subject to preferential treatment.

For high-tech start-ups, the situation is similar: China prohibits foreign companies from investing in certain telecom segments, such as internet content providers (ICPs), and yet foreign investors are anxious to put money in them. The solution: a web of offshore companies to help foreign companies to invest indirectly but legally in such mainland-based concerns.

Take the example of Sina.com, China’s best-known ICP. It has a parent based in Cayman Islands, a mainland firm that operates the website and a mainland subsidiary of the Cayman parent that provides the Chinese operator with various services. Sina.com listed its Cayman Islands parent on Nasdaq in 2000, something it could not do if it did not have an offshore vehicle.

Chinese venture capitalists go offshore to circumvent China’s unclear and restrictive laws on exiting a short-term investment. China’s foreign-investment laws are drafted for projects lasting 10 years or more, not for those with a shorter time-span that most venture capitalists go for. By operating offshore, these investors can sell or transfer their stakes more easily as they deem necessary. If not, there will be a complex process involving the approval of several government bodies for any change of ownership of China-registered companies.

Round-tripping has reduced China’s tax revenue and its control over how business is done in the country. On the plus side, however, the inflated figure of FDI is excellent advertising for China, which needs investment from all investors, even domestic ones who return with a new identity.