Phantom Goods Disguise Billions in China Illicit Money Flows

Inside China's Economic Blueprint
  • Chinese import spike from Hong Kong dubbed `implausible'
  • Deutsche Bank research highlights misreporting of trade

Days after the Switzerland-based Bank for International Settlements played down fears over capital flight out of China, new trade data has put the spotlight on a channel used to ferret out billions worth of illicit money flows: phantom goods.      

QuickTake China's Pain Points

A steep rise in China’s reported imports from Hong Kong has raised concerns that trade invoices are being manipulated to get capital out of the country amid fears the yuan will continue to weaken. February data released Tuesday show those imports jumped 89 percent from a year earlier, even as total imports fell 14 percent. While the rise wasn’t as great as in January, economists said the spike follows similar patterns in recent months that point to companies using trade channels to pay for goods far in excess of their value or even that don’t exist at all.

"There has been a huge increase in payments," said Andrew Collier, an independent China analyst in Hong Kong and former president of the Bank of China International USA. "The well-connected Chinese in state and private firms are using any tool in the shed to inflate overseas payments."

China’s capital exodus accelerated through 2015 as investors worried that policy makers would allow the yuan to weaken to cushion an ongoing slowdown in the $10 trillion-plus economy. The People’s Bank of China has insisted it isn’t contemplating a big change in currency policy and spent billions of the nation’s foreign exchange reserves defending the yuan’s value.

While China has strict rules on moving capital offshore, those seeking to evade limits can disguise money flows as payment for goods exported or imported to foreign countries or territories, especially Hong Kong. Economists have said they suspect China’s December and January trade numbers were also skewed by this activity.

"Data distortions from hidden capital flows remain a problem," Bloomberg Intelligence economists Tom Orlik and Fielding Chen wrote in a note, adding that the reported $880 million in imports from Hong Kong in January were "implausible."

Over-invoicing for goods gives a company or individual the opportunity to skirt China’s capital controls and shift money offshore. Authorities have responded to evidence of the activity by clamping down on the myriad of illicit channels used, from curbing purchases of overseas insurance products to stopping friends and family members from pooling their $50,000-a-year quotas to get large sums of money out.

‘Grown Exponentially’

"A strong desire to get assets out of renminbi and into a foreign currency is distorting China’s official trade data at present," economists at Fathom Financial Consulting Ltd. in London wrote in a note. "Our analysis suggests the scale of the problem may have grown exponentially in recent months."

But China’s capital borders remain porous. In particular, little attention appears to have been paid to companies misreporting imports and exports, according to research by Deutsche Bank AG. Economists at the bank found the practice has become a key way to skirt capital controls and accounted for $328 billion of the record outflows between August and January, or 78 percent of the decline in China’s reserves.

An estimate by Bloomberg Intelligence put the total for 2015 at $1 trillion.

‘Massive’ Movement

"China has experienced massive capital outflows since August 2015," the Hong Kong-based Deutsche Bank economists, Zhiwei Zhang and Li Zeng, wrote in their Feb. 29 report.

Over-reporting imports is likely the most important illicit channel, according to the Deutsche Bank research, which cited official banking statistics that recorded China paying $2.2 trillion for goods imported in 2015, while China Customs data only records $1.7 trillion of imports.

"The Chinese authorities have been trying to tighten control over capital
outflows in recent months, but outflows through the import channel remained
high in Jan. 2016, at $57 billion," the Deutsche Bank economists wrote. "Now that these outflow channels are revealed, they will likely be subject to more intensive scrutiny in coming months."

China has acknowledged the problem with fake invoicing in the past. In 2013, the government said export and import figures were overstated due to phony trade in order to bring money into the mainland. Trade data since December suggests the practice had flared up again, this time to get money out.

"As capital controls have been tightened, many market players have used various trade channels to take money out," Daiwa Capital Markets Hong Kong-based analysts Kevin Lai and Junjie Tang wrote in a note dated March 8. "In previous years, when the yield factors were favorable for China, they would bring money in through fake exports. For now, though, fake imports have likely become a useful way to take money out."

Debt Repayment

Not all of the money defined as leaving China can be dubbed capital flight. Chinese companies are buying foreign counterparts at a record pace. And a new analysis of some of the record volumes of cash that left China last year by the Bank for International Settlements concluded that much of it was likely due to companies paying off foreign debt and the shrinking of offshore yuan deposits.

China’s capital outflows had “led to two different narratives,” the BIS researchers said in their report Sunday. “One tells a story of investors selling mainland assets en masse; the other of Chinese firms paying down their dollar debt. Our analysis favors the second view, but also points to what both narratives miss -- the shrinkage of offshore renminbi deposits.”

Still, the BIS analysis only covered the period between July and September and captures a portion of the money being transferred out of China. For example, the data don’t cover gross flows or portfolio transactions out of China.

"They are not trying to give a comprehensive picture of the balance of payments and its components," said Louis Kuijs, chief Asia economist at Oxford Economics in Hong Kong. "Rather, they zoom in on certain specific aspects."

China’s foreign-exchange reserves fell at a slower pace last month as the nation’s financial markets stabilized. Still, analysts warn the uncertain outlook for the yuan means China’s capital scare hasn’t gone away. The biggest worry is if households accelerate the moving of their savings offshore, according to Zhu Haibin, JPMorgan Chase & Co.’s chief China economist.

"What we truly worry about is household behavior," said Zhu.

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