Incentives and Causes of PRC's Round-Tripping FDI

Incentives for Round Tripping

What are the incentives for capital to make round trip, leaving PRC first and then coming back to PRC? It is not only about profit-making but also related to the safety and risk management of the capital. We can group incentives for round tripping FDI into the following categories:

1. Tax Advantages and Fiscal Incentives

   PRC provide many preferential policies to attract foreign direct investment, including low tax rates, favourable land use rights, convenient administrative supports, and even favourable financial services from domestic and foreign financial institutions. In another word, it pays to be foreign invested enterprises even if you are really just a domestic private enterprise. But the costs of becoming a disguised private enterprise wearing a FIE hat are also high in many cases. You have to have foreign investment. If you cannot find foreign investors who are willing to invest in your enterprises, you have to bring capital aboard by yourself and come back as FDI (See Huang 2003c for detailed discussion on PRC's preferential policies on FDI).

2. Property Rights Protection

   This is an important factor as the Mainland PRC has very different legal and institutional settings from Hong Kong, China and other economies for investment and capital flows. The motivation of PRC’s private sector to park their wealth in Hong Kong, China is huge and fluctuates with the economic and political development in both places. PRC's basic infrastructure for property rights delineation and enforcement is still very weak. Many private enterprises operate in the environment of very restrictive regulation with loose and ad hoc enforcement. In most cases they have to break the formal rules to make profits. Hence, they have incentives to move their profits out of PRC first and then move them back in the form of FDI when they see profit opportunities as the Chinese governments tend to give better protection of property rights to foreign investors.

3. Expectations on Exchange Control and Exchange Rate This is also an important factor relating to exchange control and exchange rate, which is often ignored in the academic discussion but has been the most important consideration for business people as well as speculators. This factor is playing more and more important role in recent years as PRC is relaxing its control on capital account and the international pressure on PRC to revaluate RMB intensifies. Activities associated with speculation on exchange rates are not easy to identify directly as they are buried in the large volumes of normal investment. But the changes in PRC’s Balance of Payment account, including the level of official reserves and the level of errors and omissions term in the balance of payment account (a rough estimate of capital flight) would reflect partly the trend in speculative movement of cross-border capital flow.

4. Competitiveness of Hong Kong, China and Overseas Financial Services Hong Kong, China is an international financial centre but serves primarily PRC related business. Local companies in Hong Kong, China have a lot of business in PRC. Many Mainland companies also reside in Hong Kong, China. These local and Mainland companies in Hong Kong, China become the best intermediation for FDI flows between Hong Kong, China and the Mainland. A significant part of the round tripping FDI in PRC is related to Hong Kong, China companies with close ties to the Mainland entities. But there is another important reason for making round tripping FDI: the listing of the Mainland companies in Hong Kong, China’s stock markets. We will discuss this in detail in the next section.

Two Types of Round Tripping: Rent-Seeking or Value-Seeking?

The difficulty of estimating the scale of PRC’s round-tripping lies in the fact that the definition and the nature of round-tripping FDI are not clarified conceptually. Money is fungible in the modern economy. Although we have technically precise definition of FDI, the nature of round tripping FDI can be very different. Conceptually at the heart of the debate on FDI in particular and finance in general, we should differentiate two broad types of round tripping:

• The first type of round-tripping, e.g. "round tripping for escaping regulation," creates no value added but facilitates the private sector’s effort to get around the legal or administrative constraints/weakness, such as barriers to trade, high taxes, lack of property rights protection, etc. Most people apply implicitly this definition for PRC's round tripping FDI.
• The second type of round tripping, e.g. "round tripping for value added services," creates value added much like the financial sector's role for the real economy. The purpose of this type of round tripping is more than those specified in the first. Most cross-border mergers and acquisitions involve this type of round tripping of capital for value added financial services. Hong Kong, China as a modern international financial and trade centre is at the heart of the "round tripping for value added financial services."

Unfortunately after careful examination of available data sources, we conclude that it is impossible to distinguishing these two types of round tripping FDI empirically. It is like the concept of demand and supply in economic theory. You can distinguish the two in theory but in reality you need to have very good data to identifying the model. The available data do not allow us to get any reasonable estimation of the two different types of round tripping FDI. But we will see in Section 6 that qualitatively the two types of round tripping FDI do play important role in the case of PRC.

Another issue we need to keep in mind is the transaction costs of moving capital across borders. If the perceived value of round tripping by the underlying investors is less than the transaction costs, they will stop doing round tripping. However, if the value added services, such as listing in Hong Kong, China's stock markets or using Hong Kong, China's banking services, are much higher than the transaction costs involved. Round tripping may continue even if no obvious direct regulatory incentives exist for round tripping. As we will point out in Section 6, PRC currently does not include the round tripping FDI occurring in the process of listing Chinese companies in Hong Kong, China in its official FDI statistics.

PRC's Round Tripping FDI in the Context of Global Capital Flow

PRC's round tripping FDI can be viewed from a broad perspective of global mismatch of capital and investment opportunities. Globally it is recognized that Asian savings and capital are flowing to the U.S. markets because of the competitiveness of the U.S. financial markets and its economy. This is reflected in the large current account surplus a number of the Asian countries have with regards to the U.S. But U.S. and global multinational corporations are looking for investment opportunities globally and particularly in PRC and other Asian economies in the form of FDI as FDI does not need to rely on the poor domestic financial systems in the developing Asian economies. This is also round tripping capital flows in the broadest sense of the term. Although, this paper will not estimate this sort of broadly perceived round tripping capital flows, it is useful to put PRC’s round tripping FDI in this context of global capital flows.

In 2001, the U.S. current account deficit (net capital import) reached $393.4 billion. On the other side, current account surplus (net capital export) was $87.8 billion for Japan, $57.1 billion for the six Asian traders, $17.4 billion for PRC, and $39.6 for transition economies. Except for Japan, many countries with current account surplus (net capital export) are not capital rich economies. According to IMF, U.S. absorbed 64% of global net capital exports in 2000 (measured by the sum of current account surplus of the rest of the world).

Who is financing the net capital imports to the United States? The U.S. goods deficit, which is the major part of its current account deficit, is as high as $484 billion. The U.S. goods account deficit is financed by the rest of the world: 18% by North America, 18% by Western Europe, 14.5% by Japan, and 21.3% by PRC. Clearly PRC is exporting capital to U.S. to finance the U.S. trade deficits with PRC while at the same time PRC is receiving large amount of FDI from the U.S. This can be viewed as a sort of the broadly perceived "round tripping capital flows". But this "round tripping capital flows" is exaggerated because of the specialization and supply chain management among the greater PRC economies.

It is clear that in the last decade the part of U.S. trade deficits attributable to Hong Kong, China and Taipei,China are either declining or stabilizing while the part due to PRC is rising rapidly. This is largely because the production of final goods has been rapidly relocated to PRC from Hong Kong, China, Taipei,China as well as other Asian economies. But the key components or high value added parts of the supply chain are still kept in the more developed Asian economies. If this part of the contribution to the production of final goods is excluded, PRC's own value added in exports to the U.S. would be very small. What it means is that PRC lends a lot of capital to the U.S. in the form of its current account surplus with U.S. but at the same time PRC borrows a lot from its Asian neighbours in the form of PRC’s current account deficits with Asian neighbours. This sort of round-tripping capital flows and goods flows is becoming part of normal functioning of the global market economy.

Another piece of evidences on round tripping capital flows is related to the net purchases of U.S. bonds by foreign residents. During the ten years from 1988 to 1997, Asia’s net purchases of U.S. bonds reached $415 billion, compared to only $1,447 billion by the rest of the world. In 2001, Asia’s net purchases of U.S. bonds were as high as $147 billion, compared to only $405 billion by the rest of the world. PRC’s net purchases of U.S. bonds in 2001 were as much as Japan’s at about $52 billion. Both Japan and PRC have increased their net purchases of U.S. bonds after the Asian financial crisis. During the ten years from 1988 to 1997, PRC’s net purchases of U.S. bonds were only 11.5% of the Asia total. But it increased to 23% in 1999, 19% in 2000, and 35.2% in 2001. Given PRC’s $280 billion official reserves and about $260 non-official-reserves foreign exchange credit in the banking system, PRC’s increased net purchases of U.S. bonds are inevitable. But it is still surprising to know that by 2001 PRC's share is as much as 35.2% of the Asia total. Clearly PRC is putting a lot of official and private savings in U.S. government bonds. Why? A simple explanation is to get better protection of property rights! Like other foreign investors in U.S. assets, the Chinese government and the Chinese people certainly believe that the property rights of their U.S. investment are well protected. On the other hand, PRC also gives better protection to property rights of foreign investors than to domestic investors. Hence, on the whole, both sides are happy and better protection of property rights enhances value and productivity of capital. This is also one of the positive impacts of round tripping capital flows.

It is interesting to note that the private foreign bank lending to PRC is not as important as FDI. This can be seen from the changes in cross-border banking capital flows between Hong Kong, China and Mainland PRC during the last decade. Hong Kong, China used to be an important centre in Asia for making syndicated loans to PRC and other Asian economies. From 1994 to 1999, Hong Kong, China was a net lender of banking capital to Mainland PRC. After 2000, however, Hong Kong, China turned into a net borrower of banking capital from Mainland PRC. Since 1997, there has been a steady decline in Mainland’s gross banking liabilities to Hong Kong, China from more than $50 billion in 1997 to less than 20 billion after 2001. This was triggered by the bankruptcy of the GITIC (Guangdong International Trust and Investment Corporation), which borrowed from foreign banks in Hong Kong, China with the implicit understanding that the Chinese government would guarantee the loans. The Chinese government however decided not to use its money to save this regional state-owned holding company in order to avoid moral hazard problem in similar cases for other companies and in the future. After the GITIC bankruptcy, foreign banks became very cautious in extending syndicated loans to PRC.

During the Asian financial crisis in 1997, Hong Kong, China suffered a huge withdrawal of foreign banking capital. Hong Kong, China's foreign banking funds fell from $630 billion in June 1997 to $250 billion by April 2002, a drop of 60%. Among the total withdrawal of $380 billion, $251 is by Japan. In spite of fluctuations in capital flows, Hong Kong, China's banks have been extremely resilient during and after the crisis with NPLs staying no more than 5%. HSBC, Bank of East Asian and other Hong Kong, China banks have started to prepare their entry into the Mainland markets by investing in some small Chinese joint-stock banks such as HSBC’s holdings of shares in Bank of Shanghai. Hong Kong, China’s banking sector since early 2000 has become a net borrower of the Mainland PRC funds. When these funds are used in non-banking sectors of the Mainland economy, including in the form of FDI, they will become round tripping capital as well. But the fact that Hong Kong, China's banking sector is having more and more net borrowing from PRC indicates that more and more profits, income, and new capital are created in PRC. That again is the force behind the sustained capital flight and round tripping FDI.

Capital Flight and Round Tripping FDI

It is useful to take a look at the scale of PRC's capital flights. Without capital flight in the first place there would be no round tripping FDI back to PRC. Table 1 [ PDF 70.8KB | 1 page ] provides a summary account of PRC's balance of payments since 1982. Two items are related to PRC’s capital outflows. One is the current account surplus and the other is the errors and omissions term. PRC’s accumulated current account surplus since 1982 reached $134.6 billion or 11.6% of GDP in 2001 and $215.9 billion or 15.4% of GDP in 2003. The accumulated errors and omissions since 1982, a rough estimate of the accumulated capital flight were at $139.8 billion or 12.1% of GDP in 2001 and $113.6 billion or 8.1% of GDP in 2003.

Frank R. Gunter, in his recent article (Gunter 2004) provides a comprehensive study on PRC's capital flight. He provides basically two measures: one based on the balance of payment and the other using the residual method.

Balance of payment measure
= Nonblank private short-term capital + net errors and omissions;

Residual measure
= Sum of Current Account Balance + Net Foreign Investment + Change in Reserves + Change in Debt;

Gunter made a few important adjustments to the above two standard measures. The adjustments are closely related to the issue of round tripping FDI. The key adjustment is to include the capital flight associated with mis-invoicing of exports and imports between PRC and other economies. This item is very big and dominating in the adjusted estimation of PRC's capital flight.

The other two adjustments are about banking assets in the residual measure of capital flight. The legitimate foreign assets held in PRC's banking system should be deducted from the standard residual measure and the gap between and BIS reported foreign debts and PRC's reported foreign debts should be added back.

Depending how these adjustments are incorporated using the above two standard measures, Gunter generated two low estimates, two high estimates and an average of the four estimates on PRC's capital flights. Table 9 [ PDF 64.8KB | 1 page ] summarizes the estimates of capital flight in Table 1 [ PDF 70.8KB | 1 page ] of Gunter 2004: the low estimate of capital flight is the average of the two low estimates and the high estimate is the average of two high estimates. The average estimate is the average of the four estimates. As compared to PRC's GDP at the official exchange rate, the average estimate of PRC's capital flight was only about 2% during 1985-1989 but increased steadily from 5.4% in 1990 to 12% in 1998 and then fell sharply to 2.1% in 2001. Table 9 [ PDF 64.8KB | 1 page ] also shows that the average estimate of PRC's capital flight has always been higher than the FDI inflows into PRC since 1985 except for the year 2001. This is consistent with this paper's argument that PRC created a lot of new capital. A lot of the new capital went aboard and stayed aboard. But some of the flight capital went back in the form of round tripping FDI. Next section attempts to estimate the scale of the round tripping FDI.

Download this Discussion Paper [ PDF 535.5KB| 48 pages ].

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1. kundan singh
   (posted 04 September 2006 / 10:10:07 AM)
   
   
   
   Thank you for this paper on round tripping. I am currently writing my masters thesis on the reasons for growth of fdi in China and India. Round tripping plays a part in the limitations of this research. The information has been useful in my thesis.
   
   Thank you
   
   Kundan Singh