illicit financial flows from china and the role of trade misinvoicing
TRANSCRIPT
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Illicit Financial Flows from China and the
Role of Trade Misinvoicing
Dev Kar and Sarah FreitasOctober 2012
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Illicit Financial Flows from ChinaAnd the Role of Trade Misinvoicing
Dev Kar and Sarah Freitas
1
October 2012
1Dev Kar, a former Senior Economist at the Internaonal Monetary Fund is Lead Economist at Global Financial Integrity, a DC-based
research and advocacy group. Sarah Freitas is an Economist at GFI. The author would like to take Raymond Baker, Clark Gascoigne,
E.J. Fagan and other sta at GFI and CIP for their insight and assistance. Any errors that remain are the authors responsibility.
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Contents
Executive Summary iii
I Illicit Financial Flows from China and Implications 1
i Introduction 1
ii The Serious Implications of Illicit Flows 2
iii Summary of Methodology 4 iv. DevelopmentsinTotalIllicitOutows 4
a Table 1 China: Illicit Financial Flows and Trade Openness, 2000-2011 5
v Developments in Trade Misinvoicing 5
a Table 2 Commodity Misinvoicing between China and Hong Kong, 2007-2011 7
II External Assets of China in Tax Havens and Banks 9
a Table 3 China, Hong Kong: Inward FDI Positions, 2009-2010 9
b Table 4 China, Hong Kong: Outward FDI Positions, 2009-2010 9
c Table 5 China, Mainland: Inward FDI Positions, 2009-2010 9
d Table 6 China, Mainland: Derived Outward FDI Positions, 2009-2010 9
e Table 7 China, Hong Kong: Outward Portfolio Investment Positions, 2009-2010 9f Chart 1 Round-Tripping Among the Troika 11
g.Table8.EstimatedFlowsofIllicitCapitalinOshoreCenters 12
h.Table9.EstimatedTotalFlowsofLicitCapitalinOshoreCenters 12
i. Table10.EstimatedTotalFlowsofLicitandIllicitCapitalinOshoreCenters 12
j. Table11.OshoreFinancialServicesbyCenter,2006. 12
References 14
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Executive Summary
Section I
Overtheperiod2000to2011,cumulativeillicitnancialowsfromChinatotaledamassiveUS$3.79trillion,ifone
were to exclude the countrys intra-regional trade with Hong Kong and Macao We found that if adjustments for such
tradewerenotmade,theresultingoutowsduetotrademisinvoicingweresignicantlyunderstatedduetotradedata
distortions.Thesharpriseinillicitoutows,fromUS$172.6billionin2000toUS$602.9in2011,impliedanincreaseof
about7.2percentperyearinination-adjustedterms,whichwasjustbelowthe10.2percentaveragerateofeconomic
growth
Whileourestimatesarebasedongrossoutows,theydonotdiermuchfromthenetofillicitinowsfromoutowsa
methodology with which we disagree with because there is no such thing as net crime Nevertheless, even if illicit
inowsarenettedfromillicitoutows,ChinastillsuerednetillicitoutowsofUS$3.75trillionoverthisperiod.Oneof
theadverseeectsofillicitowsfromChinahasbeenaworseningofthecountrysincomeinequalityastherichget
richerthroughtaxevasion(whichcomprisesbyfarthemajorportionofsuchoutows)andthroughusingtheworlds
shadownancialsystemtoshelterandmultiplytheirillicitwealth.
MisinvoicedtradebetweenChinesecompaniesandtheUnitedStatesincreasedfromUS$48.8billionin2000to
US$59.0billionin2011.ThevolumeoftrademisinvoicingbetweenmainlandChinaandtheUnitedStatesroseto
US$72.0billionbeforethenancialcrisisof2008,buthasdeclinedsincethen,probablyasaresultoflowergrowthin
bilateral trade between the countries
ThecommoditygroupingsmostsusceptibletotrademisinvoicingincludeUNCommodityTradeStatisticsDatabase
(COMTRADE)group84(nuclearreactors,boilers,machinery,etc.)andgroup85,(electricalandelectronicequipment),
withthesub-groupforelectroniccircuits(HSCode854231)showingthelargestcumulativeillicitoutows(US$84.1
billion).Trademisinvoicingrelatedtothesub-groupformobilephones(HSCode851712)increasedatthefastestpace
from 2007-2011 This is consistent with previous studies at GFI which indicate that the more specialized a product, the
easier it is to misinvoice
Section II
AsignicantpartoftheillicitoutowsfromChinaround-tripbacktothecountryasrecordedforeigndirectinvestment
(FDI).Suchround-trippedFDIisgivenpreferentialtreatmentvis--visdomesticcapitalsuchastaxconcessions,
governmentguaranteeofloansextendedbyforeigncorporationstodomesticrms,landandotherfacilitiesat
concessional rates, etc
However,alotoflicitmoneyalsoleavesChinaasFDIinplaceslikeHongKongandtheBritishVirginIslands(BVI),only
to then be laundered into another entity and reinvested in China as FDI from Hong Kong or the BVI It is a complex
money laundering scheme used in order to take advantage of favorable regulations for FDI and to allow high net worth
individuals(HNWIs)tosecretlyaccumulatewealthincontraventionofgovernmentregulationsandoversight.
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Mainland China and Hong Kong are the largest foreign direct investors in each others economy, with the BVI serving as
the 2nd biggest foreign direct investor in both mainland China and Hong Kong, and BVI serving as the largest recipient
ofFDIfromHongKong.Indeed,itappearsthatwhiletheBVIinvestedamassive$213.7billioninmainlandChinain
2010, nearly all reciprocal investment in the BVI from the Chinese mainland was routed through Hong Kong The BVI
hasapopulationofabout28,000andaGDPofonlyaroundUS$1.1billion,soitishardtoseehowitcanundertake
suchmassiveFDIoutowsunlessfundswereroutedbackinviaHongKong,and/orsubsidizedbyillicitfunds.
OftheroughlyUS$2.83trillionthatowedillicitlyoutofChinafrom2005-2011,US$595.8billionwoundupascashdepositsornancialassets(suchasstocks,bonds,mutualfunds,andderivatives)intaxhavens.Onaverage,roughly
52.4percentofinvestmentsthatowedintotaxhavensfromChinaduring2005-2011wereillicitwhile47.6percentwere
licit
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I. Illicit Financial Flows from China and their Implications
(i) Introduction
Illicitnancialowsorillegalcapitalightinvolvemoneythatisillegallyearned,transferred,orutilized.Whilethefunds
could be earned through bribery, kickbacks, or other illicit activities, they may well be earned through legitimate means
It is the transfer in contravention of capital controls or the nonpayment of applicable taxes that renders the funds illicit
The methods used by economists to estimate the volume of illicit funds leaving a country make no attempt to link
illicitowswiththenatureofthesourceofcapital,whetherlicitorillicit.Infact,thereisnomethodthatcanapportion
totalillicitowsintotaxevasion,criminalproceeds,orcorruption.Thesurveymethod,whichreliesontheopinionsof
government regulatory agencies, private corporations, and others, can shed some light on the relative importance of
theseowsinaglobalcontext.Suchsurveyresultsindicatethatglobally,taxevasionbyhigh-net-worth-individuals
(HNWIs)andcorporationscomprisebyfarthelargestcomponent(around65percent)ofcross-borderillicitowsfrom
developingcountries,followedbytheproceedsofcrime(30percent)andcorruption(5percent).1
ResearchatGlobalFinancialIntegrity(GFI),aWashingtonDC-basedresearchandadvocacygroup,showsthat
outowsofillicitcapitalfromdevelopingcountrieshavebeenagrowingproblemoverthepastdecade.Inordertoassesstheimpactofillicitowsoneconomicdevelopmentandpovertyalleviation,GFIpublishesregularannual
updatesofthevolumeandpatternofoutowsfromdevelopingcountriesandregions.Inaddition,countrycasestudies
atGFIallowanin-depthanalysisofthedriversanddynamicsunderlyingsuchoutows.
According to the latest annual report, developingcountrieslostbetweenUS$775billionandUS$903billionin2009,
downfromthepreviousreportsestimateofUS$1.26toUS$1.44trillionin2008.2Themainreasonforthefalloinillicit
outowsin2009wasduetotheeconomicdownturn,whichreducedforeigndirectinvestments,newloans,andtrading
volumes In fact, the IMFs World Economic Outlooknoted that the 2009 decline in export and import volumes were the
sharpestsincetheSeptember2001attacks.Nevertheless,GFIndsthatillicitoutowsfromthedevelopingworldhave
increasedbyatleast10.2percentperannumoverthedecadeinination-adjustedterms.
Whatdrivesoutowsofillicitcapitalfromacountry?GFIstudies show that cross-border transfers of illicit capital are
propelledbythreemaintypesofdriversmacroeconomic,structural,andgovernance-related.InChinascase,large
andgrowingcurrentaccountsurplusesleadtocapitaloutows,someofwhichmaywellbelicitcapitalight(such
asprivatesectorhotmoneyoutows).Highandrisinginationcouldalsocontributetoillegalcapitalight,assuming
owners do not wish to see the real value of their holdings decline over time The widely held perception that the Yuan
isunder-valued(becauseofthetradesurpluses)mayfeedintoexpectationsofexchangeraterevaluationinthefuture
whichcouldleadtospeculativeinowsandround-trippedcapital(seeSectionIIforadiscussionofround-tripping).
Structural factors for China include non-inclusive growth, as a result of which there are a larger number of high networthindividuals(HNWIs)whochoosetosheltertheirburgeoningwealthabroad.Anotherstructuralfactorisincreasing
tradeopenness(exportsandimportsofgoodsandservicesaspercentofGDP),whichprovidesmoreopportunitiesto
traders to misinvoice trade as the customs administration struggles to keep pace with rising trade volumes Governance
1Baker, Raymond W. (2005). Capitalisms Achilles Heel: Dirty Money and How to Renew the Free-Market System, John Wiley & Sons,
Inc.2Kar, Dev and Sarah Freitas (2011). Illicit Financial Flows From Developing Countries Over the Decade Ending 2009, Global Financial
Integrity, Washington DC.
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factorsincludecorruptionandweakregulatorysystemswhicharereectedinanexpandingundergroundeconomy
relativetoocialGDP.Theundergroundeconomybothdrivesandisdrivenbyillicitows.
(ii) The Serious Implications of Illicit Flows
IllicitnancialowsaremainlygeneratedandtransferredbyChineseresidentswhoareconnectedtothecountrys
globalizedeconomy.Theproceedsoftaxevasion,prot-shifting,bribery,kickbacks,trademisinvoicing,incomeon
unreported external assets, and tax breaks on round-tripped illicit funds all accrue to those who are thus connected
Totheextentthatthegovernmentfailstocollectapplicabletaxes,themiddle-andlow-incomegroupssuertheconsequences.
Tax revenue collection continues to be a persistent challenge in China Revenue performance of the general
government(denedascentralplusstateandlocalgovernments)steadilyimprovedfrom13.8percentofGDPin2000
to 223 percent of GDP in 2011 However, Chinas revenue falls short of the G-7 group of major advanced economies,
which average 360 percent of GDP per annum and lags behind emerging and developing countries average revenue
collection of 266 percent of GDP3EventhoughChinahasmadesignicantprogressinstrengtheningsocialsafety
nets,theIMFnotesthatitwilllikelyrequiremoreresourcesoverthemedium-termtobroadenthecoverageofthe
systemonasustainablebasis.TheChinesegovernmentcannotfailtocollectsucienttaxrevenuestomeetits
ambitious spending promises given that its expenditures on the social safety net account for just 57 percent of GDP
Economies at comparable levels of development spend, on average, more than twice as much4
Apartfromthefactthatrampanttaxevasionlikelytobethelargestcomponentofillicitoutowshavereduced
taxrevenues,thelossofcapitalhasdirectlycontributedtoaworseningofChinasincomeinequality.Aroundthelate
1970s, when the process of economic transition from a closed to an open market system started in China, the country
had a relatively egalitarian society Since then, Chinas income distribution has become increasingly skewed, with
theGinicoecienttheinternationalstandardformeasuringincomeinequalityinacountryrisingfrom.31in1981
to 47 in 20085Therisinginequalityisalsotakingatollonaveragehouseholdconsumption,whichdeclinedbyover
10 percentage points of GDP since the early 1980s6 Indeed, increasingincomeinequalityremainsthesoftunderbellyof Chinas impressive rise in the world economy and presents a serious challenge for maintaining social and political
stability.Thatincomeinequalityisasensitiveissueisbornebythefactthatthegovernmenthasnotreleasedocial
dataontheGinicoecientsince2000.Ocialsaredoubtlessawarethatdataonhouseholdincome,whichare
obtainedthroughgovernment-sponsoredsurveys,areunlikelytoreectforeignholdingsofillicitassetsbyhighnet-
worth individuals, thereby understating the already bad news regarding income distribution
(iii) Summary of Methodology
Economistshaveestimatedcapitalightfromdevelopingcountriesinseveralways.Amongthese,theWorldBank
Residual measure adjusted for trade misinvoicing has come to be well-established since its formulation in 1985
Essentially, the method captures net unrecordedcapitalowswhicharescaledupordown(i.e.,adjusted)as
3Tax to GDP raos are based on World Economic Outlook Database, IMF, April 17, 2012 (link: hp://www.imf.org/external/ns/
cs.aspx?id=28).4Peoples Republic of China: Sta Report for the 2012 Arcle IV Consultaon (2012), IMF Country Report No. 12/195, Box 10.5Ravallion, Marn and Shaohua Chen (2007). Chinas (Uneven) Progress Against Poverty, Journal of Development Economics, 82(1):
1-42.6Aziz, Jahangir and Li Cui (2007). Explaining Chinas Low Consumpon: The Neglected Role of Household Income, IMF Working Paper,
WP/07/181, Internaonal Monetary Fund.
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indicated by the deliberate misrepresentation of exports and imports declared in customs invoices Of course, the
resultingcapitalowsarisingfromsuchfraudulentcustomsdeclarationsarealsounrecorded.Itisassumedthatsuch
unrecorded transfers of capital involve illicit funds because there is no reason why transfers of legitimate capital should
gounrecorded.Forreasonsnotedbelow,GFIstudiesonlyconsidergrossillicitoutows.
The World Bank residual measure captures the gap between a countrys recorded source of funds and its use of
thosefunds.Therearetwomainsourcesoffundsforacountrynewexternaldebtcontractedandnetinowsof
foreigndirectinvestments.Therearealsotwousesoffunds,namelynancingthecurrentaccountdecit(whichisessentiallytheshortfallofexportsoverimports)andadditiontoreserveassets.Ifsourceoffundsexceedsuseof
funds,unrecordedorillicitcapitalmusthavebeentransferredfromthecountry.Unrecordedcapitalleakagesthrough
the balance of payments tend to capture bribery, kickbacks, and proceeds from other forms of corruption In case
recorded use exceeds recorded source of funds, the country must have received illicit capital which are not netted out
ofoutowsforreasonsnotedbelow.
Twotypesofinvoice-faking,ormisinvoicing,requireadjustingtheoutowsfromtheWorldBankresidualfora
comprehensiveestimateoftotalillicitoutows:exportunder-invoicingandimportover-invoicing.Exportunder-
invoicingimpliesanunderstatementofacountrysreportedexportsvis--viswhatpartnercountriesreportashaving
imported from that country Import over-invoicing indicates an overstatement of imports by a reporting country relative
topartnercountriesdeclarationofexports.Themethodologyusedtoestimateillicitowsduetotrademisinvoicing
isbasedontheGrossExcludingReversals(GER)methodwhichdoesnotnetoutillicitinowsfromoutows.
Furthermore, we use the IMFs DirectionofTradeStatistics(DOTS)whichcapturesreportingcountriestradewiththe
world; trade discrepancies are derived by adjusting imports for an insurance and freight factor of 10 percent This is
calledimportsfree-on-board(f.o.b.)whichiscomparedwithexportsf.o.b.7 Trade misinvoicing allows the clandestine
acquisitionofforeignassetsandfacilitatesmoneylaunderingandtaxevasion.
Asnoted,economiststypicallynetoutnancialowsintheWorldBankResidualmeasureandthetrademisinvoicing
measure In doing so, their methodology is consistent with the treatment ofrecorded, orlicit,capitalowsinthebalanceofpayments.However,theuseofthenetmethodinthemeasurementofillicitnancialowsisawedfor
severalreasons.First,wemustdistinguishbetweennetrecordedowsinthebalanceofpaymentandnetillicitows.
Anetmeasureofcapitalowsasrecordedinthebalanceofpaymentsisavalidconceptasitrepresentsanetgainor
lossofcapital.Ontheotherhand,anetmeasureofillicitowsmakeslittlesensebecausetheowsareillicitinboth
directions.Afterall,thereisnosuchconceptasnetcrime.Infact,netillicitinowsdonotrepresentanetbenetto
acountryinthesensethatnetcapitalinowsrecordedinthebalanceofpaymentsdo.Second,likeillicitoutows,
illicitinowsarealsounrecorded.Howcouldagovernmenttaxcapitalthatisunrecordedoruseitforanyproductive
purposes?Infact,illicitinowsaremorelikelytodriveundergroundeconomicactivitiesthantheyaretoboostthe
productivecapacityoftheocialeconomy.Hence,intreatingillicitinowsasiftheywerebenecialtoacountry,the
nettingoutmethodseriouslyunderstatetheadverseimpactofsuchowsoneconomicdevelopmentandpoverty
alleviation
Economists have long acknowledged that trade mispricing is an important conduit for the cross-border transfer of
illicit capital8.Theirstudieshavecorroboratedthefactthatforeignassetscanbeacquiredthroughexportunder-
7See the 2010 publicaon of the IMF Direcon of Trade Stascs Yearbook for details on a c.i.f. factor of 10%.8Bhagwa (1964). On the Under-invoicing of Imports, Bullen of the Oxford University Instute of Economics and Stascs; Nayak
(1977), Illegal Transacon in External Trade and Payments in India: An Empirical Study, Economic and Polical Weekly; Gula (1987),
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invoicingandimportover-invoicing.Incidentally,themanipulationoftradeinvoicesalsooccursintheUnitedStates
among other industrial countries9Trademispricingaccountsforabout54percentofcumulativeillicitowsfrom
developingcountriesovertheperiod2000-2009,althoughtheshareintotaloutowshasdeclinedsince2004.Over
the decade ending 2009, unrecorded leakages through the balance of payments have been increasing relative to trade
misinvoicingon average, the balance of payments component account for 491 percent of cumulative transfers of illicit
capital while the trade misinvoicing component account for 509 percent
(iv) Developments in Total Illicit OutfowsEstimatesofillegalcapitalightorillicitnancialowsfromChinatendtovarybyamuchwidermarginthantheydo
for most other countries The main reason why they do so relates to intra China-Hong Kong trade For one, China-
HongKongtradeposesdicultiesinidentifyingoriginofexportsanddestinationofimportsthatarerecordedby
their partner countries For example, if Chinas exports to other countries that pass through Hong-Kong are recorded
by those countries as originating from the latter while China records those exports as originating from the Mainland,
then total Chinese Mainland exports to the world would be overstated relative to world imports from Mainland China
(implyingillicitinowsduetoexportover-invoicing).AstherearenoestimatesofhowmuchtradebetweenChinaand
Hong Kong is destined for domestic consumption and how much is merely passing through as re-exports, economists
haveestimatedillegalcapitalightfromChinabybothincludingandexcludingHongKongandMacaofromthetrade
misinvoicing calculations10 We shall therefore present both estimates here
Thereasonsforfocusingonoutowshavebeendiscussedabove.Apartfromtheadjustmentsduetointra-regional
trade,estimatesofillicitowsfromChinaalsovaryduetothecoverageofconduitsresponsibleforsuchows.For
example,somestudiesdonotincludeoutowsduetotrademisinvoicing.Socarehastobeexercisedincomparing
variousestimatesofillicitowsfromChinatoensurethattheunderlyingmethodologiesareroughlycomparable.
BasedonGFIsgrossoutowsmethodologyandexcluding Hong Kong and Macao from world and Chinese trade, trade
misinvoicing-adjustedgrossillicitoutowsfromChinaincreasedfromUS$172.6billionin2000toUS$602.9billionin
2011, a 72 percent real rate of growth per annum, which is slightly below the 102 percent average annual growth rateofGDPoverthisperiod(Table1).11WhileillicitoutowshavedeclinedinrelationtoGDPfrom14.4percentin2000to
8.3percentin2011,therateofoutowshasacceleratedfrom10.4percentinthepre-crisisperiodto13.9percentper
annumsincethen.Table1showsthatcumulatedillegalcapitalightfromChinaaccordingtotheTraditionalNet
measureamountedtoUS$3.75trillioncomparedtoUS$3.79trillionusingGFIsgrossoutowsmethod.
Illicitoutowsthatexceed10percentoftheworldssecondlargestGDPareindeedworrisome.Indeed,ifoutows
continue to ratchet upwards, adverse repercussions on social and political stability cannot be ruled out According to
a report in the Chinese media, more than half of Chinese millionaires seem intent on leaving the country12 The myriad
A Note on Trade Misinvoicing, from the book Capital Flight and Third World Debt; Ndikumana and Boyce (2001), Is Africa a net
Creditor? New Esmates of Capital Flight from Severely Indebted Sub-Saharan African Countries, 1970-96, Journal of Development
Studies; Ndikumana and Boyce (2008), New Esmates of Capital Flight from Sub-Saharan African Countries: Linkages with External
Borrowing and Policy Opons, Polical Economy Research Instute, University of Massachuses Amherst, Working Paper.9See, for example, Simon Pak and John Zdanowicz (2002), An Esmate of 2001 Lost U.S. federal Income Tax Revenues Due to Over-
invoiced imports and Under-invoiced exports.10Capital Flight and Capital Controls in Developing Countries, Gerald Epstein, Editor (2002).11Specically, the trade adjustment involves reducing (i) world imports by Hong Kong and Macaos imports from China (ii) world ex-
ports by Hong Kong and Macaos exports to China. Similarly, Chinas exports to and imports from the world are respecvely reduced
by Chinas exports to and imports from Hong Kong and Macao.12Zhang, Jianping, Ma Wenhui, and Tian Shuai (2012). The fears that are driving the ight of the rich, China Daily.
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reasonsnotedrangefrompersonalandeconomicinsecuritytoinadequatesafeguardsforpersonalpropertyand
deteriorating environmental and medical conditions As China Daily notes, any large-scale emigration of Chinese
millionaires could sap the power of the middle class and fuel social instability
If no adjustments for intra Chinese regional trade are made,thenestimatesofillicitoutowsgrowat1percentper
annum in real terms over this period, a much slower pace of growth than is derived by correcting for intra-regional
trade.Whileunadjustedoutowsalsoincreaseinnominalterms,theyundergoasteadydeclineintermsofGDPfrom
131 percent in 2000 to just 44 percent in 2011
There are several indications that a scenario without adjusting for intra-Chinese regional trade is likely to be
unrealistic.Forone,therateofgrowthofillicitoutows(1percentperannum)fallsfarshortofrealeconomicgrowth
(10.2percentperannum)withoutowsactuallydeclininginrealtermsintheperiodbeforethecrisis.Thisisoverlyoptimistic given that World Bank governance indicators related to control of corruption, political stability and absence
ofviolence,ruleoflaw,andothermeasuresshowasignicantdeteriorationovertheperiod1996-2010.Forthis
reason,wedonotpresentaseparatetableshowingdevelopmentsinillicitoutowsthatdoesnotadjustforintra-
regional Chinese trade
(v) Developments in Trade Misinvoicing
The deliberate misinvoicing of exports and imports comprise by far the major channel for the transfer of illicit capital
fromChina,althoughthesharehastendedtouctuateovertheperiod2000-2011.Inthepre-crisisperiod2000-2007,
theshareoftrademisinvoicingintotaloutowswasaround87percentonaveragewhileintheperiodsincethen,
thesharehascomedowntoabout85percent.ArecentstudyattheIMFconcludesthatwhiletheeectivenessof
customs in addressing evasion may be better in India than in China, the latter appears to be catching up over time13
GiventhattheUnitedStatesisChinaslargesttradingpartner,thequestionaboutmisinvoicinginvolvingtrade
between the two countries naturally arises However, it should be noted that we cannot make adjustments for intra-
ChinaregionaltradewhenestimatingmisinvoicinginvolvingChina-U.S.trade.Thereasonisthatwecannotnet
13Mishra, Prachi, Arvind Subramanian, and Pea Topalova (2007). Policies, Enforcement, and Customs Evasion: Evidence from India,
IMF Working Paper.
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outHongKongandMacaosexportstoandimportsfromtheUnitedStatesfromU.S.-Chinatradedataandneither
can we net out Chinas exports to and imports from Hong-Kong and Macao out of Chinese exports to and imports
fromtheUnitedStates.ToadjusttrademisinvoicingbetweenChinaandtheUnitedStatesforintra-Chinesetrade,
we would need to have an accurate estimate of the proportion of trade between mainland China and Hong Kong that
continuesontotheUnitedStates(andvise-versa).Errorsinestimatingtradeabsorbeddomesticallyversusthosethat
are re-exported would lead to large distortions in trade data discrepancies Between 2000 and 2011, based on the no
adjustmentmethod,misinvoicingbyChinesecompaniestradingwiththeUnitedStatesincreasedfromUS$48.8billion
toUS$59.0billion.Infact,thevolumeoftrademisinvoicingbetweenmainlandChinaandtheUnitedStateshasbeenincreasing steadily throughout the pre-crisis period 2007-2011 but have declined since then possibly as a result of lowe
growthinChina-U.S.trade.Thelowervolumeofmisinvoicingmayalsoberelatedtotighterregulatoryoversightbythe
UnitedStatescustoms.
Some studies have found that trade misinvoicing occurs in order to take advantage of particular incentives and to avoid
highertaxes.Forexample,FismanandWei(2004)quantiedtheimpactofimporttarisontaxevasionusingdataon
trade between China and Hong Kong14 Based on data on 1,600 groupings of imported goods at the 6-digit HS level,
theyfoundthataonepercentagepointincreaseinthesumofthetariandVATonimportsledtoatwotothreepercen
increaseinevasion.OtherstudiesonChinahavefoundthatrmsseektoreduceexportunder-invoicingwhentax
rebatesarehighifthetaxincentivesonthermsround-trippedFDIislargerthantheexportsubsidiesforegoneasa
result of under-invoicing15 The under-invoicing is used to shift illicit capital abroad (to places such as Hong Kong and
theBritishVirginIslands)whiletheround-trippingasFDIisusedtolaundertheillicitassetsinordertotakeadvantageof
taxbreaksandincentivesontheill-gottenwealth.AccordingtoFunget.al.,Chinesermssystematicallyunderreport
exportstoHongKongeventhoughtheexportrebatesdoosetsomeoftheincentivestodoso.
14Fisman, Raymond and Shang-Jin Wei (2004). Tax Rates and Tax Evasion: Evidence from Missing Imports in China, Journal of Poli-
cal Economy, Vol. 112, No. 2, pp. 471-500.15Fung, Hung-Gay, Jot Yau, and Gaiyan Zhang (2010). Reported Trade Figure Discrepancy, Regulatory Arbitrage, and Round-tripping:
Evidence from the China-Hong Kong Trade Data, University of Missouri, St. Louis, unpublished.
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TheGERmethodologycanalsobeappliedtotradeatthecommoditylevel.TheUnitedNationsCOMTRADEprovides
exportandimportdataclassiedbythesix-digitHarmonizedCommodityDescriptionandCodingSystem(HS)andby
partnercountry.Dataarecategorizedfromgeneraltospecic,withthemostgeneralcommoditygroupingslistedas
two-digitcodesandthemostspeciccommoditygroupingslistedassix-digitcodes.
Wechoseeightgroupings(2-digitHScodes85,99,39,84,74,90,71and89)ofChinasimportsfromandexports
toHongKongwiththelargesttradevalue.Withintheseeightgroupings,1,151morespeciccommoditygroupings
wereanalyzedatthesix-digitlevel.Thetencommoditieswiththehighestcumulativegrossoutowsduetotrade
misinvoicing from 2007 to 2011 are shown in Table 2 above
Thecommoditygroupingofelectroniccircuits(HSCode854231)hasthelargestcumulativeillicitoutowsdueto
exportunder-invoicing(US$77.6billion)andimportover-invoicing(US$6.5billion),whichaccountfornearly20percent
of total misinvoicing involving the top ten commodity groupings However, trade misinvoicing involving commodity
groupHS851712(mobilephones,etc.)hasincreasedatthefastestpaceovertheperiod2007to2011,commensurate
withincreasingtradeinmobilephones.ThisisconsistentwiththendinginGFIscasestudyonMexicothattrade
misinvoicing tends to increase with increasing trading volumes
There is a reason why the largest volume of trade misinvoicing involves two main commodity groupings--group 84
(Nuclearreactors,boilers,machinery,etc)andgroup85,Electrical,electronicequipment.First,themorespecialized
a product, the easier it is to misinvoice because an inspector would need specialized knowledge in order to judge
whether the product is under- or over-valued Also, most of these commodities are often declared as parts and
accessoriesofmachinesorsomesuchnon-specicdescription.Thisallowstraderstohidetheactualmarketprice
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oftheproductgiventhedicultyforcustomsunitvaluecheckstoagpriceoutliers.Theaggregationofpricefor
heterogeneous commodities presents a technical challenge because it makes no sense to price commodity groups that
are apples and oranges
Thedataanalyzedabovealsohasseverallimitations.First,misinvoicingwithincommodity-specictradecannotbe
comparedwiththeguresonChinasaggregatetrademisinvoicing.Theaggregategureshavebeenadjustedfortrade
withHongKongbyremovingtheentityfromourclosedsystemofcountries.However,asFung,Yau,andZhang(2010)
point out, trade misinvoicing between China and Hong Kong will not be systematically biased at the commodity level,
becausere-exportsandre-importshavebeenlteredoutofouranalysis.Second,theUNCOMTRADEDisclaimer
also makes it clear that there may be some statistical error between reporter and partner country trade statistics due
tovariousfactorsincludingvaluation(importsCIF,exportsFOB),dierencesininclusions/exclusionsofparticular
commodities, and timing Third, the estimates of export under-invoicing and import over-invoicing above assume that
China and Hong Kong are in a closed system of two countries Thus simultaneous collusion cannot exist; export under-
invoicing(importover-invoicing,respectively)fromChinatoHongKongisamirrorstatisticofimportover-invoicing
(exportunder-invoicing,respectively)fromHongKongtoChina.Inotherwords,wecannotassumethattradersinHong
Kong are trying to over-invoice importsat the same time that their counterparts in China are trying to under-invoice
exports
IllicitnancialowsfromChina,whetherestimatedonanetorgrossoutowsbasis,aremassiveaccordingtoseveral
economists.Suchoutowsadverselyimpactthecollectionofgovernmentrevenuesandworsenthedistribution
ofincome.Chinaneedsmoreeectivecollectionoftaxesinordertonanceitsexpandingsocialexpenditure
commitments The matter is urgent given that the countrys rapidly aging population is expected to generate additional
scalpressures.Itisthereforeimperativethattheauthoritiestakestrongmeasurestocurtailthegenerationand
cross-bordertransmissionofillicitcapital.Suchmeasuresshouldcoverallthreetypesofdriversofillicitows
macroeconomic, structural, and governance-related
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II. External Assets of China in Tax Havens and Banks
As noted above, there is considerable evidence that the cross-border transfer of illicit capital from China into tax havens
and developed country banks take place mainly through the deliberate misinvoicing of trade Case studies on China
showthatasignicantportionofillicitoutowsre-entersChinaasFDIinacircularprocessknownasround-tripping.16
16Hung-Gay Fung, Jot Yau, and Gaiyan Zhang (2010), Reported Trade Figure Discrepancy, Regulatory Arbitrage, and Round-tripping:
Evidence from the China-Hong Kong Trade Data, University of Missouri, St. Louis, working paper. See also, Eswar Prasad and Shang-
Jin Wei (2006), Understanding the Structure of Cross-border Capital Flows: The Case of China, paper presented at the Columbia
University Conference, China at Crossroads: FX and Capital Markets Policies for the Coming Decade.
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Whiletheoutowsareunrecordedorillicit,round-trippedFDIarelicitbecausetheyarerecordedinthebalanceof
paymentsandreportedtotheIMF(seeTables3-6).Indeed,theround-trippingprocesscanbelookeduponasan
elaborate money-laundering exercise
Totheextentthatsuchround-trippedcapitalcompriseasignicantandgrowingportionoftotalFDIintoChina,the
countrysuersadoubleloss.First,itfailedtogeneratetheinitialcapitallegitimatelyandtoinvesttheproceeds
productively(reectingonthecountrysweakgovernanceandregulatoryoversight).Second,thecountryalsolost
revenues in providing subsidies and tax rebates to what essentially are elaborate money laundering mechanisms
entailingthereturnofillicitcapitalmasqueradingaslegitimateFDI.Itisclearwhobenetsandwholosesfrom
suchnancialshenanigans.WewillshowthattheowofFDIfromtaxhavenslikeHongKongandtheBritishVirgin
Islands(BVI)intoChinaissomassivethattheyareunlikelytobesustainediftheywerenotnancedbyasteady
infusionofequallymassiveinvestmentsofillicit(andlicit)fundsbyChinese HNWIs and private corporations in those
jurisdictions
ItiswellknownthatChina,inaneorttoattractforeigndirectinvestmentandportfoliocapital,hasadoptedinvestor-
friendly policies such as tax concessions, government guarantee of loans extended by foreign corporations to domestic
rms,breaksonthetaxratesapplicableonrepatriatedprots,easingofFDIregulations,etc.Whiletheseregulations
havefacilitatedmassiveinowsoflicitforeigncapital,theyhavebyraisingthereturnonforeignrelativetodomestic
capitalalsocreatedtheincentivesforbothlicitandillicitcapitalight.AsSicular(1998)notes,Suchprovisionshave
apparentlybeeneectiveincreatinghigherreturnstoforeigncapital,asthereisevidencethattheycauseChinese
investorstomovemoneyoshoreandthenbringitbackintothecountrydisguisedasforeigninvestment.17 Other
incentivesforcapitalightarethelimitedrangeofdomesticnancialinstruments,theadditionalriskofconscation
associated with illicit funds, and the still-felt insecurities related to ownership of private assets He also notes that
Chineseinvestorsareincreasinglydiversifyingthroughbothvisibleandhiddenchannelsintooshoreinvestments.
The Sicular study is somewhat dated Moreover, Siculars hypotheses were not backed up by hard data on Chinese
assetsinoshorecentersordataonFDIowsbetweenChinaandthosejurisdictions.TheIMFsrelativelyrecent
initiatives,namelythecoordinateddirectinvestmentsurveys(CDIS)andthecoordinatedportfolioinvestmentsurveys(CPIS),allowresearcherstotracethemovementofthesemajorcapitalowsbysourceanddestinationcountries.
Whilethisisalarge-scaledatacompilationexerciseandisquitecomplicatedtoputtogether,researchishamperedby
the fact that CDIS and CPIS data are only available for 2009 and 2010 Many countries including China have not yet
reported such data to the IMF Nevertheless, there is some evidence based on the limited data that the Chinese round-
tripping investment trends that Sicular mentioned are continuing
Howdoesround-trippingwork?AccordingtotheIMFCDISManual,fundsmovefroma business enterprise in the
host or source economy to another enterprise in a routing economy, only to have them come back to the original or
another enterprise in the host economy According to the IMF, the enterprise receiving the funds in the routing economy
has little or no business operations of its own An example of round-tripping would involve a domestic investment by a
ChineseenterprisedisguisedasFDIgoingtoasubsidiaryinaroutingeconomy(typicallyinanoshorecentersuchas
HongKongorBVI).Theprocesscanbedepictedasfollows:
17Sicular, Terry (1998). Capital Flight and Foreign Investment: Two Tales from China and Russia, World Economy, Vol. 21, Issue 5, pp.
589-602.
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Chart 1. Round-Tripping among the Troika
The CDIS Manual recommends that host countries record round-tripped funds in conformity with the guidelines
applicableforFDItransactionsandpositions.Theserecorded(licit)fundswouldthereforeappearasoutwardFDIfrom
the host country to the routing economy, and as inward direct investment from the routing economy to the host country
Analogously, the routing economy should record the funds received from the host country as inward FDI and as
outwarddirectinvestmentforthereturnofthesefundstothehosteconomy.However,thedatarequiredtoanalyzethe
round-tripping process is not complete as China does not report outward FDI, let alone those into routing economies
suchasHongKongandBVI.TheseneedtobederivedbasedontheinwardFDIpositionsoftheseoshorecentersvis-
-visthehostcountry,China.ButheretootherearedatagapsastheBVIalsodoesnotdirectlyreportCDISdatatothe
IMF(theBVIisanoverseasterritoryoftheUnitedKingdomandisnotamemberoftheIMF).
AnexampleoftheowoffundsdepictedinChart1involvesacompanyinthehosteconomy(China)whichinvests
intoasubsidiaryintheroutingeconomy(BVI)foron-wardFDIinanothercompanybackinthehosteconomy.Thisis
depictedbythearrowsshowingtheowsbetweenChinaandtheBVI.Ontheotherhand,round-trippingcanalsobe
viewed from the perspective of the routing economy whereby a company in BVI receives FDI from a parent company in
China, the host economy, which then reinvests these funds in another company in China
Table3showsthatforeigndirectinvestmentsfromChinaintoHongKongincreasedfromUS$312.3billionin2009to
US$366.5billionin2010,representingrespectively36.9and37.6percentoftotalFDIintothatoshorecenterwhile
Table5showsthatChinareceivedUS$553.7billionandUS$710.9billionfromHongKonginthoseyears.Thus,China
andHongKongarethelargestforeigndirectinvestorsineachotherseconomy(Table3and6).TheBVIplaysasimilar
role in the round-tripping of FDI except that Chinas FDI into BVI seems to be routed through Hong Kong We can
seethatBVIsFDIintomainlandChinaincreasedfromUS$187.2billionin2009toUS$213.7billionin2010.Giventhat
BVI is a British Overseas Territory located in the Caribbean with a population of about 28,000 and a GDP of around
US$1.1billion,itishardtoseehowitcanundertakesuchmassiveFDIoutowsunlessfundswereroutedbackinvia
Hong Kong18 Sure enough, according to Table 3, the BVI is the second largest recipient of FDI from Hong Kong, which
increasedfromUS$288.7billionin2009toUS$324.3billionin2010.ThefactthatFDIfromHongKongintoChina
(Table5)increasedfromUS$553.7billionin2009toUS$710.9billionin2010(comparedtojustUS$63.5billionfromthe
UnitedStatesin2010)wouldleadonetobelievethattheonlywaysuchmassivecapitalcouldhaveround-trippedback
toChinafromHongKongandBVIwouldbeifequallymassiveillicitoutowsfromChinaweretonancetheminthers
place.Otherwise,itisinconceivablethatBVIandHongKong(withamuchsmallerGDPthantheUnitedStates)could
18Central Intelligence Agency (2012), World Factbook. (reference link: hps://www.cia.gov/library/publicaons/the-world-factbook/
geos/vi.html).
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havemarshaledthenecessarynancialwherewithaltocarryoutFDIonthatscaleyearafteryear.MassiveFDIoutows
fromHongKongtoBVI(Table4)outstripthoseintoChinainboth2009and2010;in2010,FDIinowsfromHongKong
intoBVIamountedtoUS$356.7billion,wellinexcessofUS$327.6billionintomainlandChina.
Portfolioinvestments(Table7)intoChinafromHongKong,whichincreasedfromUS$152.4billionin2009toUS$190.7
billionin2010,aremuchsmallerbutbynomeansinsignicant.Interestingly,theCaymanIslandsattractedmore
portfolio capital from Hong Kong than did mainland China, an astonishing fact in itself Bermuda attracted more
portfoliocapitalfromHongKongthandidanyoftheindustrialcountriesincludingtheUnitedStates.Perhaps,thecloserscrutinybymoreeectiveregulatorsinadvancedcountriesmakesportfolioinvestmentswithillicitfundsmore
dicult,accountingforthebulkofsuchfundstoowtotaxhavenslikeBermudaandtheCaymanIslands.
Consideringreported(orlicit)dataonly,Chart1showsthatamassiveamountofFDIisswirlingbetweentheChina-
HongKong-BVItroika.Forexample,in2010,ifwegoclockwisestartingfromChina,US$366.5billionowedoutto
HongKongwhichinvestedUS$356.7billioninBVIwhichinturninvestedUS$213.7billionbackintoChinaaccounting
forUS$936.9billioncirculatingasFDIamongthetroika.Inthatsameyear,ifwegocounter-clockwise,BVIinvested
US$324.3billioninHongKongwhichinvestedUS$710.9billioninChina.Evenifreporteddatadoesnotshowthatthe
latterinvestedbackinBVI,theamountincirculationamongthetroikatotalslightlymorethanUS$1trillion.
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It is possible to derive some rough estimates of licit and illicit assets held in tax havens GFIs study on absorption
foundthatbetween24-44percentoftotalillicitoutowsfromdevelopingcountriesarestashedintaxhavens,
dependinguponwhetheroneusesthenarrowerBISdenitionorthebroaderIMFdenitionofsuchjurisdictions.The
IMFsbroaderdenitionclassiesSwitzerlandandIrelandasoshorecenters.19Weestimateillicitandlicitowsintotax
havensusingtheIMFdenition,asfollows.
Cashdepositsare10%oftotalows(basedonCapGeminiworldwealthportfolioholdings)whileothernancialassets
makeup37.9percentoftotalassetsintaxhavens(basedonholdingsinHongKong).Thebalanceisinvestedinnon-nancialassetssuchasrealestate,preciousmetals,etc.Forexample,accordingtoTable8,totalillicitoutowsfrom
Chinain2011wasUS$602.9billionoutofwhichUS$60.3billionwasdepositedascashandUS$228.3billioninother
nancialassets(suchasstocks,bonds,mutualfunds,derivatives);44percentoftheUS$288.6billionheldascashand
othernancialassetsorUS$127.0billioninillicitassetsowintotaxhavens(seeTable8fordetailsonprivatesector
illicitowsintotaxhavens).
Regardingtheestimationoflicitows,westartwithtotal(publicandprivate)internationalinvestmentposition(IIP)
assetsreportedbyChinatotheIMFofUS$4.7trillionin2011thatareheldworldwide(inbanksandtaxhavens)(see
Table9).NotethatIIPsarestockguresnotows.Fromthistotal,wetakeoutociallyheldreserveassetsofUS$3.2
trillion in order to derive private sector asset holdings There could be other publicly held assets in IIP assets, but these
are impossible to identify as the IIP system does not show assets held by sector To that extent, the 2011 estimate of
privatesectorIIPassetsofUS$1.46trillionmaybesomewhatoverstated.Now,outofthis,ifweassumethatsome44
percentareheldintaxhavens,thentheamountheldtotalsUS$643.4billion.Thisproportionmaybeoverstatedaslicit
owsintotaxhavensarelikelytobelowerthanillicitows.Inanycase,thisisastockgureandachangeinthestock
gureisourbestestimateofaowgiventhatwedonothaveinformationonwithdrawals.
Table10estimatestheproportionoflicitandillicitinvestmentowsbasedonthesebroadassumptions.Onaverage,
52.4percentofinvestmentsthatowedintotaxhavensduring2005-2011wereillicitwhile47.6percentwerelicit.These
estimatesvarysignicantlyfromyeartoyeardependinguponanumberoffactorssuchasthegenerationofillicitcapital, regulatory changes, investor preference, extent of illicit funds generated and transferred, risk appetite, etc
Theproblemofillicitowscannotbesolvedbysimplyfocusingondomesticpolicymeasuresthatneedtobetakenby
developingcountriessuchasChina.Theworldsshadownancialsystem,whichfacilitatestheabsorptionofillicitows
must also be subject to greater regulatory oversight so that the system is held to higher standards of transparency
and accountability regarding transactions and operations A whole host of policy measures is necessary to make the
absorptionofillicitassetsmoredicultrangingfromgreatertransparencywithregardtothereportingofdataand
informationtotherequirementthatnancialinstitutionscollectinformationonbenecialownershipofcorporations,
foundationsandtrusts,therequirementofcountry-by-countryreportingbymultinationalsontheirtransactionsand
operations, and the automatic exchange of tax information between sovereign nations and tax havens
19Kar, Dev, Devon Cartwright-Smith, and Ann Hollingshead (2010). The Absorpon of Illicit Financial Flows from Developing Countries:
2002-2006, Global Financial Integrity, Washington DC.
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