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While China continues to attract much of the foreign capital that comes into Asia’s emerging market economies, it appears these inflows are increasingly needed to offset capital flight. A flood of unregistered outflows from China has been compounded by the difficulty in tracking outbound movements of private capital and trade payments. At the same time, there is a massive amount of tax evasion and avoidance.

Individuals and enterprises are engaging illegal transfers, money laundering and the use of extralegal financial institutions to keep their assets out of the view of officialdom. An indication of the extent of capital leakage can be seen in the fact that exports have risen while growth in foreign currency reserves has slowed. Despite higher foreign income from net exports, foreign reserves are not increasing.

One way to gauge such leakage is to examine the entry for “errors and omissions” in the balance of payment accounts. This residual is calculated by subtracting foreign currency payments for imports, investment, debt service and additions to official reserves from receipts for exports, borrowings and investments by multinationals. The difference provides a ballpark figure for the value of capital flight.

In 1997, the size of this entry was $16.95 billion and, in 1998, $16.5 billion. However, a study conducted by Beijing University estimates leakage from the nominally closed capital account to have ranged from $36.4 billion in 1997 and $38.6 billion in 1998 to $23.8 billion in 1999.

More recently, a report in an official magazine, Banyue Zazhi, pointed out that more than 4,000 people have absconded with more than 5 billion yuan ($600 million). These funds are thought to have been stolen state funds or were received as bribes. Despite all this, it is hard to imagine China’s vast reserves totaling substantially more than $240 billion if official data captured all the capital flows.

Like much of the rest of endemic corruption, much of capital flight has involved party cadres, government officials or managers of state-owned enterprises, or SOEs. Enterprises can accumulate foreign exchange and transfer it offshore, either by underreporting the value of exports or overreporting the cost of imports. Individuals can use overseas accounts opened either by subsidiaries of their enterprises or overseas relatives to transfer their ill-gotten gains.

After China partially opened its current account, currencies could be exchanged for trade purposes but conversion for items on capital accounts, including portfolio investments, was forbidden. It became increasingly clear that this arrangement of partial convertibility would halt speculative attacks on the yuan. But opportunities for graft and illegal financial movements have weakened both the moral fabric and the economic vitality.

Keeping the capital account closed was intended to reduce large capital outflows. Now it is evident that the layers of bureaucracy used to inhibit capital flight resulted in the opposite; and worse, it also interfered with trade flows.

Of course, the best way to stem capital outflows is to offer a set of policies and institutional arrangements that are attractive and credible. In such a setting, there is no need for capital controls. In fact, such controls could be counterproductive since they interfere with mechanisms useful for currency hedging.

SOEs are the principal perpetrators of illegal capital outflows by underreporting their export earnings and overreporting the value of their imports to the State Administration of Foreign Exchange, the body with oversight powers. By underreporting export values, enterprises can keep more of their foreign exchange revenues. Over-reporting import costs enables them to convert more yuan into other currencies.

To carry this off, offshore shell companies are set up by the enterprise that places excess amounts into foreign bank accounts. At the same time, setting high invoice prices for inputs exaggerates their foreign-currency liabilities.

One might sympathize with enterprise managers who seek to maintain control over financial assets, especially when state bureaucrats too often squander these funds. Other managers could be trying to protect the earnings of their enterprises against losses in value by holding them in convertible assets.

In sum, most of the diversion of capital outside of official scrutiny and control is the result of the distorting effects of Beijing’s policies. Thus, the answer to this problem does not lie in improving collection procedures or in prosecuting individuals or punishing companies for noncompliance. Instead, a long-term cure would be to change the distorted incentives while improving operations of the domestic capital market so that there are fewer reasons for the funds to be diverted.

Lifting controls on capital flows would change the incentives faced by enterprises as well as public officials who oversee economic policies. Granting free and open mobility of capital would eliminate the temptation for enterprises to keep funds in foreign accounts, especially when motivated by economic reasoning rather than dishonesty.

This would provide greater stability in the value of the yuan and enable China to become more closely integrated with the global economy. It remains to be seen whether the interventionist inclinations of the leadership in Beijing will continue to delay such an important and inevitable change.

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