After yesterdays release of Chinese trade data, I think it is important to note the structural discrepancy that exists within Chinese international trade data. The mathematical impact on GDP is clear but the real impact is less clear.
In China, foreign exchange transactions for international trade in goods and services purposes are largely free. Foreign exchange transactions for capital movement purposes are tightly controlled and largely prohibited. However, smart businesses knowing this simply disguise capital movement as goods transactions. I have written about one form of this known as the copper carry trade.
Import and export over or under invoicing is another means of disguising flow in the restricted sector to look like flow in the unrestricted sector to move capital between countries. A sample transaction turns a $5m export into $10m to move $5m in capital into China. First, the exporting company issues a $10m invoice, declares $10 export to customs, and ship goods to importing company in another country. Second, the importing company declare $5 of import to customs, pays $5 for the good which is the real value of the goods trade. Third, the capital inflow of $5m will be remitted together with the payment for goods received of $5m, and be accepted by the Chinese company as $10m. In many cases, the receiving company wants to invest in the company it is buying product from or there is an agreement where to move the money after it is received or there is a third company providing the capital for remission. Fourth, the exporting company convert the $10 into RMB with invoice of $10 as supporting documents with a bank onshore. This entire process can work in reverse known as import over invoicing to move capital out of China.
The easiest way to know this is happening is to compare official Chinese import and export data to the import and export data of its trade partners. In other words, if China declares $10m in exports to Australia but Australia only reports $5m in imports from China, we consider that a significant discrepancy. Differences are to be expected in trade data but they are typically and should be quite small.
In fact if we look at the discrepancies between Chinese reported exports to its five top trading partners in the past three years and their reported amounts of imports from China, the numbers in relative terms are quite small. From 2012-2014 the total export over invoicing discrepancy between China and its top five trade partners was approximately $40billion USD. While that may sound like a lot, give the enormous amount of trade with the top five partners over three years, this is little more than a rounding error averaging about $13b a year. However, import over invoicing, which moves capital out of China, has grown rapidly in the past few years. From 2012 to 2014, the import over invoiced discrepancy amounted to $525 billion rising every year from a low of $148 billion in 2012. Import over invoicing for the top five trade partners of China represents approximately 30% of the value of imports. That is what we call a structural difference.
Now mathematically, the impact on GDP growth is unambiguous. If real imports are lower, this raises net exports and therefore by definition GDP. However, I believe the reality is more complex and here is why. Let’s assume a firm imports $1m of goods and sends $1m to the counterparty in another country. In this case, there is $1m worth of goods entering the country and $1m in currency leaving the country. Now let’s assume a firm imports $500k of goods and sends $1m out of the country, potentially to multiple accounts. Financially, there is no difference between scenario one and two as $1m has left the country in both scenarios. Economically, the country is actually worse off because the receiving firm has few inputs to make products or few goods to sell in a store. In other words, the same amount of money leaves the country and the country has fewer goods to sell after receiving the imports. I’m sure there is some model that would allow us to estimate the impact on GDP but I suspect it would not be the strict increase described in undergraduate economics.
More importantly for our understanding of China, this is proving an enormous channel of capital outflow from China. Despite the PBOC being well acquainted with it, there has been little effort to stop it. Given the rising surge of capital out of China and the high interest rates in China needed to sustain capital inflows, this cross current of events puts China in a difficult position. It needs to lower interest rates but this risks increasing the capital outflow and lowering international investor interest in China. This is the real importance of international trade data in China.