Pursuing Lasting Progress in Emerging Markets®

On Double-Invoicing and the Yuan, Part 1

Among global investors, it’s widely held that the Chinese yuan is a “cheap” currency, and that it is undervalued relative to the U.S. dollar. I am inclined to agree, especially in light of how expensive some other foreign currencies appear to be (see my recent commentary on the Brazilian Real). However, I would quickly caveat my opinion by clarifying that it applies only to a long-term horizon. In my view, whether the yuan is under-valued in the short or medium-term is far more ambiguous.

If you are looking for pessimism regarding the yuan, there is no shortage of popular arguments against it. There are questions over the stability of China’s domestic financial system; there are concerns over the quality of growth in the economy; and there are fears over a potential property bubble. In my view, such arguments hold varying degrees of merit, but their proper examination requires detailed discussion, so I’ll leave them aside for now. Instead, empirical data offers a different approach: by examining a little-known practice called “double-invoicing,” we can observe commercial traders’ preference for the yuan versus other currencies. Double-invoicing is a technique by which traders (e.g., exporters and importers) move private funds into and out of China, skirting controls that would otherwise prevent them from doing so. Their actions may belie popular notions about the yuan and its valuation.

Before we begin, it’s important to review a few basic facts about the yuan. For most of its modern history, the yuan has been a “closed” currency; in other words, trade in the yuan has been restricted to sanctioned activities. Foreign parties have been blocked from trading the yuan for most purposes, save one. With proper government approval, foreigners could buy yuan in order to engage in foreign direct investment (FDI): they could undertake physical investments in plants and factories that might stimulate development and create jobs in the country. However, trading the yuan for investment purposes – so as to buy stocks, bonds or other financial assets – was almost wholly forbidden.

Meanwhile, similar restrictions were placed on parties of domestic origin. Regulations forbid Chinese from exchanging yuan for foreign currency, except to engage in legitimate trade for merchandise and services. Buying foreign currency in order to save or invest abroad was off-limits to most Chinese. In recent years, a number of reforms have relaxed restrictions on both foreign and domestic parties (a testament to the government’s resolve to modernize its currency and its economy), but trading in the yuan is still tightly regulated. The yuan, for most intents and purposes, remains a “closed” currency even today.

Under such constraints, how does a savvy commercial trader move private capital into and out of China, assuming they wish to do so? Export and import trading affords the only sanctioned, large-scale means by which to exchange yuan for other currencies. Trade can thus be used to mask such flows, using the double-invoicing technique. The practice works like this: imagine you are a Chinese citizen, lucky enough to have 5 million yuan in your pocket (about $770,000 at today’s exchange rates). You wish to buy stocks on the NYSE, or a condominium in San Francisco, but you are not allowed to take that much money out of the country for such purposes. However, you can legitimately use capital to buy foreign imports, so you line up a trading partner in Taiwan. She sends you a container of computer chips, and an invoice for the equivalent of 2.5 million yuan. Next, you ask for the regulator’s approval to buy enough foreign currency (New Taiwan dollars) to settle the transaction. However, instead of presenting the original invoice, you present a second, fudged one for the equivalent of 3 million yuan. You receive approval because the regulator doesn’t have the skill to assess the actual market value of your imported goods. You settle the transaction for the equivalent of 2.5 million per the original invoice, and stash offshore the equivalent of 500,000 yuan (or $77,000) in foreign currency.

Next, you take the remaining 2 million yuan (the amount still in your pocket, back home in China), and you set up a factory to process those chips; perhaps you attach them to a circuit board. In doing so, you add the equivalent of 2 million yuan worth of market value to the finished product. The product’s total value is now 4.5 million yuan (2.5 million you paid for the chips, plus 2 million of value you added via your manufacturing process). Next, you apply to export your circuit boards to a U.S.-based computer company. The regulator approves your transaction; however, he warns you to remit your proceeds back to yuan, or you will not be given permission to trade again. You agree to do so, but you submit an alternate invoice for only 3 million yuan – again, the regulator cannot assess the actual market value of your goods. You sell your goods in the U.S. and pocket $693,000 (the equivalent of 4.5 million yuan). You then remit 3 million yuan ($462,000) as promised to the regulator. You have left $231,000 offshore in U.S. dollars. Out of your original 5 million yuan – or $770,000 equivalent – you have funneled out a combined total of $308,000. Not bad – now just repeat that process a few more times, and that San Francisco condo will soon be yours.

Now, imagine tens of thousands of exporters and importers, from all over the world, utilizing this technique to move private capital into and out of China at will. (Though it’s trickier to do so, capital can be moved into the country by reversing the process: under-invoicing for exports sent to China, and over-invoicing for imports purchased from China). Double-invoicing is arguably the most important means by which so-called “hot money” finds its way into China.1

Let’s briefly look at the U.S. trading relationship with China for evidence of such activity. In 2010, the U.S. recorded $369 billion in imports from China and Hong Kong together (I include Hong Kong because some Chinese merchandise is re-exported through the city-state). Meanwhile, China recorded $283 billion in exports to the U.S., and Hong Kong tallied $42 billion in re-exports bound for the U.S., for a total of $325 billion. There’s a $44 billion gap between what the U.S. claims to have paid, and what China and Hong Kong claim to have received.

A small differential is to be expected: measurement errors, timing differences, and tax evasion mean the data will never match up perfectly. Also, markups are added to the goods as they cross the Pacific to cover the cost of transport and insurance. However, even adjusting for such factors, there is a surprisingly large and sustained invoice gap. A similar, smaller gap exists on the export side, worth another $3 billion; the total gap is therefore $47 billion. Even if one adjusts that gap by $18 billion as an estimate of shipping and insurance costs, there is still $29 billion that can’t be explained – except by capital flowing out of the yuan, into the dollar.2

Estimated Invoice Gap for U.S.-China Trade USD BL, Adjusted*
*Adjusted for estimated CIF vs. FOB invoice treatment, and for estimated re-exports from Hong Kong.
Source: U.S. Census Bureau; U.N. Comtrade Database; BRICS Joint Statistical Publication 2011; Seafarer

The chart shows my estimate of the invoice gap over the past six years. The numbers are persistent and substantial: about $30 billion (or more) in private capital has leaked out of China every year. It suggests that some private market participants – traders, exporters and importers – are keen to convert their yuan into dollars, despite prevailing wisdom that the yuan is undervalued. To be sure, the chart does not capture the whole picture: traders in many other countries use double-invoicing to leak capital into China, and those flows are even greater than that which leaks out. Perhaps there is excess demand for the yuan after all, though I am skeptical. I’ll discuss that topic and the broader implications of double-invoicing in my commentary next week.

Andrew Foster
The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer’s current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
  1. Gunter, “Capital Flight from China, 1984-2001,” 2003, page 13.
  2. I have adjusted export flows by 9% to account for the cost of freight and insurance (cif) per Gunter, page 11: “First, one must adjust for the additional costs of insurance and freight (cif) that adhere to an import that are not included in the price of an export. According to the International Monetary Fund, this cif difference is approximately 9% for the PRC.”