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On Double-Invoicing and the Yuan, Part 2

Last week’s commentary on the yuan discussed how export/import traders can use an invoicing technique to circumvent controls that otherwise restrict the flow of private capital in and out of China. The commentary also highlighted the U.S.-China trade relationship: it noted that large and sustained discrepancies in the invoices between those two countries imply capital outflows. Funds appear to be leaking out of the yuan and into the dollar. I concluded by suggesting that some Chinese traders have thus revealed a preference for the dollar over the yuan. I estimate those outflows to be the equivalent of tens of billions of dollars; the chart below depicts the historical trend.

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

Certainly, it’s counterintuitive to imagine that capital might flow out of China and into the U.S., especially at this juncture in history. The financial media is replete with reports of the dollar’s secular decline, and also of tremendous sums of “hot money” flowing into the yuan, largely in secret. Why have I suggested the opposite?

The answer is complex. I acknowledge that the media’s story is partially correct: though no one knows for certain, it’s likely that more capital leaks into rather than out of China. Using double-invoicing and other techniques, traders from around the world appear to have shifted a surplus of capital into China. But here is where I want to challenge the popular perception: because the yuan enjoys net inflows from the rest of the world, many conclude that the yuan is broadly undervalued, poised to rise against most currencies. I think a conclusion of that sort is overly simplistic, as it ignores the revealed preferences of a critical group of well-informed traders: Chinese exporters that wish to exchange yuan for dollars when they have the opportunity to do so. Given such imbalances – the yuan experiences inflows from some currencies, outflows to others – I believe demand for the yuan is far more nuanced, varying country by country.

In order to get a broader understanding of demand for the yuan, let’s look at another case – one where double-invoicing leaks capital into China. The Association of Southeast Asian Nations (ASEAN1) trades actively with China; according to China’s own statistics, the association has run a moderate trade surplus with China over the past five years.2 Based on public data, it appears that trade between ASEAN and China generates a large and persistent invoice gap, but it is the reverse of what we saw before. Chinese exporters claim to have received more than what ASEAN claims to have paid. Over-stated exports of this sort suggest that capital is leaking into China from ASEAN. The chart below shows my estimates of the ASEAN-China invoice gap from 2004 to 2009.3

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

If my estimates are correct – and they are conservative – they suggest that a large and growing amount of private capital has flowed from ASEAN to China. This would fit the common perception that “hot money” is leaking into China. Undoubtedly, some of this money is hot. Exporters and importers in southeast Asia are as keen as any to speculate on property, stocks or other financial assets in China.

However, there is an alternative explanation for these flows: manufacturers based in ASEAN have leaked capital into China in order to establish factories there. Since 1998, when I began investing in Asia, I have witnessed several ASEAN-based industries lose competitive ground to China. Feeling the pinch, many exporters have sought to relocate their production facilities there. Foreign direct investment (FDI4) is accepted in China, but it is regulated and restricted to specific industries.5 It’s therefore easy to imagine that traders would circumvent currency controls to move capital into China, perhaps to support FDI that did not garner official approval. Thus some of the supposedly “hot” money sloshing into China may not be speculative after all. A number of export zones in southeast China are rumored to owe their existence to foreign capital that was leaked into the country through unofficial channels.

So where does this leave us? ASEAN’s example is the common one; capital is more likely to leak in than out. It also fits the popular narrative: Chinese authorities have struggled to stem speculative inflows, and not the other way around. Yet still, what about the outflows from the yuan to the dollar? This does not fit the general pattern. Why do informed Chinese traders – who know well how much they stand to gain from a yuan revaluation – still prefer to move substantial sums into the dollar?

There is no easy explanation for this behavior. In the past, “round-tripping” gave Chinese traders an incentive to leak funds into the dollar. By holding funds offshore in the U.S., they could form a shell company to invest back into China (a “round trip”). As a foreign-domiciled entity, the shell company benefited from an advantaged tax status. Chinese authorities closed the loophole years ago; outflows from the yuan to the dollar moderated, but continued. Not even the catastrophic market events of 2008 stemmed the outflow; it has persisted despite rising concerns within China over the stability of the U.S. dollar.

I believe the persistent invoice gap that occurs on the U.S.-China trade account is indicative of an underlying demand for the safety, security and liquidity of dollar-denominated assets. The past decade has shown how the Chinese government prefers to store the bulk of its foreign reserves in U.S. treasuries; the invoice gap suggests that the private sector has a matching taste for dollars. The motivations behind this preference are unclear; but the demand for dollars appears to be an abiding one. Until the yuan becomes an open, convertible currency, we will never know the true nature of private demand for foreign assets – but I believe the invoice gap yields an important clue.

Double-invoicing is a murky business. It is difficult to measure the underlying capital flows with precision, and impossible to divine the intentions behind those flows. However, what it clearly reveals is that China’s trade accounts are highly complex, and that its vaunted trade surpluses mask other forms of activity. Most of all, I believe double-invoicing indicates that the yuan’s relationship with other currencies is far more nuanced than is commonly understood. If the yuan was to float freely, it is quite possible that it would fall against some currencies, even as it rose against others. Some savvy insiders are apparently betting against the yuan, even as the rest of the world sees the currency as a “one way bet.” Ultimately, double-invoicing reveals how little we really know about the yuan in practice; in my opinion, we should take nothing about it for granted – so approach it with caution.

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. ASEAN is an economic and political association; its primary members are Singapore, Indonesia, Malaysia, Philippines, Thailand and Vietnam.
  2. BRICS Joint Statistical Publication 2011, Chapter 15, page 133.
  3. Data for 2010 are not yet available.
  4. Foreign direct investment (FDI) is long-term investment from a foreign origin; it generally entails a controlling stake, and it typically involves investment in physical premises and equipment rather than securities and other financial assets. For more discussion, please see the prior commentary, On Double-Invoicing and the Yuan, Part 1.
  5. IMF, 2006 Annual Report on Exchange Arrangements and Exchange Restrictions, page 297.