The Chinese example
Issues of poverty and economic under-development have, appropriately, got a great deal of attention from policy-makers and non-governmental organisations (NGOs) over the last few decades. But the relationship between International Financial Centres (IFCs) and economic growth and poverty alleviation in developing countries is largely unexplored. What little scrutiny this relationship has received has tended to portray IFCs as exerting a baleful influence on developing countries. In contrast, it is argued here that at least in the case of China, IFCs may actually assist economic development and poverty reduction. There is evidence that IFCs can make a positive contribution by helping foreign and domestic firms in developing countries access the kind of efficient institutions necessary to drive growth, but which are often unavailable locally.
To put the case for this alternative perspective briefly, governance and institutions are now regarded as some of the key determinants of economic growth, and related poverty reduction. Efficient institutions promote growth by lowering transaction costs and thereby facilitating exchange. Transaction costs refer to the costs of fully specifying and enforcing economic exchanges. Because regulations and laws in developing countries are commonly confusing, rigid, obsolescent, politicised and poorly enforced, transaction costs at home are generally high, so local firms may seek efficient institutions abroad to make exchanges cheaper and easier.
IFCs can offer a natural complementarity for developing countries, as they provide an environment characterised by simple, flexible, modern, sophisticated and impartially-enforced regulations and laws that are readily accessible by foreigners. Small- and medium-sized enterprises from developing countries, the engines of job and income growth, may be able to access capital much more efficiently in or through IFCs than they can domestically. Judging from China’s experience, IFCs are seldom final destinations for capital from the developing world, which is commonly brought back and put to work in the country of origin.
The starting point for an investigation of the links between IFCs and China are what look to be some bizarre figures relating to capital flows. Why, for example, does the British Virgin Islands contribute more Foreign Direct Investment (FDI) to China than the United States, the European Union and Japan combined? How can it be that flows between China and Samoa or China and Barbados are bigger than flows between China and the United Kingdom? Why is there ten times more investment from China in the Cayman Islands than there is Chinese investment in the United States?
Those looking to account for these anomalous figures have so far relied on two answers: either that these flows represent criminal money flowing to IFCs, or a process of ‘round-tripping’, whereby locals send money out of the country, only to return it via IFCs to qualify for tax breaks. A closer look at the evidence, however, suggests that neither answer stands up.
As with any large flows of money across borders, it is almost certain that some proportion of the money flowing from developing countries to IFCs does indeed represent plundered wealth. But there is no reason to suppose that the proportion of illicit wealth is any greater than that moving from developing countries to G20 financial centres. Indeed, G20 countries in many important cases provide a warm and secure welcome for the wealth of kleptocratic dictators. For example, in 2009 the NGO Global Witness published an expose showing how Teodorin Obiang, son of the president of Equatorial Guinea, has acquired a USD35 million mansion in Malibu, California, despite the US government’s judgment that the property was purchased with the proceeds of corruption. France has done nothing to stop corrupt heads of state and other senior public officials from Francophone Africa from owning luxury properties and maintaining their bank accounts in Paris. More broadly, my research has shown that OECD countries are much more likely to allow the formation of anonymous shell companies, invaluable in laundering corruption money, than are IFCs.1
What of the second answer, round-tripping? Here it is said that Chinese firms and individuals send money out of the country to an IFC, only to repatriate the same funds. The rationale is said to be the desire to capitalise on special tax breaks provided for foreigners: domestic money passed through IFC becomes foreign, and hence eligible for tax savings. If tax arbitrage through round-tripping explains the China-IFC link, then the real consequences for the Chinese economy would be slight, and probably negative as the government lost out on tax revenue it would otherwise be entitled to. But this view is highly incomplete.
If it were just the same funds being cycled between China and the Caribbean, the out-bound and in-bound flows would have to cancel out. In fact, however, flows from the Caribbean to China are more than twice as large as the equivalent flows in the other direction. Thus much, and probably a majority of the foreign investment through IFCs in China is indeed foreign, once again posing the question of why IFCs are such disproportionate contributors of foreign capital in developing economies like China.
What of the money that is round-tripped? Here there are good reasons to think that there is a lot more going on than simple tax arbitrage. Fiscal reforms in China have meant that most tax concessions for foreign investors have now been withdrawn. And yet at the same time that the tax advantages of IFC-mediated investment have been reduced, investment from or through IFCs continues to increase.
The solution is to return to the subject of institutions and transaction costs introduced earlier. In China at least, and probably in other developing countries too, the reason why capital flows from IFCs are increasing as the tax rationale fades is because both local and foreign investors seek to combine the advantages of the economic dynamism of these markets, with the transparent, reliable and efficient institutions hosted by IFCs. Some examples illustrate how this logic applies in practice.
Small and medium-sized enterprises in China are the main engines of job creation, income growth and hence poverty alleviation. Yet these same firms find it very difficult to access adequate capital. The few large local banks have neither the capacity nor the inclination to come up with the risk models needed to assess the creditworthiness of disparate smaller firms, instead preferring to channel credit to large, state-owned enterprises.
To help address this problem, the Asian Development Bank (ADB) provided USD13 million to a Chinese loan guarantee company, COG, but was surprised to find the firm was incorporated in the Caymans. Asked to explain, the Bank’s response is highly illuminating:
‘The Cayman Islands’ legal system is based on British law, and therefore the legal concepts are familiar and acceptable to international investors... Most PRC [People’s Republic of China] companies seeking a listing on the Hong Kong Stock exchange incorporate their listed companies in the Cayman Islands. ADB’s external counsel and COG’s external counsel have confirmed that, in the present circumstances, a direct listing of COG as a PRC company is not feasible, as listing would involve... a highly bureaucratic process, which is why PRC companies tend to use offshore jurisdictions... the Cayman Islands is generally considered desirable because (i) the legal requirements regarding capital reduction and the distribution of capital are less complicated than are those in Hong Kong, (ii) Hong Kong stamp duty is not chargeable for share transfers that take place prior to the IPO, and (iii) the Cayman Islands are FATF compliant and not on OECD’s tax haven blacklist (Asian Development Bank 2007: 5).’2
As this legal opinion states, this is far from being a one-off situation. Ease of incorporation, the ability to reduce capital and issue different classes of shares, the reliance on tried and tested legal concepts and systems, the flexibility of corporate structures and the tax-neutral treatment of investment from different sources all argue in favour of using IFCs to invest in China. Thus Chinese technology and media firms have tended to form an IFC-based company that can list in New York, Hong Kong, or elsewhere depending on where the great amount of foreign capital can be raised. The IFC company then holds a wholly-owned Chinese operational subsidiary.
Joint Ventures may also choose to form companies or trusts in IFCs that then hold the underlying collaborative venture in China. Joint Venture firms in China must apply for permission from the government to change board members, re-adjust ownership shares, or change the focus of business. If underlying IFC vehicles are employed, however, partners may make all of these changes quickly and easily. Disputes that arise between foreign partners can be settled in a familiar and credible legal setting using courts that have considerable expertise in solving complex commercial disputes.
In these and other examples, Chinese and foreign investors can profit from IFC-based institutions that allow contracting parties to both more accurately assess the value of exchanges, and be more confident that contracts will be upheld in an impartial and reliable manner. In an ideal world, of course, China and other developing countries would be able to provide the institutions that serve to lower measurement and governance transaction costs locally. Yet creating, for example, an expert and impartial court system is a long-term process. As Huang writes in his book Capitalism with Chinese Characteristics (Cambridge University Press, 2008), ‘China’s success has less to do with creating efficient institutions and more to do with permitting access to efficient institutions outside of China’. IFCs provide these efficient institutions. Given China’s unmatched success in lifting hundreds of millions of people out of poverty since 1978, we need to investigate whether other developing countries could also profit from closer relations with IFCs.
For a longer version of this paper, visit the International Financial Centres Forum website.
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