Meanwhile, tensions between the US and China show no sign of diminishing under the Biden administration, with recent naval sorties near Taiwan increasing the likelihood of a further decoupling of the world’s two largest economies.
New data suggests that the situation may be even more fragile than previously thought. US researchers have found that, once the distortionary effect of offshore financial networks is accounted for, the size and volatility of emerging market external debt is far greater than shown by official statistics, as is the exposure of Western investors to China.
Tax havens distort official statistics
The destination of capital flows as recorded in official statistics is typically based on the recipient’s legal residence. In recent years, however, multinational corporations have increasingly used subsidiaries in tax havens as vehicles for issuing bonds and equities, obscuring the real destination for billions of dollars of investments.
The result is that official statistics show enormous flows of investment to improbable locations, such as the British Virgin Islands and Bermuda. According to the UN Conference on Trade and Development, the Cayman Islands recorded $20.6bn of inward FDI flows in 2018 – 374% of its GDP.
New research shows just how inflated these figures are. When the destination of funds is measured by the actual nationality of the recipient rather than their legal residency, the value of foreign equity and bond holdings in tax havens falls by $4.9trn.
Developing countries are the most likely to access capital markets through offshore structures. Official statistics based on residency capture only 41% of foreign equity holdings in China, with 59% being issued through foreign subsidiaries. For poorer countries such as Nepal and Kyrgyzstan, the figure is close to 90%.
The large emerging economies of Brazil, Russia, India, China and South Africa (BRICS) accounted for $656bn of bonds held by Western investors via low-tax jurisdictions in 2017, with $226bn owed by Chinese borrowers alone.
The new data makes sense of the improbable financial flows recorded in official statistics. For instance, official figures indicate that in 2017 US investors held $606m in equity in companies legally resident in BRICS countries, significantly less than the $850bn they held in just four island low-tax jurisdictions (Bermuda, the Cayman Islands, the British Virgin Islands and Jersey).
These figures suggest a total investment in BRICS of just $3 per $1m of GDP, compared with a combined investment in the low-tax jurisdictions of $48m per $1m of GDP – a 16 million-fold difference.
When the figures were adjusted to account for the issuing of equity abroad, the total equity held by US investors in BRICS doubled to $1.2trn, while the sum held in low-tax jurisdictions plummeted by 99.5%.
Western investors are highly exposed to China
The vast majority of these low-tax jurisdictions equity purchases by Western investors are for Chinese corporations, which have taken to issuing stocks via tax haven subsidiaries as a means of circumventing capital controls.
Foreign ownership in the IT and telecommunications sector is banned entirely, and so in order to raise capital on global equity markets Chinese companies such as Alibaba, Baidu and Tencent have constructed elaborate and opaque offshore structures, typically based in the Cayman Islands.
According to figures from GlobalData, Chinese companies operate 73 subsidiaries in the Cayman Islands (more than any other country after the US, the UK and Taiwan), 14 of which belong to retailing giant Alibaba.
As of 2017, US, UK and eurozone investors held $830bn in shares in Chinese companies via tax havens, including $705bn via the Cayman Islands alone. Other investors held a further $129bn via this route.
Such a high level of exposure to China at a time of rapidly rising geopolitical tensions would be concerning enough, but the mechanism used by investors to access Chinese markets leaves them particularly exposed.
The researchers found that most offshore Chinese equities were held through variable interest entities, opaque corporate vehicles that allow Chinese companies to present themselves as fully Chinese-owned to domestic regulators while offering foreign investors effective equity ownership. Such investments are highly vulnerable to a regulatory crackdown by the Chinese government.
The new data shows that British bond holdings in China grew more than twice as fast in the decade to 2017 than official figures suggest, while US lending grew almost four times as fast (rising by 442%). US equity holdings in the world's second-largest economy grew by 126%, more than twice as fast as previously thought.
Emerging economies have significant debt risks
In other large emerging economies, offshore structures are used to avoid not capital controls but taxes.
Bonds or shares issued to foreigners from India or Russia, for instance, are subject to taxes of up to 20% on interest and dividends, whereas low-tax jurisdictions such as Bermuda and the Cayman Islands offer tax-free payouts.
This may be why companies based in emerging economies were far more successful at attracting investors from developed countries when issuing shares through low-tax jurisdictions. For instance, the researchers found that although Brazilian companies issued about 52% of their bonds domestically, 90% of those sold to investors from developed economies were issued abroad.
The issuance of bonds and equity via tax havens also allows companies to avoid corporate taxes. Capital raised offshore can be loaned back to the parent company at a high rate of interest, artificially depressing the company's reported profits in its higher-tax home jurisdiction while increasing them in the tax haven – a practice known as 'profit shifting'.
Aside from obscuring the true financial connections that bind the global economy, the flow of investment through low-tax jurisdictions gives a distorted image of the nature of international investment. Portfolio investments that are channelled through tax haven subsidiaries emerge from the other side as FDI from the subsidiary to the ultimate parent.
As a result, the researchers found, official statistics mistakenly classify billions of dollars of investment as FDI instead of portfolio foreign investments (PFI).
PFI flows are far more short-term and volatile than FDI, and therefore pose serious risks to a recipient country's macroeconomic stability. Policymakers relying on official statistics may therefore not fully appreciate the exposure of their economy to hot capital flows, flows that can cause sudden and catastrophic currency movements or balance of payments issues.
The misclassification of PFI as FDI also leads official statistics to significantly underestimate the scale of many countries' total external debt. FDI is supposed to be measured by its book value, the value of the investment at the point of transfer, while portfolio investments are meant to be pegged to the market value of the underlying asset.
By misclassifying portfolio investments as FDI, statisticians fail to account for increases in the market value of investments, leading to an ever-growing gulf between the official and real value of a country's external liabilities.
The researchers found that reclassifying financial flows by company nationality increased China's external liabilities by $1.1trn – enough to cut its famously large net creditor position in half.
As government debt is rarely issued via low-tax jurisdictions, this revaluation of external debts also increases the ratio of private to public external debt for many countries. For instance, corporate bonds account for just 25% of Brazilian bonds sold to the US under official statistics, but 66% after reallocation.
Low-tax jurisdiction-issued debt is also much more likely than domestically issued debt to be issued in a foreign currency, typically dollars or euros, meaning that revaluation can significantly increase the share of a country's external debt held in foreign currency.
For instance, the share of Russia's external debt denominated in foreign currencies is officially just 1%, but after revaluation the true value was found to be 39%. The share of South Africa's external debt denominated in foreign currencies more than triples under revaluation, from 4% to 13%.
Debt denominated in foreign currencies poses a severe risk to emerging economies in particular. If capital flight or trade imbalances lead to a depreciation of the country's currency, the burden of repaying foreign-denominated debt may become unsustainable, leading to a spiralling crisis of debt default and austerity.
The negative effects of low-tax jurisdictions on governments’ ability to fund infrastructure investment and key social programmes is well known, but the new data sheds light on an often underappreciated harm perpetuated by these illicit capital flows: their ability to distort our image of the global economy and to obscure systemic risks.
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Ben van der Merwe is a data journalist at Global Data Media, specialising in FDI.