By Zhong Jing
According to a research report completed recently by a research group with the Chinese Academy of International Trade and Economic Cooperation (CAITEC) of China's Ministry of Commerce (MOC), a number of offshore financial centers like the British Virgin Islands, Cayman Islands, Western Samoa and Bermuda have become important sources of foreign investment for China, and the fast-growing investment from these regions have become quite prominent in the capital inflow that China has experienced in recent years. By actual investment amount, in 2002 and 2003, the British Virgin Islands ranked the second largest source of foreign investment for Mainland China. And now there are "tens of thousands" of Chinese offshore companies registered at offshore financial centers.
Dr. Mei Xinyu, author of the report and one of the experts of the research group with CAITE, notes that we cannot afford to neglect the effect of offshore financial centers on cross-border capital flow in China. Why do so many Chinese enterprises go to such distant islands - "offshore financial centers" to register "offshore companies", and then make a "detour" to invest in China? Dr. Mei sees five motives behind this move:
First, to strip non-performing assets off. To obtain a good stock price, before getting listed an enterprise must strip non-performing assets off, which takes a long time and high cost. By registering an offshore subsidiary company, an enterprise may strip its non-performing assets off to the offshore company thanks to the limited liability relationship between the parent company and the daughter company and the loose requirements set by the offshore financial centers on the quality of assets of offshore companies.
Second, to avert the threshold of size and get listed overseas through a "detour". For a long time, China has stringent requirements on qualifications of Chinese enterprises seeking to get listed overseas directly and the utilization of funds raised by them after listing. Firstly, there is a threshold of size; secondly, the "no comment letter according to Chinese laws", which carries uncertainty, is required; thirdly, for the utilization of funds raised, when getting listed overseas, enterprises incorporated in Mainland China are required to bring all funds raised through the listing overseas to the mainland. Against such backdrop, by pursuing the tactic of getting listed through the detour, i.e. setting up a holding company at the seat of the overseas securities market it seeks to get listed or another country or region allowed by the market, a Chinese company may apply for getting listed in the name of the holding. That is indeed a feasible approach for averting the threshold of size and capital control.
Third, domestic businesses may acquire the same treatment with their foreign counterparts through the "detour".
Fourth, to conceal the company's actual controller. Chinese companies often register more than one "shell" company at offshore financial centers. As a result, when these companies inject their domestic assets into the overseas "shell" companies, the stockholding relationship and asset replacement are very complicated and confusing. It is very hard for people other than the core insiders to find out the true relationship among the offshore companies and the actual controllers. This facilitates enterprises engaging in related-party transactions; at the same time, it makes it easier for insiders to blur the true attribution of ownership of the company for certain purposes.
Fifth, to seek lawful tax avoidance. According to Dr. Mei, that the offshore financial centers take greater importance in China's cross-border capital flow has some positive significance. However, what is most noteworthy is the considerable "negative impact" and "potential risks" posed to China by the rise of offshore financial centers. The problems caused by offshore financial centers and the numerous Chinese offshore companies involve at least five aspects:
1. It becomes an "effective avenue" for corrupt people and bad businessmen to embezzling state-owned assets and public properties. Many large-scale modern enterprises have their rights of management separated from ownership, which exposes them to risks: The executives may embezzle shareholders' assets, and large shareholders with shareholding right may infringe on other shareholders' rights and interests. Offshore financial centers precisely provide "convenient channels for asset transfer". There are two approaches to such asset transfer: hollowing out listed companies' assets through related-party transactions, and concealing the true identity of the acquiring party to public stock equity at low cost. Such cases are common occurrence in the SOE reform.
2. It becomes a " transit depot" for capital flight from China, and adds fuel to the expansion of scale of capital flight, and poses major pressure to arrangements about the exchange rate of Renminbi and China's monetary policy. At present, this country is experiencing capital flight on a staggering scale. Caribbean offshore financial centers like British Virgin Islands, Western Samoa and Bermuda and Cayman Islands act as "transit depot" for capital that flees Mainland China and then flows back, and that is an open secret in the international financial circles. Capital flight is an important part and source of international hot money. Since the second half of 2002, the massive inflows of international hot money have posed heavy pressure on the appreciation of Renminbi, causing severe disturbance to the monetary policy formulated by the People's Bank of China to curb the runaway of credit quota increase in this country.
3. It triggers potential disputes over investment. The much-talked-about Yang Rong Case is a case in point.
4. It facilitates fraud by companies. So far there are two known avenues of committing fraud through offshore financial centers: 1. False increase in assets; 2. False improvement of business performance. False improvement of business performance is often aimed to acquire money by getting listed, but it usually requires sizable amounts of extra taxes. Yet the tax exemption treatment offered by the offshore financial centers allows an enterprise to achieve the goal at low cost. Such account cooking behaviors are so common that there are listing services companies that conduct the whole package of account cooking practices in Hong Kong now.
5. It makes it easier to shift financial risks. By setting up offshore companies, a group company which is mired in heavy debts on the whole may keep at a low level the book debts of its subsidiaries with great obligations of information disclosure. In this way, the group's high level of debts is kept secret.
The report points out that China should take moves on various fronts to prevent risks: improving monitoring of capital flow; moderately restricting relevant agencies in conducting offshore financial services in the mainland; stepping up financial regulation over enterprises invested by offshore companies so as to prevent them from shifting overseas financial risks to this country; loosening control of capital flow to facilitate enterprises' business operations across the borders and annulling excessive preferential treatment for foreign businesses to grant equal treatment to both domestic and foreign enterprises, and improving tax system to impair enterprises' motives of making those offshore financial centers the country of incorporation for their companies.