Tax Havens Mask Global Risk Exposures

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Because of the proliferation of shell companies in tax-friendly countries, most official estimates of overseas investments are grossly inaccurate. | Reuters/Gary Hershorn

If you rely on official statistics from the International Monetary Fund and the U.S. Treasury, large developed economies’ investments in Chinese stocks and bonds are small when compared with the economic importance of China.

But a new study, coauthored by Matteo Maggiori, associate professor of finance at Stanford Graduate School of Business, shows that the most commonly used data offer a distorted view of what’s really going on. Instead of holding $160 billion in Chinese stocks, as the Treasury reported for 2017, U.S. investors actually hold about $700 billion.

Put another way, American investors hold a volume of Chinese equities that is not much less than the $1.1 trillion worth of U.S. Treasuries that Chinese corporations hold. China may be one of the United States’ biggest foreign creditors, but the U.S is still a leading banker to China and the world.

The reason for the huge gap between official data and reality is simple: tax havens. Corporations around the world, including American ones, raise hundreds of billions of dollars through equities and bonds issued via subsidiaries in tax havens such as the Cayman Islands, Bermuda, Jersey, Guernsey, and Ireland.

Alibaba, China’s giant online retailer, raised $25 billion by selling shares issued in the Cayman Islands in a public equity offering in the United States in 2014. Petrobras, Brazil’s state-controlled oil company, used its Caymans subsidiary to raise tens of billions in corporate bonds.

Officially, holdings of these stocks and bonds are booked as investments in the Cayman Islands rather than in China or Brazil. The same thing occurs for vast numbers of deals through other tax havens. Indeed, the researchers say, about 8% of the world’s corporate stocks and 10% of corporate bonds are issued in tax havens. In 2017, U.S. investors held a staggering $547 billion in stocks resident in the Caymans — almost as much as they hold in Canadian stocks.

A Massive Recalculation

Maggiori teamed up on the study with Antonio Coppola at Harvard, Brent Neiman at the University of Chicago, and Jesse Schreger at Columbia University. Their paper and supporting data are available from the Global Capital Allocation Project.

After reallocating money raised through tax havens, the researchers calculated that U.S. investors held $50 billion worth of Brazilian corporate bonds in 2017 — more than six times the $8 billion reported in Treasury data. Likewise, U.S. holdings in the five largest emerging markets totaled $122 billion, or six times as much as the $19 billion reported in IMF statistics.

The researchers also document billions of dollars in “spurious foreign investments,” which are U.S. investments in what appear to be foreign companies but that are actually American. Some of that is tied to American firms that switch their official nationality through corporate inversions. Another part, however, is tied to securities that bundle together large numbers of U.S. loans. These collateralized loan obligations fund American companies but are often issued in tax havens.

Companies raise money in tax havens for a range of reasons. They often do it to reduce their tax liabilities at home. In China, some corporations do it to avoid tough government limits on the share of their stock held by foreigners.

Hidden Risks

These maneuvers, however, can also hide potential risks. “Suppose there’s a shock to China’s economy and its stock market is collapsing,” Maggiori says. “If we want to know the potential exposure of U.S. households, the official figures would say that it’s about $160 billion, when the reality is more like $700 billion. And those Chinese equities are an order of magnitude riskier than the U.S. Treasuries that China holds.”

One of the risks, in fact, is that the Chinese government will suddenly crack down on foreign subsidiaries. While China has tolerated these offshore structures so far, Maggiori notes, there is no guarantee that it will continue to do so, especially if global political tensions keep mounting.

The researchers, however, are not sounding the alarm bell about any particular vulnerability so much as shining a light on the true state of global financial balances.

One significant implication is that China isn’t quite the creditor nation that it appears to be. The researchers find that while the stock market value of Chinese companies listed abroad has soared, these higher valuations have not been reflected in China’s official liabilities. As a result, the official data may overstate China’s net foreign asset position by as much as 50%, or about $1 trillion.

That’s much more than a rounding error, says Maggiori, and it could be big enough to distort much of what policymakers think they know about global imbalances.