Sound bites… We need to dig deep into the bowels of these nasty little things, which are eagerly snapped up by an increasingly frivolous media.
An argument put forward to me recently is why I am engaging this topic. The argument was that foreign capital flows into China are completely unsustainable, and that any hiccup in world markets would see these fund flows reverse causing a massive crash. Not wanting to be one to jump to a knee-jerk reaction based on aforementioned frivolous media coverage, I had to do a little more digging.
Now don’t get me wrong. I think China has the potential to see some serious problems in the near future, especially in certain real estate sectors. I discussed one element of this here. That said let’s look at the premise for this particular argument. As with many other things in life and business, regulations, laws, taxes and other such counter-productive pursuits cause people to react in ways that they would not otherwise act.
In the case of China, “foreign companies” enjoy tax breaks. Once registered in an offshore tax haven (very often BVI), Chinese companies can then return to China in the form of foreign direct investment, thus qualifying themselves for favorable taxation rates and tax incentives, paying income taxes as low as 10%. Contrast this to the 33% rate that companies outside of the Shenzen economic zone are liable to pay, and you can see how there can be serious benefits for making some changes to your business structure.
Furthermore, foreign companies inflate the cost of production equipment, raw materials and labor. They can then export products at what amounts to falsified low prices, transferring most of the profits, and thus tax liabilities, to their sister companies in offshore locations capitalizing on lower tax rates. In the Investment banking world this is commonly known as tax transfer pricing.
This can get particularly amusing, since the effects of this sort of “restructuring” enable enterprises in China to appear unprofitable; but, even more amusing to me is that politicians in the EU and US see this taking place and file anti-dumping charges on Chinese products. They claim that the Chinese are dumping their inventory at prices below market. Their evidence is that these Chinese companies are operating at a loss. Kinda right – but not quite.
According to research done by Mei Xinyu, a Chinese researcher who has been widely quoted in the FTchinese.com and many other financial publications, over one third of FDI is simply Chinese investment overseas that comes back masquerading as foreign capital to take advantage of the tax breaks.
So if we take 30% of the FDI out of the equation, the argument that foreign capital flows into China are creating a bubble takes on an entirely different light.
So what? you might say. Interesting point but why bother with this anyway?
Follow my line of thinking here for a minute. If Chinese companies are so eager to get “offshore” then does this not mean that there could just be a supply/demand picture shaping up for the offshore providers who service these customers? And more importantly, can it make us some money?
I have been talking to many offshore providers here in Asia, now that I’m based in Thailand (albeit temporarily). They have indicated that this certainly seems to be the case. It’s no secret that Singapore has been aggressively acquiring talent pools from London and NY in order to better service their growing customer base, and taking a page out of the always proactive Singaporeans handbook, Hong Kong which has historically had a very laissez-faire approach to their economy, has also been embarking on promotional trips to London and NY in order to attract talent.
Watching the two financial powerhouses of Asia duke it out has been very entertaining. In 2009 Hong Kong opened the HKIA precious metals depository facility, setting the infrastructure to enable bullion trading of the global kind on China’s doorstep. Then in May of last year the Singapore Freeport opened its doors providing one of the worlds most secure storage facilities, for amongst other things, precious metals.
For Chinese offshore investors, both jurisdictions are pretty compelling destinations. Possibly the largest factor for any offshore investor is of course tax. Competition on the taxation of corporations is nowhere more prevalent than between Hong Kong and Singapore. My friend Simon Black discussed this issue here. Hong Kong and Singapore are competing not just on the tax front, but for human capital as well.
Hong Kong has historically had a low personal income and corporate tax rate. The 1980’s saw the introduction of their current tax regime and aside from a small increase in taxes earlier this decade it has consistently been among the world’s lowest.
Singapore never really competed on this front until relatively recently. The last 10 years have been awesome in the magnitude of changes. In 2000 its headline corporate tax rate was 26% – 10 percentage points higher than Hong Kong today, where the rate stands at 17%, a whisker more than its main competitor. The highest rate of personal income tax has also fallen from 22% in 2003 to 20% today. Singapore however still has a 7% GST which its rival does not have. The regulatory process in Singapore has also been streamlined, and bankers and lawyers from the island profess it to be an easier destination in terms of bureaucracy.
You will not often find me being encouraged by anything governments do. I like what I’m seeing in Hong Kong and Singapore, with governments being forced by the “hand of the market” to provide services rather than unilaterally taking while providing low quality, or little or no services in return. Technology has allowed this to happen, and I believe that this is the model that governments the world over will be forced to follow, but that’s a discussion for another day.
We’ll be keeping our eye on offshore providers in the region for allocation of capital, and I am looking at a very small boutique start-up operation in this field at present. It might be worth your looking into this arena. Either way I’d love to know your thoughts.
“Economists report that a college education adds many thousands of dollars to a man’s lifetime income – which he then spends sending his son to college.” – Bill Vaughn