Lots of fun stuff going on in the Cayman Islands this spring, according to its tourist bureau. A fishing tournament, a music festival, a carnival named after “the tracks left in the sand by sea turtles as they crawl onto the beach to nest.”
What you won’t find out from the tourist websites is what a team of researchers from Stanford, Columbia and Yale recently discovered: The Cayman Islands has quietly become the main conduit through which Chinese companies raise money by selling shares to foreigners.
The Cayman Islands — an island chain south of Cuba and east of Mexico’s Yucatán Peninsula that is a British territory but has its own laws — has long been an international tax shelter because it has no corporate income tax. But China wasn’t a big presence there. As recently as 2002, only 1.7 percent of the outstanding equity issued in tax havens worldwide consisted of equity issued by Chinese shell companies in the Caymans, the researchers calculated.
By 2020, the team found, Chinese shell companies in the Caymans accounted for 52.5 percent of all outstanding equity issued in tax havens. Chinese companies’ issuance of equity in Bermuda accounted for an additional 3.4 percent and their issuance in other tax havens 0.5 percent.
Tax havens have become the main way for foreigners to invest in Chinese securities, the researchers said. “At the end of 2020, approximately 70 percent of foreign fund investment in China by nationality was via a tax haven affiliate of a Chinese firm, with the Cayman Islands-domiciled entities accounting for the bulk of this phenomenon,” the team wrote in a January working paper titled “China in Tax Havens.”
Even most of the people who track tax shelters and Chinese equity issuance haven’t been aware of this phenomenon, one of the researchers, Matteo Maggiori of the Stanford Graduate School of Business, told me recently. “When we presented this, people were shocked,” he said. “When you mention who uses tax havens, you think of wealthy individuals and large firms from very developed countries. But the picture has changed substantially over the last 10 or 15 years.”
This chart, which I made using their data, tells the story:
In an era of intensifying competition between the United States and China, this story is a bit of an outlier. The U.S. government doesn’t like what’s happening, but the Chinese government doesn’t appear to be happy, either. Neither side is enthusiastic about Americans having big stakes in Chinese companies.
For the Americans, one big concern is consumer protection. The shares issued by shell companies in the Caymans, Bermuda and other tax havens don’t represent direct ownership of Chinese companies. They’re complex financial structures called variable interest entities that have been engineered to get around the Chinese government’s limits on foreign control of domestic companies. The fear is that the structures don’t give American investors enforceable rights of ownership of the underlying companies.
I spoke to two U.S. senators on opposite sides of the aisle — Chris Van Hollen, a Maryland Democrat, and Rick Scott, a Florida Republican — who in September announced they were sponsoring a bill “to protect American investors from risky investments in variable interest entities.”
“On 99 percent of issues, I’m not aligned at all with Scott,” Van Hollen said. He said the two share an interest in consumer protection. When I told him about the new findings about China’s increased use of tax havens, he said, “That makes it even more important that we move with urgency.”
Scott said he’s concerned about not only consumer protection but also avoiding financial support for the Chinese government through investment in Chinese companies. “It all just keeps adding up,” he said. “The balloons, Uyghurs, Hong Kong, Taiwan. Four years ago, I said nobody should buy anything made in China. When I say that now, people applaud.”
The authors of the latest paper, aside from Maggiori, are Christopher Clayton of the Yale School of Management, Antonio Coppola of the Stanford Graduate School of Business and Amanda Dos Santos and Jesse Schreger of the Columbia Business School. (They are also all part of the Global Capital Allocation Project, a research lab that’s directed by Maggiori and Schreger.)
As they explain in the paper, when you buy a share in a company such as Alibaba, Tencent or Baidu using a variable interest entity structure, you don’t own shares in the operating Chinese company. You own shares in a shell. Even the shell doesn’t own shares in the operating company. Instead, the shell owns a unit in China called a wholly foreign-owned enterprise, or WFOE (pronounced “woofy”). The woofy — oops, WFOE — has contracts with the operating company and its owners. These contracts entitle the WFOE to a share of the company’s profits and a voice in its operations. The WFOE can funnel dividends to the tax haven shell, which passes them through to investors in New York, London and elsewhere (though most don’t pay dividends).
The beauty of this Rube Goldberg arrangement is that the variable interest entity structure counts as equity for foreigners by international accounting standards, while the companies operating in China can report to local regulators that they are fully owned by residents of China.
The risk is that this is too clever by half. For now, the Chinese government seems to tolerate variable interest entities because its companies need to raise money abroad. But if the Chinese government doesn’t recognize the foreign holders as true owners, it might not respect their interests if push comes to shove. The authors note that when Jianzhi Education used a variable interest entity to list on Nasdaq in October, Jianzhi warned that the Chinese government could find “these contractual arrangements noncompliant with the restrictions on direct foreign investment in the relevant industries.”
Elsewhere: Time Spent on Work and Study
It’s hard to spot patterns in the following bar chart of the amount of time people around the world spend working or studying. The countries at the top of the ranking include ones from East Asia, Eastern Europe and Mexico. The ones at the bottom are mostly wealthy nations in Western Europe, but Greece, which is less wealthy, appears as well. Bear in mind that all people ages 15 to 64 figure into the averages, whether they work or study or not. The Organization for Economic Cooperation and Development, which compiles the national time-use surveys, cautions that differences in methodology make it hard to compare countries precisely.
Quote of the Day
“I learned through experience that power didn’t have to be bad to be potent. There’s such a thing as good power.”
— Ginni Rometty, a former chief executive of IBM, “Good Power: Leading Positive Change in Our Lives, Work, and World” (2023)
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