Processed Trade, Hong Kong’s National Income Accounts, and Transfer Pricing Abuse

William Thorbecke recently discussed the statistics on China’s process trade balance:

Figure 1 plots China’s processing imports and exports and Figure 2 its ordinary imports and exports. These are China’s principle customs regimes. Processing imports can only be used to produce goods for re-export (processed exports). This regime reflects the operation of global value chains in East Asia. Ordinary imports are destined primarily for the domestic market and ordinary exports are produced primarily using domestic inputs….Figure 1 indicates that the gap between processed exports and imports for processing keeps growing. This implies that more and more of the value-added of processed exports such as smartphones, tablet computers, and consumer electronics goods comes from China.

His figure shows processed exports reaching $900 billion in 2014 with imports for processing reaching $500 billion suggesting value-added (wages and profits) being $400 million. If you are checking your iPhone, remember this is assembled by Foxconn Technology Group (aka Hon Hai Precision Industry). Most accounts of this suggest a model where Foxconn pays $200 per phone for components and then adds $10 per phone in value-added paying $5 in wages and reaping $5 in profits. If you multiply that by 625 phone and then convert US$ to NT$ by an exchange rate of 32, you get something close to their 2014 Financials. You also might get a hot transfer pricing issue in China as noted by Windson Li:

Toll manufacturing is also a popular business model for MNCs that provide products 'made-in-China'. The China toll manufacturer imports most materials and components from an overseas affiliate on consignment basis, completes the manufacturing process, and then exports the finished products to the same overseas affiliate. As the material and product title remain with the overseas affiliate, there would be no (or very limited) Cost of Goods Sold in the P&L of the China toll manufacturer. The China toll manufacturer normally would charge a service fee to the overseas affiliates based on … the total processing cost and expenses on book, plus a mark-up.

What should be the new markup now that the cost based has been lowered from $205 per phone? Multinationals are telling the Chinese government that the new markup should be the old cost plus 2.5 percent markup, which is absurd as the ratio of operating profits to labor costs used to be 100 percent (which is what the Chinese government wants). The difference between these two positions is yuuuge. Who is pushing toll manufacturing structures and why? The Big Four accounting firms are the culprits and the game is to shift income to tax havens like Hong Kong. I was thinking about this as I looked at the 2015 GDP accounts for Hong Kong. Converting these accounts to US$ by an exchange rate of 7.8, we see GDP at $308 billion while total exports were $619 billion and total imports were $612 billion. That is a lot of processed trade and a big potential for transfer pricing manipulation.