Real Explanations for Chinese Trade Surplus 3

In the previous two posts, I discussed two explanations for Chinese trade surplus. I now continue to offer another one.

I will once again start with a story. Imagine you are the firm of one multi-national. You have one branch in country A and one branch in country B. You discovered that you have to pay lots of taxes on profits in country B, but you can evade taxes in country A due to its loose taxation enforcement, poor auditing system, and favorable tax conditions. You also know that there is gigantic intra-firm trade---some things are made in country A and sold to country B and vice versa. What can you do to maximize profit.

This is strategy 101. When you sell things made in country A to the branch in country B, you simply price them a lot higher, so that when branch in country B resell it, it does not seem to make any profit. You will do the opposite for things made in country B. In this way, you have transferred your profits to country A.

I hypothesized this in my sophomore year, and after sending out an email describing hypothesis, I learnt this strategy is not new at all, it is called "Transfer Pricing". Yesterday while working in HBS, I learnt that it is a hot topic in strategy.

Let me make this more lucrative. You happen to think that the currency in country A gonna appreciate against the currency of country B. wow, such a good deal. Thus transfer pricing takes place and it looks as if country A is having a gigantic trade surplus.

Back to China. It is quite self-explanatory how to apply this theory to China. Nike shoes are produced at cost of about $1, and is sold around $60 say. There is plenty of room to transfer profits.

Another aspect of this is the mere expectation that Yuan will appreciate make this transfer pricing more attractive. However, what many people did not realize is that some of the trade surplus might be exactly due to such practices---in other words, such practice is self-reinforcing due to opacity. What you see in trade surplus is not real (due to the reasons I explained in previous two posts), and you expect Yuan to appreciate, so you engage in transfer pricing, enlarging the trade surplus, amplifiying the "false trade surplus".