The illegal carry trade in China


How capital controls are not effective when it comes to the movement of goods across borders

When interest rates differ across countries, speculators who want to make profits have a strong incentive to borrow money at low interest rates and lend the money at higher interest rates.

For example, if banks in the United States gave out loans at 1% while banks in China paid an interest rate of 3% to depositors, investors would borrow from U.S. banks and lend to Chinese banks to capture a nice profit. This trade is popularly known as the carry trade. Such flow of capital across borders in search of higher yields would last till the interest rate difference between the two countries, after factoring in the various transaction costs, disappeared. The flow of capital across borders, however, is not always desired by central banks.

For instance, when capital flows into a country with high interest rates, this can cause the country’s currency to appreciate and affect the size of the country’s overall exports. So central banks often impose capital controls that limit the movement of capital across borders.

Despite strict capital controls, there is still the economic incentive for speculators to engage in carry trade. So, speculators look for ways to bypass capital controls. “Currency Carry Trade by Trucks: The Curious Case of China’s Massive Imports from Itself” by Xuepeng Liu, Heiwai Tang, Zhi Wang, and Shang-Jin Wei looks into how speculators may be using goods to engage in indirect carry trade across Chinese borders.

The economists first note that controls on the movement of goods across borders are not as stringent as controls imposed on the movement of financial capital. So a speculator, for instance, may not be able to move a huge sum of U.S. dollars into China directly through banking channels due to capital controls. But he can still move the money into China through the current account route. The speculator can convert his U.S. dollars into Chinese yuan under the pretext of importing cars into Hong Kong from a friendly Chinese company.

The Chinese company can then invest the yuan in a Chinese bank to earn a higher interest rate. Eventually, when the speculator wants to convert his investment in yuan back into U.S. dollars, the friendly Chinese company can withdraw the money from the bank and re-import (or purchase) the car back, thus returning the investment proceeds back to the speculator.

The economists note that it is hard to come up with solid data on how much capital is moved illegally across the borders of China through the current account channel. But they look at other proxies which indeed suggest that, despite capital controls, the size of illegal carry trades rises with increase in the potential returns from engaging in such carry trades.

To gauge the potential returns from carry trades, the economists tracked changes in U.S. and Chinese money supply since these influence interest rates. And to gauge the size of illegal carry trade, they look into the value of goods moving across borders and compare them to their weights. It should be noted that high value goods with low weights are more likely to be used for the purpose of illegal carry trades as the cost of transporting and storing them is low. The paper also looks into whether state-controlled enterprises in China are more likely to carry out illegal carry trades than private enterprises.

It comes to the conclusion that state-controlled enterprises are indeed more likely to engage in illegal carry trades that bypass capital controls. The economists speculate that this could be because, unlike private businesses, state-controlled enterprises have more friendly connections with the Government and may thus believe that they can get away with the crime.

(Liu, Xuepeng and Tang, Heiwai and Wang, Zhi and Wei, Shang-Jin, Currency Carry Trade by Trucks: The Curious Case of China’s Massive Imports from Itself (January 2022). NBER Working Paper No. w29633, Available at SSRN:

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