Faking Trade for Capital Control Evasion: Evidence from Dual Exchange Rate Arbitrage in China

Abstract

Using a unique institutional setting of dual exchange rates of Chinese currency, this paper provides novel evidence that firms manipulate trade data to evade capital controls. We develop a model showing that the trade data over-reporting is positively (negatively) correlated with the exchange rate spread when the spread is positive (negative), and such correlations are more pronounced for products with low risks of being caught. Empirical results from threshold regressions using time series data and Benford's law using firm-product trade data between mainland China and Hong Kong support the theoretical predictions of dual exchange-rate arbitrage camouflaged under the trade account.

Keywords: Capital controls, dual exchange rates, missing trade, Benford's law

JEL Classification: F31, F38, F14, G14, G15, G28