Faking trade for capital control evasion: Evidence from dual exchange rate arbitrage in China

Abstract

Capital controls prohibit the standard financial market transactions for foreign exchange arbitrage. However, this paper provides novel evidence that firms manipulate international trade data to arbitrage across foreign exchange markets in mainland China and Hong Kong. We develop a model showing that international trade data overreporting is positively (negatively) correlated with the exchange rate spread when the spread is positive (negative) if firms fake trade data to engage in foreign exchange arbitrage, and such correlations are more pronounced for products with a low risk of being detected. The above theoretical predictions are supported by the empirical results from threshold regressions using the aggregate time series data and Benford's law using the disaggregated firm-product trade data between mainland China and Hong Kong. Our findings highlight the challenges to implementing capital controls and may help improve the effectiveness of such policies.