«Estimating capital flight and offshore wealth in Russia»
In order to estimate the rise and magnitude of offshore wealth held by Russian households, it is natural to start by looking at the evolution of Russia’s trade balance and balance of payments. Here the striking fact is the contrast between the very large trade surpluses and the relatively modest foreign assets.
Russia has run large trade surpluses every single year since the early 1990s. These trade surpluses – mostly driven by exports in oil and gas – have been around 5% of national income per year between 1993 and 1998, up to as much as 20% of national income in 1999-2000, and have stabilized around 10% of national income per year between 2001 and 2015. Over the 1993-2015 period, the average trade surplus neared 10% of national income per year (9.8%). In other words, every year during more than 20 years, the Russian economy has been exporting about 10% of its annual output in excess to what it has been importing. Given that the initial financial position of the country was close to zero in 1990 (very little foreign assets, very little foreign debt), this should have led to a massive accumulation of foreign assets by Russian residents (government, households and corporations). The paradox is that net foreign assets accumulated by Russia are surprisingly small: about 25% of national income by 2015.
If one looks in more detail at Russia’s balance sheet vis-à-vis the rest of the world, we find that both foreign assets (i.e., assets owned by Russian residents in the rest of the world) and foreign liabilities (i.e., assets owned by rest-of-the-world residents in Russia) have increased significantly since the fall of the Soviet Union. Both were extremely small in 1990 (about 10% of national income), reflecting low levels of financial integration with the rest of the world and strong capital controls. By 2015, foreign assets reached almost 110% of national income, and foreign liabilities were close to 85% of national income, hence the net foreign asset position was about 25% of national income.
How can we account for such a low level of net foreign wealth accumulation?
The obvious explanation is capital flight: some Russian individuals (and/or some Russian corporations acting on behalf of individuals, and/or some Russian government officials acting on behalf of individuals) were somehow able to appropriate some of the trade surpluses in order to accumulate offshore wealth, i.e. foreign assets that are not properly recorded as such in Russia’s official financial statistics. Given the weaknesses of Russia’s legal and statistical system, and the widespread use of offshore entities to organize business and financial transactions in Russia over this period (see, e.g., the work by legal experts such as Nougayrede 2014, 2015, 2017), it is maybe not too surprising that such leakages might have occurred.
How large is the corresponding capital flight and associated offshore wealth?
If we simply cumulate the trade surpluses over the 1990-2015 period, we obtain about 230% of national income. So one might conclude that cumulated capital flight is of the order of 200% of national income (given that official net foreign assets are less than 30% of national income). In principle, one should also include the cumulated capital income flow on these foreign assets, which depending on the rate of return could lead to substantially larger estimates for missing foreign wealth (with a total around 300% of today’s Russia national income, or more, depending on the return). The key question is: where has this missing wealth gone, and how can we reconcile the different pieces of evidence and explanation?
First, one should take into account the fact that the flow return earned on foreign assets might be lower than the flow return paid on foreign liabilities. This is indeed what the balance of payment of Russia indicates: we observe persistently negative net foreign income flow throughout the 1990-2015 period (about -3% of national income), in spite the generally positive net foreign asset position (see Figure 5a).
In effect, a significant part of the annual trade surplus – between one quarter and one third – has been absorbed by this net capital income outflow. It is possible that this reported return differential also reflects some forms of capital flight, but we have no precise way to know.
Next, one should take into account the capital gains and losses realized on the portfolio of foreign assets and liabilities. Such valuation effects could potentially be enormous and account for the observed discrepancy between annual current account surpluses and the observed evolution of net foreign assets. That is, if all Russian investments abroad ended up in worthless assets (capital losses), while all foreign investments in Russia benefited from huge increases in value (capital gains), then one could in principle explain why Russia’s net foreign assets are so small. Indeed this is partly what has happened: foreign investors bought Russian assets in the 1990s when stock market prices were extremely low and benefited from the booming stock market of the 2000s. This partly explains why foreign liabilities rose so much.
However, the return differential and valuation effects are not large enough to entirely explain the discrepancy between the cumulated trade surpluses and the change in the net foreign asset position. In order to estimate the magnitude of offshore wealth (missing foreign assets), we apply the following method. We take as given the observed differential in rates of return and capital gains and losses on foreign assets and liabilities, and we compute the sum of net errors and omissions and capital transfer outflows in the balance of payments. Net error and omissions reflect unrecorded saving: they correspond to the gap between the current (plus capital) account balance and recorded net foreign saving.
To these net error and omissions, we also add capital transfer outflows, which according to balance of payments guidelines and definitions are supposed to capture changes in residency of wealthy Russian residents. The sum of net error and omissions and capital transfer outflows is our estimate of annual capital flight (the second component is usually relatively small, i.e. less than 10% of the total). We then cumulate yearly capital flight making various assumptions on the rate of return and we obtain the benchmark estimates and lower and upper variants reported on Figure 5c.
According to our benchmark estimates, offshore wealth reaches about 75% of national income by 2015 (vs. about 100% in the upper-bound variant and 55% in the lower-bound variant). These estimates are by construction relatively conservative: we take as given the differential in returns and portfolio effects, which may also reflect some form of capital flight and accounting manipulation by foreign investors or by Russian nationals or ex-nationals. Our benchmark estimates suggest that Russians own approximately as much financial wealth offshore than onshore (about 70-80% of national income in both cases), i.e. they own about 50% of their true total financial wealth offshore. This is the same estimate obtained by Zucman (2014) using a different approach, which can be viewed as reassuring.
We should stress again, however, that the frontiers between the different forms of missing wealth are highly uncertain and difficult to estimate with absolute precision, given the general lack of international financial transparency. What we know for sure is that the magnitude of cumulated Russian trade surpluses and total missing wealth over the 1990-2015 is extremely large (at least 200% of Russia’s national income). It is more complicated to know who holds the missing wealth and the form it takes.
At a general level, one can distinguish between three different categories of beneficiaries: first, there are pure foreigners (individuals or corporations with no initial tie to Russia), who accumulated wealth by doing business in Russia since the 1990s via differential rates of return and valuation effects (there foreigners might now hold the corresponding wealth in Russia or elsewhere, or might have consumed it; in some cases, this mechanism might have also benefited Russia nationals or exnationals). Next, there are Russian nationals (or ex-Russian nationals) who are now foreign residents, and who were able to divert assets via offshore transactions. Last, there are Russian nationals who still have their primary residence in Russia, and who were able to divert assets via offshore transactions.
Our estimates of offshore wealth can be viewed as the sum of the last two components. We do not attempt to provide a formal breakdown between them, i.e., between Russian residents and non-residents. According to balance-of-payments statistics, capital transfers represent less than 10% of total net errors and omissions and capital transfers, so one might be tempted to conclude that Russian residents are the primary holders. This would also be consistent with the global Forbes billionaire data, according to which the vast majority of Russian billionaires have their primary residence in Russia.
Even more uncertain is the nature of the destination assets: some of the offshore wealth might be invested back in Russian corporations, and some might be invested abroad (e.g., a mansion in London, a castle in France, or a company in Germany, the U.S. or elsewhere).
Co-authored with Gabriel Zucman.
To be continued...