Open Question

Can Economic Research Enable Central Banks to “See Through” Tax Havens?

Commentary /

Stanford’s Global Capital Allocation Project (GCAP) partners with the European Central Bank (ECB) to use large-scale data to examine how—and where—capital flows

Global capital allocation

A group of economists working on a collaboration funded in part by a Stage 2 investment from Stanford Impact Labs (SIL) is piercing through the opacity of the $200 trillion global capital markets to gain clarity about how funds are allocated around the world. In other words: who owes what to whom.

Beyond pure academic research, the findings of the Global Capital Allocation Project (GCAP) have practical relevance. Regulating financial markets, preventing financial contagion, and building equitable financial systems require financial institutions and policymakers to know how much money from which corporations and individuals is flowing across borders and where and how it is invested.

This is especially true in helping governments and the private sector brace for, and cope with, financial shocks.

For example, as shown in recent work by GCAP, U.S. investors hold more than a trillion dollars in Chinese stocks and bonds, most of which are issued in offshore tax havens such as the Cayman Islands. If China’s economy, which is already slowing, were subject to a meltdown and the country was unable to make any payments, how might the financial losses flow through the U.S. economy? Without understanding the patterns of cross-border investment – i.e. who holds China bonds – the answers about who will be harmed are unclear and could cause unexpected shocks to the investment portfolios of U.S. cities and counties or pension and retirement funds that might hold the bonds, not to mention cascading effects on other financial markets.  

Moreover, tax havens around the world cost governments nearly $600 billion a year in lost corporate tax revenue and trillions of dollars in lost individual tax revenue, according to 2019 estimates from the International Monetary Fund (IMF). Understanding capital flows and where money is allocated can help governments track down and collect taxes on these hidden assets.

Based at Stanford, GCAP was formed in 2019 by three economists from Stanford, Columbia University, and the University of Chicago Booth School of Business. Since then, the team and their associates have created research tools to study capital flows and published economic papers on subjects such as the foreign holdings of China bonds and the rise of the dollar as an international currency. They also produced large sets of data that track equity and debt securities across the globe, showing who the underlying owners and issuers of the assets are.

At a virtual conference hosted by the European Central Bank (ECB) in 2020, the team drew the attention of officials from the ECB for their work on tracking global capital flows, and a collaboration was formed. “Their work appeared to us as highly policy-relevant to Europe,” said Roland Beck, Senior Team Lead Economist at the ECB.  “We were keen to apply their approach to the Euro area, specifically to countries that act as hubs for foreign funds and securities through offshore financial centers.”

As the U.S. and European joint team began working together, their collaboration was anchored in an impact-driven approach built around a theory of change.

A theory of change is a methodology that involves a way of planning, participating, managing, and evaluating a process that is intended to lead to some intended result or change. It offers a foundational scaffolding to a solutions-oriented research team in particular. One important feature in this case was the commitment to an iterative process by which project members – researchers and end users -- go back and forth making sure they understand the results and goals each has at every step of the process. In GCAP’s work with the ECB, this means the economists listen carefully to the central bankers about what are the most pressing questions they want to answer, and then use that knowledge to help direct their research. On the flip side, it means the ECB members of the team listen to what the researchers need to know to help them find the data that will help deliver answers to the central bank.

The team initially focused research efforts on the huge financial centers of Luxembourg and Ireland, both of which are known to hold trillions of dollars in so-called “missing wealth.” Working with Beck and Martin Schmitz, Team Lead Economist and Statistician at the ECB, GCAP produced new estimates on cross-border investments. They combined specific financial data on portfolio investments by mutual funds, exchange traded funds, insurance companies, sovereign wealth funds, and datasets from official institutions, such as the ECB, to improve an understanding of these global portfolios.

Luxembourg and Ireland reported, as of 2020, that foreigners held nearly 8 trillion euros in funds domiciled there. However, statistics kept by all other countries only indicate assets held in Luxembourg and Ireland of roughly 5 trillion euros, meaning that 3 trillion euros in wealth were missing. Who owned the missing 3 trillion? The economists hypothesized they’d find that banks in Switzerland or the Cayman Islands would hold the missing wealth on behalf of wealthy global households, but continued research revealed a surprise. Switzerland’s relative position as a holder of wealth had declined over the past few decades and now financial institutions in the United Kingdom held trillions in these missing assets. 

This points to a new important question for future research--to get to the bottom of the issue of global missing wealth: who are the ultimate investors behind these financial institutions? Could the holdings rest with Russian oligarchs or with Middle Eastern money? It’s a question the team plans to examine next. The answers could be important for a variety of policy and regulatory reasons. For example, if Russian investors were the ultimate holders, would that knowledge play a role in any future sanctions against that country?

Beck said the team’s work so far has “possibly profound implications for a broad range of macro-financial questions,” not the least of which is “shedding more light on hidden wealth” in offshore financial institutions. He added that now the ECB has new estimates and analytical tools to better understand Euro area investment patterns and to create even more effective “stress tests” to determine the safety and soundness of Euro area financial institutions. “This is highly policy-relevant, for example, if a new sovereign debt crisis materializes.”

But shaping policy directly is not the role of this economic research. Instead, giving governments and international bodies the tools to do so is the aim. “We are interested in clarity, and one of the things we’re keen on is to be data driven and balanced,” said Matteo Maggiori, a founder and co-director of GCAP and a professor at the Stanford University Graduate School of Business. “We’re driven by the data and the facts; we try to stay away from political views.” At the same time, he added, “We’re also aware that facts can be part of the political discourse.”

A prime goal for the GCAP team is to arrive at what they call a set of experimental statistics – essentially estimates that show the breakdown, or allocation of assets, initially for Europe. “High quality research is the necessary condition of what we do; it establishes credibility,” Maggiori said.

The next step for GCAP is getting their work published in academic journals and letting the results flow through to policy makers whose role it is to manage risk. It’s important to note, however, that the research does not violate privacy rights as the statistics do not reveal individual investors or investments but, rather, aggregate country-sector holdings.

A key measure of success for GCAP will turn on how their estimates and methodologies prove most useful and what level of demand emerges for the estimates they are producing.  So far there has been widespread interest. Maggiori notes, “The GCAP lab is expanding the set of partnerships by adding more policy institutions that are interested in applying insights from the current research, as well as developing new research.”        


Ken Howe is a Bay Area freelance writer and editor. He was a reporter, investigative journalist, and business editor at the San Francisco Chronicle for 20 years before moving to Hong Kong to serve as deputy editor at the South China Morning Post and, later, editor at the Hong Kong bureau of the Wall Street Journal.