The Art of Capital Flight

by Kenneth Rogoff Kenneth Rogoff, a former chief economist of the IMF, is Professor of Economics and Public Policy at Harvard University. 06.09.2015
CAMBRIDGE – What impact will China’s slowdown have on the red-hot contemporary art market? That might not seem like an obvious question, until one considers that, for emerging-market investors, art has become a critical tool for facilitating capital flight and hiding wealth. These investors have become a major factor in the art market’s spectacular price bubble of the last several years. So, with emerging market economies from Russia to Brazil mired in recession, will the bubble burst?

Just five months ago, Larry Fink, Chairman and CEO of BlackRock, the world’s largest asset manager, told an audience in Singapore that contemporary art has become one of the two most important stores of wealth internationally, along with apartments in major cities such as New York, London, and Vancouver. Forget gold as an inflation hedge; buy paintings.

What made Fink’s elevation of art to investment-grade status so surprising is that no one of his stature had been brave enough to say it before. I am certainly not celebrating the trend. I tend to agree with the philosopher Peter Singer that the obscene sums being spent on premier pieces of modern art are disquieting.

We can all agree that these sums are staggering. In May, Pablo Picasso’s “Women of Algiers” sold for $179 million at a Christie’s auction in New York, up from $32 million in 1997. Okay, it’s a Picasso. Yet it is not even the highest sale price paid this year. A Swiss collector reportedly paid close to $300 million in a private sale for Paul Gauguin’s 1892 “When Will You Marry?”

Picasso and Gauguin are deceased. The supply of their paintings is known and limited. Nevertheless, the recent price frenzy extends to a significant number of living artists, led by the American Jeff Koons and the German Gerhard Richter, and extending well down the food chain.

For economists, the art bubble raises many fascinating questions, but an especially interesting one is exactly who would pay so much for high-end art. The answer is hard to know, because the art world is extremely opaque. Indeed, art is the last great unregulated investment opportunity.

Much has been written about the painting collections of hedge fund managers and private equity art funds (where one essentially buys shares in portfolios of art without actually ever taking possession of anything). In fact, emerging-market buyers, including Chinese, have become the swing buyers in many instances, often making purchases anonymously.

But doesn’t China have a regime of strict capital controls that limits citizens from taking more than $50,000 per year out of the country? Yes, but there are many ways of moving money in and out of China, including the time-honored method of “under and over invoicing.”

For example, to get money out of China, a Chinese seller might report a dollar value far below what she was actually paid by a cooperating Western importer, with the difference being deposited into an overseas bank account. It is extremely difficult to estimate capital flight, both because the data are insufficient and because it is tough to distinguish capital flight from normal diversification. As the late MIT economist Rüdiger Dornbusch liked to quip, identifying capital flight is akin to the old adage about blind men touching an elephant: It is difficult to describe, but you will recognize it when you see it.

Many estimates put capital flight from China at about $300 billion annually in recent years, with a marked increase in 2015 as the economy continues to weaken. The ever-vigilant Chinese authorities are cracking down on money laundering; but, given the huge incentives on the other side, this is like playing whack-a-mole.

Presumably, the anonymous Chinese buyers at recent Sotheby’s and Christie’s auctions had spirited their money out of the country before bidding, and the paintings are just an investment vehicle that is particularly easy to hold secretively. The art is not necessarily even displayed anywhere: It may well be spirited off to a temperature- and humidity-controlled storage vault in Switzerland or Luxembourg. Reportedly, some art sales today result in paintings merely being moved from one section of a storage vault to another, recalling how the New York Federal Reserve registers gold sales between national central banks.

Clearly, the incentives and motives of art investors who are engaged in capital flight, or who want to hide or launder their money, are quite different from those of ordinary investors. The Chinese hardly invented this game. It was not so long ago that Latin America was the big driver in the art market, owing to money escaping governance-challenged economies such as Argentina and Venezuela, as well as drug cartels that used paintings to launder their cash.

So how, then, will the emerging-market slowdown radiating from China affect contemporary art prices? In the short run, the answer is ambiguous, because more money is leaking out of the country even as the economy slows. In the long run, the outcome is pretty clear, especially if one throws in the coming Fed interest-rate hikes. With core buyers pulling back, and the opportunity cost rising, the end of the art bubble will not be a pretty picture.


Kenneth Rogoff, a former chief economist of the IMF, is Professor of Economics and Public Policy at Harvard University.

Copyright: Project Syndicate, 2015.
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