Fight Austerity with Growth

More money would solve the world’s economic woes.  It would come with growth.  Mexico, as 2012 Chair of G20, has made this its key priority. 

Global GDP per person has doubled over the last generation - a leap unprecedented in human history. Fast (if uneven) growth has been the norm in the West. Hundreds of millions of people have also been lifted out of poverty in developing countries, thanks in part to lowered frictions for trade and investment. As Harold MacMillan might have said, the world has never had it so good.

Despite this peak of affluence - judged in historical context - recent decelerating growth and widespread unemployment mean that Western nations are gripped by a pervasive sense of malaise. The financial crisis and related stress on public expenditure and borrowing capacity has prompted urgent calls for reform. Demands for change pose the risk of damage to the healthy parts of the tree as the rotten branches are trimmed. 

Is more tax the solution? Tax redistributes; it does not create the resources society needs to prosper. Borrowed funds (government debt) provide short term relief, but in the end simply represent deferred taxes. Spending restraint is required though growth is the most appealing solution. 

What is the role of financial services? Many perceive the industry as disruptive and have little direct contact with the international financial and business centres which serve them.  How many Trade Union Congress members in the UK, for example, appreciate that their life in retirement will be eased with international investments globally diversified through efficient collective investments?  

The IMF notes “largely unambiguous gains from financial integration for advanced economies”. Tools like kitchen knives, information technology and finance leverage human activity but also have anti-social applications or unintended consequences. An interconnected world promotes economic development, but also has enhanced capacity to transmit shocks across the system and into the broader economy. Recent events mean that these risks posed by financial services understandably alarm politicians, policy makers and the broader public. These concerns now overshadow recognition of the important contribution of financial services to global output and development. 

Small international financial centres (IFCs) have balance sheets holding 8.5 per cent of global financial assets, yet such centres have less than 0.2 per cent of global population and GDP. Their clients accordingly rely on the professionals and financial institutions in such centres to channel more than 40 times the capital represented by their population and economies. 

Small IFCs have, with notable exceptions, made modest contributions to the global policy process reregulating the financial services which form the central activity in their economies. Within small IFCs this ‘contribution deficit’ is often assumed to arise from deliberate manoeuvring by the dominant countries to outflank them. Perhaps another contributing factor is that public and private sector policy support within such centres is tiny despite the local – and international – importance of their financial services industries. 

Rigorous empirical evaluation of regulation and tax transparency in small financial centres routinely places their standards in the top quartile of global compliance. For most of the last decade it was assumed that these high standards earned small centres the right to conduct business. The dominant countries and their agencies appeared to agree.

In the financial crisis of 2007/8 the taxpayers of the large countries bailed out failing financial institutions. The smaller centres stood by - less culpable than portrayed by the popular media perhaps, but also less exposed to the costs of rescue. Leverage in the debate over the role of small IFCs changed accordingly. After all, should the small IFCs be entitled to play when they didn’t pay? The larger countries bearing the cost, many of whom are represented in G20, seek control to align power with responsibility.  

In this new environment, high standards for transparency and regulation are no longer enough. All financial services providers have a lot of explaining to do to a sceptical world, and the small IFCs carry more onus than most. Absence from the fora controlling change means that IFCs have less opportunity to explain their contribution.

Small IFCs need to work harder to show that they are constructive partners in the global economy. How should they do this?

First, identify and work together with natural allies. Small centres have common interests and should collaborate more effectively on those matters. It is not necessary for cooperating centres to adopt congruent positions; it is enough to share and pool scarce resources which support policy development and implementation. The private sector in such centres also needs to play a much more active role in supporting governmental colleagues who are necessarily in the front line every day - with stretched resources - on strategic and regulatory issues.  IFC Forum, a private sector organisation supported by the leading professional firms across British offshore centres, exemplifies the critical contribution which is essential to a successful effort.

Second, publish better information. Small financial centres provide little aggregated data on financial flows to support policy analysis. IMF and similar bodies accordingly find dark spots around small IFCs when they move the lens across the global financial landscape. Economists and policy makers fear what they do not understand; improved data would ameliorate an understandable tendency to colour in greyed out areas with dated stereotypes.

Third, explain why IFCs should be seen as constructive partners in the global economy.  Big countries have tax systems designed for domestic revenue collection - not efficient interface with trading partners.  International financial services centres (large and small) supply the basic plumbing necessary to support the trade and investment activity which has fuelled the leap in global prosperity over recent decades. 

Fourth, adjust strategies to take account of the changing geometry of global power.  G7’s role as the lead actor in emerging global governance has yielded to G20, reflecting the fact that emerging market economies are projected to supply two thirds of global growth over the coming decade. IFCs should work at expanding their important support for emerging economies, for both trade and financial services intermediation. This will require substantial investment from both the private and public sectors while nascent relations are nurtured. 

Thoughtful policy makers see other problems with IFCs which merit consideration.  IFCs rightly see themselves as efficient conduits channelling investment into the larger countries which surround them.  However, while funding to collective investment schemes and other sources of liquidity provided to such centres is flush during the good times, it may be quickly withdrawn when investors repatriate their investments in a downturn. IFC capacity to facilitate the efficient and quick movement of funds can be a source of concern when funds abruptly leave countries just when they are needed most.  Regulators are understandably anxious about this ‘pro-cyclical’ effect.

Foreign direct (equity) investment is less liquid, so less prone to such roller coaster movements.  Where IFCs design offerings which contribute to stimulating equity investment they will benefit from IMF advice that ‘long-term, non-debt-creating flows, such as FDI, should be liberalised before short-term, debt-creating in-flows’. 

Small and medium sized enterprises (SMEs) provide the majority of jobs in most countries. Policy makers accordingly place a particular premium on funding for these enterprises, which commonly lack effective access to public capital markets and often have trouble accessing bank financing.  IFCs tend to deploy their capital into large enterprises and public markets.  IFC investment directed to SMEs would bolster their contribution to recovery and development, and may generate attractive returns given current challenges for SMEs in accessing other funding sources. IFCs which successfully promote SME finance will find that they are more welcome members of the global community.

The outlook for developing countries also attracts significant attention in the financial and regulatory policy circles. IFCs have untapped potential to support constructive action.   Enhanced financial intermediation has an important role to play in improving the prospects for African countries seeking external investment capital. IFCs help break down corruption and restriction of credit allocation to cronies of the ruling elite by providing competitive sources for capital. Success stories showing IFC support for developing countries would be well received.

IFCs must continue to deal with the (mis)perception that their tax neutral platforms promote tax mitigation undermining public finances in high tax countries. ‘All crimes’ legislation (which includes tax evasion as a predicate crime for money laundering purposes) is commonplace in small IFCs, and imminent in the FATF context.  The role of leading IFCs in facilitating tax evasion in the major countries is now statistically negligible.

Onshore government programs to promote reporting of tax evasion have been vigorously pursued for several years. Collections in the UK from the Liechtenstein Disclosure Facility and the New Disclosure Opportunity, for example, have produced around £140m and £82m respectively. While these are impressive figures in household budgeting terms, in a country where the current annual budget deficit is in the range of £150bn, improved tax collections are not the answer to closing the budget gap. No doubt onshore governments are right to ensure everyone pays taxes due. However, it is time for NGOs and other tax campaigners to stop misleading the public by suggesting that structural deficits in onshore finances can be addressed by increasing the tax take.

Greater austerity will predominate as western countries adjust to living within their means. The EU commitment to their social welfare model will make this transition particularly challenging as baby boomers coming up to retirement start to draw down on their longstanding entitlements. Baby boomers will also have clout at the ballot box, making the necessary adjustments politically hazardous.

As the IMF notes, ‘a breakdown in globalisation – meaning a slowdown in the global flows of goods, services, capital and people – can have extremely adverse consequences’.  IFCs assist by providing the transaction ease for cross-border business which has contributed to an extraordinary upsurge in global prosperity in our lifetimes.  The world needs international business centres to help fight austerity by fostering economic growth. 

Richard Hay
Richard Hay is a Stikeman Elliott London partner specializing in international tax law, and head of the London office's International Private Banking and Financial Regulation Group. Mr. Hay advises financial institutions and private clients on tax, regulatory and political risk aspects of cross-border estate planning structures for high net worth families, including those in Canada, Latin America, Asia and Europe. Mr. Hay also advises IFC Forum (www.ifcforum.org), banks and private clients on financial regulation and the information exchange initiatives conducted by the G-20, the OECD, the EU, FATF and the IMF. Mr. Hay is also Co-chairman of the London based International Committee of the Society of Trust and Estate Practitioners, a member of the International Bar Association and the International Tax Planning Association.