We live in a topsy-turvy world. Just as everyone was getting to grips with the ‘new world order’ of post-Cold War rules-based globalisation, we appear to have lurched violently in a strikingly different direction. But this isn’t a reason to feel gloomy about future economic prospects.
From the Brexit vote in the United Kingdom and the rise of the populist right in virtually all European Union countries, to the elections of Donald Trump in the United States and Jair Bolsonaro in Brazil, democratic processes have delivered ‘populist’ results that challenge previously received notions of the value of international institutions and the benefits of globalisation.
There are real issues and sound logic underpinning these movements, and it would be wrong to assume these are only temporary phenomena. While the global economy overall has recovered from the financial crisis of 2007/8, improvements have been unequal, with many electorates feeling bruised by capitalism and left behind by globalisation. Those in the West who earn lower and middle incomes have seen their cost of living increase, their real wages fall, their benefits decrease and house prices becoming more unaffordable. They have not shared in the prosperity that globalisation has brought to others.
Research published by the World Bank reveals that in the 20 years of rapid globalisation leading up to the financial crisis, the lower middle classes of the United States and Western Europe have seen little or no real income growth. In stark contrast, the Asian middle class and the richest one per cent have seen their real incomes rise by over 60 per cent between 1988 and 2008. (See Figure 1.)
Figure 1: Global growth in average per capita household income by income distribution percentile, 1988 to 2008, (2005 PPP adjusted US$), per cent.
Source: Christoph Lakner, Branko Milanovic and the World Bank
Nevertheless, globalisation continues apace and, with it, the demand for those services that facilitate it. In recent decades leading up to the financial crash of 2007/8, global trade in both goods and services grew consistently – both in terms of its monetary value, and in comparison to world economic output. By 2008, the value of world trade was estimated to be equivalent to around a third of the planet’s total Gross Domestic Product (GDP), compared to just over twenty per cent in 2000. In the aftermath of the crash, with much of Europe and North America in recession, the amount of cross-border trade fell but it has more than recovered its pre-crisis value. Trade in services alone has increased at an average annual rate of roughly two per cent per year over the last five years. So there remain good reasons to believe that many of the drivers of success of International Finance Centres (IFCs) – including trade, migration and deeper and more sophisticated capital markets – will continue.
While the rate of growth in international trade and investment is not what is was 20 years ago, demand for services offered by IFCs remains. Investors still seek greater opportunities to match their portfolios of investments to their desired profiles of risks and expected returns. Firms that want to borrow still desire increased competition among providers of capital to ensure that they can do so at a lower cost. Countries suffering a temporary recession or natural disaster still require financial help through borrowing from abroad. And consumers around the world still want the newest iPhone – made in China.
Future demand for the services provided by IFCs will remain strong, and are likely to shift from the West to more emerging markets. As trade across borders has become more widespread and increasingly free of tariffs and other barriers, economies across the globe have experienced improved rates of growth. Indeed, the era of globalisation has seen a marked rebalancing of economic performance – with growth in the established industrialised nations of Europe and North America being outpaced by so-called ‘emerging’ nations. (See Figure 2.)
Asian clients are expected to have higher demand for cross-border finance in the years to come, more so than clients from Europe, especially as measures from the European Union (EU) relating to what they consider harmful tax practices are liable to intensify.
Figure 2: Comparison of real average annual rates of economic growth, per cent.
Source: Capital Economics and International Monetary Fund, World Economic Outlook. Note: * International Monetary Fund forecast
Yet IFCs will have to work harder to access and benefit from this underlying demand.
There have been, and continue to be, many obstacles to overcome. These include rising international pressure around compliance and transparency from international organisations; the threat of ‘blacklisting’ by the EU; and calls by governments from around the world for the introduction of public registers of ultimate beneficial ownership.
IFCs have already worked hard to meet these standards, and many are ahead of the curve and have higher benchmarks than large Western nations in their commitment to tax transparency and adopting modern exchange of information. But these continual international pressures will dictate what markets these centres are able to access, and therefore what types of services they focus on.
To be successful going forward, IFCs must work out where their role is in the current and future economic landscape. While they substantially vary in their size, scope, areas of specialisation, geographical coverage and services offered, we can broadly think of the development stylised terms: from ‘safes’ through ‘pipelines’ to ‘hubs’.
IFCs originated as offshore ‘safes’ (such as the early days of the Channel Islands): places to store assets, not being actively traded or managed, offering protection and privacy for internationally mobile private wealth clients. Many developed into ‘pipelines’, where cross-border transactions between two or more typically corporate counterparties are structured; ‘pipelines’ are used for their jurisdictional neutrality, regulatory specialisation and tax advantage in order to efficiently carry out cross-border transactions, including joint venture, business transactions and real estate purchases. Some have become ‘hubs’ which are regional, and global; centres where a wide array of financial activity is carried out across a spectrum of clients and vehicles. ‘Hubs’ attract investment from around the world and facilitate this investment into other regional centres. The vehicles they support often have investors and investments in multiple jurisdictions. (See Figure 3.)
Figure 3: Capital Economics’ propriety conceptual model of international finance centres.
Source: Capital Economics
In general, the value of business carried out within an IFC increases as the products offered become more complex. With relatively simple products that need only involve counterparties in one other country, and which are offered predominantly to private clients, ‘safes’ will probably generate relatively low revenues per customer. At the other end of the spectrum, ‘hubs’ can provide individual structures encompassing many corporate clients in multiple jurisdictions in complex legal and financial arrangements. Depending on the breadth and depth of the professional and financial services available in the IFC, ‘hubs’ can command the highest revenues per client.
Similarly, the more counterparty jurisdictions a country deals with, the greater the ’compliance’ burden. Generally speaking, ‘safes’, who operate with clients in just one or a few nations, will have less of a compliance burden than ‘hubs’ who must take into account the circumstances in many locations. Compliance with requirements across many locations adds additional responsibility and weight on jurisdictions, as well as additional costs. When deciding to access new markets, countries need to consider both the costs and benefits of enacting any new compliance measures involved with gaining this access. Additionally, the higher the value of business, the greater the ’compliance’ burden tends to be.
It is not just the number of client-based locations that IFCs must consider, but where these clients are located. There is a further trade-off to weigh up: that between growth and value, both in terms of market size and monetary value. Many high-growth markets, like China and India, demand less ’compliance’ than established markets in the E EU and Organisation for Economic Co-operation and Development (OECD) nations. However, they tend to elicit lower fees per transaction than the established markets as the products and services offered are inclined to be less sophisticated. (See Figure 4.)
Politicians and businesses in IFCs face tough decisions. The challenge is for them to grow into valuable hubs while compliance is getting tougher and growth in higher-value markets is under increasing pressure. In order to become a ‘hub’, open to new markets and new clients, the jurisdiction will be forced to increase and improve their compliance on a number of measures. However, in the increasingly regulatory environment, these jurisdictions will have to improve on many of these measures regardless, if they intend on reaching out to new markets, as global standards and pressures will require increasing compliance even to meet the same levels of business. There is little room to negotiate. IFCs must work out where their role is and recognise the trade-offs between growth and value – it will be challenging to have both.
Figure 4: Stylised illustrations of the trade-offs faced by international finance centres.
Source: Capital Economics
Alexandra Dreisin is a Senior Economist at Capital Economics, London. Before joining Capital Economics in 2014, she was a research analyst at macro investment company SLJ Macro Partners. Prior to that, Alexandra worked at the US Bureau of Labor Statistics as an economist for the Consumer Price Index.
Mark Pragnell, director of Pragmatix Advisory, has over 25 years’ experience as a macroeconomics consultant and forecaster. He has worked with a number of IFC governments, promotional bodies and businesses, and has led seminal research to explain and quantify the value of IFCs.