As the COVID-19 pandemic rolls on, leaving death and economic destruction in its wake, governments around the world have responded with massive “stimulus” programs funded by issuing debt. Many governments, including the US, UK, and most EU governments now have debt: GDP ratios that exceed 100 per cent. Unless economic growth rebounds rapidly, the repayment of this debt is likely to become a major burden.
Many interest groups have already begun arguing that this situation is exacerbated by offshore international financial centres (IFCs), which they accuse of eroding the tax base of onshore jurisdictions, and are calling for a clampdown on the use of such centres. But the history of the development of financial centres contradicts this narrative. Attempting to limit the use of IFCs would increase the cost of capital and exacerbate the debt crisis, harming the world economy.
Finance is as old as civilisation. As far back as the third millennium BC, Sumerian priests acted as bankers, providing loans that enabled investments and innovations in agriculture, building, engineering, and art,[i] and likely contributed to the invention of writing and mathematics.[ii] International finance is nearly as old: at least as far back as the third century BC, Indian merchants were using bills of exchange, or promissory notes, to facilitate long-distance trade.[iii]
But the first true international financial centre was arguably Bruges, which in the 14th Century was at the intersection of trade among merchants from the Hansard League cities of Northern Europe and the Italian city states, whose trade extended across the Mediterranean and beyond. To facilitate this trade, Bruges was home to the world’s first commodities exchange (the Bourse) and many Lombard and Jewish bankers who themselves had networks across the Western world.[iv] As a member of the Hansard League, merchant trade in Bruges was governed by the Law of Lubeck.
In the 16th century, the need for larger scale financing for risky trading ventures led to the development of joint stock companies and, shortly thereafter, stock exchanges in both Amsterdam and London. With these innovative markets and their many bankers, the cities were indisputably the main IFCs of their day.
As trade became increasingly globalised, stock and other financial markets were established in ports such as Lisbon, Copenhagen, and New York, major inland trading centres such as Vienna, Frankfurt and Paris, and, later, in the Asian trading centres of Shanghai and Bombay, and Australia’s mining hub, Melbourne.
By the beginning of the 20th century, the world was studded with IFCs, facilitating finance for trade as well as investment in many and diverse enterprises. As such, they played a central role in enabling rapid economic growth and improvements in living conditions in many countries. Underpinning these IFCs were a combination of well-respected law, both domestic and maritime, relative political stability, and, of course, their importance as trading hubs.
The belligerent convulsions of the 20th century caused some IFCs, such as Shanghai and Bombay, to decline in significance—at least until the end of the century. In their place arose Hong Kong and Singapore. But other factors also dramatically changed the nature, location and prominence of many IFCs. Most notably, new technologies such as the airplane, telephone, telex and fax reduced the need for proximity. As a result, investors and corporations increasingly sought opportunities in far-flung places.
Government regulation also played a significant role. Interest rate caps in the US, combined with an acceptance by the Bank of England of the desirability of foreign deposits and an entrepreneurial leadership team at Midland Bank, led to the development of the Eurodollar market in London in the 1950s. [v] This was boosted by US capital controls, which incentivised American banks and businesses to hold US dollars outside the US. Between 1964 and 1970, total assets of foreign branches of US banks rose from US$7 billion to US$53 billion.[vi]
London remained at the centre of the Eurodollar market—which was arguably responsible for its re-emergence as the world’s premier IFC.[vii] But entrepreneurs soon identified other jurisdictions through which to conduct business. On mainland Europe, Luxembourg quickly became a major centre for Eurobond issuance, supplying capital to major infrastructure projects across the continent. While its position at the heart of Europe likely played a role, “above all, Luxembourg had little bureaucracy and could move much more quickly than the London Stock Exchange”.[viii] Meanwhile, “listing in Luxembourg avoided both the 4% stamp duty and, even more to the point, the 42.5% income tax for which the bonds would have been liable in the UK”.[ix]
Eurodollars also began to flow through Jersey, Guernsey, the Isle of Man, the Bahamas, Bermuda, Cayman, the British Virgin Islands, Singapore, and Hong Kong. With the exceptions of Singapore and Hong Kong, the arrival of the Eurodollar was arguably instrumental in establishing these islands as IFCs.[x] As with Luxembourg, low taxes and a flexible regulatory system were essential to the emergence of these markets. In addition, political stability and a robust legal system were also very important.[xi]
Having been given a kick-start by Eurodollar markets, these IFCs each progressed in unique ways. However, they share a common path inasmuch as they began with deep expertise in particular areas based on their comparative advantage, then built out into next-adjacent fields. In this sense, they mirror the development of older IFCs such as London and Amsterdam, which developed initially as centres for the financing of local and regional trade, shifted into the financing of intercontinental trade, and then ultimately became more generalised centres of finance.
This pattern is typical not only of IFCs but also of other clusters of economic activity. Take Nashville, for example, which began as a centre for country music in the 1920s as a result of its combination of local talent, such as the Carter family and Jimmy Rogers, a radio station, the Grand Ole Opry, and an entrepreneurial record producer, Ralph Peer, who brought modern recording equipment and then pressed and distributed records nationwide.[xii] In 1955, RCA records bought Elvis Presley’s contract from Sun Records in nearby Memphis and brought him to Nashville to record, in one fell swoop making Nashville a centre for then-nascent rock n’ roll.[xiii] Today, Nashville is a centre for all kinds of music.
While technology has meant that proximity has declined in importance for IFCs, it remains relevant. For the Crown Dependencies, proximity both to the UK and Europe is important. A study by Capital Economics in 2016 estimated that deposits in Jersey, Guernsey and the Isle of Man account for the equivalent of just under 13 per cent of British retail deposits.[xiv] These deposits lower the cost of capital in the UK, generating additional investment and supporting thousands of jobs. Jersey alone contributed about US$1 trillion in investment to the UK; it also contributed about US$390 billion to the rest of the EU.
For the Caribbean islands, proximity to the Americas, and especially the US, is important. For example, in 2016, Capital Economics estimated that Cayman entities alone contributed US$3.1 trillion in investment to the US and Canada. By contrast, Cayman entities contributed about US$590 billion to the UK and US$200 billon to the EU.[xv]
For Hong Kong and Singapore, proximity to key Asian markets is important.[xvi] These local IFCs facilitate trillions of dollars of investment in mainland China, Vietnam, Taiwan, Malaysia and other Asian countries. But the IFCs are also increasingly inter-related. For example, many companies based in Asia use Cayman structures.[xvii]
Given the importance of these IFCs as facilitators of capital for the US, UK and EU, which result from the combination of their tax neutrality, high quality governance, flexible regulation, specialisation, and associated expertise, there would clearly be huge downsides to any effort aimed at reducing their role. To take one example, Capital Economics estimated that if the up-streamed deposits from Jersey were cut off from the UK, it would create a liquidity loss of 8.6 per cent, which would have to be replaced, leading to a short-term rise in sight deposit rates of as much as 6.4 per cent. Imagine the consequences of such a move in today’s highly indebted world: the shock would lead to an instant credit crisis followed by a recession or more likely a depression, as the UK government was forced to raise taxes to cover its debt burden, harming growth for a generation. And most adversely affected would be the poor, many of whom would see their prospects dashed. So those NGOs shouting loudly about offshore IFCs, claiming that they harm the poor should be careful what they wish for.
[i] Patrick J. Kiger, “9 Ancient Sumerian Inventions That Changed the World,” History.com, August 1, 2019. https://www.history.com/news/sumerians-inventions-mesopotamia
[ii] Cuneiform tablet: balanced account of Dugga, ca. 2039 B.C., Metropolitan Museum of Art. https://www.metmuseum.org/art/collection/search/322447
[iii] In Mauryan India, these were known as adesha. https://m.rbi.org.in/scripts/PublicationsView.aspx?id=155.
[iv] James M. Murray, Bruges: Cradle of Capitalism, 1280-1390. Cambridge: Cambridge University Press, 2005
[v] Catherine Schenck, “The Origins of the Eurodollar Market in London: 1955–1963, “Explorations in Economic History, Vol. 35 (2), April 1998, Pages 221-238.
[vi] Marcel Cassard, The Role of Offshore Centers in International Financial Intermediation, Washington, DC: International Monetary Fund, September 1994.
[vii] Gary Burn, “The State, the City and the Euromarkets,” Review of International Political Economy, Vol. 6 (2), Summer 1999, pp. 225-261.
[viii] Adrian Murdoch, “The Birth of the Eurobond Market,” in A Guide to 50 Years of Eurobond Listings in Luxembourg, International Financing Review Guide, 2013.
[x] Cassard, op. cit.
[xi] Dhammika Dharmapala and James Hines Jr., "Which countries become tax havens?" Journal of Public Economics, Vol. 93(9-10), October 2009, pages 1058-1068.
[xiv] Capital Economics, Jersey’s Value to Britain, 2016.
[xv] Capital Economics, The importance of international finance centres in the global economy, 2018.
Julian Morris FRSA
Julian Morris has 30 years’ experience as an economist and policy expert. In addition to his role at Unicus, he is a Senior Fellow at Reason Foundation and a Senior Scholar at the International Center for Law and Economics. The author of dozens of peer reviewed publications, white papers, and book chapters, Julian is a member of the Editorial Board of Energy and Environment. A graduate of Edinburgh University, he has masters’ degrees from UCL and Cambridge, and a Graduate diploma in law from Westminster. Julian is also a member of several non-profit boards.