The threat of an exodus away from today's leading Western financial centres looms as regulators draw up measures to reduce systemic risk, and the appeal of tax havens and expanding Asian centres rises, Writes Silvia Pavoni.
The pressure on International Financial Centres (IFCs) to prove their value to economies around the world is higher then ever. Politicians' intentions to come up with solutions that would reduce systemic risk in the financial market have often resulted in proposals that, some say, are off the mark.
The EU's draft directive on alternative investment fund managers (AIFM) is a case in point. If passed in its current form, it will have a devastating effect on London's hedge fund business, which accounts for 85% of the European market. It is feared that strict rules on leverage, domicile and other impositions may well push this industry away to other jurisdictions. Switzerland is one of the most likely new hosts, while many also expect hedge funds of North American origin to simply move back.
Moreover, Asian international ambitions threaten to dent established centres' market share even further. In addition to the established jurisdictions of Hong Kong and Singapore, China and South Korea have big plans for their main financial cities. With Western markets still wrestling with the financial crisis, the plans announced this year by China's State Council to make Shanghai an international financial centre by 2020 are being taken very seriously by the leading IFCs.
"In the short term, [London will keep on competing] with New York, but the biggest threats come from the places where the most money will be made, where the huge growth rates are. It is going to be in China, India and Latin America," says Stuart Fraser, policy chairman of City of London Corporation. "If you go to China, they'll tell you: we have all the buildings, the infrastructure, what we need now is to attract the talent. These people are determined to become an IFC."
Attracting talent is certainly one of the key ingredients for any aspiring international hub, be it Shanghai, Seoul, Qatar or São Paulo. And heavier financial market regulation, combined with higher tax rates for top earners in the Western world, might just be what pushes young professionals to new locations.
Impact of tax
Anecdotal evidence suggests that the UK's planned top income tax rise to 50% would encourage entrepreneurs and financiers to move abroad. The measure is expected to be enacted next April and, coupled with new rules limiting tax relief and allowances, it could push high earners in the UK to the relatively close-by Guernsey, Monaco or Switzerland, or to consider relocating altogether further afield.
"[In the UK] we already have professionals and now expect younger people to go to Hong Kong, Singapore and other centres to gain experience in those markets," says Mr Fraser. "It doesn't take long to build up a more resident population of young people who might want to be in London when their career is more mature, but that for now are quite happy to work in places that don't offer conditions quite as attractive as London, but where they can make more money and save more money for when they come back. And it could be that the more difficult [the situation in London and Europe] gets, the faster will be the exodus."
Favourable tax treatment in offshore centres is under pressure from the Organisation for Economic Co-operation and Development (OECD), which is concerned about a loss of tax revenues - a particularly important issue for governments stuck in an economic recession.
The G-20 political commitment has begun to work. Before the G-20 summit in April, only a small part of tax havens had mechanisms in place to exchange tax information with other jurisdictions. It was not too long ago that only very limited information could be obtained, even from centres that are part of the OECD, such as Switzerland and Luxembourg, not to mention jurisdictions such as Hong Kong or Macau.
Recently this has changed. The reputational risks associated with being a non-compliant centre, and the relative sanctions, are just too high. "What happened over the past six months, particularly after the London summit in April, was a global endorsement of OECD's tax standards of tax transparency and exchange of information," says Jeffrey Owens, director of the centre for tax policy and administration at the OECD. "This resulted in a massive increase in the number of agreements that have been signed. Over the past six months, we had more agreements signed than over the past 10 years."
Market transparency
These days, explains Mr Owens, all of the major onshore and offshore centres, whether it is Singapore, Hong Kong and Macau in Asia, Uruguay and Costa Rica in Latin America, or Luxembourg and Switzerland in Europe, have mechanisms in place to exchange tax information. This is why no centre is currently on the OECD's black list.
Many, however, are on the grey list. And some believe that grey is the new black. "Once you are on a grey list, nobody sees the difference between [a jurisdiction] that is not regulated and one where there isn't enough exchange of tax information," says Fernand Grulms, CEO of Luxembourg for Finance.
Tax does matter. It matters so much that the OECD's tax standards are used in the AIFM draft directive to discriminate which offshore centres hedge funds should be dealing with. The industry protests that tax has nothing to do with financial markets' systemic risk or regulation, while the OECD looks at this matter from a different angle.
Since the mainstream standpoint is that offshore centres take tax revenues from the country where a certain transactions should have been registered, and since governments cannot run with big deficits - to which that tax value should have contributed - that, in itself promotes instability, says Mr Owens. "We also need to look at how tax promoted this crisis," he adds. "Nobody has said that tax havens are a cause, not even a minor cause, of the crisis, but I do think that tax has to be part of the solution." The question posed by the G-20 is: how do we get more transparency and integrity in the financial market? "If we're going to achieve this in the tax area, I think that it is going to be easy to achieve in other areas," says Mr Owens.
Towards best practice
Some look at the way financial institutions go about tax in remuneration packages. Does tax promote arbitrage between different rules and different standards? Has it encouraged more risk taking?
Others offer a contrarian perspective. Professor Walid Hezaji of the University of Toronto's Rotman School of Management has engaged in detailed research to prove that offshore centres do add value to the global economy. According to his data, Canada has about $30bn in Barbados. The general perception is that this $30bn in assets was transferred from Canada to Barbados to avoid taxes, damaging the Canadian economy.
However, Mr Hezaji says that retained earnings generated offshore are not taken into account. Although these earnings are not taxed initially, there are other tax implications that must be factored into the analysis, such as the fact that allowing Canadian firms to access the global economy through an offshore centre generates higher Canadian trade, more economic activity in the country and hence higher tax revenues. Also, the dividends that flow back to the Canadian companies' shareholders are higher, again generating more tax revenue for the Canadian government.
These are all interesting points that will most certainly be at the heart of financial markets discussions for many more months to come. Whatever governments around the world conclude, the one thing that is clear is that no centre, be it established or emerging, with a global reach or a specialised position, can afford a bad reputation.
"From our perspective, we're just keen for people to realise that you can't evade taxes [in Jersey], you can't hide drug money here," says Robert Kirkby, technical director of Jersey Finance.
"We want people to understand that. This is a regulated jurisdiction. [Being on] the white list helps to some extent, but we'll keep on banging the drum and say that we have very strict anti-money laundering rules and we have to do that because the perception out there is still that places such as Jersey are tax havens with lots of money sat in the banks and gold bars lying on the beach," he adds.
