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Caribbean centers: Stricter rules change climate for offshore financial centers

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
January 2002
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The English-speaking Caribbean countries face a particular set of challenges. Their small, open economies have long been vulnerable to external shocks. In the past, many of these islands depended heavily on agriculture—often specializing in one main export, such as bananas or sugarcane. Preferential trade agreements with the European Union helped maintain the profitability of these exports, but these arrangements are now considered a violation of World Trade Organization rules, with likely significant adverse effects for employment and external current account balances.

In the search for higher growth, a number of countries have pursued expanded tourism, but here, too, there have been shortcomings. The sector’s highly competitive nature and the region’s vulnerability to hurricanes have limited the gains that can be reaped from this sector.

The offshore financial center option

In looking for other areas in which to diversify, more island economies began to consider developing offshore financial centers. This sector is particularly appealing because it does not require a large skilled workforce or major investment in infrastructure.

The sector has a long history in the region. The Caribbean’s first offshore operations were established in The Bahamas in 1936 and, shortly thereafter, in Anguilla, the British Virgin Islands, and the Cayman Islands. Their success inspired other Caribbean nations, such as Antigua and Barbuda, Dominica, Grenada, Nevis, St. Kitts, St. Lucia, and St. Vincent and the Grenadines, to enter the sector—some as recently as the late 1990s.

The older offshore financial centers developed slowly over time, and their economies reaped long-term benefits in the form of a more highly skilled workforce; improved infrastructure; better services, such as hotels, restaurants, and catering; and, more generally, additional foreign investment in their economies. Some older offshore centers, such as the Cayman Islands, now have a large and diverse international financial sector.

What do offshore financial centers do?

Offshore financial centers provide financial management services to foreign users in exchange for foreign exchange earnings. The comparative advantage for clients? Several, including very low tax rates, minimal administrative formalities, and confidentiality and discretion. This environment allows wealthy international clients to minimize potential tax liability while protecting income and assets from political, fiscal, and legal risks. There are many vehicles through which offshore financial services can be provided. These include the following:

• Offshore banking, which can handle foreign exchange operations for corporations or banks. These operations are not subject to either capital, corporate, capital gains, dividend, or interest taxes or to exchange controls.

• International business corporations, which are often tax-exempt, limited-liability companies used to operate businesses or raise capital through issuing shares, bonds, or other instruments.

• Offshore insurance companies, which are established to minimize taxes and manage risk. Onshore insurance companies establish offshore companies to reinsure certain risks and reduce their reserve and capital requirements.

• Asset management and protection allows individuals and corporations in countries with fragile banking systems or unstable political regimes to keep assets offshore to protect against the collapse of domestic currencies and banks. Individuals who face unlimited liability at home may use offshore centers to protect assets from domestic lawsuits.

• Tax planning. Multinationals may route transactions through offshore centers to minimize taxes through transfer pricing. Individuals can make use of favorable tax regimes offered by offshore centers through trusts and foundations.

The tax concessions and secrecy afforded by offshore financial centers can be used for many legitimate purposes, but they have also been used for illegitimate ends, including money laundering and tax evasion.

But can their success be replicated by the new offshore financial centers in the region? In a review of the Caribbean’s experience, the authors find solid evidence of the benefits that have accrued to the economies of established centers but doubt whether the newer centers will find it cost-effective to operate in a more stringent, and initially more costly, regulatory environment.

New regulatory climate

The volume of flows into offshore financial centers, concerns about money laundering, and links to illegal and terrorist activity (heightened after September 11) have translated over the past few years into increased calls to better regulate and supervise offshore financial operations. Various international committees, such as the Financial Action Task Force (FATF) and the Financial Stability Forum (FSF), have drawn up best-practice guidelines for offshore financial centers. These new guidelines aim at making offshore centers’ operations more transparent, and sanctions have been proposed for centers that do not meet international standards.

Compliance with these higher standards has posed particular issues for some of the newer entrants to the offshore financial sector. Many of these nascent centers had sought to offer broad banking secrecy as one way of luring business away from the older offshore financial centers. Now these new entrants will not only lose this means of differentiating themselves from their more established competitors, but will also incur additional expenses to comply with the new rules, which entail establishing a series of regulatory institutions and hiring independent auditors to oversee their activities.

The FSF and FATF reports list “uncooperative” countries—countries that are judged to fall short of meeting, or of moving toward meeting, international standards—and these reports bring adverse publicity to offshore operations. Since reputation is key in this business, being cited as uncooperative can compromise the development of the whole financial sector in these countries. If a country acquires a reputation—rightly or wrongly—as a haven for criminal activities, then onshore banks will not want to be associated with them and the offshore sector will not thrive.

Cost-effective?

According to the authors, the well-established offshore financial centers, which had developed unfettered by intense international scrutiny, are not likely to be greatly affected by the cost of complying with international standards. These centers have already reaped many of the benefits associated with this sector and often have the required institutions already in place.

Offshore financial centers that began operating in the 1990s, however, may find themselves in a more difficult position. They must establish their operations in the glare of the international spotlight, and, at least over the short run, they must absorb the cost of complying with international standards—costs that may nearly equal the revenues gained from offshore financial activities.

The authors conclude with a word of caution. Countries with nascent offshore financial centers may not find these operations profitable in the newly stringent regulatory environment. They are urged to conduct a careful cost-benefit analysis before devoting more resources to developing this sector. The authors also counsel that the in-depth analyses that are needed will require that national authorities obtain and share necessary data and pursue greater openness—all steps that may not be easily accomplished in a sector that has traditionally operated in the shadows.

Copies of IMF Working Paper No. 02/88, Caribbean Offshore Centers: Past, Present, and Possibilities for the Future, by Esther C. Suss, Oral H. Williams, and Chandima Mendis, are available for $10.00 each from IMF Publications Services. See page 251 for ordering details.

Many of these nascent centers had sought to offer broad banking secrecy as one way of luring business away from the older offshore financial centers.

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