BMI View: The international crackdown on Offshore Financial Centres (OFCs) will lead to a continued structural decline of the Caribbean region's financial services sector over the foreseeable future. This will have a profound impact on the region's growth prospects . As such, t his trend, which we first identified during the global financial c risis four years ago, is set to continue over the coming years, informing our expectations for the Caribbean economy to continue underperforming Latin America.
The Caribbean region's offshore financial service sector is in the midst of a secular decline, which will continue to delay a meaningful economic recovery in the region for years to come . Having been hi t particularly hard during the global financial c risis and subsequent recession of 2009, the Caribbean region will remain an economic underperformer relative to Latin America. Although existing tourism infrastructure may offer some limited respite given the ongoing recovery in US economic growth, the sheer size of offshore banking sector liabilities in relation to domestic output leaves small island Caribbean economies at risk of further economic decline.
|Caribbean To Remain An Underperformer|
|Regional Real GDP Growth Forecasts|
From Clouds To A Perfect Storm
As part of a BMI Special Report on the rising external challenges confronting Caribbean economies four years ago, titled "Caribbean 2009/10: Trouble In Paradise", we noted that the outlook for the region's Offshore Financial Centres (OFCs) was deteriorating. We argued at the time that this would have significant repercussions for the Caribbean region's economic outlook ( see our online service, April 24 2009, 'Clouds Form Above Offshore Financial Centres'). Some four years later, after playing out to an even greater extent than we had anticipated in early 2009, this view remains firmly in place. Indeed, tighter international regulation and increasing external pressure have already forced a large number of British Overseas Territories, including Anguilla, Bermuda, the British Virgin Islands, the Cayman Islands, Montserrat and the Turks and Caicos Islands, to adopt greater transparency laws. These new laws will see the OFCs share detailed information on bank account holders with the UK, France, Germany, Italy and Spain.
Hailed as a breakthrough in the fight against tax evasion and illicit financing, the recent development marks a culmination of years of intensifying pressure on OFCs to enter into formalised tax agreements with OECD member states. The tighter regulations can be attributed to the combination of global budget crises, triggered by the global financial meltdown of 2008/2009, and more recently escalating during the eurozone sovereign debt crisis, and a series of high-profile tax evasion scandals across the developed world. Since the global financial crisis forced governments to bailout large parts of their banking sectors, the unveiling of large executive bonuses, in combination with growing revelations of offshore holdings by wealthy individuals across developed countries, injected a significant political impetus to cracking down on tax evasion.
This arguably intensified as the eurozone found itself in the midst of a sovereign debt crisis. Indeed, closer examination showed that a large number of funds were moving out of euro area economies into safe havens, while the need for large financial bailouts intensified the pressure to crack down on tax evasion. Moreover, leaks of offshore holdings data in Switzerland, Lichtenburg, Luxembourg and more recently, across Caribbean OFCs, such as the Cayman Islands and the British Virgin Islands, generated public pressure to go after such individuals.
The past few decades have seen the rise of the financial intermediation sector in the Caribbean, which benefitted from a strong legacy of stable political environments and robust legal systems, as a result of British and Dutch jurisdiction over these territories. Looking at the offshore sector in particular, total foreign claims on OFCs in the Caribbean measure in excess of 4,000% of GDP at the end of 2012, based on Bank of International Settlement (BIS) data and national account statistics. Although several Caribbean economies have developed large tourism sectors, the prospect of falling revenues from financial services fees and a withdrawal of foreign funds leave the small Caribbean island economies highly vulnerable to further sharp contractions, as seen in the wake of the global recession in 2009.
|OFCs Dwarf Domestic Output|
|Banking Sector External Liabilities, % of GDP|
On aggregate, Caribbean economies were hit harder during the global recession than their Latin America counterparts , contracting 3.0% in 2009, compared with a 1.8% contraction in Latin America's economy, according to BMI 's calculations. Although this can to an equal measure be attributed to a slump in the tourism industry and weaker mining and quarrying output, the region registered just 0.2% real growth in 2010, followed by another full-year contraction of 1.1% in 2011. With Caribbean OFCs in secular decline, we believe that a meaningful economic recovery in the region is unlikely for the foreseeable future, as any improvement in other sectors will be largely offset by the decline in financial services.
|No Longer An Engine Of Growth|
|Caribbean - Financial Services Sector|
Having accounted for almost 20% of regional economic output a decade ago, the Caribbean region's financial services sector made up just under 17% in 2011, according to data from the Economic Commission for Latin America and the Caribbean (ECLAC). Taking into account not only financial intermediation, but also the beneficial secondary effects on real estate and business activities, many of which have prospered as a direct result of the region's rising share of global OFCs, financial services have become an important employer in the Caribbean, as well as a key source of government revenues. As such, c onsidering the size of this sector, we note that an ongoing decline in banking sector turnover and registrations of new offshore companies will have lasting consequences for the local economies.
|Removing A Large Piece Of The Pie|
|Caribbean - Breakdown of GDP by Activity (2011)|
Entering Choppy Waters
We are seeing increasing evidence that Caribbean OFCs are already in the midst of a secular decline. Although non-residential deposits and offshore company registrations have recovered somewhat after the 2008/2009 crisis, we are seeing little to suggest that financial services activity is picking up in a meaningful way. Among one of the largest OFCs, the number of offshore company registrations has likely peaked in the Cayman Islands, with data from the Economics and Statistics Office (ESO) revealing that new company registrations only moderately exceeded 2009 numbers. The key category of shell companies registered on the Cayman Islands are so-called 'exempt' companies, referring to their offshore activities, exempting them from paying any taxes.
The number of 'exempt' companies rose by 7,980 in 2011, well short of the 10,000-plus offshore companies registered in each of the three years to 2008, bringing the total number of such companies to 74,782 in 2011. This means that the number of offshore companies registered on the Cayman Islands only barely exceeded the peak number of 74,107 seen in 2008, for the first time in 2011. Meanwhile, total external liabilities in the Cayman Islands banking sector shrank by 10.5% in 2011, notably accelerating a multi-year trend of declining liabilities.
|"Exempt" Company Migration At An End?|
|Cayman Islands - Total Companies Registered By Type|
Although we do not have more recent data than 2007 for the British Virgin Islands (BVI), the stakes are also very high for the other key OFC bellwether in the Caribbean. According to data from the Caribbean Development Bank, the number of total International Business Companies (IBCs) at the end of H107 stood at 802,850, a 10.7% increase on the previous year. With the BVI featuring prominently among a series of international data leaks, according to recent media reports, including Russian oligarchs and allegedly a large cross-section of Greek society, we believe that the BVI will be hit as hard as any OFC in light of the latest tax agreement with the UK.
|Small Islands In The Eye Of The Storm|
|Caribbean - Financial Intermediation Services Indirect Measure (FISIM), % of GDP|
The decline in outstanding liabilities of the Aruban offshore banking sector has accelerated in recent years, shrinking by 45.8% in 2011 alone to just AWG218.3mn, the equivalent of 4.6% of GDP. This contrasts sharply with 9.3% of GDP a year earlier and 12.4% of GDP in 2009. This has hit the offshore sector hard, as total deposits fell to just AWG57.9mn in 2011, from AWG210.8mn the previous year. With the sector already having to write off a total of AWG200.1mn in losses in 2010, we see few prospects of total banking sector income to recover in the current conditions.
|Aruba - Offshore Banking Sector Deposits & Income, AWGmn|
Another British Overseas Territory, which has entered into a tax agreement with the UK and boasts large financial services and insurance sectors is Bermuda, which has so far struggled to produce a recovery in the financial intermediation industry. This has seen the Bermudan economy post four consecutive years of negative real GDP growth since 2009. Moreover, a lthough we project real GDP growth of 1.1% in 2013, we do not rule out further economic contractions over the coming years.
|Bermuda - Financial Intermediation|
Structural Adjustment Will Take Many Years
We believe that it will take a long time for Caribbean economies, particularly those with large OFCs, to rebalance away from financial services exports. The challenges will be manifold, particularly with host governments having grown chronically dependent on one-off fees generated from new company registrations each year. Moreover, although OFCs have a relatively low labour intensity compared with manufacturing, mining and quarrying, agriculture, or the tourism industry, the next several years are likely to see the share of employment in financial services in the region shrink.
|Leading The Way|
|Curacao - Breakdown of Services Exports, % of GDP|
Much will depend on the ability to attract tourist arrivals and new investment into the local infrastructure. This could be on the rise as economic conditions in the developed world begin to improve after years of poor visitor numbers. Moreover, over the longer term, we believe that tourist arrivals will gradually diversify away from key destinations such as the US, UK and Netherlands, to faster-growing economies in South America and Mexico. Curacao's economy has been among the first in the region to begin a long drawn-out shift out of financial services exports into tourism, with international financial and business service exports accounting for just 3.1% of GDP in 2011, compared with 14.8% for tourism exports. Some 10 years prior, international financial and business services exports exceeded tourism service exports as a share of GDP (11.8% vs 10.0%), as illustrated in the chart above.
As the Curacao example illustrates , these dynamics will take years to play out elsewhere in the region. O ur long-term forecast s for the region , therefore, do not currently reflect the impact on growth from a diversification away from financial services to tourism . For the time being, the Caribbean region's small and financial sector-dependent economies will endure a prolonged period of weak economic growth as greater transparency and double-taxation agreements are formally implemented across the region's OFCs over the coming years.