Non-Sovereign Small Islands in the International Economy - Essay Example

?Non-Sovereign Small Islands in the International Economy Introduction Since the late 1960s, pursuing a goal of developing and diversifying its economies, many small islands have grasped the opportunity to develop offshore financial services in their states. And 30 years later, these offshore financial centers (OFCs) were already in the focus of leading states, who accused OFCs in various misdemeanours from sponsoring financial crises, undermining development by allowing the peculation of aid budgets to eroding tax bases. Generally speaking, the OFCs were accused in undermining the stability and inviolability of the global financial system. To manage the situation, a group of initiatives were taken by the Financial Stability Forum, the International Monetary Fund, the Organisation for Economic Co-operation and Development (OECD), the European Union and the Financial Action Task Force (Woodward 686). In addition to the development of small islands as offshore financial centres, there are some other examples of cases when many small islands have exceeded in small-scale, high-value service and product-niching in various fields of economic activities, including: finance and banking, brokerage, tourism and hospitality (Baldacchino 254). This paper is focused on the research the small islands, performing an important role in the international economy and on the global arena. The more detailed analysis is carried out for the British Isle’s Crown dependencies: the Isle of Man, and the Channel Islands of Jersey and Guernsey, as well the Prince Edward Island. The Financial Services Sector: the Isle of man, the Channel Islands and New "Havens"Among Developing Small Islands There are many various definitions of the offshore, which is the evidence of the challenges which many scholars and economists face in attempt to explain this concept precisely. For example, Palan defines the offshore as a “special territorial or juridical enclave”, in which regulation or taxation in the state is either partially or fully withheld (cited by Payne 627-628). While significant stress in the definition of the offshore falls on the territorial dimension, juridical properties is what really matters. Richard Woodward clarifies this view by the statement: “offshore is a legal as well as physical domain; where an activity takes place is secondary to the rules under which it takes place” (cited by Payne 628). Even though there are some slight variations in definitions, offshore financial centres have a set of common characteristics. The offshore financial centers can be characterized by the following attributes: minimal taxes or tax free; bank anonymity and secrecy laws at a high level, a high number of financial institutions, which serve mainly non-residents; flexibility of use of various company structures, the proportions of financial systems are exceeding needs of the domestic economy, light financial regulation (Levin 2), protection of the secrecy of transactions and few or no restrictions of financial transactions (Palan 155). The most successful OFCs are characterized also by stable economic and political climate, support from of a large international financial market, money laundering or drug money scandals free, availability of agreements for avoiding double-taxation with major countries, and are easily reached due to established information-exchange facilities (Palan 156). Referring back to the last item, many OFCs are developing laws and investing in telecommunications for attracting e-commerce providers (Levin 5). Obviously, telecommunications and IT is a very important factor that enables OFCs to respond to the needs of their customers and operatively react to external changes. Financial centres can be distinguished by many different ways. Thus, for example, International Monetary Fund (n.p.) has developed its own way of differentiation of the financial centers by splitting those into three categories: 1. International financial centres (IFCs) – are large international full-service centers supported with advanced payment and settlement systems, liquid markets and adequate legal and regulatory frameworks. Examples of IFCs can be the following countries: London, Tokyo, New York. 2. Regional financial centres (RFCs) – these centres have relatively small domestic economies, but they have developed financial markets and intermediate funds both in and out of their borders. Examples of these are: Singapore, Luxemburg, Hong Kong, etc. 3. Offshore financial centres (OFCs) – are much smaller than the previously mentioned two categories. OFCs are different mainly due to its lighter regulations, provision of almost entirely tax driven services, and very limited resources to perform supportive function of a financial intermediate. Another way of distinguishing of the OFCs seems to be less complex and doesn’t require classification or categorization. It is simple differentiation between booking centers and financial centers. While booking centers mainly perform intermediary function for transactions, value of which was generated somewhere outside OFC, the functional centers are serving a real economy (Levin 2). As OFCs do not disclose much financial data, it is fairly difficult to measure the size of OFCs. On the demand side, these specific “non-disclosures” make OFCs particularly attractive to its users, among which are: international companies and international investors, insurance companies, wealthy individuals and criminals. Whatever the way of transaction is, practically all these users are willing to minimize the costs from government control, regulation and taxation. Below is presented a summary table of key actors and the benefits they receive by using the OFCs (Levin 3): Actors Benefits International companies Assets protection from claimants; Profit maximization; Issuance of securities through special purpose vehicles Financial institutions with affiliates in OFCs Taxes minimization; Assets protection from claimants; Avoidance of regulatory requirements in onshore jurisdictions Investors (funds, individuals, trusts) Taxes minimization; Assets protection from claimants; Avoidance of investment positions disclosure Criminals Financial frauds; Protection against inquiries through the local secrecy rights; Laundering Insurance companies Reserves’ accumulation in low-tax jurisdictions; Conducting business in favorable regulatory environment Offshore financial centers (OFCs) simultaneously play several roles in the economic development: through the collection of rents by those jurisdictions that host offshore financial centers, and by hiding ownership of the capital (Vlcek 1477). According to Palan, about half of the world’s stock of money either passes through the tax havens or resides there, and about 22 per cent of banks’ external assets are invested offshore. Taking these estimates seriously, it is possible to imagine what a great effect do OFCs have on the world economy. Under certain conditions it can cause a short cut to a more rapid economic development and provide benefits to poor countries (Levin 5). However, besides the potential positive impact of OFCs on certain category of countries and its obvious impact on globalization, the OFCs may impose real danger on global financial stability by its opaque and complex financial transactions and corporate structures (Levin 17). Thus, it is possible to assume that the OFCs work as a specific mechanism influencing not only on the global economic situation, but also on political and legal behaviors of certain countries. Small Islands in Global Political Economy Among the OFCs there are many small islands that began to provide offshore financial services through international banking corporations. This type of businesses that are willing to escape regulatory limitations and taxations is a particular category among the clients of small islands. According to Richard Woodward (691), small islands are particularly attractive for being domiciles of the offshore financial centers, and there are at least two reasons for it. First of all, indispensability of small islands to larger states, which rely on offshore flows to fund government deficits and trade and for whom multinational corporations play significant role in their economic welfare. The second reason is economic openness of the small islands, which is a natural consequence of their small sizes and therefore, their ability to adjust to coping with the needs of the globalised environment more effectively than the larger states. Haggerty (9) explains that one of the other attractive features for an offshore center could serve understandable regulation, as it was in case of the Isle of Man. Small island offshore financial centres interact with the global economy in several ways: through local cooperation with global supervisors and regulators, through cooperation with other financial services professionals worldwide, and through knowledge creation, information exchange, and trust development with neighboring international financial centre (Cobb 165). Thus, for example, the British Isles’ OFCs together with the Isle of Man being very close to London interact in the last way scheme. While economic openness of the small islands exposes them to the environment of changing global forces, they do not have enough power to make their own decisions independently or influence on the rules of global commerce (Woodward 697). Thus, being excluded from the process of “setting up the rules”, the position of some small islands is dependent on the decision makers on behalf of the core economies, and therefore is quite doubtful. However, even without having its “weight” on the global financial arena, it is possible to notice how some of the small islands have significantly strengthened their competitive positions by supplying cheap offshore funds to the core economies. This service was attractive and useful to more powerful global players whose personal interests resulted in shielding small islands from future harm (Woodward 697). It means that not only local actions of the OFCs have impacted on their subsequent growth but also the power of global communities. The law of supply and demand as well as simply logic dictates that if there was no demand for OFCs due to their specific nature, there would be no OFCs as they would not survive. As Woodward (691) explains, the economic strategies pursued by the leading economies hardly would be sustainable if there were not a steady flow of funds from small-island OFCs. Taking into consideration all these arguments, it is possible to conclude that the OFC in small islands especially those with efficient and effective government instruments required for proper global financial governance do survive and will survive unless the global community and core economies will decide otherwise. The further research is focused on the small islands, reputable for due to their offshore banking activities: the Island of Man, and the Channel Islands (Jersey and Guernsey). The Isle of Man and the Channel Islands of Guernsey and Jersey are semi-independent territories of the United Kingdom. Due to its relationships with the UK, these islands are characterized by political stability. While the banking laws of the islands were developed on the base of the British laws, the tax systems were applied differently on every Island (Bartholomew 40). According to Palan (154), the Channel Islands and the Isle of Man, together with Liechtenstein, Monaco, Luxembur, Austria, Singapore and the Neatherlands are referred to the category of countries, which offer special tax benefits to different types of businesses for carrying out certain set of operations. During the late 1990s-beginning of 2000s, the Channel Islands and the Isle of Man were accused by the European Commission of having lax regulation that was not acceptable even according to the offshore standards, and was blamed for lack of administrative and legal transparency (Harris 2, Gascoigne 7). After these attacks of fraud investigators, the Islands have introduced specific regulations, ensuring a well-regulated financial industry and money laundering legislation (Ferbrache 10). Below is provided more detailed analysis of the current state of the OFCs of the Isle of Man, and the Channel Islands of Jersey and Guernsey. The Isle of Man Located in the Irish Sea between England and Ireland, the Isle of Man is considered to be one of the leading offshore financial centres in the world. This small British Isle’s Crown dependency has managed to create a competitive offshore financial advantage and to sell it to many countries making those their permanent clients. The formation of the offshore financial centre in the Isle of Man began in the 1960s, but only by 1980s it has started to develop rapidly. Rapid growth was the result of taking the regulatory measures aimed at rehabilitating reputational issues after the collapse of the investment bank (Cobb 166). The Financial Supervision Commission and the Insurance and Pension Authority are two bodies responsible for regulating the financial sector on the Island and developing clear regulatory environment for its permanent and potential clients; specifically due to its understandable regulation, the Isle of Man is attractive as an offshore centre (Haggerty 9). Besides proper regulation, the Isle of Man also guarantees investor’s protection, offers companies a well-educated workforce, and in addition to intangible services, offers necessary physical infrastructure (Haggerty 9). The finance sector has been demonstrating significant growth particularly within the last 15 years. If in 1999, the finance sector employed 14 % of the total workforce or 5 000 people (Cobb 166), in 2011, the number of employees working in banking, finance, and insurance spheres comprised 22% (9,444) of the total employed population (Isle of Man Treasury 35). The total unemployment is virtually approaching to zero level (Corlett 21). According to Levin (38), in 2001 the total contribution to national income by the financial sector was 41%. There were more than 40,000 officially registered companies in the Island of Man, 50% of which were non-resident or exempt (Levin 38). Today, financial regulation of the Isle of Man is known to be efficient and transparent. Stable financial centre is a result of introducing of the strong licensing tests, protection of depositors and investors, and establishment of a special division of legal enforcement (Levin 39). Offshore financial services providers in the Isle of Man provide its services to a clientele from all over the world (Cobb 167). The key financial activities on the island include: deposit taking, management and protection of assets, packaged investments, trustee services, and life assurance services. In addition to this, the Island of Man is considered to be a highly competitive offshore center among the others in the insurance sector and company administration (Levin 38). There are about 50 banks operating on the island, majority of which are subsidiaries or branches of the UK or Ireland (Corlett 21). Most major players are present here, including: Global Asset Management, Bank of Ireland Asset Management, Allied Dunbar, and Mercury Asset Management (Haggerty 9). As Corlett states (21), the Isle of Man collects about 40 per cent of its GDP in tax; the VAT, accounting for 56 per cent of government finances allows the island to afford a zero rate taxes. The Isle of Man has a customer union with the UK, and therefore, the VAT of 17,5% is applied the same as in the UK (Levin 38). Both corporations and individuals are subject to income tax which depends on the size of the revenues. However, there are not applied any estate, capital gains, and wealth or capital transfers taxes (Levin 38). On February 15, 2005 it was announced that the island was on course to establish a zero rate of income tax on all companies by April 2006. The only exception were banks, as for them was applied 10 per cent tax rate (Corlett 21). Even though banks would pay this income tax, the loss of the government still seems to be very notable. Meanwhile, Corlett (21) explains the two main reasons for this initiative: to stop differentiation between resident and non-resident ownership and thus to respond to critical comments of the international regulatory organizations. However, small registration fee applied to every company, and growth of the economic activity as a result of a zero per cent tax, are expected to balance these “losses” or probably even excel it (Corlett 21). The Channel Islands The history of existence of these Islands began in 1204 after they won the right of self-government (Levin 35). The Channel Islands are comprised of five islands, including: Jersey, Guernsey, Alderney, Sark and Herm. Jersey and Guernsey are two tax havens that will be discussed further in more details. The Channel Islands of Jersey and Guernsey are located in the English Channel, in proximity to France. In result of high-profile bank scandals that took place at the beginning of 1990s, the UK initiated a review of the Channel Islands’ financial regulation. According to Bartholomew (40), the British government has imposed restrictions on its citizens for depositing in these OFCs, but the islands have gained its financial strength by focusing its financial activity on investment funds. Today, the UK cannot directly influence on tax legislation of these islands, but is responsible for international relations, defense and good governance of the islands (Levin 35). As the international finance centers, the Channel Islands are often viewed as a single pool of financial service providers, but actually Guernsey and Jersey are natural competitors which share common goals and strive to meet the highest international regulatory standards. Thus, for example, both Guernsey and Jersey have excellent Organization for Economic Co-operation and Development and Financial Task Force reports (Romer 22, 24). In addition to the obvious goals to meet the international regulatory requirements and standards, the Channel Islands initiate some innovative projects in order to become more competitive and attractive to its clients. For instance, in 2011 the governments of the Jersey and Guernsey have opened the Channel Islands Brussels office (Romer 22, 24). The primary goal of this joint venture was to develop the islands’ international identities through lobbying and presenting its position in Europe. In order to provide deeper and more liquid securities markets, the Channel Islands have created a small offshore stock exchange (Levin 5, Hearn 48). International banks and well developed offshore financial services made possible for the Channel Islands to create and develop additional competitive advantages, such as depository receipts, ordinary and preference shares (Hearn 37). Jersey Jersey is the largest of the Channel Islands. First of all it is a notable international banking centre with nearly 80 banks for total deposits of €212 billion. In Jersey operate more than 35, 000 offshore companies and nearly 90 fund management houses (Levin 40). Insurance industry is developed in smaller extent than the banking sphere, but the island puts lots of efforts for growing insurance business. There are no wealth or capital taxes in Jersey but taxation regime is applied to the international businesses that pay tax on their profits (up to 2%) and other income (30%) (Levin 41). In addition to favorable tax regime, Jersey is attractive for special purpose vehicles in asset-backed securitization transactions due to the presence of major accountancy companies, large commercial law players, and international banks on the island (Levin 40-41). In response to the various accusations of having lax regulatory base, in 1999 the leaders of Jersey introduced a comprehensive anti-money laundering legislation. As a result of this initiative, according to the Financial Stability Forum, Jersey was recognized as the state adhering to the international standards. It continues to introduce various regulations to improve its international cooperation, to enact new regulatory regime for companies and businesses, to develop a new protection instruments for depositors, etc. (Levin 41). Guernsey The Bailiwich of Guernsey is also a British Crown Dependency and one of the main islands of the Channel Islands. While some consider the Bailiwick as one of the tax havens, Morris (273) claims it is not, clarifying his view by naming it “a well developed functional offshore finance centre hosting real and substantial financial activity”. Due to its nature and size, Guernsey is also one of the major international players in the offshore business. Guernsey’s economy for 46% is based on the financial sector, including such main sectors as investment management, international banking, and offshore trusts (Levin 40, Morris 274). Nearly 80 banks operating in Guernsey work with deposits worth ?119 billion (Morris 274). To a greater extent, these banks are branches or subsidiaries of the large parent banks in the UK, Australia, Asia and the European Union. Not surprisingly that banking sector is the largest “employer” on the island, as its employment force of 2700 people accounts approximately for 25% of the total workforce (Levin 40). In addition to the developed banking sector, Guernsey is a concentration of the captive insurance services (Levin 40, Morris 274) and is recognized to be one of the biggest domiciles for offshore insurance in Europe. The investment business also plays a significant role in the economics of the Guernsey as more than 80 investment groups from various countries are managing funds there. The investment activity consists of administration, management and custody of collective investment schemes; company and trust administration is another popular business activity in Guernsey (Levin 40). There are more than 15,000 offshore companies, based in Guernsey. Such an impressive number of offshore companies might be explained by the favorable taxation regime in accordance to which only two taxes are applied: corporate and income. However, exempt companies are due to pay an annual fee of ?600, while the tax levels for the companies, owned by the international companies, are negotiatible with the local authorities; also, Guernsey has double-taxation treaty with the UK (Levin 37). According to conclusion of the Financial Services Commission, Guernsey is lacking well developed consumer depositor protection scheme, while the overall financial regulation and supervision are adequate. With a functioning of a comprehensive anti-money laundering system, it is not permitted to have anonymous bank accounts; however, confidentiality in banks is guaranteed at a high level (Levin 37). Small Islands and a Changing Global Trading Regime: The Case of Prince Edward Island Most of the small states are islands or geographically scattered multi-island states. Very often small states are characterized by limited territory, constraints in the domestic supply of labor and natural resources (Armstrong & Read 567). The range of goods and services that can be feasibly supplied locally is limited by the small market size, export markets, the need for specialization of production (Armstrong & Read 568). However, despite all these constraints and other limitations, many small islands have exceeded in offering high-value services and products in various fields of economic activities, including: finance and banking, agriculture, manufacturing, tourism and hospitality. The purpose of this study is to explore a changing global trading regime and the role of small islands in it followed by review of the case of Prince Edward Island (PEI). Theoretical review of the role of small islands in the international economics As Armstrong (569) highlights, most small states can be highly integrated with the international economy if they have a high degree of openness. Being exposed to globalization trends and becoming potential gainers from trade liberalization, small islands/states can have a strong commitment to a liberal global trading system. However, a high degree of openness also makes a small state more vulnerable in result of the exposure to the global economic downturns as well (Armstrong 571). The risks of economic vulnerability and volatility, common for small island economies, can be reduced by adopting sound economic policies, through the involvement of the international community, and regional integration and cooperation (Jahan & Wang 46-47). The case of Prince Edward Island illustrates implementations of these theoretical strategies by its own example. The Case of Prince Edward Island (PEI) Prince Edward Island (PEI) is Canada’s smallest province with a 137, 000 resident population (Baldacchino 255). Land Area of the Island is very small – only 5, 660 Km and this results in fact that population density in PEI is the highest in Canada – 23, 8 per sq.km (Committee on Knowledge Assessment 6). Based on the population size parameters, PEI is referred to the category of microstates (Jahan & Wang, 44). In the late 1990s the employment rate on the Island was 56, 4% and the unemployment rate was the second highest in Canada – 14,9%. In a smallest province of Canada there are three levels of government on the Island: the local, the provincial, and the federal (Committee on Knowledge Assessment 12). While historically this island was known as a peripheral economy based on resources (Baldacchino 255), today PEI is more known for its development as one of the players of the international markets. International trade: PEI and key international trading partners Prince of Edward is one of the players in the international market that has established a good international reputation, particularly with the United States. Since 1992, the bilateral relationships between the PEI and the United States have significantly improved. Consequently, the island’s export is dominated by the United States – sales volumes approached 90 per cent levels. The largest share of export of PEI goods goes to Maine and Massachusetts (Kukucha 32). In terms of import activity, the United States also plays a significant role for the Canadian province. Thus, for example, in 2005 PEI imported $8 million in fertilizers, $21 million in electric generating sets and less than $1 million in each sector, including fruits and spores, transmission shafts, seeds, liqueurs, harvesting and threshing equipment, parts of machinery The two other main import partners of PEI are France and Mexico. PEI imports grape wines from France, and Mexico imports beer; both these importers supply the Island with spirits and liqueurs (Kukucha 32). Strategies and initiatives for transforming the small island into international trade partner According to Janan and Wang (45), states with tiny populations cannot achieve economies of scale as larger states do, as it results in high costs in the private and public sectors (Armstrong & Read 570). As the production capacity of the PEI was on its limit, and there was no more land for expansion, the Island had to find some other solutions. In order to compete with North America, PEI built its strategy on quality and differentiation (Farnworth, et al. 118). The PEI has got significant support for its economic development from government. Some of the other initiatives and measures introduced or adjusted by the PEI are listed and analyzed below: Farm consolidation and agriculture development There were all favorable conditions for the agriculture industry development on the Island: good soil and plentiful rainfalls; in addition to agriculture, there was a strongly developed livestock sector in hogs, dairy, and beef (Committee on Knowledge Assessment 12). While agriculture still was the foremost industry, consolidation of the farm has enabled the Island to rationalize production and introduce usage of cutting edge-technology (Baldacchino 258). Today, PEI is known for exporting its potatoes and seed potatoes all over the world. Government subsidies The government subsidized industries and gave money for building new plants, expansion of a local software company as well as of Altantic Turbines (Committee on Knowledge Assessment 16). Thus, besides exporting frozen and fresh potatoes, live crustaceans and mollusks that are dominant in exporting, today PEI is also known for being an active exporter of turbopropellers and turbojets (Kukucha 32). Development of the fishing industry Fishery industry was grown for becoming the major resource industry on the Island, supported with the farming of aquaculture-based mussels (Baldacchino 258). Development of the tourism industry The Prince of Edward has a mythology of being an island of fishers and farmers. Despite seasonal factors, tourism and ecotourism industry is generating more than a million visitors per year and becoming one of the major contributors to the GDP of the Island (Baldacchino 258, Farnworth, et al. 118). As a result of increased tourists flow to PEI, the scales of manufacturing as well as other services sectors (accommodation, transport, etc.) also have increased respectively. Joining of PEI to New Brunswick in 1997 There is an assumption that this specific joining has positively impacted on the construction, food processing and commercial services (Baldacchino 258). Besides government efforts undertaken, the exposure to the international markets is also considered to be partially a result of activities of some PEI businesses. The case of Prince Edward Island reveals a set of initiatives undertaken by the Island authorities and one of the largest locally-based and owned manufacturing operations on PEI - The Prince Edward Island Preserve Company. The Prince Edward Island Preserve Company employs 50 persons and generates an annual revenue of US $l.2 million. In order to make economic development of the island to happen, the company has: deliberated commercial exploitation of the small-island myth, utilized tourism traffic and IT as vehicles for low inventory export, attracted and domesticated expatriate businessmen, transformed manufacturing facility into a service outlet, embedded manufacturing operation within the local environment, for human resource as well as raw material inputs (Baldacchino 258). Another initiative resulted in the economic development of the PEI was the FoodTrust initiative. Focused on promotion of high-quality foods, the FoodTrust has developed sustainable production systems as well as proper and equitable partnership relations with all actors of the value chain, from the producer and the retailer to the consumer (Farnworth, et al. 118). Thus, the mutual efforts undertaken by government, private businesses and entrepreneurs and local authorities have enabled the Prince Edward Island transform from the ordinary small island with scarce resources into a full-fledged member of the international economy. Conclusion Offshore financial centers (OFCs) simultaneously play several roles in the economic development. Besides the potential positive impact of OFCs on certain category of countries and its obvious impact on globalization, the OFCs may impose real danger on global financial stability by its opaque and complex financial transactions and corporate structures. Many OFCs are small islands that began to provide offshore financial services through international banking corporations. While economic openness of the small islands exposes them to the environment of changing global forces, they do not have enough power to set the agenda or influence on the rules of global commerce. However, even without having its “weight” on the global financial arena, some of the small islands have significantly fortified their competitive positions by supplying cheap offshore funds to the core economies. Good examples of such small islands can be taken from the Isle of Man and the Channel Islands of Guernsey and Jersey. Despite the attacks of fraud investigators in the late 1990s – early 2000s, the Islands managed to create a well-regulated financial industry and money laundering legislation by introducing special regulations and by following the international financial regulatory standards. As a result, the economies of these small islands demonstrate steady growth on both local and global scales. The cases of the Isle of Man and the Channel Islands reviewed in this paper illustrate a significant impact of its activity on the balance of the financial stability and international economy. In addition to the small islands that have succeeded in developing their banking and financial sectors, there is the category of small islands that have exceeded in small-scale, high-value service and product-niching in various fields of other economic activities, including: tourism, agriculture and hospitality. The case of Prince Edward Island (PEI) is one of the real-life examples. In order to make economic development of the island to happen, there were undertaken various important measures, including: farm consolidation and agriculture development, improvement of technological literacy and introduction of the cutting edge-technology to the industry, increased manufacturing, development of the fishing industry by farming of aquaculture-based mussels, and development of the tourism industry. Today, Prince of Edward Island is one of the players in the international market, exporting agricultural products all over the world. 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