The Cayman Islands has long thrived as a place to conduct international business. A reputation for tax efficiency and strong professional services has seen the country develop into one of the world’s largest banking centers, with a full complement of top financial institutions, law firms and accounting firms. Financial services generated US$1.4 billion in 2007, or 55% of national GDP.
But cracks are now appearing in Cayman’s domestic economy after spending on personnel and ambitious infrastructure projects far outstripped public income. Should the country fail to address these problems, its status as a leading offshore financial center (OFC) – and, crucially, a stable one – could come under threat. In March, the Miller Report – the result of an independent commission set up to analyze Cayman’s fiscal sustainability – revealed that the British overseas territory’s economy is in an imbalanced mess, amassing total government debt that increased by 129% from US$300 million to US$$689 million between 2004 to 2009.
“This rate of expansion cannot continue in the long run without causing irreversible damage to the private sector and making Cayman’s economy uncompetitive,” the Miller Report stated. “It would change Cayman’s reputation from a ‘place to do business’ to a ‘place to avoid.’”
While Cayman’s dire economic situation begs the question of how its financial sector and the confidence of offshore clients will be affected, it’s not the only OFC facing fiscal problems. How to assure economic sustainability – and maintain an environment ripe for international business – is an issue that many OFCs now have to look at seriously.
Running on empty
Last year Michael Foot, chairman of the UK office of Promontory Financial Group, also completed an independent review of British offshore financial centers that was commissioned by the UK government.
In his report, released in October 2009, Foot argues that the nine jurisdictions under review – including Guernsey, Isle of Man, Jersey, Anguilla, Bermuda, British Virgin Islands (BVI), Cayman, Gibraltar, Turks and Caicos Islands – cannot be complacent when it comes to controlling public expenditure and increasing revenue, especially at a time when OFCs’ operations are being increasingly scrutinized.
The global economic downturn tested the resilience of most centers but the negative impact on public revenues was most prominent in jurisdictions that rely heavily on tourism and construction (which is closely related to tourism), particularly Anguilla, the Turks and Caicos Islands, and Cayman.
In 2009 Anguilla’s recurrent revenue collections sank 30% year-on-year to US$54 million. The figures were not only lower than its 2008 revenues, but also Anguilla’s 2006 and 2007 collections. In other words, Anguilla’s public revenues have been set back nearly five years. Meanwhile, the Turks and Caicos’ government reserves were exhausted and unpaid creditors were owed at least US$50 million as of June 2009.
“In any event the global downturn has provided a sharp reminder of the need for some of the jurisdictions to take urgent measures to ensure that robust economic planning and fiscal control measures are in place and observed,” Foot’s report said.
As for Cayman, the root of its financial woes is not so far removed from the bad expenditure habits that have infected many governments in the world to date. Nominal GDP grew at an average annual rate of 2.2% over the last four years with operating revenues rising 5%; yet total operating expenses increased at an average annual rate of 9%.
The authors of the Miller Report – Jim Miller, former chairman of the US Federal Trade Commission, along with former UK politician David Shaw and Cayman Financial Secretary Kenneth Jefferson – argued that the major problem was money spent on government personnel.
“When the economy was doing well, [the Cayman Islands government] made plans for expansionist spending programs,” Miller told Offshore Quarterly. “And then when the economy went sour, they found themselves in a bind. Revenues may have been kept fairly strong, but it’s the spending pattern that’s gotten out of hand.”
Even if the financial crisis had not occurred, Cayman’s fiscal problems still would have been revealed, Miller said.
“If you look at the figures, spending on personnel in the last four or five years is what jumps out at you most. Increases in pay and benefits went up quite dramatically and it’s not justified when you compare it against Cayman’s competitors.”
The Miller Report showed that Cayman government employment compensation consumed almost 50% of the total government budget, ranking among the highest in the world. By comparison, the UK’s civil service expenditure accounts for about 25% of its budget.
Still, Miller emphasizes that all is not lost for turning struggling OFCs around: There are serious problems with fiscal planning but these can be fixed and long-term financial sustainability can be achieved.
In addition to cutting civil service employee costs and bringing spending under control, Miller would like to see Cayman bolster economic activity through a number of initiatives such as extending its airport runway and building a cruise ship berth.
Foot’s review recommended jurisdictions align their financial planning with that of the Crown Dependencies – Jersey, Isle of Man, and Guernsey – which were the best performers out of the nine OFCs under analysis. A firmer footing in controlling public finances could be helped by a diversified tax base, mechanisms to control public spending, and building up financial reserves during periods of economic growth.
And although heavy reliance on particular sectors has left some OFCs vulnerable to external shocks, Foot does not see diversifying their economies as a practical solution, at least for those in the Caribbean.
“These jurisdictions, with their low lying islands and sea, are ideal for tourism. It’s quite impossible to suggest that they become manufacturing or distribution bases. These are just tiny lumps of rock – your choices are not great,” Foot told Offshore Quarterly.
What Foot really hones in on are matters of taxation. His main recommendation is that OFCs ensure they maintain international standards on tax information exchange, financial regulation, anti-money laundering and financing of terrorism as ways to prevent their wealth from drying up even further.
Jurisdictions that are not under immediate fiscal pressure should also look at whether their current tax regimes expose them to international pressure – which the report warns may have a material impact on their economic sustainability and potentially reduce their “tax take.”
“Most of these jurisdictions have their heart in the right place, but some fall short in the execution and they need to make much deeper inquiries into how they can continue to meet international obligations,” Foot said.
Those in Cayman’s offshore industry, however, don’t think the OFC’s fiscal problems are detrimental to its financial services sector. Richard Thorp, partner at Thorp Alberga, an offshore service provider with offices in Cayman, BVI and Hong Kong, says that business has remained robust.
“I don’t think it’s the end of the world for the Cayman Islands. People have referred to the Miller Report but they’ve also carried on setting up businesses [in Cayman],” Thorp said. “It’s been maintained as a business-friendly jurisdiction with business-friendly legislation, and this will not radically change.”
Thorp is also optimistic about the jurisdiction’s future now that Cayman is being led by the opposition United Democratic Party, which defeated the People’s Progressive Movement in the May 2009 election. The new leadership has “a different approach and good ideas about how to attack the deficit”, he said.
Much can still be done in Cayman, said Anthony Travers, chairman of Cayman Finance, to prevent a “race to the bottom” with more competitive jurisdictions.
Last year the government hiked up financial services fees in hopes of balancing its budget, but Travers believes that unless there is an improvement in the range of services provided the increase could undermine the offshore industry. Compounded by effects of the global downturn, last year company incorporations dipped 38% from 2008 – largely a result of deleveraging in the UK and US financial markets – while total hedge funds were down 4% from its peak numbers of 2008.
The way to ensure the OFC’s sustainability is providing higher value-added services that generate higher fees, Travers said.
“For each transaction you need a broader range of services. You need to do more: investment management, broker-dealer activities, expand the fund administration industry.”
Jennifer Thomson, a Cayman-based partner with Walkers Global, supports the strategy of pursuing higher-value business. Achieving this goal, she argues, requires improvements in products, services and legislation, as well as reform of the country’s immigration policies to attract more high quality financial services professionals.
“Cayman became a leading international financial centre by providing a well-regulated, tax neutral corporate environment which is flexible and conducive to business and serviced by high quality, responsive service providers,” Thomson said.
“Having said that, we cannot afford to rest on our laurels as other international financial centers will always be looking to win our business and we must remain competitive.”
The BVI, for one, has continued to capitalize on its image of popularity. Although the country saw a 20% year-on-year decline in international business company (IBC) incorporations during the first quarter of 2009 and struggles in its tourism industry, the drop-offs were less severe than in Anguilla, Cayman or the Turks and Caicos.
Simon Owen, director of the Folio Group, a financial services provider based in BVI, believes the country has retained its edge because it has managed to move with the times and maintain a large volume of business.
“Diversity has been a key factor of our continued success and the BVI has worked extremely hard to offer clients the ability to form a range of structures including investment funds, special purpose vehicles, trusts and captive insurance companies,” he said.
“There’s been lots of competition over the last 10 to 15 years but BVI has come through unscathed…We’re still seen as a premier destination for company corporations.”
And in the offshore industry, image counts for a lot.