Capital Mobility

Read the article in the Cayman Financial Review Magazine 

After several millennia of no change in the standard of living, economic well-being began to rise with the industrial revolution, which began around 1760 until around 1830. A second burst of growth, from around 1860 until the start of World War I, is associated with the globalisation of trade and investment during that period.  

After a long period of retreat into highly protected national economies and two world wars, the latest wave of globalisation after WW II, which really took off around 1990, reduced the number of people living on less that $1 per day by half over the last twenty years.1

The standard of living rises when each worker is able to produce more. The sources of increased worker productivity are many and complex but broadly speaking, these gains come from better tools (technology, and investment in capital), better skills (human capital, ie education and training), and better allocation of the resources devoted to the creation of human and physical capital (efficient markets and institutions for protecting property and allocating resources, honest and efficient institutions and governance, sound money etc).

An explosion of prosperity around the world has followed the increasing liberalisation (globalisation) of trade and investment.

The value of trade (goods and services) as a percentage of world GDP increased from 42.1 per cent in 1980 to 62.1 per cent in 2007.

Foreign direct investment increased from 6.5 per cent of world GDP in 1980 to 31.8 per cent in 2006.

The stock of international claims (primarily bank loans), as a percentage of world GDP, increased from roughly 10 per cent in 1980 to 48 per cent in 2006. 2

“Global capital flows fluctuated between 2 and 6 per cent of world GDP during the period 1980-95, but since then they have risen to 14.8 per cent of GDP, and in 2006 they totalled $7.2 trillion, more than tripling since 1995.”3

This is not just a matter of increasing the wealth of the already wealthy. As Ernesto Zedillo, the former president of Mexico, observed, “In every case where a poor nation has significantly overcome its poverty, this has been achieved while engaging in production for export markets and opening itself to the influx of foreign goods, investment, and technology.”4

Increasing amounts of investment alone, however, are not enough. If investment is not made in the most productive and valued uses, income will not increase as much as it might have. Every man, woman and child in the world has an interest in seeing capital applied to its most productive uses. While governments are essential for establishing the common infrastructure of markets and commerce and to enforce contracts and protect property, only free markets have been efficient at encouraging the best uses of our scarce resources and of filtering out failed experiments.

Opening markets across borders – globalisation – has had benefits beyond the obvious ones of improving the allocation of resources, including investment, and thus directly lifting living standards. A study by International Monetary Fund staff finds evidence that “in addition to the traditional channels (eg capital accumulation), the growth and stability benefits of financial globalisation are also realised through a broad set of “collateral benefits…. Financial globalisation appears to have the potential to play a catalytic role in generating an array of collateral benefits that may help boost long-run growth”.5

The traditional channels by which capital mobility increases growth are the more efficient allocation of capital, capital deepening, and broader risk diversification and sharing. Its collateral benefits include the promotion of financial market development, development of stronger and more effective market institutions, better governance and macroeconomic discipline. All of these are things that improve well-being across the board.

The post-WW II wave of capital mobility reflects significant reductions in tariffs and non-tariff restrictions on trade, falling transportation costs and the dramatic and wide spread reduction in exchange controls, restrictions on the exchange of a country’s currency for other currencies for trade and current account transactions, as required by membership in the IMF. The liberalisation of capital controls, restrictions on investments abroad or from abroad, has been extensive as well, but is not a requirement of IMF membership. The IMF encourages the liberalisation of the “capital account”, but in a measured way as a country’s financial sector development and macroeconomic stability enable it more safely to absorb the potential shocks of capital flows, which can be volatile.

While direct controls on capital mobility have steadily fallen, the tax policies of many developed countries, especially the US, have often reduced the attractiveness and thus the extent of globalisation. While each country establishes and enforces its own approach to taxing the income its residents receive from their activities, including their investments abroad, business taxes on activities taking place in many different jurisdictions have become numbingly complex.

People and firms may choose where to live and operate wherever they like. Personal and business income taxes that are significantly higher than in other jurisdictions can drive individuals and businesses away, though this is only one among many factors influencing where people live and businesses operate – cultural and legal environment, climate, security, other costs of doing business etc. Increased globalisation has made many governments sensitive to their tax burdens relative to those of their neighbours.

The newly independent Baltic countries started the modern flat tax movement in 1994-5 dropping their corporate tax rates to zero, 15 per cent and 15 per cent for Estonia, Latvia and Lithuania respectively. These are now the fastest growing countries in Europe. In the 2000s nine, largely new European countries, drop their corporate rate to 10 per cent and two dropped their rates to 9 per cent and 5 per cent. The same sensitivity to tax rates applies to the financial services industry, which facilitates capital mobility directly.

A large industry has developed to help investors seek out and finance the most profitable investments globally and to attract and manage the funds needed. The many components of that industry can and are located in many different jurisdictions. The front offices of hedge funds (the brains – investment managers), for example, are predominantly in London or New York City and its suburbs, but their company headquarters are predominantly in International Financial Centres (IFCs) such as Cayman.

The legal and judicial environment of many IFCs are often superior to those of many underdeveloped countries, providing a safer and more attractive venue for individuals and firms in these countries to invest, often back in their own countries. Their regulatory systems are often lower cost and qualitatively more suited to large-scale financial transactions than those of larger jurisdictions, whose consumer protection regulations can drive up costs even for those selling financial products to institutional investors rather than to widows and orphans. This can increase the accumulation of financial wealth and the rate of growth in these countries.

Cayman and other off shore financial centres contribute to the more efficient allocation of capital around the world, by providing tax neutral jurisdictions through which capital can more freely and efficiently flow. This contributes to the expansion of the efficient flow of capital globally, thus to higher incomes around the world, and thus to higher income tax revenue to the countries in which the investors reside. 

“No doubt there are many factors that explain why China since 1978 (and India since 1991) has managed to lift hundreds of millions of people out of poverty. But a key factor that has previously been ignored is the relative openness of developing economies to IFC-mediated flows of capital from both domestic and foreign investors.”6

Endnote: 

  1. IMF staff, “Globalization: A Brief Overview”, International Monetary Fund Issues Brief, May 2008, page 1.
  2. Ibid page 2.
  3. Ibid page 4.
  4. Ernesto Zedillo, World Economic Forum, Davos, Switzerland, January 28, 2000.
  5. M.  Ayhan Kose, Eswar Prasad, Kenneth Rogoff, and Shang-Jin Wei, “Financial Globalization: A Reappraisal” IMF Working Paper, WP/06/189, August 2006.
  6. Andrew Hickley, Global Financial Strategy, 13 July 2010

 

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