Offshore financial centers in the global capital network

Offshore financial centers (OFCs) are controversial entities at the center of an ongoing global discussion about their usefulness and legitimacy. They engage in tax competition by offering low or no tax to international businesses who make the decision to domicile within their jurisdiction. While tax competition has proven to be very profitable for multinational corporations, countries with high tax rates tend to be shunned in the process.  

Some authors suggest that tax competition between governments is as productive as competition between firms, while others argue that it creates a free rider economy and increases inequality. 

A fascinating product of this discussion is Christensen and Kapoor’s (2004) contention that the advent of offshore finance has encouraged short-term investment at the expense of long-term direct investment. Kim and Wei (2002) point out that offshore investment funds trade more intensely than those onshore. The question of whether short-term investment is to be preferred to long term investment is beyond this article. Instead, we will look at whether this hypothesis is true – do OFCs encourage greater portfolio investment activity? If so, what could be the reason for this connection?

Theories for this relationship emerge: offshore financial centers allow greater regulatory flexibility, fewer procedural delays in executing trades, lower investment restrictions, and, most importantly, zero or low capital gains tax. The effect of these characteristics is to considerably reduce the required expected gains from trading and therefore encourage higher levels of short-term investment.

The global capital network

To empirically identify whether these factors did have an impact on short term investment, we study the space of capital flows – the global network of portfolio investment. Using the IMF’s Coordinated Portfolio Investment Survey for 2001 to 2011 that gives data for 240 nations, we build a dynamic network in order to rank the importance of a number of OFCs in diffusing investment to productive end users around the globe. We want to determine whether offshore financial centers are better than high-tax jurisdictions at ‘transshipping’ money from investors to end users.

The network identifies the size and direction of portfolio investment flows between each pair of countries. To be able to determine the importance of OFCs in transmitting portfolio investment, we need to employ two concepts from network theory. They are both variants of the idea of centrality that tells us how central each country is to the entire network. One is called random walk centrality and the other is counting betweenness centrality.

Random walk centrality measures how well integrated a country is into the global financial network. When an additional dollar of capital is added to a random country in the network, how long does it take to reach each OFC? By identifying how sensitive an OFC is to a shock in portfolio investment originating in any part of the network, we can tell how well connected the OFC is.

Counting betweenness centrality measures how much of the networks capital flows in and out of a country. This measure tells us how important the OFC is in the ‘transshipment’ or redirection of portfolio investment from one place to another – usually from the investor to productive end users. This examines the core function of the OFC: are OFCs playing an important role in the international financial network as global intermediaries?

Having applied these measures to the network of portfolio capital flows for each year from 2001 to 2011, the countries are ranked based on these measures of their centrality in the network. Long Finance’s (2013) list of the top OFCs in the world gives us a starting place in identifying OFCs for the study; another seven important OFCs are added to the list of countries under investigation. Clearly examining the measures, it was obvious that rankings would depend heavily on the magnitude and types of services each OFC performed.

OFCs as diffusing agents

Luxembourg performed exceptionally in both cases – only once falling outside of the top 5 for either measure. A population of 520,000 is actually pretty large compared to a number of the other OFCs on this list, yet miniscule in comparison to many of the developed countries it engages with. Ranking second in the world for assets under management in mutual funds and the number one wealth management center in the Eurozone, Luxembourg is very topologically important for the diffusion of capital to and from a vast range of countries.

These measures both take into account the inflow and outflow of capital, meaning that if there were a significant imbalance, it would not perform well by either of these standards. Hampton (1996) and Murphy (2009) define a secrecy jurisdiction as one designed to strangle the flow of capital by providing cover for money while it remains hidden from the world. These two definitions are at odds with one another – a country performing well by these measures of network centrality cannot be strangling the flow of capital.

It would be harsh then to define a country such as Bermuda as a secrecy jurisdiction – it maintains a top 20 ranking for both measures. Possessing the world’s largest fully offshore electronic securities market, Bermuda is very well integrated into the global capital network. Singapore has a reputation as a shipping center, transshipping a fifth of the world’s shipping containers. It carries a similar reputation for portfolio investment, maintaining a top 20 ranking in all periods as the fourth largest offshore banking center and home to one of the world’s fastest growing financial markets.

What do the results say?

In fact, all 17 OFCs fall within the top 35 percent for counting betweenness centrality – the measure that tells us how much of the world’s portfolio investment passes through these centers. Clearly the reduced frictions of investing through an OFC makes them an excellent choice for routing short term investment. However, there is far greater variability for random walk centrality – suggesting that not all of the OFCs we are considering are well integrated into the capital network. The British Virgin Islands, Monaco and the Netherland Antilles have particularly unstable rankings over the time period. The first two of those have significantly higher rankings for counting betweenness.

What does this suggest? Many OFCs are intermediaries for a very narrow range of countries and offer very limited financial services. Even though their services are heavily employed and likely highly trafficked, they do not appeal to a broad market base. They are specialized OFCs.

It is very noticeable in the results that only four OFCs have improved their rankings for counting betweenness centrality, while 10 have fallen in the random walk centrality. From 2001 to 2011, OFCs have generally seen their influence on the global capital markets reduced as a result of reputational and regulatory damage. However, falling importance of the most efficient pivots in the capital network will simply serve to increase the drag on international capital flows.

The final word

It is clear then that OFCs are important for increasing the flow of portfolio investment from investors to productive end users by being efficient, flexible and reducing the cost of investing. Shrinking the required rate of return on an investment allows investors to move money to capital-deficient regions in the world where investment would not normally flow. Some point out the possible pitfalls of short term investment – sudden stops, capital flight, low returns to sustainable growth – but if portfolio flows are generated where there would reasonably be no long term ‘direct investment,’ short term investment has a great role to play in developing the global economy.

OFCs are able to transmit portfolio investment more efficiently than 65% of the countries in the world. If they are able to remove the remaining implicit risk of doing business in an OFC by seeking greater legitimacy and information sharing, this would contribute to their reputation as efficient capital pivots. It would also further reduce the required returns on investment, allowing even greater investment into emerging and developing economies that carry higher country premiums but are in great need of capital flows. Targeting a broader market will increase influence and profitability of OFCs, while allowing more investors to access the benefits they provide.

This shows that offshore financial centers play an integral role in the international movement of capital by providing reductions in friction. These centers have the potential to stimulate further growth in international portfolio investment by lowering the costs of investing – policy makers may recognize that this combination of cost elimination and increased investment is the globally optimal choice.

 

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Simon Naitram

Simon Naitram is a Research Associate at Pencarrek Limited, Investment Advisors. He is a former Research Officer at the Central Bank of Barbados in the Economic Policy Unit. He received his MSc with distinction in Financial and Business Economics from the University of the West Indies, Cave Hill campus. He has co-authored “Nowcasting Tourist Arrivals to Barbados – Just Google It!” focusing on machine learning methodologies for incorporating Google Trends data into forecasting. He is currently working on modeling uncertainty through ensemble probability forecasting and pursuing his CFA qualification. He has a strong research interest in international financial economics.

Simon Naitram
Research Associate
Pencarrek Limited

e: simon.naitram@gmail.com