Globalization and nationalism: Good and/or bad?

Globalization is under attack and nationalism is on the rise.  The evidence includes the election of Donald Trump. But what is this globalization these people are so opposed to?

After 1945 – following the Great Depression and two world wars – Western nations established an international system of rules that honored national sovereignty, facilitated the flourishing of global commerce, and encouraged respect for human rights and liberties. This liberal international order resulted in the longest period of peace among the world’s major powers the world had ever seen, broad-based economic growth that created large middle classes in the West, the revival of Europe, growth in poor countries that lifted hundreds of millions of people out of poverty, and the spread of freedom across the globe.  This is the liberal international order that I largely support.

What exactly is under attack and what is on the rise?  In a very insightful article in the National Review, Michael Lind characterizes the globalist view as follows: “In the 1970s and 1980s, libertarians made all of the major arguments heard from globalists since the 1990s: Favoring citizens over foreign nationals is the equivalent of racism; national borders impeding the free flow of labor and goods are both immoral and inefficient; the goal of trade and immigration policy should not be the relative security or relative wealth of particular countries, but the absolute economic well-being of all human beings.”

What about the rise of nationalism in relation to globalism? I believe strongly in the economic benefits of the freest possible global trade, but it would be a mistake to overlook or ignore the concerns of those who oppose it.  In this note, I attempt to restate the case for freer trade in terms that should appeal to economic nationalists who wish American trade (and other) policies to reflect the interests of Americans first (before taking into account the benefits to the rest of the world). I also reflect on the international rules of trade from the perspective of the sovereignty concerns of nationalists, or what economist Larry Summers calls “responsible nationalism.” Voters deserve responsible nationalism not reflex globalism.

I was forced to think more carefully about the case for freer trade by the opposition to globalization expressed by many of Trump’s supporters. But I quickly discovered that my friend Michael Lind has been there before (see above) as has the brilliant social psychologist Jonathan Haidt, who noted that “Those who dismiss anti-immigrant sentiment as mere racism have missed several important aspects of moral psychology related to the general human need to live in a stable and coherent moral order.”

Haidt’s closing words succinctly summarize our challenge: “The great question for Western nations after 2016 may be this: How do we reap the gains of global cooperation in trade, culture, education, human rights and environmental protection while respecting – rather than diluting or crushing – the world’s many local, national, and other “parochial” identities, each with its own traditions and moral order?  In what kind of world can globalists and nationalists live together in peace?”

Immigration and trade are intimately linked – if Mexicans can make it in Mexico and export it to the U.S. they will be less interested in moving to the U.S. in order to build it there (in fact, net Mexican migration to the U.S. has been negative for the last few years) – and thus I will look at both.

The most promising starting point in my view is with the sovereignty of each American citizen.  Unlike the Magna Carta, which wrested more autonomy for the people from the king, the free men and women of revolutionary America gave up a limited amount of their autonomy to a new state in order to better protect their property and individual rights. The direction of delegation was the exact opposite of what the world had ever seen before. It is not without profound significance that our Constitution begins with “We the people.”

Thus, it is quite appropriate to judge governmental authority and policies by the standard of how well they serve our individual sovereign interests.  In evaluating those interests, it is appropriate to do so from the perspective of John Rawls’ veil of ignorance, i.e. principles of fairness – rules of the game – that we accept as fair without knowing which positions in society we will occupy.  This is the perspective of free market, competitive capitalists and is opposite to the perspective of crony capitalists who exploit the power of government for their personal benefit.

We have surrendered limited (enumerated) powers to our governments (local, state, federal, etc.) in order to enjoy greater security and protection of our property, but also to support and protect our freedom to trade and to enjoy its benefits.  No one really needs to be convinced that being able to specialize in what we make best and trade it for other things we need has enormously increased our wealth over being self-sufficient (no trade).  No one needs to be convinced that by investing in tools and better technologies we have been able to produce more for trade and thus become wealthier. But investing and trading require common understandings with those with whom we trade – the rules of trade.  We have long ago understood that we all benefit from giving up some of our sovereignty to our government to negotiate and enforce the agreed rules of trade, protect our property and mediate disputes over whether the rules were followed.

The simple act of entering into a contract with someone involves giving up the freedom to act as we want each moment in exchange for a similar commitment by our counterparty for the mutual benefit of both of us.  Where the mutual benefits of such rules are greater than the cost of the forgone freedom of action, the agreement is a positive sum arrangement – win-win.  Conforming to international product standards, e.g. adhering to standards of weights, measures, voltage, labeling, etc., facilitates trade.  The key policy issues in this area are the nature and details of the rules of trade that best serve our personal interests (in the Rawlsian sense) and thus our community and national interests, and the extent of the market in which we are able to trade (village, province, nation, world).

The more widely we can trade, the greater is our opportunity to specialize in what we produce and to develop and apply more productive technologies.

Our founding fathers were rightly concerned about the power of the new American government to limit the right of its citizens to trade.  In fact, the U.S. Constitution prohibited the states from interfering with trade across state borders (interstate commerce). Article I, Section 8 Clause of the Constitution states that the United States Congress shall have the power “to regulate commerce with foreign nations, and among the several States, and with the Indian Tribes.” While Congress has occasionally used this power to impose restrictions on trade across national borders, the majority of Americans (65 percent in 2015) still believe that cross-border (international) trade has been mostly good for the U.S. The wrong-headed effort to save American jobs during the Great Depression with high tariffs imposed by the Smoot Hawley Tariff Act of 1930 precipitated retaliatory tariffs around the world and a disastrous collapse of global trade and employment. U.S. imports and exports fell by more than half and the whole world was made poorer by it.

As noted above, the resulting increase in the world’s wealth from technical progress and trade has been enormous.  But the incentive created by trade in a large market to innovate new products and more efficient ways to produce them has also meant that some of the existing products and/or technologies lose out and must give way to the improved ones.  Those producing the old products and services are forced to find new ones and if necessary, new productive skills.

The United States has generally grown economically faster than most other countries, in part because its citizens have not been willing to allow those who lose out in such competition to block progress by the “winners” by protecting their products and jobs.  The ultimate willingness of Americans to accept and protect the dynamic economics of competitive national and global markets rests, I think, on the three pillars: maximum wealth creation, maximum opportunity for everyone (the chance to win at a fair game), and help for those who lose out.

Americans should only be willing to give up some of their personal sovereignty to their government when they gain more in exchange in the Rawlsian sense of a positive sum, fair game. We should impose the same conditions on the extension of the rules of trade beyond national boundaries.  This is the standard by which bilateral, regional and global trade agreements should be judged. They have the largest potential for win-win expansions of mutual trade and the greater income and wealth that expanded trade can produce.  The Bretton Woods institutions created after World War II (the IMF, World Bank and World Trade Organization) established the institutional arrangements for such international cooperation.  It is important to ensure that such agreements do not increase the protection of “privileged” industries or sectors of the economy.  In fact, they should diminish such protections where they already exist, which is why many European industries and interests oppose the Transatlantic Trade and Investment Partnership (TTIP).  Much of the Trans Pacific Partnership (TPP) has this positive character.  American leadership in creating the international institutions through which we interact with others abroad, i.e., through which the rule of law is established and enforced internationally, has ensured that the international order has remained true to the values on which America was founded.

The evolution of man established the family as the unit of first and primary concern.  The well being of one’s family stands above the interests of all others.  However, the process of civilization has been one in which mechanisms of trust and mutual assistance have convinced individuals to yield some of their sovereignty to larger units (village, state, etc.) under conditions that strengthened the security and well being of family units.  Globalization is the logical conclusion of such a process. It is the development of laws of cooperation and the mechanisms of their enforcement (i.e. the rule of law) that potentially raise the welfare of everyone. But the details of the expanding circles of cooperation are important and must not violate genuine national and family interests.

In listening to the views of many Trump supporters, I concluded that their anger and demand for big change derives from feelings that their government – especially the federal government – is not serving their legitimate interests and in fact is interfering with their lives without commensurate benefits.  “The reason Mr. Trump won,” Steve Bannon says, “is not all that complicated.  The data was overwhelming: This is a change election.  People weren’t happy with the direction of the country. So all you had to do was to give people permission to vote for Donald Trump as an agent of change, and make sure he articulated that message.’”

So what are the Trump supporters mad about? What do they want to change?  To the extent that they are concerned about the same things I am, it is that too much of our individual sovereignty has been taken by an overweening government, which has become a big brother who attempts to make our decisions for us for our own welfare. Our personal choices have increasingly been taken away from us and with them our opportunities.  The “elites” have arranged the rules for their own benefit.  It is no longer a fair game.

The weaknesses of current arrangements at the national level that seem to anger Trump supporters largely concern: a) regulatory capture of an over-extended regulatory state, b) inadequate provision of a level playing field and c) an inefficient and poorly designed safety net for the losers in the competitive game.  Very briefly:

a)     The crony capitalism reflected in President Eisenhower’s famous concerns with the risks of a military-industrial complex have metastasized into a much broader capture by legacy industries of a much more extensive government intrusion into the economy. Wherever government regulates (and some are actually helpful), the most affected, established firms are best placed to ensure that such regulations benefit rather than hurt them, usually by protecting themselves from the competition of newcomers.  Wall Street comes to mind.

b)     A level playing field. Good quality education (especially K-12) is one of the most important ways for the poor and initially disadvantaged to get into the productive economy and to rise as far as their talents and energy will take them. But the education provided to this group is often of poor quality.  The iron grip of teachers’ unions has often served the interests of teachers at the expense of their students.  School choice (tuition vouchers) would introduce badly needed competition in the provision of education to all – the poor as well as the rich (who already enjoy considerable choice).

c)     An efficient safety net. When jobs disappear to technological advancements (e.g., increased automation), the affected workers and capital need to be reallocated to more productive uses. But this is economist speak. The workers involved often lose their human capital (i.e., their existing skills lose value in the market place) and need to retrain for new tasks. Older workers might never rebuild new skills sufficient to restore their previous incomes. Government policy should give more attention to vocational training (and retraining).  But the ultimate safety net should be strengthened and redesigned by replacing existing welfare programs and social security with a guaranteed minimum income for each and every citizen (in the spirit of Milton Friedman’s negative income tax). US federal tax policy, Cayman Financial Review, July 2009.


Responsible nationalism and globalization

As Michael Lind observed earlier, America has been dividing into liberal internationalists like myself who live in the big urban centers, and civic nationalists, who live in the rest of the country. The civic, economic, responsible and just plain old nationalists seem to be reacting against their sense of a loss of control over their own lives. Big brother seems to be regulating more and more what we can do, say, produce or buy. Their opportunities are being thwarted by an unfair game – crony capitalism for the well-placed elites.  This sense of a loss of control is compounded by concerns over the lack of control of our borders against undesirable immigrants and potential terrorists. While the assimilation of different cultures into the framework of basic American values of personal freedom and responsibility can be touchy and challenging at times, the finger pointing and pressure from the American left for full cultural integration feeds the fears of many of a loss of cultural, ethnic and religious identity.

When some groups receive preferential treatment, some other groups are necessarily discriminated against.  While I have tried hard to accept the logic of “Black Lives Matter,” it always rubbed my sense of fair play the wrong way.  All lives matter.  Thus while I am saddened that it seems necessary to some white males (I am guessing they are males because that is what the press always says) to carry signs saying “White Lives Matter,” I can understand.  If we need to say the one, we need to say the other if we still have any sense of fairness.

So there are plenty of things for Trump supporters to be angry about and to want to change.  But now that we have him, what changes should we push for?  I am particularly interested in changes that will reassure Trump’s angry voters to support American participation in the liberal global order. In evaluating what is in our national interest, we need to consider the long term rather than immediate benefits of a rule-based, freely competitive world order.

We should push for a thorough reform of our tax system, strengthen our safety net for those displaced by technology (by far the major source of job losses in the U.S.) and trade, and shift more of the regulation of commerce to the market (to consumers and owners), thus significantly reducing government regulation. We must also fashion an immigration policy that meets the needs of our economy without overwhelming the capacity of our society to absorb new members. Existing long-term, undocumented residents need to be offered a realistic path to legal status. But most of all, in fashioning these and other changes, we need to listen carefully and constructively to each other’s concerns and take them into account.

Trade and shipping: The world is not flat anymore

It was a decade ago when a celebrated book claimed that now we lived in a world that was flat: technology in a post-Berlin-Wall-world had created a level field where information was to flow easily and people could collaborate worldwide, thus stretching the reach of the supply chain. In this inter-connected world where information and labor and technology could effortlessly come together, there could be few drawbacks and many winners. Without explicitly stating it in the book’s conclusions, trade was tapped as one of the primary beneficiaries of a flat world.

And, boy, did the world trade grow in the last decade! According to the World Trade Organization, worldwide trade of goods was propelled by more than 60 percent to more than US$19 trillion in nominal value by the end of 2014. It was a great time, indeed. And the shipping industry had a fantastic time for most of that same period when freight rates and vessel prices were at a multiple of historic averages.

While capesize vessels for the transport of coal and iron ore historically were earning $20,000 per day and costing $30 million to build in 2008, their freight rates has increased ten-fold to close to $200,000 per day and their value was standing at more than $180,000 million, an eight-fold increase. Shipowners responded by ordering more vessels and the world’s dry bulk fleet more than doubled in the same period.

Contrast this with the present. Anyone who follows the shipping industry knows that 2016 has been one of the worst years in recent memory for the industry. Earlier in the year, approximately 30 percent of the world’s fleet was idling and freight rates were at the lowest point of the last 30 years. This has been true for dry bulk vessels, containership vessels, drill ships and offshore supply vessels, and, to a smaller extent, for tanker vessels. The last couple of years have been brutal for shipping with many shipping banks and shipowners experiencing varying degrees of distress.

The current problems in the shipping industry are partially self-inflicted: quite frankly, there seemed to be an oversupply of vessels. Credit was cheap and easy a few years ago by both shipping banks and shipbuilders, and given the prevailing optimism of a rosy market, it was too tempting to place more newbuilding orders than required for a balanced market. The fact that there is typically a time lapse of at least two years between ordering a vessel and seeing her delivered from the shipbuilder only ensured that when signs of an oversupplied market appeared, it was too late to turn the spigot on the spot. Thus, tonnage oversupply (too many vessels) should be getting a great deal of the blame of the weak shipping markets.

On the demand side for shipping, the availability of cargoes to be traded, the picture has not been as enticing as in the immediate past and not nearly as strong as during the boom years of the cycle. According to data by the WTO, trade in goods dropped by 12 percent between 2014 and 2015, the latest years were complete data is available. Likewise, in 2016, based on monthly data so far, growth seems positive, but minimal. Specifically, demand for marine (seaways) transport is expected to have scored minimal growth (a couple of percentage points) in 2015 and 2016. In short, there is no doubt that demand for ships has been slowing down in the couple of years, and worse, demand for vessels is overwhelmed by supply of vessels (deliveries from the shipbuilders).

The supply aspect of the equation is rather well understood: cheap money, excessive optimism and good old-fashioned greed caused the market to be oversupplied. It has happened before in shipping and in many other industries throughout recorded history of human commercial activity. So far, so bad.

However, deciphering the collapse of demand seems to be much more esoteric and complicated, nevertheless much more crucial in order to create an opinion about the prospects of a market recovery for the industry. By just browsing the international business headlines in the last few years, one can sense several factors for declining trade:

a)    China, the definite driver of growth in the past decade, has seen its economy slowing from about 16 percent to a state-estimated 6 percent. For an economy in excess of US$ 11 trillion, each percentage point decline represents US$ 110 billion in foregone output.

b)    The EU and the overall European continent seems to be besieged with political and sovereign concerns in the last years with only Germany and the U.K. resembling barely growing economies.

c)    In the U.S., rather anemic GDP growth rates of 2 to 3 percent will do little to support world trade.

d)    In Japan, despite the aspirations of the Bank of Japan and the Abe administration, it seems that another “lost decade” is about to be added to the once formidable “Japan Inc.”

In short, the growth picture seems rather bleak when one focuses on the OECD countries, which comprise almost half of the world’s economy; in other words, half of the world’s economies are either stagnant or underperforming, leaving smaller economies of emerging markets to pull the growth wagon forward.

As a rule of thumb, world trade grows over long periods of (normalized) time at double the rate of world GDP growth. Intuitively, this make sense as in the course of normal economic activity countries typically import a great deal of raw materials and commodities to be processed and then exported as semi-finished or end products. The above graph, drawn from GTO and World Bank data, more or less confirms the rule. However, one has to notice that, in the last couple of years, there have been overlapping concerns on whether this is a “seasonal” effect or a structural change in the market. If the former, it would be a matter of time before trade growth reaches normal levels; if the latter, then one should be expecting more headwinds for the shipping industry.

To complicate the analysis further, one has to notice that our flat world has been showing some ghastly signs of ripples lately. In 2016, in the U.K., voters opted for a Brexit from the EU, and while the details of any agreement of said departure have yet to be negotiated, one has to assume that going forward it will be more than just the English Channel separating the U.K. from the continent. In continental Europe, meanwhile, there seems to be a trend towards “nationalization” by several member countries of the EU, challenging the promise of the free movement of goods and people across borders both within the EU and through treaties (TIPP with Canada, for example) with countries outside the EU.

Across the Atlantic, U.S. voters surprised the experts late this year and voted Donald Trump into office on a clear anti-globalization and re-shoring agenda where trade agreements, whether existing (NAFTA) or to be ratified (TIPP), could be expected to be treated with skepticism.

There is a clear trend in the western world against trade and the movement of people across borders. Countries in Asia still seem more inclined to have regional trade agreements (ASEAN and RCEP), which, however, seem to be de-coupled from the western world.

Shipping, and the transport industries in general, are considered leading indicators of economic activity; intuitively again, first raw materials and cargoes are shipped before they show up in indices counting economic activity. In the last couple of years, shipping has held little promise for the future, if its forecasting prowess is to be depended upon. There is certain “noise” in that shipping as a leading indicator is weak due to problems with excessive vessel supply, but again, there are just too many clouds around the industry that seem to darken a bright future. From slowing demand to an anti-globalization wave, the headwinds are hard to ignore.

Basil M Karatzas is Founder and CEO of Karatzas Marine Advisors in New York, a shipping finance advisory and shipbrokerage firm. For more information, see

The impact of the Panama Papers

In contrast to the coverage of the Panama Papers, professionals in many offshore financial centers might argue that there are significant differences between offshore centers. They would say we are not Mossack Fonseca and we are not Panama. What is your view?

Bastian Obermayer
Bastian Obermayer

You really have to differentiate. If you look at the Panama Papers, you see this is a law firm in Panama that very clearly ignored a lot of laws. That is what the Panama Papers is mostly about, how their clients used this lack of regulation in Panama and within Mossack Fonseca.

The offshore system as a whole is seen by many as a problem because its anonymity is a good basis for a lot of dubious activity. Many think that you could really harm people who engage in money laundering, drug trafficking and terrorism financing by having registers of beneficial owners. Once this happens, the whole offshore problem is reduced to the question of tax.

When we talk about the Panama Papers, people are sometimes not so concerned with tax evasion, but we are saying it is not only about taxes. There are so many other real crimes and this is what we care about. The taxes – there will be a solution: The automatic exchange of tax information will come.

But the real question – because it has not been solved yet – is what are we going to do with all these anonymous companies?

But many of the anonymous companies will also be caught under the automatic tax information exchange. There is also a push for a register of beneficial ownership and the exchange of that information with law enforcement and tax authorities. All that is likely to come at some point, is it not?

Yes, but the likelihood is always depending on the political will. We know with our politicians in Germany that as soon as the pressure abates, the political will disappears.

It is important that not only authorities have access to the information on beneficial owners. We think it is important for the public to know, because founding a company is a public act. In many countries, you will get tradeoffs in taxes and other benefits from the government for doing business. We think, therefore, at the same time the people living in the country should be able to look up who the beneficial owner of a company is. Once you have this in place, there will be fewer opportunities to use anonymous companies for illicit reasons.

What we do see now is when governments ask about the identity of beneficial owners, in many countries they will get a response but it takes time. And often, once a year has passed, the company in question is already dissolved and the owners have moved elsewhere. We need to start making this information transparent when the companies are set up.

Another point that people in offshore centers would make is that the Panama Papers coverage at times gives the impression there are no legitimate uses for offshore entities at all, when in fact the opposite is true. If you looked at a company register in the U.K. and you examined 200,000 companies, you would in all likelihood find a lot of criminal activity as well. But when it is offshore, it is always portrayed as an offshore problem.

That’s because of the anonymity. Once that is gone, there is really a chance to present offshore as a transparent thing, and to focus on the real discussion, which is: Is it OK for one country not to take taxes from the citizens of another country who are doing business there; which leads to the strange situation that many countries are losing billions in tax money because some countries receive only millions [or less].

This is something that we already saw in the Luxembourg Leaks. There were these big multinational companies that were taxed at a rate of 0.001 percent. So Luxembourg only got a few millions but the countries where the multinationals operated lost billions. [Luxembourg] did not care. This is just a question of fairness.

In terms of fairness, the ability to avoid taxes offshore also relies on the tax systems onshore. They are the ones who are opening the loopholes sometimes deliberately, sometimes accidentally. How do you view the impact of the Panama Papers on the political will onshore to reform some of those tax laws?

It is a little early to draw a conclusion but we can see in Germany that there are new laws being passed. For example, we have a register of beneficial ownership and we require people to name their offshore companies and to explain the nature of their income in offshore accounts. It is not offshore against onshore, it has to be a huge effort of all the forces to eliminate money laundering, tax evasion etc.

The politicians who are very happy to rail against offshore, they have not done their homework in the past 20 years. They just watched and let it happen. And many of them were involved in offshore activities.

People from the U.S. are now pointing at small low tax jurisdictions but this is not fair, they should look inside the U.S. where they have some of the biggest tax havens.

And the argument made in Cayman is exactly that. For example, with regard to beneficial ownership, it is said “how can we introduce beneficial ownership transparency first and then all we see is that our business is moving to Delaware or Wyoming.”

Exactly. It has to happen at the same time. We mentioned it in many of our articles that the U.K. and the U.S. especially say we have to close down tax havens. And we would argue: Yes, you do but you have to start in your own country. In a way, it is good to have some common sense, which is also articulated by the U.K. and the U.S. government, and you can turn it around against them. Now everyone is against tax havens and everyone is against using those tax avoidance arrangements. Now that they have stated that, we can ask why does it not apply to [them, too]?

When you started out and you saw the data and the kind of stories you and other journalists were potentially going to write. Looking back at it now, has it turned out the way you expected it to?

It was much, much bigger than I thought even in the last days before we published, when I looked at all the stories that I knew of. I did not know all the stories because we had 400 partners and each had arranged between 10 and 40 stories in the first days. It was impossible to know all the stories. But from what I saw, I thought it was going to be really interesting but I never thought that Barack Obama or Vladimir Putin would react to the Panama Papers, or that the European Union would set up an inquiry committee looking into our findings. It got so big, one could not imagine this at the outset. When we had the stories about the godfather of Vladimir Putin’s daughter, we thought that was really good stuff and we kept finding new heads of states all the time. So it was going to be a really interesting story but no one, at least not me, thought it was going to be the monster of a story that it turned out to be.

I heard that initially you were concerned that people might not be interested, that they may not care. Is that true?

Yes, I was. It was not the first time that we wrote about tax havens. And in Germany we would get the reaction, “yes, they exist; we know that.”

But the majority of people are annoyed by the fact that there are two different democracies, like two different sets of rules, one that applies to [all the people] who have to pay taxes on their wages and the other [that applies to] people who can afford three or four good lawyers, who set up a structure involving maybe four or five tax havens, where in the end no one can really say is it legal or is it illegal?

And this is the future of those systems, I believe. The easy solutions that German banks offered 10 years ago where they would put a bank account holding a million euros into the name of a Panamanian company [to avoid paying withholding taxes under the European Savings Tax Directive], that is not working anymore because it is too dangerous for both sides. But if you have 50 million euros, they will find a way to reduce your taxes to a minimum, if you have to pay any tax at all.

The people are really annoyed by this inequality that the wealthiest pay the smallest amount. This is not fair. And it is not something that you can change unilaterally. If the Cayman Islands was the most transparent place in the world, it would not change it. It has to be a common effort.

So what is your expectation, is the system going to change by making it a little bit more transparent one step at a time? Or are the tax lawyers and advisors always going to be ahead of the regulators?

It already has changed, the very easy tax evasion that places used to offer is nearly gone. You must have a more imaginative form of tax evasion. The problem will stay with us for a while, it is hard to make a prognosis.

But I think [to change the system] we will see a lot more transparency onshore and offshore as long as the political will is there. We can see that now, but I don’t know what will happen in four or five years.

In the meantime, there will be a lot more regulation and the pressure on each country to comply will be huge.

India’s currency ‘reform’

A number of countries have introduced new currencies for a variety of reasons.  All 14 former republics of the Union of Soviet Socialist Republics (USSR), including Russia, replaced the Soviet ruble in 1992-3 with each newly independent republic’s own national currency. The break-up of Yugoslavia into Bosnia and Herzegovina, Croatia, Macedonia, Montenegro, Slovenia and Serbia resulted in the replacement of the Yugoslav dinar by six national currencies. The so-called Saddam dinar of Iraq, which had the face of its former President Saddam Hussein, was replaced with notes without his picture in 2003.  The Turkish lira was replaced in 2005 with a new series that dropped six zero’s from the old lira following the successful stabilization of its value after more than 20 years of high inflation.  The public was given one year to replace the old currency with the new lira.

The exchanges of these new currencies for their predecessors followed many months and sometimes years of careful preparations, including clear instructions to the public on the nature and process of the exchange.  The process was sometime messy in the context of freshly ended war, as in the case of Bosnia and Herzegovina, but was usually well organized and orderly.

The actions taken by the Reserve Bank of India to demonetize and withdraw the two highest-denomination banknotes (the 500-rupee and 1,000-rupee, worth about US$7.30 and US$14.60) was anything but.  The loss of legal tender status of these two notes was announced without warning on Nov. 8, 2016.  “In consequence thereof these Bank Notes cannot be used for transacting business and/or store of value for future usage.  The Specified Bank Notes can be exchanged for value at any of the 19 offices of the Reserve Bank of India and deposited at any of the bank branches of commercial banks/ Regional Rural Banks/ Co-operative banks (only Urban Co-operative Banks and State Co-operative Banks) or at any Head Post Office or Sub-Post Office.”  (From the RBI website.)

Other restrictions, such as limits on the maximum of new cash that could be withdrawn, also applied.  At the same time, the RBI announced the intension to issue a new series of 500 rupee notes and a new larger denomination 2,000 rupee note sometime in the “near” future.

Suddenly, 86.4 percent by value of the cash in circulation was no longer legal tender.  Ninety-eight percent of all consumer transactions by volume in India are in cash.  The public was shocked, and the deliberate government-imposed hardship on hundreds of millions of poor Indians would be unimaginable elsewhere and would have been widely reported.

A Reserve Bank of India Press Release on Nov. 8, 2016 stated, “This is necessitated to tackle counterfeiting Indian banknotes, to effectively nullify black money hoarded in cash and curb funding of terrorism with fake notes.”  An unofficial goal, however, was to force more of the cash economy into banks, i.e., to “encourage” India’s poor to open bank accounts.  Time will tell whether much untaxed “black money” was forced into the open and thus taxed, a one-off benefit, as well as how much of the cash economy moved permanently into the formal financial system.

India’s objectives for its currency exchange are wrongheaded, and its preparation for and implementation of the operation abysmal.  It imposed a huge hardship on India’s poorer citizens. The new notes will not be ready in sufficient quantity to replace the old ones (22 billion notes in all) for five or six months.

Virtually all of India’s income taxes fall on the better off, who are less reliant on cash and who are better able to find alternative avenues of tax evasion if they are determined to.  This is especially true for income from illegal economic activities. Seizures of illegal wealth in the past found that only between 3.75 percent and 7.3 percent was kept in cash.  As with very costly, worldwide efforts to combat crime by confiscating its suspected proceeds (so-called Anti-Money Laundering measures), it would be more consistent with the rule of law and could ultimately be more effective in combatting crime to attack it directly rather than through AML measures.

Money is an extremely useful instrument for facilitating production and commerce.  Like the hammer, which can crush a man’s skull as well as drive nails that help build homes, money can facilitate bad as well as good.  It has been a serious mistake to burden money and the good it can do with AML restrictions.  While better advance planning could have greatly reduced the considerable collateral damage from India’s currency exchange, it considered surprise essential in order to force out and capture its “black money.”  When all is said and done, the benefit of one-off, higher tax revenue will almost surely be dramatically smaller than the considerable cost, which has fallen largely on the poor.  The new 2,000 rupee notes are already turning up in the “black” economy.  India would do better to improve its tax systems and their administration directly.

The unofficial goal of India’s currency “reform” is to force more Indians to open bank accounts in order to use the official financial system.  The goal is laudable but the method is not.  Currency is likely to fall out of use in the future around the globe because of new technology that is simplifying and lowering the cost of payments with transfers of bank balances and /or digital currency.  To the extent, this happens it is reflecting voluntary shifts by the public to more convenient means of payment.  Kenyan authorities did not push their citizens to massively replace the use of cash with digital currency (see my earlier article on M-Pesa “The Technology of Money” Cayman Financial Review, Jan. 18, 2012).  Rather, they wisely facilitated the develop and use of dramatically safer, cheaper and more efficient ways of moving and using (digital) cash.  Indians will open bank accounts and adopt other modern means of payment when it is advantageous for them to do so.  In fact, India’s banking and digital currency infrastructure is not up to a large shift to such means of payment and bad experiences with them by those “forced” to use them will only slow their adoption.  The government can help open those doors and remove road blocks to financial system developments but forcing the public is bad policy.

Broadly speaking, the Modi government is making a mistake in executing coercive approaches to economic and financial modernization.

Cowperthwaite’s ‘un-Keynesian’ Hong Kong

Causeway Bay, Hong Kong

The story of the emergence of Hong Kong in the post-war era from city devastated by war to a light manufacturing and transport center for Asia, to the financial and services hub for the region is an encouraging tale of the dynamism of markets left largely to their own devices. It owes much to the inspirational achievements by millions of refugees creating a new and prosperous home and offers a real-world comparison that allows an assessment of the classical liberal policies of open borders, free trade, low taxation and light-handed regulation that were pursued in Hong Kong at the time, even when abandoned in other parts of the world.

The path Hong Kong took was no accident. It was the result of the approach by the then-colonial administration and the institutions it had created. In the 1960s, as Hong Kong began to thrive, it had a vigorous Legislative Council. This was no rubber-stamp colonial parliament. The people of Hong Kong were well represented by the eminent Chinese and businesspeople in the chamber and civil servants with a strong sense of duty to justify the public trust in their judgment. The Hansard record of Legislative Council debate leaves a window to a world that seems distant, but faced issues that are very contemporary.

At the center of these debates was Sir John Cowperthwaite, Hong Kong’s financial secretary from 1961-71, who is remembered today by advocates of free market policies as a champion of “positive non-intervention” by government: low taxation, a stable currency, lean regulation and prudent financial management. (He is also pilloried by some, largely based on the writing of aggrieved civil servants whose grand plans he thwarted.)

Cowperthwaite’s deliberations on policy-making are very relevant to financial centers today. He starts his task as financial secretary from a very clear view that the economy is not synonymous with the government, saying:

“I am known for my opposition to state planning of the economy; but planning, so far as that is practicable, the state’s own exercise of its compulsory powers of appropriating and spending the resources of the community is a very different matter.” (Budget 1968-69)

Legend has it that Sir John refused to collect statistics because it would facilitate government intervention. The truth is a little more complex. He did fund the Census and Statistics Bureau and facilitated the purchase of new computer equipment. However, having studied the issue, he was a vigorous opponent of national income accounting, informing legislators that:

“…relating to the need for formal Gross National Product figures. Such figures are very inexact even in the most sophisticated countries. I think they do not have a great deal of meaning, even as a basis of comparison between economies. That other countries make use of them is not, I think, necessarily a good reason to suppose that we need them. … I suspect myself, however, that the need arises in other countries because high taxation and more or less detailed Government intervention in the economy have made it essential to be able to judge (or to hope to be able to judge) the effect of policies, and of changes in policies, on the economy … we are in the happy position, happier at least for the Financial Secretary where the leverage exercised by Government on the economy is so small that it is not necessary, nor even of any particular value, to have these figures available for the formulation of policy. We might indeed be right to be apprehensive lest the availability of such figures might lead, by a reversal of cause and effect, to policies designed to have a direct effect on the economy. I would myself deplore this.” (Budget debate 1970)

Small open economies and financial centers are closely integrated with the global economy, and while national accounts are meaningless, the unit of account and currency are a vital element of stability. Well before the link to the USD was established in 1983, Cowperthwaite set out the principles for suitable monetary arrangements, stating that “it was not easy for a currency in an economy like ours to function as it should without a strong link with an established reserve currency or with gold.” (Budget Reply1968-69) In his view, the goal of monetary arrangement in a financial center is stability, not active management:

“[The] Hong Kong dollar’s exchange rate is in a sense irrelevant, so long as it is stable, because the cost and price structure of our economy, including wages, adjusts itself automatically to rates of exchange; while, on the other hand, the long and stable relationship with sterling and our established use of it as both a trading and a reserve currency, had set up a complex of financial relationships, and had evolved trading practices, based on the existing rate, which it was likely to be disruptive, and possibly dangerous, to upset.” (HKD Devaluation debate 1967)

International financial centers have long been criticized for their low rates of taxation, but Cowperthwaite makes the case that low tax has both moral (saying, in 1970, when introducing tax legislation, that “all taxes are in principle bad things”) and economic foundations:

“I have a keen realization of the importance of not withdrawing capital from the private sector of the economy, particularly when it is responsible for an important part of the public services. I am confident, however old-fashioned this may sound, that funds left in the hands of the public will come into the Exchequer with interest at the time in the future when we need them.” (Budget Speech 1962)

His long experience in fiscal administration also convinced him, well before Art Laffer gave a name to the idea, that:

“Economic expansion remains the door to social progress and I am convinced that in our circumstances low taxation can in general produce a greater growth in revenue than can tax increases.” (Budget Speech 1964)

Hong Kong faced a deep financial crisis in 1965 that saw two banks fail and Hang Seng bank taken over by HSBC. These problems were not isolated in Hong Kong, and Cowperthwaite’s explanation of the crisis could be applied to many that followed:

“Looking back on these events from the distance of a year, one can see their origins and nature rather more clearly than at the time. I am not referring to the immediate causes, which lay in the bad banking practices of the two banks which then failed, but to deeper causes. In a sense our local events were part of a pattern observable in much of the developed world (and frequently in much more serious form than here), a pattern of over-rapid expansion of credit and consequent strains in and pressures on economies; over-investment in real estate development and over speculation in stocks and shares; and, of course, the political situation in South-East Asia, sterling difficulties and the British import surcharge had brought a degree of economic unease in late 1964 and early 1965.”

However, he vigorously resisted over-reaction to the crisis; while he sought quickly to address the direct causes and costs, he did not think the structure of the system needed to be upended:

“The events of the last year have shown dramatically the great basic strength of our economy and its remarkable resilience; and unpleasant as has been the medicine we have administered to ourselves, it is a powerful and for that reason fast-working medicine (I have always said that we can expect no easy way out of any economic difficulties we may get into); and I feel sure that we are emerging from our recent troubles in a much healthier state, with some of the diseased parts of our economy excised and some of its strains and stresses alleviated; and can look forward with confidence to renewed, and more solid, growth. (Budget Speech 1965)

In times of crisis, the pressures for the government to do more were relentless, yet Sir John resisted what he saw as typical lobbying by vested interests:

“I must confess my distaste for any proposal to use public funds for the support of selected, and thereby, privileged, industrialists, the more particularly if this is to be based on bureaucratic views of what is good and what is bad by way of industrial development … What mystifies me is how he or anyone else can determine what is a desirable type of industry such as should qualify for special assistance of this kind. In my own simple way I should have thought that a desirable industry was, almost by definition, one which could establish itself and thrive without special assistance in ordinary market conditions. Anything else suggests a degree of omniscience which I, at least, am not prepared to credit even the most expert with. I trust the commercial judgment only of those who are themselves taking the risks.”

For Cowperthwaite, then, as for Nobel-Prize winning economist Friedrich Hayek, government’s capacity to act is inherently limited both by a lack of knowledge and by an absence of appropriate incentives. By contrast, businesses left to their own devices generally serve the public interest, not because businessmen are always right, but because – in the absence of intervention – failures are smaller in scale and are dealt with swiftly:

“I largely agree with those that hold that Government should not in general interfere with the course of the economy merely on the strength of its own commercial judgment. If we cannot rely on the judgment of individual businessmen, taking their own risks, we have no future anyway. …. For I still believe that, in the long run, the aggregate of the decisions of individual businessmen, exercising individual judgment in a free economy, even if often mistaken, is likely to do less harm than the centralized decisions of a Government; and certainly the harm is likely to be counteracted faster.” (Budget Debate 1966)

Open financial centers have unique economic challenges, and Hong Kong’s financial secretary was an early scholar of the limits to the then-Keynesian economic orthodoxy. Indeed, he observed that “we have an un-Keynesian economy in the sense that we cannot spend our way out of depression.” (Budget speech 1966). He understood that in an open economy changes in prices and expectations rendered Keynesian proposals ineffective:

“Economists of the modern school will no doubt protest that I have said nothing of the use of budget deficits or surpluses for the control of the economy in general. I doubt if such techniques would ever be appropriate in Hong Kong’s exposed economic position; and I think they are certainly not appropriate at present, when in strict orthodoxy they would suggest the need to plan for a very substantial surplus “to take the heat out of the economy”.”  (Budget speech 1963).

As an administrator, Cowperthwaite was focused not just on economic measures, but also on the prosperity of individuals in Hong Kong. He understood that success as an economy and a financial center meant higher wages, changing prices and adjustments to business. He would not have shied away from Hong Kong’s ranking as an expensive city, so long as productivity allowed wages to rise:

“We hear much today about the danger of rising wages as if wages were the price of a commodity or a raw material, the increase in which should somehow be controlled … I myself welcome increasing wages which result by ordinary economic processes from the pressure of economic growth on our resources of labour, because they help to ensure both maximum export prices and the most productive use of our scarce resources; and at the same time redistribute more fairly our growing national income, even if this inevitably means, in our circumstances, generally rising internal price levels.” (Debate on inflation, 1970).

The template for how modern international financial centers can thrive was set by Hong Kong. That template requires a government vigorously ordering its own affairs and budget disciplines, but leaving the economy to businesses and risk takers. It requires a stable currency regime and low taxes. It means an “un-Keynesian” open economy, but leads to high wages and prosperity that are unmatched by the most carefully planned economy.

Money matters for investors and officials

Over the past eight years, monetary mischief restrained the economy by 1) encouraging businesses to use cheap money to buy back their own stock rather than invest in plant, equipment and people; 2) denting the return on investment for retirees and others willing to save for the future; and 3) damaging liquidity in financial markets for institutions and individuals.

Specifically, monetary data clearly illustrate how:

  • The world may have been different had Center for Financial Stability (CFS) Divisia money been on the Fed’s dashboard.
  • Market participants and officials can use CFS Divisia data to gauge economic prospects and better inform decisions.

CFS data are available free of charge and without regard to interpretation.    In fact, our goal is to encourage others to use the data and debate interpretation and analysis. Yet, what follows is my perspective and not that of CFS, its members or its board.  I alone am fully responsible for the practical and applied views espoused, as well as any errors.

In order to navigate through present challenges and advise on future policies, we must first dispassionately answer three questions:

  • How could we have been so wrong about monetary policy and the financial system?
  • How did we get into such a mess?
  • What are the costs and benefits of recent monetary moves?

To answer these questions, money matters.


Money and central banking: Yesterday and today

In 2001, then Fed Governor Laurence Meyer asked the question, “Does money matter?” He noted that money or quantities played no role in the conduct of monetary management or in consensus macro models.  However, he also opined that often the “pendulum swings too far” and that “monitoring money growth has value.”  Sadly, the pendulum swung in the wrong direction for another decade after Meyer’s remarks.  Central banks still have done little to add quantities to their policy calculus.

Yet, Fed Vice Chairman Stanley Fischer recently noted that popular macro models used in central banks provide “justification for the behavior of … central banks that think and talk of monetary policy purely in terms of the policy interest rate and other financial return variables, but not of the money stock.”  “However, we need to remind ourselves that it is built on an assumption … not a theorem.”

Fortunately, signs are emerging that some economists are beginning to integrate money and finance into macro models.

Today, I will offer essential takeaways from CFS’s experience producing monetary aggregates and measuring money in the U.S. since 2012.  Major themes will include: 1) private sector versus state money, 2) deflation and inflation scares, 3) a damaged monetary transmission mechanism, 4) collapse in shadow banking, 5) shortage of financial market liquidity, and 6) ideas for the future.


Private sector (bank) versus state money

One of the most fundamental observations from our data is that the Fed alone cannot grow the economy.    Although this seems obvious, incentives must exist for the private sector to invest and help drive the creation of monetary liabilities forward. Our data drive this point home. Hence, policy options must rely on other strategies, rather than simply reducing interest rates or adding fiscal stimulus.

For instance, the ratio of state money, or the Federal Reserve’s monetary base, relative to total monetary expenditures highlights unprecedented growth from 5 percent in December 2006 to 18 percent in November 2016.  In other words, the Fed’s balance sheet expanded meaningfully at a time when economic growth remained stalled. Perhaps of greater importance is the notion that growth in the remaining 82 percent of bank or private sector money in the economy has remained stalled.  The private contribution to total monetary expenditure continues to account for the overwhelming majority of money in the economy.  So, the data suggest that the secret to unleashing growth in the economy rests on identifying paths for the private sector to expand investment. See Figure 1.

Deflation and inflation scares

In the past several years, erroneous deflation and inflation scares have adversely influenced policy decisions. In some cases, misperceptions can be traced to faulty data. In many instances, monetary analysis would have resulted in different conclusions about the economy and policy. See Figure 2.


The first example is in September 1983 – when Milton Friedman wrote a Newsweek article warning of an explosion of M2 money. He suggested that an aggressive Fed tightening and recession would follow. Ironically, on the same day, CFS Director William A. Barnett (the originator of Divisia monetary aggregates) was featured in Forbes explaining why no recession was in sight.  Financial innovation rendered simple sum M2 faulty. The difference in views was purely due to measurement or the divergence in the broad Divisia versus narrow simple sum aggregates.

Second, in late 2002, then-Governor Ben Bernanke offered remarks on “Deflation: Making Sure ‘It’ Doesn’t Happen Here.”  Today, the speech is often lauded today for contemplating extraordinary monetary measures years in advance. Yet, more critically, the ideas espoused helped put the Fed and financial markets on the wrong track.  The remarks justified sharp cuts in the Federal Funds rate and the retention of rates at levels now often viewed as “too low for too long.” See Figure 2.

Had CFS Divisia money been part of Governor Bernanke’s dashboard – perhaps the Fed may have avoided the extraordinarily easy monetary policy enabling financial institutions and individuals from taking excessive risks between 2002 and 2006.  Our broadest monetary aggregate (CFS Divisia M4) was growing at an annual rate of 6.6 percent in 2002, when Governor Bernanke spoke at the National Economists Club in Washington, D.C. Similarly, a glimpse back in time at the growth in monetary services would have also revealed a less threatening picture.  For instance, the year-to-year percentage change in CFS Divisia M4 registered prior lows of 1.2 percent in 1995, 1.6 percent in 1989, -0.2 percent in 1981, -0.3 percent in 1980 and 0.6 percent in 1970.  In other words, CFS Divisia M4 growth needed to be much lower before sounding deflation warning bells.

Had CFS money been on the Fed’s dashboard, perhaps we may have avoided the global financial crisis or perhaps at a minimum bypassed the severity of the crisis.

Similarly, in 2010, a group of prominent economists wrote an open letter to then-Chairman Bernanke urging reconsideration of quantitative easing and other experimental monetary policies.   The letter made many important arguments regarding the dangers of quantitative easing.  However, an unfulfilled claim that “planned asset purchases risk currency debasement and inflation” ultimately met with sharp criticism and unfortunately diminished the impact of the economists’ message.

Quite simply, had CFS Divisia been part of the dashboard of these economists, emphasis on inflation and currency debasement might have been muted or, at a minimum, the threat would have been pushed into the future.  At the time, CFS Divisia M4 had collapsed, demonstrating a drop of 1.3 percent when the letter was released.


A damaged monetary transmission mechanism

In response to the financial crisis, the Federal Reserve engineered the largest surge of its balance sheet since the founding of the Fed in 1913.  For instance, the Fed’s high-powered money or monetary base expanded by nearly 400 percent from the peak-to-trough over a period of six years. See Figure 3.

In fact, the second largest six-year cumulative expansion was less than half of the recent swell in the size of the Fed’s balance sheet.  This expansion – ending in 1944 – was arguably much more beneficial.  It helped the U.S. exit from the Great Depression and a World War.

With economic growth stuck at subpar rates in recent years, there are legitimate questions regarding the cost/benefit calculus today from such recently deployed extraordinary policy measures.

CFS monetary and financial data vividly illustrate that the monetary transmission mechanism has been damaged. Our monetary data reveal counter-intuitive and surprising trends since 2012. See Figure 4.

First, when QE2 ended, money and liquidity created by the private sector improved.  This is measured by CFS Divisia M4 (the green line in Figure 4).   For investors, this signaled the “perfect macro cocktail” in the U.S.

Second, when extraordinary monetary policy resumed with QE2 (the blue line), private sector liquidity plunged.

Third, with the cessation of QE3, liquidity created by the private sector began to improve again (the green line).

Specifically, CFS Divisia better maps and explains the financial sector.  Here, economists can now employ quantity measures rather than solely relying on interest rates to model finance in macro models.

But, I need to be stronger.  Our data also reveal in technicolor fashion, the counterproductive effect of the current monetary and regulatory policy  on the financial sector transmission mechanism.


Collapse in shadow banking

CFS Divisia data also help measure and monitor market finance (or what some dub shadow banking).   Market finance provides the fuel for corporations in the form of commercial paper and liquidity for financial markets via money market funds and repurchase agreements. See Figure 5

Of course, market finance grew too large in advance of the recent financial crisis. It reached historic highs prior to the crisis and facilitated many well-documented excesses.  Yet, since 2011, the needed correction in reducing the role of market finance in the economy has fallen too far.  For example, our measure of market finance typically contracts coincident with recessions, but by an average of only 10 percent. Similarly, the average peak-to-trough associated with recessions is usually a scant 13 months. See Figure 6.

Now, the reduction in of market finance is excessively steep (see Figure 6).  The CFS measure of market finance was down a stunning 47 percent in real terms since its peak in March 2008! Similarly, the contraction occurred over a period of 86 months.  This phenomenon starves financial markets from needed liquidity and is detrimental to future growth.


Shortage of financial market liquidity, despite plentiful monetary liquidity

Our work measuring monetary liabilities was helpful in illustrating a trend challenging many market participants, namely less liquid financial markets.

A shriveling of liquidity (or an inability to move assets without unusual jumps or drops) puts markets and economies at risk for excessive amplification of minor shocks and a resultant major loss of confidence.  Although seemingly arcane, market liquidity is of vital importance to foster financial stability.

Threats from illiquid markets are often especially acute toward the end of momentum trades or herding investment behavior patterns.  The trigger to reverse unidirectional investment trends often arises during a period of overstretched valuations (2000) and/or the reversal of an easy monetary stance (2007).

What takes years to develop can reverse quickly with violent price swings – putting markets and the economy at risk.

It is no wonder that in this environment we have already experienced:

  • A Treasury flash crash,
  • Complaints of vanishing prices in G-10 FX,
  • A plunge in EUR/CHF, and
  • Ongoing fears in corporate bond markets.


Concluding thoughts

In conclusion, I will answer the three questions posed and offer a way forward.

How could we have been so wrong?  Quite simply, financial markets changed.  Innovation over the years rendered outmoded monetary measurement techniques and definitions spurious. Abandonment of quantities in favor of more compact interest rates was easy – albeit at the loss of informational content.  Today’s modern financial system or Keynes’ bank money was ignored.

How did this become such a mess?  Clear signals from monetary aggregates were ignored, prompting the Fed to fear deflation in 2002 and ease monetary policy by too much for too long.

In later years, damage to the monetary transmission mechanism was ignored.  The policy response was simply to double down on base money expansion.  The collapse in shadow banking was viewed as healthy.  Officials were backward-looking, believing that market finance was the root of the crisis and, therefore, its demise would be a favorable development.  Sadly, monetary measures were not used to make this assessment.  Had actual measures of market finance been employed, officials would have witnessed a sizable overshoot on the downside for the sector and economic growth – more broadly.

Even advocates of a more prudent monetary stance during the crisis lost credibility due to less reliance on monetary measures.

What are the costs and benefits of recent monetary moves?  The response to the crisis may have been different had officials evaluated monetary data in real time as the crisis unfolded.  Perhaps reciprocal swap lines would have been implemented sooner, possibly avoiding QE1.  Certainly, QE2 and QE3 may have been avoided.  Rates may already have been normalized; during times when the unemployment rate had fallen to the Fed’s initial target of 6.5 percent, the liquidity trap showed signs of subsiding, and growth began to emerge.

I do believe that it is fair to say that the world would have been a better place had CFS Divisa money been on the Fed’s dashboard.  Perhaps we would have bypassed the crises by avoiding the excessively easy monetary conditions between 2002 and 2006 that ultimately enabled the expansion and absorption of credit by institutions and individuals.  Certainly the severity would not have been as deep and long-lasting.

Going forward, the present represents an exciting period for investors, public officials, and scholars.   Whether you are a Keynesian, Monetarist or simply agnostic, monetary and financial measurement and its integration into policy and models is essential for the future.


The Center for Financial Stability (CFS) is a private, nonprofit institution focusing on global finance and markets. Its research is nonpartisan. This publication reflects the judgments and recommendations of the author(s). They do not necessarily represent the views of Members of the Advisory Board or Trustees, whose involvement in no way should be interpreted as an endorsement of the report by either themselves or the organizations with which they are affiliated.

Economic growth continues

The Cayman economy continued to grow in 2016, recording a 3 percent increase in the first half of 2016. It was the highest growth rate since 2007 and exceeded initial forecasts of 2.1 percent for the year.

The first half-year result improved on the 1.3 percent growth for the same period in 2015.
In 2015 gross domestic product grew by 2.8 percent to $2.8 billion bolstered by a drop in gas prices and low unemployment which led to an increase in consumer spending.

While gross domestic product has grown since the 2008 recession, the growth has not kept pace with a population increase of 3.6 percent. As a result, GDP per capita, a measure of economic activity per person, dropped last year by almost half a percent to $48,167.

Unemployment, meanwhile, dropped again in the second quarter of 2016 to a low of 3.9 percent.

Construction, wholesale and retail, and utilities sectors led the expansion  during the period.
Stay-over tourist arrivals from Europe and Canada dropped during the first six months of last year, bringing the total number to 210,000, down 1.4 percent from the same period last year. The stay-over losses reversed the gains of 2015, putting the numbers at the same level as 2014.


Consumer prices increase for first time since 2014

The Consumer Price Index, a measure of prices people pay for goods and living expenses in the Cayman Islands, increased overall by half a percent in the third quarter of 2016.

It was the first time the Economics and Statistics Office has reported inflation in the Cayman Islands since the last quarter of 2014.

During the past two years, the falling oil prices led to general decline in consumer prices and masked price increases in other areas.

Last year rents in Cayman and school fees increased, together with the cost of hotels, restaurants and recreational activities.

The ESO report states that the overall rise is “mainly due to the sharp increases of 8.7 percent in the accommodation services price index and 6.3 percent in catering services.”
Compared to the year before, 2016 housing costs increased by half a percent. Rent went up an average of 6.5 percent; home maintenance and repair increased 7.8 percent. Utility prices in September dropped significantly from last year, with water prices dropping about 13 percent and electricity, gas and other fuels down by 18.4 percent. See figure 1


Work permit numbers stabilize at about 24,000

The number of foreign workers on work permits in the Cayman Islands leveled off at the end of 2016, with just less than 24,000 non-Caymanians employed on island as of early December.

The number does not include those who have already received permanent residence or the non-Caymanian spouses of Caymanians.

Overall, the 23,739 permit holders were a slight decline from 24,077 recorded in early July.
According to Immigration Department statistics provided to the Cayman Compass under the Freedom of Information Law each quarter since January 2010, the territory has seen a steady increase in work permits granted in the past six years.

Work permits and government contracts have increased from a low of about 18,500 in fall 2010 to about 20,360 in July 2014. The numbers increased again in January 2015 to 21,400, and then to 22,232 in July 2015.

As of February 2016, there were 23,097 permits and contracts held by non-Caymanians working in the islands, which was eclipsed by July’s figure, stated at 24,077.
The figures show an 18 percent increase in work permits in Cayman since 2014.

Work permit and government contract numbers are still far below the record 26,659 of November 2008.


New EU blacklist targets offshore

The Cayman Islands and other offshore centers could soon find themselves on a new EU list of “non-cooperative jurisdictions” in tax matters.

The European Council of finance ministers published the criteria for including countries in the blacklist in November2016.

The EU will decide whether to blacklist third countries based on three factors: tax transparency, fair taxation and the implementation of anti-Base Erosion and Profit Shifting (BEPS) measures.

The concern that any country without corporate and income taxes would be automatically blacklisted was not confirmed.

However, under what the EU calls fair tax rules, the provisions emphasize that a jurisdiction “should not facilitate offshore structures or arrangements aimed at attracting profits which do not reflect real economic activity in the jurisdiction.”

How the EU will interpret the rule is not clear, given that most offshore centers facilitate offshore structures or arrangements and are attracting capital flows which do not reflect real economic activity in their jurisdiction.

The EU Code of Conduct Group (Business Taxation) is charged with defining the scope of the fair tax criterion and will “evaluate the absence of a corporate tax system or applying a nominal corporate tax rate equal to zero or almost zero as a possible indicator.”

Cayman does not offer preferential tax measures, another fair tax criterion considered harmful by the EU, as it applies its zero-tax rate uniformly.

Cayman should at the same time have no trouble meeting the tax transparency requirements.

Countries will fulfil the tax transparency criteria if they commit to implement the Organisation for Economic Cooperation and Development’s common reporting standard for the automatic exchange of tax information, and have arrangements in place to exchange information by the end of 2017.

Countries must also be assessed “largely compliant” by the Global Forum, an intergovernmental tax transparency group, in tax matters regarding their systems of exchanging tax information on request through tax information exchange agreements.

Cayman has also committed in principle to a project reforming the application of tax rules in cross-border business to combat the erosion of tax bases and the artificial shifting of profits to low or no-tax jurisdictions.

As a cornerstone of this BEPS action plan, country-by-country reporting requires multinational companies to detail tax and financial information in relation to the global allocation of their income, taxes and other indicators of their economic activity. The aim is to increase transparency on where profits are generated, value is added and risks are taken compared to where a company pays tax.

“Subject to industry consultation, we will be implementing the transparency component of country-by-country reporting,” said Dax Basdeo, chief officer in the Ministry of Finanical Services in December.

The legal platform for its implementation already exists in Cayman through the Multilateral Convention on Mutual Administrative Assistance in Tax Matters.


Cayman government consulted on beneficial ownership platform

Government consulted industry and the public on the implementation of a centralized platform to support the exchange of beneficial ownership information with foreign law enforcement and tax authorities.

Based on an agreement with the U.K. government that was concluded in April 2016, government proposes to establish a platform that centralizes access to information about the true owners of Cayman-registered companies.

The suggested information exchange system requires several amendments to the Cayman Islands Companies Law, the Companies Management Law and the Limited Liability Companies Law.

If approved by the Legislative Assembly, the amended legislation will provide the framework to develop the centralized platform by June 30, 2017.

Minister of Financial Services Wayne Panton said the proposed changes are not an attempt to introduce a public or central register of beneficial ownership information.

“Currently, fewer than a dozen countries around the world have introduced or plan to introduce public registers,” the minister said in December. “Cayman is not one of those countries, and we will not do so until this is the accepted and implemented international standard.

“We do, however, recognize that there has been a strong push globally for greater transparency and information exchange, and that Cayman must act in order to protect our reputation as a leading international financial center.”

Cayman conducted a public consultation on beneficial ownership of registered companies in general in late 2013. It found that the strength of Cayman’s current regime, which collects, maintains and updates beneficial ownership information through licensed and regulated corporate service providers, was an appropriate and preferred system that complies with international standards.

To further enhance the existing system and speed up access to information, the Ministry of Financial Services, together with Cayman Finance, developed the concept of a centralized platform of beneficial ownership information.

In response to data security concerns, the platform ensures that the data remains decentralized.

Under the plans, Cayman service providers continue to be responsible for collecting and maintaining the data but would have to grant access to the information through the new platform.

The information will be accessible by the Department for Tax Cooperation of the Ministry for Financial Services, which collects and exchanges the data with foreign authorities on request within 24 hours.


Financial services fees pay for 40 percent of Cayman’s government

Fees, registrations and licenses charged to the Cayman Islands financial services industry earned about 39 percent of all revenues for central government last year.

According to figures produced in annual financial statements by the Ministry of Financial Services, $102.7 million was earned in regulatory licenses and fees and another $138.2 million was earned in entity registrations (such as company registrations) during the government’s 2014/15 fiscal year, the latest year for which financial statements are available.

In addition, trade and business licenses for financial services companies earned $1.7 million while immigration-related fees charged to financial services companies totaled $13.1 million for the year.

For the year, those taxes and fees accounted for $255.6 million of the $659.6 million the government earned in revenue – not counting the operations of statutory authorities and government companies.

In addition to providing the cash for government operations, the ministry estimated the financial services sector provided about 16 percent of the jobs in the Cayman Islands labor force during 2014. That number includes legal and accounting services within the industry.

“The jobs generated by the industry are relatively high-paying and, in 2014, 71.5 percent of financial services jobs were held by Caymanians,” the ministry’s annual report stated.

According to the government’s latest human resources report, roughly 74 percent of the jobs in the central civil service were held by Caymanians.

In terms of impact on the economy, the annual report estimated some
52 percent of Cayman’s gross domestic product was attributable to the financial services industry and related legal and accounting professions.

“These are measures of direct impact only,” the report stated. “The indirect and induced impacts [purchases of goods, services etc.] account for a further five to 10 percent contribution to gross domestic product.”

This comes in addition to other tourism-related impacts from the financial services sector to the local economy.

A 2009 Oxford Economics study found that more than 31,000 visitors came to Cayman during 2007 as clients, vendors or participants in conferences, staying for a total of 100,000 nights and spending an estimated $20 million.

The odd history of the petroleum futures markets

Energy futures now dominate the commodity futures markets in terms of the total value of contracts, but the oldest, heating oil, is less than four decades old.  Commodity futures markets have been around for a couple of centuries because they are an efficient mechanism for transferring price change risk to speculators and thus protecting both producers and consumers.

In the spring, farmers need to decide what crops to grow in their fields – corn, wheat, soybeans, etc.  If they base their decision solely on the current price, they may get a nasty surprise at harvest time if there is big price decline. Commodity futures markets give the farmers the ability to protect themselves from at least part of a big drop in prices by agreeing to sell some or all of the crop at harvest at a guaranteed price to speculators.  The futures price is often less than the current cash price, but still can guarantee the farmer a profit if his costs are low enough.  Speculators take the other side of the transaction by guessing that any change in price will be less than what they have to pay the farmer for the product.

The economic advantages of shifting risk from producers (farmers) to speculators is sufficiently powerful to also be applied to most non-agricultural commodities, such as metals. The New York Mercantile Exchange (NYMEX), now part of the CME Group, is the world’s largest energy markets commodity exchange. As of the end of 2016, it stopped the last of the open-outcry trading and moved totally to electronic trading.  (Film makers will mourn the loss of trading floors covered with frantic, shouting people.)

NYMEX was formed in 1872 to trade butter and cheese, but over the years added other commodities, acquired other small exchanges, and in 1882, renamed itself the New York Mercantile Exchange. By the early 1970s, the major commodities NYMEX traded were Maine potatoes, platinum, palladium and miscellaneous others. It was during this period that I became directly acquainted with NYMEX when a close friend and mentor, Alan Abrahams, became its chief economist and was part of a team to modernize the Exchange and find new commodities to trade.  At that time, NYMEX was still located in an old building in lower Manhattan that it had occupied since 1885. It finally moved to a new building in the World Trade Center in 1977. Back then, all trades were done by open-outcry on the trading floor, and price changes were recorded by boys using large blackboards with chalk on a walkway above the trading floor (even primitive then by the standards of the day).

In 1975, Congress created the Commodity Futures Trading Commission (CFTC) to regulate commodities futures and the exchanges. By that time, I had finished graduate school at Columbia University in New York and had moved to Washington. NYMEX had no Washington presence at that time but was suddenly being required to submit all sorts of reports to the new CFTC, including justification studies for each of the commodities they traded. This was an absurd requirement, because if there was no economic justification for futures trading in a commodity, there would be no trading. NYMEX then hired me to prepare the studies and do other miscellaneous tasks for them in Washington that were now being required (the start of their Washington office).

In May 1976, Jack Simplot, the biggest potato producer in the country (and the developer of freeze-dried potatoes during WWII), as a result of a failed attempted price squeeze, engaged in default of a huge number of potato contracts on the NYMEX.  It was a major financial scandal at the time and almost killed the Exchange. The members and management of the Exchange were understandably desperate to find new commodities to trade to replace the now dead potato contract.

As I recall, several of the board members of the Exchange also owned rent-controlled apartment buildings in New York City. One of their major costs was heating oil for their buildings.  Under the rent control regulations at the time, apartment building owners could only be reimbursed for increases in their heating fuel costs after they had been incurred and paid, which was often many months.  The suggestion was made that NYMEX start a heating oil contract.  (At that time, there were no contracts on organized futures exchanges in petroleum or petroleum products.) A heating oil contract was developed with a North Sea delivery point (Rotterdam) where the international oil price was set at that time by traders each day. Much to the disappointment of the people at NYMEX, there was little trading in the contract. I was asked to go to London and Rotterdam to interview oil traders to find out why they had no apparent interest in the NYMEX heating oil contract.  In short, what I found was they had a long-established old-boy network for determining prices among themselves, which they found both convenient and profitable.

Fortunately, the leaders of NYMEX were not willing to give up after receiving my discouraging report.  They changed the delivery point in the contract to New York Harbor and engaged in a marketing campaign directed at all of those who might find it potentially useful and economically beneficial.  The new contract started trading in 1978 and by 1979 had become a success. Over time, the success of the heating oil contract led NYMEX to add crude oil, gasoline, natural gas, propane, coal, uranium and electricity. Subsequently, NYMEX acquired and merged with other major exchanges, such as COMEX, which had major markets in aluminum, copper, gold, and silver.

In 2006, NYMEX underwent an IPO and was listed on the New York Stock Exchange, and other parts were sold to the Chicago Mercantile Exchange (CME), which is the world’s largest and most diverse derivatives marketplace, handling three billion contracts.

How ironic, that the trillions of dollars of trading now done in the various oil futures products had their beginning in an economic need to mitigate part of the costs of New York City’s apartment rental price controls by enabling landlords to protect themselves from changes in the price of heating oil for their buildings.

Trump’s regulatory reforms

Donald Trump has said that he plans dramatically to reduce the regulatory burden facing American businesses. If his administration is successful, the U.S. could become a far more competitive location for business and grow at a more rapid rate.

There is little doubt that regulations impose a huge cost on U.S. businesses. Using survey data, the National Association of Manufacturers estimated that the cost of federal regulations in 2012 was over $2 trillion. Meanwhile, in April 2016 the Mercatus Center published the results of an economic model which estimated that the additional since 1980 additional federal regulations have reduced economic growth by 0.8 percent of GDP per year.

In October, Donald Trump stated, “I would say 70 percent of regulations can go.” That may be a little ambitious. Trump’s website states that his administration will, “reform the entire regulatory code to ensure that we keep jobs and wealth in America” and it describes a process for achieving this aim. Specifically, he plans to:

  • Ask all department heads to submit a list of every wasteful and unnecessary regulation which kills jobs, and which does not improve public safety, and eliminate them.
  • End the radical regulations that force jobs out of our communities and inner cities. We will stop punishing Americans for working and doing business in the United States.
  • Issue a temporary moratorium on new agency regulations that are not compelled by Congress or public safety in order to give our American companies the certainty they need to reinvest in our community, get cash off of the sidelines, start hiring again, and expanding businesses. We will no longer regulate our companies and our jobs out of existence.
  • Cancel immediately all illegal and overreaching executive orders.
  • Eliminate our most intrusive regulations, like the Waters of the U.S. Rule. Scrap the EPA’s so-called Clean Power Plan which the government estimates will cost $7.2 billion a year.
  • Decrease the size of our already bloated government after a thorough agency review.

While this plan is admirable in its intent, implementation will not be easy. First, agencies may amend or rescind regulations that are already in force, but to do so they must comply with the Administrative Procedures Act, which requires them to: (a) issue a notice of any proposed rulemaking by publishing details in the Federal Register; (b) offer interested persons an opportunity to comment on the proposal; (c) publish the final rule, at least 30 days before it becomes effective; and (d) “give an interested person the right to petition for the issuance, amendment, or repeal of a rule.”

This process can become very protracted, especially since many attempts to repeal existing regulations will likely be challenged in the courts, either by incumbents or by interest groups. Incumbent businesses have in many cases already implemented existing regulations, so repeal would benefit new entrants relative to incumbents, who will seek to keep those regulations in place. Meanwhile, special interest groups will claim that the regulations are necessary to protect public health, the environment, or some other cause.

Given the practical challenges of advancing reform, it is important that the new administration carefully identify reform opportunities that are likely to be both successful and meaningful.

The two regulations specifically identified in the plan seem like good examples. The so-called “Clean Power Plan” imposes a range of requirements on states to regulate electricity production and, even by the EPA’s own estimates, its enormous costs (put at $39 billion/year by National Economic Research Associates) are not justified by the benefits in terms of reduced emissions of greenhouse gases – its ostensive aim. Moreover, the regulation has been challenged by more than two dozen states, which have questioned its constitutional legitimacy, and it is currently being reviewed by the Court of Appeals.

Likewise, the Waters of the U.S. Rule reinterprets the meaning of “navigable waters” for the purposes of implementing the Clean Water Act in such a way as to include many locations that would not normally be considered navigable, such as ditches and parking lots on which water occasionally collects. By expanding the meaning of “navigable,” the rule grants jurisdiction over those “waters” (i.e. parking lots) to the EPA and Army Corps of Engineers. In so doing, it restricts all manner of economic development, while doing practically nothing to protect the environment.

Trump’s proposal to ask department heads to identify other suitable candidates for reform seems reasonable. But where will those department heads get their candidates? Under the existing agency structure, they would presumably be reliant on the same staff who oversee the regulations – and whose self-interest lies largely in expanding the role of regulation, not constraining it.

Instead of relying on information from agencies, the new administration might draw on existing appraisals of the cost of regulation such as those produced by the American Action Forum and the Competitive Enterprise Institute. This could be combined with a prioritization effort modeled on the approach developed by Bjorn Lomborg’s Copenhagen Consensus Center, bringing experts and agency heads together to develop a ranking of which regulations to target based on the net benefits of repeal/reform and the likelihood of success.

In principle, reform efforts might be assisted by the White House Office of Information and Regulatory Affairs (OIRA), whose remit is to review regulations issued by the executive. But OIRA’s powers are very limited. In a recent article in Regulation magazine, Sam Batkins of the American Action Forum and Ike Brannon of Capitol Policy Analytics recount the sorry tale of an attempt by OIRA to stop a regulation issued by the U.S. Department of Agriculture that would effectively force a groups of farmers to tear out their apricot orchards. Even though the total cost of the program was estimated at only $20 million, Batkins and Brannon note, “the fight was kicked to Office of Management and Budget Director Mitch Daniels, who in turn kicked it to Vice President Dick Cheney. Cheney then met with the agriculture secretary, Ann Veneman, to negotiate a resolution – which amounted to letting the USDA go ahead with the program, but with a promise that OIRA would ‘win the next one.’”

One solution would be to increase the budget and authority of OIRA, giving it a role in reviewing existing regulations, as well as those being proposed. An alternative would be to create a new, independent agency responsible for deregulation. The incentives of those working at such an agency would be aligned with the removal of unnecessarily burdensome regulations.

While the Clean Power Plan and Waters of the U.S. Rule are discrete regulations implemented by agencies, Trump has also talked about overturning whole pieces of legislation, including Obamacare and Dodd-Frank. While in principle desirable, such reforms will clearly be more challenging. To repeal entire statutes will require new legislation. Indeed, given the problems already outlined, new legislation may be the most effective way to reform many existing regulations. But only Congress can pass new legislation. And while there are many supporters of regulatory reform in the Republican Party-dominated Congress, support for reform is by no means guaranteed, in part because the same groups that would object to reforms by the executive wield considerable influence through lobbying.

Given the difficulties of identifying and implementing regulatory reform, it is too early to say with any precision what practical effect Trump’s actions will have. But assuming they achieve some of their aims, the effect will be to make the U.S. more competitive in the production of goods and services. Such a prospect is presumably part of what has driven the rally in U.S. stocks since the election on Nov. 8.

From the perspective of offshore jurisdictions, deregulation in the U.S. presents both opportunities and threats. Opportunities are likely to exist in the form of new capital investments from funds that focus on industries that have been over-regulated, such as energy and manufacturing. In addition, reform of FATCA and AML rules might increase the attractiveness of offshore jurisdictions, deepening the pool of global capital, benefitting both the U.S. and offshore jurisdictions. Threats may come from changes to regulations such as Dodd-Frank and Sarbanes-Oxley that currently make the U.S. a less attractive location for financial services.

Stopping the tide

King Canute and the waves

A year ago, the world looked set to continue on its post-World War II path to ever closer economic integration. The European Union seemed to have weathered or, at least, papered over the worst of the post-2008 crisis, as Greece slipped from the front pages. The United States was concluding negotiations with its Asian partners on the Trans-Pacific Partnership trade deal and looking ahead to an equally ambitious trade deal with Europe. While the OECD continued to try to ensnarl global financial services in a choking morass of red tape through BEPS, information exchange, and other anti-growth initiatives, the world seemed set on continuing to connect economies with ever more robust ties.

What a difference a year makes! Today, the U.K. is consumed with figuring out what Brexit means (beyond, of course, “Brexit”). One estimate suggests that it will take 30,000 additional civil servants to negotiate all the trade deals and draft all the laws it will take to extricate the U.K. from Brussels. In the United States, President-elect Donald Trump has promised to kill the Trans-Pacific Partnership, renegotiate NAFTA, and generally upend U.S. trade relationships around the world. There is no estimate yet on how many more civil servants will be needed to handle all those negotiations in Washington. Either Italy or France could elect a populist government that would further challenge existing structures.

Despite Mr. Trump’s protectionist instincts and the difficulties of figuring out just what Brexit does mean, economic integration is likely to continue, albeit a bit more slowly than otherwise. Mr. Trump may attempt to play King Canute and order the wave of goods, services, and people away from American shores but he is likely to be as unsuccessful as Canute was in stopping the waves. Here are three reasons why:

  • Cutting existing ties is expensive. It took decades for trade to recover from the body blow of World War II. Once it did, economic ties between countries, firms, and individuals expanded until today much of the world is so interconnected that it is almost impossible to imagine a return to the less-interconnected world of the 1950s. For example, a recent Wall Street Journal story noted that car seats made by Adient in the United States involve parts from plants in four states and four Mexican locations. This is not an isolated example: Fourteen thousand trucks a day cross the U.S.-Mexican border at Laredo, Texas (moving in both directions). One study estimated that 40 percent of the content of the goods assembled in Mexico originate in the United States. Undoing the supply chains underlying all those goods would be costly for everyone involved.
  • Undoing integration would dramatically reduce consumer choice. Lucky Foods can deliver broccoli from its fields outside San Miguel de Allende, Mexico, to Texas grocery stories in 24 hours, with product tracking that tells it from which field each piece came. It takes just 24 hours more to get it to stores in Canada. Mexico’s expanded growing season makes fresh vegetables available to Americans for more of the year. U.S. consumers are unlikely to happily return to 1950s-style canned vegetables if the movement of goods across the U.S.-Mexican border were to slow.
  • International investment into the United States is an important driver of the U.S. economy. Iconic U.S. brands like Sara Lee, Arnold, Brownberry and Thomas’ English Muffins are owned by Grupo Bimbo, the Mexico-based firm that is the largest bread producer in the world. Borden Milk is owned by Mexico’s Lala, which is the second largest dairy producer in the United States. Cemex, also based in Mexico, is the second largest cement manufacturer in the United States.

King Canute presumably got soaked when he waded into the water to command the waves to stop.  Mr. Trump risks serious economic harm if he tries to reverse the economic integration of the world economy. Assuming he’s too clever to do that, what might the Trump administration plus Brexit (plus a possible Five Star government in Italy plus a possible National Front win in France) mean for the world economy?

Uncertainty. If there is a lesson from the Trump campaign for how President Trump will govern it is that he is more unpredictable than most politicians. As his acceptance of a phone call from Taiwan’s president illustrated, and his subsequent musings about whether or not he would remain committed to the “One China” policy, foreign policy will not be run from the State Department but from the president’s Twitter account. Compound that with the uncertainty introduced by the British referendum and the U.K. government’s floundering response and the future is particularly hazy. Add in the upcoming elections in France, Germany and probably Italy and things get even murkier. Uncertainty is generally bad for businesses.

Direct intervention. As his deal with Carrier to “bring back” jobs to the United States shows, President Trump will be directly intervening in the economy. This will not be a laissez-faire administration. Similarly, the May government in the U.K. has shown a fondness for industrial policy and aggressive measures to keep the economy growing. Rather than a new Reagan-Thatcher era, Trump-May seems more likely to repeat the economic policies of the Carter and Callaghan governments, at least in these dimensions. Both the National Front and the Five Star Movement promise more intervention in the economy as well, furthering my gloomy sense that we might be about to relive the 1970s.

Rewriting tax codes. Both the U.K. and the U.S. can be expected to be more aggressive in asserting their interests in the global tax system debates now underway. Even the Obama Administration has stuck up for U.S. businesses like Apple, preferring to tax their profits when repatriated to the United States to letting the EU members grab the revenue. As the U.K. fights to maintain London’s status as a major financial center, tax policies will be a valuable tool. Moreover, since neither May nor Trump are committed to any particular philosophy of tax, and both will be looking to conclude deals, we shouldn’t expect a philosophically consistent tax reform but rather a bundle of provisions that pays off a large enough coalition to be enacted.  This will likely leave room for offshore financial centers to continue to play a role in cross-border transactions.

Rewriting regulations. As the U.K. moves to bring government authority back from Brussels, it will have the chance to rewrite a great many regulations. Similarly, Trump pays (at least) lip service to a deregulatory effort, and at least some of his Cabinet nominees seem inclined to reduce the scope of federal regulations. In the past, the combination of a Tory government in the U.K. and a Republican one in the United States has at least slowed international regulatory efforts. This time, however, the commitment of both May and Trump to more than the rhetoric of broad deregulation is uncertain. No one really knows what a Five Star government’s regulatory policy might look like, including, it appears, the politicians in the “movement.” The National Front promises more regulation rather than less, making it likely that the French election campaign will be a competition to promise special interests extra benefits despite the initial “Thatcherite” rhetoric of the Republicans’ candidate, Francois Fillon. At the least, we should expect some shifts in regulatory emphasis around the world.

I believe that greater trade in goods, services, and capital will advance the world economy and that the fundamental problem in the world today is the lack of growth. As a result, comments like Trump advisor Steve Bannon’s declaration that “I’m an economic nationalist” and incoherent policy statements like Theresa May’s “Brexit means Brexit” and the Five Star platform worry me. The world economy is adrift, with growth rates well below where they need to be to expand opportunity for the world’s poor and ensure our children have better lives than we do. “Economic nationalism” and incoherence are not ingredients to boost growth. Nonetheless, even Donald Trump, Theresa May, Marie Le Pen, and Beppe Grillo will find it impossible to undo the deep integration of the world economy. Of course, they can slow progress and even wreck particular industries, and probably will.  With just a little luck, we may later look back on this period as a slight detour on the road to a prosperous world rather than a complete wrong turn.

What the Caribbean should do about the new Trump administration

On Jan. 20, 2016, the Trump Administration entered into power, and Caribbean interests will have a number of issues to discuss with the new administration: financial services and de-risking; tourism and travel; migration; energy; security and disaster resilience; debt; trade; climate change; and foreign assistance.

The time for lobbying is ripe because on June 13, 2016, the House of Representatives passed H.R. 4939 (the United States-Caribbean Strategic Engagement Act of 2016) by a vote of 386 to 6.

H.R. 4939 requires the secretary of state, in coordination with the administrator of the U.S. Agency for International Aid, to submit a multi-year strategy for U.S. engagement with the Caribbean region to Congress no later than 180 days after enactment. This strategy would in part focus on improving citizen security, reducing trafficking of illicit drugs, strengthening the rule of law and promoting greater economic development. Although it has not yet acted, there is significant bipartisan interest in a similar bill in the Senate.

H.R. 4939 is motivated primarily by U.S. national security interests in the region and the way in which Venezuela, China and Cuba have filled the void in the region. The bill offers the first opportunity since the Caribbean Basin Initiative in 1983 for the region to engage the U.S. government.

On July 14, 2016, the U.S. House of Representatives Committee on Foreign Affairs Subcommittee on the Western Hemisphere held a hearing on the “Strategic Importance of Building a Stronger U.S.-Caribbean Partnership.” The hearing examined the void in the region due to the collapse of Venezuela and the limitations of PetroCaribe, the Venezuelan program which provided highly subsidized oil to the Caribbean. The hearing emphasized the need to relieve the region from its dependence on imported energy and shift to alternative energy sources, such as solar, wind and thermal. The hearing discussed the need to strengthen the Obama administration’s Caribbean Energy Security Initiative to facilitate a cleaner, more energy secure future consistent with the Paris climate change accords.

The hearing underscored the fact that the preferences in the Caribbean Basin Economic Recovery Act, last revised in 1990, are limited to trade in goods, while current trade in the region is in services. Hence, any new trade arrangement should strengthen trade in services between the U.S. and the Caribbean, including in health, education and business. The hearing discussed the need to enable  Caribbean jurisdictions to take advantage of financing and feasibility studies by the Overseas Private Investment Corporation, even though at present their small size has until precluded the possibility.

The hearing discussed the recent withdrawal by U.S. banks from correspondent relationships with Caribbean indigenous banks, and how such withdrawals harm U.S.-Caribbean cooperation by cutting Caribbean people from U.S. banking and producing a void that makes the Caribbean vulnerable to interests inimical to the U.S.

In order to lobby effectively, the Caribbean must identify key members in the different Congressional Committees (e.g., foreign affairs, finance, energy) as well as in the key caucuses (e.g., Caribbean Caucus, Congressional Black Congress, Travel and Tourism Caucus). The Caribbean must simultaneously identify and communicate with the key members of the executive branch (e.g. state, Treasury, National Security Council, Office of the Controller of the Currency, Commerce). Caribbean governments must try to influence a Trump administration to pursue policies for which there is, at the very least, mutual benefit. The Caribbean ambassadors in Washington, DC are most important in this regard.   Just as importantly, the Caribbean must communicate with the diaspora and identify like-minded organizations in the private sector (e.g. trade and business groups, private voluntary organizations whose mission is the Caribbean and Western Hemisphere). The region must immediately start a dialogue with all persons who may be interested in the topics prioritized by the region.



The region should also prioritize a discussion of de-risking, as well as education and cultural exchanges. It should also advocate expanding the Caribbean Basic Economic Recovery Act to include services.

The Caribbean should ask the U.S. government to make exceptions on financing and feasibility studies, notwithstanding the small size of the Caribbean, so that U.S. investors can compete in the region with Canadian, Chinese, Brazilian, Russian and Middle Eastern investors.

On financial services, the region is likely to find the new Administration more friendly when it comes to tax transparency, anti-money laundering, and entity transparency. However, the horse is already out of the barn: the major challenge is now the OECD’s Common Reporting Standard. The Caribbean jurisdictions will be sanctioned if they do not comply. Yet many structures are already moving to South Dakota, Wyoming, Nevada and Delaware because the U.S. has informed the OECD it lacks authority to sign the CRS. Prospects will not improve in the Trump Administration.  The Caribbean also frequently finds itself the target of the anti-tax haven initiatives from U.S. states. Until now, the executive branch has said it does not have the authority to control the tax authority of the states.

One element the Caribbean can request is bilateral tourism agreements, whereby the U.S. agrees to collaborate with Caribbean countries in developing tourism joint ventures, tourism promotion and marketing, and technical assistance. The Department of Commerce concluded many such agreements in the 1980s, but has stopped recently.

On travel and tourism, the region should request the U.S. to take a strategic look at increasing U.S. immigration pre-clearance presence through a hub and spoke system to provide enhanced security. Another suggestion was to provide technical assistance, such as in the area of increased training for the development of a shared watch-list for travelers into and within the region. The region also should express interest in helping with ongoing efforts of the U.S. to ensure that third countries adequately screen all travelers for terrorist concerns. In light of Trump’s immigration proposals to suspend the issuance of visas to any place where adequate screening cannot occur until proven and effective vetting mechanisms can be put into place, to ensure that other countries take their people back when the U.S. orders them deported, and to ensure that a biometric entry-exit visa tracking system is fully implemented at all land, air and sea ports, the region may want to signal its willingness to work with the U.S. in upgrading its screening and cooperation with the U.S. and obtaining and use of a biometric entry-exist visa tracking system.

The region should educate the new administration on the importance of continuing and expanding the current U.S. initiative on clean and renewable energy; the U.S. energy initiative will help provide an alternative in the region to Venezuelan PetroCaribe. U.S. technical assistance concerning financing, technology transfer, and debt-for-nature swaps would all help the region’s quest for clean and sustainable energy while reducing significantly its large imported energy deficit.

The region must engage the new administration on climate change. The Caribbean experiences annual and intense natural disasters. Climate change and the accompanying sea-level rise have already adversely impacted the region’s fragile economies, coral reefs and land areas.

Just as importantly, the Caribbean should try to engage with U.S. states. Many long-term tourists from Asia and Northern Europe like to combine trips to Florida and Eastern U.S. with the Caribbean. By having tourism agreements with states, those states and the Caribbean, working with the private sector, can develop and market joint tourism agreements in areas such as plantocracy, music, visual arts, food and other culture. Such collaboration will benefit the states as much as the Caribbean. The region should engage U.S. states to collaborate on educational, cultural and health care exchanges, in the same fashion as the current collaboration between Cuba and the CARICOM countries.

The New Confidential Information Disclosure Law 2016

Trustees and confidentiality has long been a central theme in the fiduciary relationship of trust and confidence which exists between a beneficiary and a trustee. One of the most notable changes to our local legislation recently is therefore in relation to our confidentiality statute. There has not been any substantive change from the prior iteration (with one major exception), but it is another example of the way that we are becoming encouraged to regulate accessibility to personal, and what until very recently would have been regarded as private, information.

One consequence of the drive to increase financial transparency and maximize tax revenues has been an increasing focus on the so-called “secrecy jurisdictions,” a category in which the Cayman Islands has been included by our critics.  One reason for this, they argued, was our Confidential Relationships (Preservation) Law or CRPL, pursuant to which a breach by disclosure of confidential information about property outside the “normal course of business” and without the consent of one’s “principal” would, potentially, carry criminal penalties ranging from fines to imprisonment.

That this gives statutory force, among other things, to a common law duty which a trustee already has to its beneficiaries, did not sit well in the new international landscape, exacerbated at least in part by the threat of criminal sanction for a breach of that duty. Consequently, it was decided to repeal the CRPL, and in July of last year a new statute came into force, the Confidential Information Disclosure Law (“CIDL”), emphasizing the disclosure rather than preservation of confidential information.

Broadly, the CIDL modernizes the approach to confidential information in the Cayman Islands and illustrates Cayman’s commitment to respect for personal privacy, but within a framework acknowledging its obligations in the fight against international crime and consistent with its commitment to the automatic exchange of information. It abolishes the criminal sanctions and creates a statutory framework for the common law duty of confidence, setting out the circumstances in which disclosure of confidential information is permitted.

What is confidential information for the purposes of the CIDL? For trustees, confidential information is information which arises in or is brought into the Islands concerning “property” of a “principal” to whom a duty of confidentiality is owed.  Important to the operation of the statute in practice is the “normal course of business,” that is, “the ordinary and necessary routine involved in the efficient carrying out of the instructions of the principal.” The principal in a trust context, depending on the circumstances, is likely to be a beneficiary, settlor, protector or enforcer.

It’s confidential information about property, so what property are we talking about?  It is defined as “every present, contingent and future interest or claim, direct or indirect, legal or equitable, positive or negative, in any money, moneys worth, realty or personalty, movable or immovable, rights and securities thereover and all documents and things evidencing or relating thereto.” This is a wide definition of “property” likely to encompass a wide range of confidential information in a trusts context.

But what are the exceptions? When can a trustee disclose confidential information without fear of breaching the statute? Many of the exceptions are retained from the CRPL, that is, there is no breach of the duty of confidence if disclosure is made:
(a)    With the prior consent of the principal or in the normal course of business;
(b)    In compliance with requests by a regulator or local law enforcement, e.g. the Cayman Islands Monetary Authority (CIMA) or the police;
(c)    Pursuant to international requests from overseas regulators through CIMA or the court;
(d)    In the investigation of a criminal complaint to a police officer with the rank of inspector or above in relation to a crime alleged to have been committed in the Cayman Islands;
(e)    To the Financial Reporting Authority under the Proceeds of Crime Law or the Terrorism Law;
(f)    To the Anti-Corruption Commission under the Anti-Corruption Law;
(g)    In compliance with the direction of a Judge of the Grand Court; or
(h)    In accordance with any other right or duty created by any other Law or Regulation, for example pursuant to the Common Reporting Standard or anti-money laundering regulations.

Interestingly, there is one new exception permitting the disclosure of confidential information “on wrongdoing” or where there is a “serious threat to life, health, safety of a person or in relation to a serious threat to the environment, shall have a defence to an action for breach of the duty of confidence, as long as the person acted in good faith and in the reasonable belief that the information was substantially true and disclosed evidence of wrongdoing, of a serious threat to the life, health, safety of a person or of a serious threat to the environment.”

This effectively reinforces the concept of a “whistleblowing” defense in Cayman Islands law consistent with disclosure in the public interest.  As for penalties for a breach of the duty of confidence, there are no express provisions so the court will apply common law and equitable rules.

One final important point for trustees to remember: the CIDL does not remove the obligation on trustees or any other person who owes a duty of confidence, to seek directions from the Grand Court before they give evidence in or in connection with any proceedings “being tried, inquired into or determined by any court, tribunal or other authority whether within or without the Islands and the evidence consists of or contains any confidential information within the meaning of the Law” if the giving of that evidence would involve provision of otherwise confidential information without the permission of their principal.

The giving of evidence includes making a witness statement or affidavit, testifying during a hearing, producing documents, deposition or answering interrogatories.  This will have relevance for trustees who may be joined to overseas divorce proceedings, for example, and directed to provide confidential information or documentation to the parties in the divorce and do not have the consent of their principals to disclosure. This may also have relevance for example to trustees who wish to disclose confidential trust documentation in the context of an overseas arbitration and do not have the consent of the relevant principal or as may be the case on occasion, the relevant principal is, for example, a patient, and cannot give consent for themselves.

It remains a matter for the discretion of the Grand Court as to the manner in which that information is provided.  The court will have regard to whether such restrictions would deny the rights of an individual in enforcing a just claim, so bearing in mind the rights of the claimant, whether any offer of compensation or indemnity has been given and generally, whether disclosure would be in the interests of justice.

It is likely that as in previous cases, trustees will combine an application to court pursuant to the CIDL, with an application for directions pursuant to section 48 of the Trusts Law (2011 Revision). A trustee’s “principal” for the purposes of the CIDL is likely to be the settlor as the person who has imparted the confidential information to the trustee, but as the trustee is a fiduciary who has a duty to preserve and administer the trust property for the benefit of the beneficiaries, an application for directions as to the propriety of disclosure of confidential trust information and documentation pursuant to section 48 of the Trusts Law is likely to be required as well.

The changes to Cayman’s confidentiality statute are only part of the wider negotiation and cooperation with the OECD and international law enforcement and, as I mentioned in my last column, this includes a commitment to introduce a new Data Protection Law (DPL). While the DPL is still in draft, there are aspects of its application which will have implications on the trusts business in the Cayman Islands and so I look forward to discussing those in my next article.

A Trojan horse for creditors of Cayman companies

Access to justice is a fundamental right in developed legal systems. But, as with many rights, a balance has to be struck. The right of one citizen to seek redress from the courts must be weighed against the right of another not to be put to the expense of defending bad claims.

Historically, the Cayman Islands has addressed this through the allocation of liability for the costs of legal proceedings. In this regard, it is like many common law jurisdictions, with the notable exception (for most purposes) of the United States. But when it comes to the right of creditors of insolvent Cayman companies to challenge decisions by the appointed liquidators, a recent amendment to the Companies Winding Up Rules changes all that. The amendment appears to be a gift to those claiming to be creditors, but may actually leave genuine creditors worse off than before. In this article, the authors call for this change to be reconsidered, rather than leaving true creditors of an insolvent estate vulnerable to the unmeritorious claims of false creditors.


Costs follow the event

The Cayman Islands follows the England and Wales approach that the loser in litigation pays – or “costs follow the event.” Subject to the principles governing the nature and extent of costs that may be claimed, this means that the party that has (by definition, wrongly) forced the other side to court, pays the other side’s costs of the action in addition to its own.

Those costs recoveries are important. In jurisdictions where plaintiffs are able to bring claims with impunity, this can be combined with “no-win no-fee” arrangements to make speculative claims more common and result in settlements that are leveraged as a result of nuisance value rather than merit. For a plaintiff, the risk of having to bear the other side’s costs of being unsuccessful is a powerful deterrent to bringing claims that do not have real merit. In a system where the costs of pursuing legitimate rights are recovered, access to justice is preserved.


Security for costs

Even with these costs rules, there are some circumstances where an order from the Cayman court requiring a payment of costs may be worthless. If the plaintiff is a shell company stripped of any material assets, or is incorporated in a jurisdiction that does not recognize a Cayman costs order, the successful defendant is likely to remain out of pocket. And, of course, it is quite possible for claimants deliberately to engineer that situation.

To prevent this abuse, the Cayman court (like the English court) allows the defendant in civil litigation to take anticipatory steps to protect against that risk by applying to the court for an order that the plaintiff provide “security for costs” – a bank guarantee or deposit into court of a sum that may be used to satisfy any costs award in favour of the plaintiff. Therefore, the defendant is assured that if the court finds in its favor, its victory is not a hollow one.

As this potentially infringes on access to justice, the circumstances where such an order may be made are limited. The Grand Court Rules allow the court to order security to be given primarily where the plaintiff is a nominee plaintiff (and the real person for whom the action is brought is therefore not subject to the costs order) or resident outside of Cayman and therefore less likely to be responsive to a Cayman costs order. In addition, where the plaintiff is a company, the Companies Law provides for security to be ordered where the plaintiff company has insufficient assets to satisfy any costs award, unless that lack of assets was caused by the defendant.

The case law on security for costs is very well established and seeks to prevent it being abused inappropriately as a sword or shield. An order for security will not be allowed to stifle a meritorious claim, but the court has to balance the risk, if it does not require security, of the plaintiff being able to pursue a cause of little merit, at no financial risk to itself. This requires the Court to assess the merits of the case at an early stage, rather than determining the liability for costs after the full hearing. However, no payment is actually made to the defendant, and if the plaintiff is successful it will have the security back in full. The plaintiff must either establish that its case is bona fide, with a reasonable prospect of success, or that it can pay the costs of an action that the Court considers may be of questionable merit.


Application in the winding up of companies

The procedural rules relating to the winding up of companies are separate to the Grand Court Rules – the Companies Winding Up Rules (CWR). The CWR are made by the Insolvency Rules Committee, under powers delegated by the Companies Law. The committee is empowered to make rules and prescribe forms for the purpose of giving effect to, amongst other things, the parts of the Companies Law dealing with the winding up of companies. The CWR borrow lightly from the Grand Court Rules, adapting or creating new rules to fit the principles of insolvency law.

One of the key principles of insolvency is that it is a collective remedy: individual actions are subject to a moratorium and proofs of debt are submitted to the liquidator who has a quasi-judicial role in adjudicating these proofs of debt to determine whether the plaintiff may participate in a share of the assets of the company. In the Cayman Islands, only official liquidators have the capacity for adjudicating proofs of debt: voluntary liquidators, who may only remain in post if the company is solvent, must pay the claims of creditors in full. Official liquidators are court appointed officials who must possess certain qualifications, independence and experience and who then hold office as officers of the court with a duty to report to it.

However, if an official liquidator rejects a proof of debt, the putative creditor has a right of appeal to the Grand Court. The court hears the application as a de novo adjudication of the claim but the liquidator is required to provide evidence supporting or opposing the appeal and will usually need to have counsel attend the appeal. All this costs money, which comes out of the assets of the company as an expense of the liquidation. If the court rejects the appeal, then costs normally follow the event and the “creditor,” who may by this stage have been found not to be a creditor at all, or may have had his claim reduced, may be ordered to pay the official liquidators’ costs.

To the extent that the costs order is not then satisfied by the losing appellant, the estate will therefore be left to bear the costs, meaning a reduction in return to all of the legitimate creditors of the company. This is where the concept of security for costs becomes important. Crucially, until recently the CWR said nothing about security for costs.

That lacuna was filled by jurisprudence of the Cayman Islands’ courts which held that the court had an inherent jurisdiction to grant security for costs in insolvency proceedings, to be exercised in accordance with the principles relating to a non-resident limited liability company when there is reason to believe that its assets will be insufficient to pay the costs of the defendant. Essentially, a creditor in winding up proceedings was not allowed a risk-free roll of the dice, and was treated in the same way as an ordinary plaintiff in court proceedings. If liquidators rejected a proof and the creditor appealed then, if the liquidators considered it appropriate to do so, they could apply for an order that the appellant provide security for costs in the absence of credible evidence that it could (and would) pay the liquidators costs thus reducing the risk to the estate that an unsuccessful appellant would not pay the costs. The true creditors of the estate were therefore protected against the actions of those deemed not to be creditors, unless and until the appeal was successful.


The recent amendment

As part of an amendment brought into effect on Aug. 1, 2016, the Insolvency Rules Committee decided that “On an appeal to the Grand Court an appellant shall not be required to provide security for costs in any appeal to which this Rule applies.” There is no ambiguity in this: the court no longer has discretion to order security for the estate’s costs in the event of an appeal.

The Insolvency Rules Committee is not required to explain its decisions. The Cayman Islands is known as a creditor-friendly jurisdiction. This amendment could be considered as a gift to creditors, to improve their access to justice.

However, on its true application, it is wholly detrimental to the true creditors of the estate, achieves no better prospect of justice and removes the gates of judicial discretion that protect insolvent estates.


The downside for true creditors

In short, the change in the CWR takes away the discretion of the court to consider whether it is appropriate for security for costs to be ordered. Previously, the court would only have ordered this in cases where the appeal was of questionable merit and there were concerns about the enforceability of a costs award. There was therefore a threshold test before additional costs of the estate were incurred.

The prejudice to the creditor in providing security was limited: a creditor’s appeal has a short timeline compared to standard litigation in which security is regularly ordered, and the creditor will have the security returned (potentially even a costs award in its favour) if its appeal is successful.

Now, any creditor may force the estate to incur the costs of responding to an appeal, regardless of the merits of the creditor’s position. It should be remembered that the liquidator, a court-appointed officer, will already have adjudicated on the claim and determined that the appellant is not a creditor, or at least not to the extent claimed. In cases where a plaintiff appeals a judgment of first instance, the court is less reluctant to order security for costs of the appeal as the plaintiff has already had substantial access to justice.

The Committee’s change appears to send a signal that they have little faith in liquidators’ initial decisions and that any appeal, regardless of merit, should go before the court. The only threshold to an appeal is whether the creditor can lodge a standard form with the Cayman court. Even in cases where the court could otherwise have exercised its discretion to protect the insolvent estate, the liquidators are required to incur the costs of responding to the appeal.

Cayman-registered companies that unsuccessfully appeal (rightly) cannot avoid enforcement of a costs order. In contrast, a liquidator may not feel that the costs and risks of enforcing a costs order against a foreign company of questionable solvency, which may include the need for recognition of the order or their appointment and the engagement of local attorneys, are justified. A foreign company therefore stands less risk of needing to satisfy any costs award than a Cayman-resident company, so the rule in practice creates a bias against local companies.

The liquidators’ costs are paid from the estate anyway, so the true creditors of the company are penalized to ensure the access to justice of a party that is twice affirmed not to be a creditor.



It is not clear why a claimed creditor, who already has access to an initial adjudication of its claim at minimal cost (there is no fee for submitting a proof of debt and having it adjudicated), should enjoy a greater right of access to justice than an ordinary plaintiff in civil litigation who needs recourse to the court to establish its rights – or should be allowed to make itself immune from the consequences of bringing bad claims in a way that ordinary court litigants are not. True creditors of Cayman Islands companies stand to suffer at the hands of this apparent gift.

The argument that security for costs would prevent the bringing of appeals with merit by those genuinely unable to provide security is adequately addressed by the discretionary nature of the remedy. In such cases it was always (until the court’s discretion was removed by the amendment) open to the court to refuse to order security.

In the authors’ opinion, the recent changes are detrimental to creditors of Cayman companies, and expose liquidation estates to unmeritorious claims at the true creditors’ expense, and should be reconsidered.


Andrew Bolton is a partner and Practice Group Head of Appleby’s Litigation & Insolvency department. Based in the Cayman Islands, he specialises in contentious insolvency matters and commercial litigation, including fraud, asset recovery and professional negligence.
Jeremy Snead is a Cayman Islands-based senior associate within Appleby’s Dispute Resolution practice group.

Reflections on globalization

In 1981, when Ronald Reagan became U.S. president, 44 percent of 4.5 billion people on the planet lived on less than $1.90 a day. In 2015, only 9.6 percent of the world’s 7.3 billion people lived in extreme poverty. Put differently, the number of extremely poor people declined from 2 billion to less than 700 million in spite of the global population increase of 62 percent. Poverty declined on every continent, including sub-Saharan Africa, and nowhere was it more pronounced than in East Asia, where extreme poverty declined by an incredible 95 percent. According to Laurence Chandy and Geoffrey Gertz of the Brookings Institution, “[The] rise of emerging economies has led to a dramatic fall in global poverty …. Poverty reduction of this magnitude is unparalleled in history: never before have so many people been lifted out of poverty over such a brief period of time.” See figure 1.

Human progress was not limited to a decline in global poverty. Over the past two and a half decades, Johan Norberg estimates, hunger declined by 41 percent, child mortality by 53 percent, illiteracy by 56 percent and pollution by 61 percent. Many, if not all, of these improvements were connected to economic expansion in the developing countries. That is particularly true of China – population of 1.4 billion. Consider the following historical perspective: Between 1980 and 2010, average annual income per capita in China rose by 657 percent. It took the United States more than a century (1900-2010) to see its average annual per capita income grow by 645 percent. See figure 2.

There can be little doubt that globalization, rather than foreign aid, was behind the rapid growth of the Asian economies. Once again, consider China. In the 32 years after economic liberalization (1978), Chinese incomes rose by 721 percent. In the 32 years before liberalization, they grew by 101 percent. Similarly, in the 19 years after economic liberalization (1991), Indian incomes rose by 158 percent. In the 19 years before liberalization, they grew by 57 percent. Both countries received a minimum amount of foreign aid – especially when compared to sub-Saharan Africa, which received much more aid, yet performed worse with regard to growth and poverty alleviation. See figure 3.

Last, but not least, researchers including Xavier Sala-i-Martin of Columbia University, Surjit Bhalla of the Rand Corporation and Paolo Liberati of the University of Rome have found that rapid growth in developing countries led to the closing of the income gap that emerged at the dawn of industrialization, when the West took off and left much of the rest of the world behind. Global inequality, in other words, is declining.

I started with a reference to Ronald Reagan because it is his presidency that is generally considered the start of the current period of globalization. But what is globalization? The Organization for Economic Cooperation and Development defines globalization as “an increasing internationalization of markets for goods and services, the means of production, financial systems, competition, corporations, technology and industries. Amongst other things, this gives rise to increased mobility of capital, faster propagation of technological innovations and an increasing interdependency and uniformity of national markets.” There are many definitions of globalization, of course, but they all seem to agree on the centrality of global trade.

Why do people trade? Trade improves global efficiency in resource allocation or, to put it differently, it provides a superior way of delivering goods and services to those who value them most. An expanded market allows traders to gain from specializing in the production of those goods and services that they do best (i.e., the law of comparative advantage, which David Ricardo discovered exactly 200 years ago). Trade allows consumers to benefit from more efficient methods of production. Without large markets for goods and services, it would not be economical to separate production into specific operations and plan large production runs. Large production runs, in turn, are instrumental to reducing the cost of a product. The reduction of the cost of production leads to cheaper goods and services, which increases the real standard of living.

Trade is such a powerful engine of human progress that the current wave of globalization is merely the latest of many. The trade links between the Sumer and Indus Valley civilizations go back to the third millennium BC. Then there was the Silk Road between Europe and Asia, and European voyages into India and the Americas. And who can ignore the globalization of the second half of the 19th century that ended with the outbreak of the Great War and that was so beautifully described by John Maynard Keynes in The Economic Consequences of the Peace:
“The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could dispatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference.”

The benefits of trade are not limited to economic gains. The “capitalist peace theory,” for example, holds that interdependence, which trade encourages, lessens the likelihood of military conflict between trading parties. The philosophical roots of the theory can be traced back to Immanuel Kant, who in his 1795 essay Perpetual Peace argued that “the spirit of commerce . . . sooner or later takes hold of every nation, and is incompatible with war.” Today we know that trade cannot guarantee a perpetual peace. The belligerents in the Great War were each other’s main trading partners (e.g., Great Britain accounted for 12 percent of German trade, which was more than German allies, including Austria–Hungary, Bulgaria and the Ottoman Empire, combined). But we also know something else. We know what happens when trade ceases and industrialized nations go to war. It is precisely the memory of the Great War and the subsequent horrors of the 20th century that make the capitalist peace theory relevant today.

Speaking of peace and prosperity, the recently concluded U.S. presidential election, which saw both Republican and Democratic candidates for America’s highest office embrace protectionism, is a cause for concern. The victory of Donald J. Trump, many people fear, could lead to a trade war with China, with negative consequences for world trade and, consequently, global growth. But what are we to make of Trump’s claim that thanks to globalization, “Americans don’t make anything anymore”? First and foremost, American manufacturing output has been rising and is at an all-time high. True, the sector accounts for a smaller share of the American economy than it used to, but that is because services have been growing faster than manufacturing. The reason why so many goods in American stores say “Made in China” is not because America has stopped “making things,” but because U.S. manufacturers have shifted toward high value-added products, like aerospace equipment. See figure 4.

Trump is on more solid ground when he commiserates with Middle America, which saw “manufacturing jobs disappear.” The struggles of these people are real enough – as the Nobel Prize-winning economist Angus Deaton showed by looking at the spiking opiate addiction and suicide rates among poor whites. Contemptuously, Hillary Clinton called many of these people “deplorable,” and it was they who turned out in large numbers and put Trump over the top in America’s “rust belt.” However, Trump is wrong to ascribe the disappearance of manufacturing jobs to globalization in general and China in particular. The U.S. manufacturer employs fewer Americans than it once did because of technological advancement, which has led to efficiency gains. The main culprit of job losses in the manufacturing sector, in other words, is automation, not trade. And isn’t the ability to make more, while using less, the key to productive growth?

A protectionist trade policy intended to “bring back American jobs,” would hurt the U.S. economy. American tariffs on manufacturing inputs, such as Chinese hot-rolled steel, for example, protect American workers making hot-rolled steel, but they harm American welders and construction workers who use hot-rolled steel as I-beams and railroad tracks. Put differently, cheap inputs lead to cheap outputs and that makes America’s exports more competitive. Moreover, a tariff on Chinese imports would lead to reciprocal Chinese tariffs on imports from America, thus harming the U.S. workers even further. Logically, therefore, solutions to the misery in America’s hinterland must lay elsewhere. While beyond the scope of this article, let me suggest a few reforms that would actually help the American workers:

  1. Education reform that brings competition and accountability to America’s schools would make the American worker more knowledgeable and productive.
  2. Cheap energy facilitated by the deregulation of the energy sector would cut production costs in America’s private sector.
  3. Restraining the EPA’s and DOL’s overreach would also help in reducing costs and encourage business creation.
  4. Tax reform that cuts the high corporate tax rate, while making it more egalitarian and less arbitrary, would also stimulate the economy.

It is easy to blame foreigners for the woes of the American economy. In reality, most of the enemies of the American worker reside not in Beijing, but in Washington, D.C.

U.S. considers border adjustable tax folly

One of the key separators between U.S. and European tax policy has long been the presence of value-added taxes. That might change thanks to a provision in the proposed blueprint that will serve as the starting point for corporate tax reform in the new U.S. Congress. If enacted, the fundamental change to U.S. corporate tax rates will also have significant implications for the international community.

VATs are efficient revenue raisers that enable bigger government, which is why it is all the more puzzling that Republicans are the ones whose actions might finally result in bringing a VAT to the United States. Republicans aren’t proposing a VAT exactly, but one aspect of the blueprint put out last year by Speaker Paul Ryan and House Ways and Means Chairman Kevin Brady comes worryingly close, and is likely to lead to a straight VAT in the future.


The Ryan-Brady blueprint

After an election in which Donald Trump won the White House and Republicans maintained majorities in both the House and Senate, tax reform is looking more likely to happen than ever. Donald Trump issued a tax reform plan during his campaign, but the major legislative legwork is going to take place in Congress. And Congressional Republicans are likely to draw heavily on the Ryan-Brady blueprint released last year as they work to get tax reform quickly out the door.

The House blueprint contains many desirable, pro-growth provisions. It would replace depreciation with full expensing for most capital purchases, end the worldwide taxation of income, and lower rates to more competitive levels.

Yet included with these much needed reforms is a provision that has divided free market advocates, the business community and economists alike. The blueprint would convert the corporate income tax into a destination-based cash flow tax (DBCFT). It is “border adjustable,” which the blueprint accomplishes by exempting revenue derived from exports from taxation and denying deductions for the cost of imports.


Full impact uncertain

Despite the apparent protectionist nature of the DBCFT, proponents insist that because much of the rest of the world uses border-adjustments in their VATs, it is neutral between domestic and foreign produced goods and thus an improvement over the present system. Some politicians also tout it as stimulating exports, but even those economists who otherwise support the DBCFT deny that would occur.

Proponents also suggest that price increases for consumer goods would be offset by increases in the value of the dollar relative to foreign currencies. That’s uncertain at best. Real world data raises questions as to whether the theoretical assumption of perfectly efficient currency markets is warranted. Even if the dollar appreciated enough to offset higher consumer price tags, that would “deliver a sizeable hit to US residents’ foreign wealth and could create risks of dollar-denominated debt problems abroad,” according to Goldman Sachs.


Heading toward a VAT-tastrophe

Consumer price increases – which may or may not be offset by changes in the value of the dollar – and potential market disruptions to existing supply chains are problematic enough. But the real danger from the DBCFT is the likelihood that it will evolve into a straight VAT and enable bigger government for decades to come.

As proposed, the DBCFT is very similar to a VAT. The main difference is that the DBCFT allows for the deduction of payroll costs. But even that difference might not last.

It’s highly dubious whether the DBCFT would be permitted under WTO rules. Historically, the WTO has made a distinction, whether justified or not, between direct and indirect taxes when it comes to border-adjustability. Rebates on direct (i.e. income) taxes are considered to be illegal export subsidies, while rebates on indirect (i.e. consumption) taxes are permitted. VATs, in other words, can be border adjustable while income taxes cannot.

The uncertainty regarding the DBCFT is due to the fact that it’s an income tax that resembles a consumption tax base. The blueprint, however, is very clear that its authors do not consider it to be a VAT. If the WTO takes them at their word, the DBCFT is likely to be ruled impermissible.

Such a ruling would not simply be a lawmaker inconvenience. It could be the first domino to fall on the way toward seeing a VAT adopted in the United States. After all, the most likely solution for members of Congress facing a bad WTO ruling would be to make a few tweaks and turn the DBCFT into a VAT.

More worrisome still, there’s no telling the partisan makeup or disposition of Congress by the time the WTO rules. If the left is back in power, the result could be a nightmare scenario where the U.S. corporate tax environment becomes more like that of Europe, with both income and consumption taxes.


Diminished competition

Whether the DBCFT is adopted doesn’t just matter to the United States or those doing business with America. One of the primary reasons for adopting a DBCFT, according to its many left-leaning academic supporters, is the fact that it would relieve politicians from pressure to lower rates in the future. Because it is destination-based, in other words, there’s no chance for taxpayers to seek an alternative system should tax rates become too onerous.

That’s bad for U.S. taxpayers, as it means the pressure of tax competition would no longer help keep politicians from pursuing their most avaricious fantasies. And if other nations follow suit, it would mean higher taxes all around.


The political fight

The DBCFT has already led to the formation of unusual political alliances. Proponents include some free market advocates who value a tax they see as less destructive than corporate income taxes, left-leaning academics who see potential to raise rates and make taxes more progressive once competition is eliminated, and protectionist politicians who either see it boosting exports or at least the ability to sell it to the public as if it does. The latter group includes Trump Chief of Staff Reince Priebus, who said the administration wants border adjustability “so that American jobs are protected,” and House Ways and Means Chairman Kevin Brady, who says it is a “key part” of the tax reform plan and “going to stay.”

Opposed to the change are other free market advocates who see danger in providing an efficient revenue engine for future government growth, along with a large group of retailers and other industries which rely heavily on imports and who fear their ability to remain profitable going forward. The free market advocates who oppose the change lament that the insistence of Republicans that the good pieces of the plan must be “paid for” amounts to premature surrender to the flawed, static scoring models -used by the Congressional Budget Office and the Joint Tax Committee – which favor government growth and have long been used by Democrats to prevent pro-growth or government shrinking reforms. It’s a departure from the precedent set by Ronald Reagan, who cut taxes and let revenues fall in the short run in order to grow the economy, and thus revenues, in the long run. By providing future elected officials an easy means to raise revenue, they also see it as trading long-term pain for only short-term gain.

The split in the business community creates an additional political obstacle to passage of corporate tax reform. There are almost always going to be winners and losers, but whereas businesses would otherwise support corporate tax reform practically in unison, the inclusion of border adjustments has led to a rift, primarily between importers and exporters. With Republicans barely holding a majority in the Senate and needing the support of a few Democrats to prevent a filibuster, a fractured business community could prove the difference between passage and failure.



It remains to be seen just how likely the DBCFT is to be adopted. It creates unnecessary political obstacles to reform by dividing the business community and free market advocates alike. The idea has not been thoroughly vetted compared to other key reforms under consideration, likely because Republicans probably did not foresee the extent of the electoral victory when the blueprint was being crafted. Now they have to deliver on campaign promises, and unfortunately, new administrations have limited time in which to get major agenda items done before the next campaign season begins. There is not much time left for lawmakers to come to their senses.

Trump and the Cayman Islands

The political situation in the United States will always have a direct effect on the Cayman Islands economy because of our currency connection, our physical proximity and therefore frequent travel to and from the U.S., our reliance on imported goods from the U.S. and the fact that our tourism industry is so heavily supported by the U.S. market. Our financial services industry plays a crucial part servicing the global economy, helping banks and corporations to lower their costs which will ultimately be passed on to the U.S. consumer.

Ensuring we have a positive relationship with the United States means our economy, which of course includes our real estate industry, can continue to thrive. Our own economy is therefore tightly interwoven with that of the U.S.

The transition of U.S. presidency from President Obama to President Trump will therefore be watched with close scrutiny by all of us in the Cayman Islands.


An historical perspective

It is difficult to ascertain exactly what the impact will be on the Cayman Islands once Trump is the U.S. President, as, at the time of writing, he has not even yet been sworn in as president, so I thought it would be useful to start by assessing how the Cayman Islands has traditionally fared under successive previous U.S. presidencies.

The two sides of the U.S. political spectrum differ vastly in their philosophies as they relate to offshore.

Generally speaking, I believe that the Cayman Islands has done well under a Republican presidency. The reason for this is the Republicans better understand the benefits a tax neutral environment has on business and as a result how the public at large can benefit from this type of environment. Offshore financial centers such as the Cayman Islands provide corporations with the opportunity to reinvest their capital and returns, ultimately providing better share returns for investors and thereby allowing U.S. corporations to compete in this global market place. Employing tax neutral strategies gives U.S. companies the opportunity to afford to hire expensive local labor, benefitting the man in the street and bolstering the American economy. U.S. pension funds invested in offshore funds benefit from their investment’s tax neutral environment and the Cayman Islands is the leading jurisdiction for healthcare captives, representing around a third of all captives, and a very large percentage of this is focused in the main within the North American market. Republicans mostly understand and appreciate all the benefits the offshore financial services industry brings to their own economy.


Negative effects of a Democrat presidency

What usually happens under the Democrats is a clamping down on tax neutral environments in an attempt by the U.S. government to hold on to tax revenue from corporations and individuals, thereby making it harder for offshore financial services to operate and compete with the U.S.

It is interesting to note that, over the past eight years under the recent Obama administration, I have witnessed grave concerns by U.S. investors who have are looking to invest in Cayman Islands real estate. In the main, these investors did not appreciate how their government was spending their tax dollars and they were not happy supporting an environment where monies were taken from those who provided the taxes and revenue, and given to those who did not contribute to the U.S. economy via taxes. Instead, they preferred to look at attractive and secure locations such as the Cayman Islands to make property investments that they felt were sound and would offer steady returns for the long term. This has therefore caused a marked interest by overseas investors looking to expand their property portfolios into Cayman Islands real estate.

There is no denying that President Trump is pro-business and it has been his mantra to grow business and ‘make America great again’, but without a clear stance from the new American president on his administration’s views on the offshore financial services industry, it is difficult to make any predictions as to how this jurisdiction will fare. Time will tell as to whether our relationship with our influential mainland neighbor will benefit from the new Trump presidency.

The changing landscape of private fund investor due diligence

The importance of private fund investor due diligence in the investment allocation process, in capital formation and in private fund litigation has reached unprecedented levels and is further increasing. Using two datasets: (1) private investment fund advisers’ SEC Form ADV II filings from 2007 to 2014 (N=100392), and (2) the publicly available litigation record pertaining to private fund investor due diligence from 1995 to 2015 (N=572), my paper ( provides the first and only theoretical and empirical evaluation of the evolving private fund investor due diligence requirements and the applicable legal environment in the United States. I highlight important changes in the quality and quantity of private fund investor due diligence in SEC Form ADV Part II and evaluate the corresponding litigation record as well as expert guidance on applicable best practices.

The private fund industry has incrementally improved due diligence standards and requirements in the aftermath of the financial crisis of 2008-09. Before the financial crisis of 2008-09, investment advisers/managers usually performed at least part of their due diligence by starting with the AIMA or MFA due diligence questionnaires and edited the templates to suit their circumstances. The old versions of those questionnaires were often used in attempt to avoid investors’ questions challenging the manager on possible weaknesses in their controls.  In the aftermath of the financial crisis of 2008-09 and various associated crises, such as the Madoff scandal, among others, investors, at least those on the relatively more sophisticated end of the continuum, such as pension funds, etc., no longer accepted the slanted phrasing of the due diligence questions and their answers. As a result, the questionnaires became relatively more rigorous.

Since 2010, investment due diligence has also become an increasingly litigated issue in the capital formation and allocation process. In lockstep with the growth of the private investment fund industry, private fund investor due diligence litigation has increased significantly since the financial crisis of 2008-09. Courts in early 2010 started to set out private fund investor due diligence standards and provided guidance on the requirements and limits. The increasing due diligence litigation record underscores the heightened importance of due diligence in the capital formation and allocation process since the financial crisis of 2008-09.

Little to no guidance exists, other than in my paper, on applicable standards for investment due diligence. Despite the increasing relevance of investment due diligence in the capital formation and allocation process and despite increasing litigation in the context of investment due diligence, the industry is mostly left to its own devices to ensure adequate due diligence standards apply.  Available resources describe best practices but do not sufficiently outline the legal requirements pertaining to private investment fund due diligence. The available case law only marginally provides relevant guidance on private fund investor due diligence.

In the paper, I provide evidence that from 2007 to 2014 an increasing number of SEC Form ADV II filers deemed investor due diligence worth mentioning in their filings and an increasing number of SEC Form ADV II filers qualitatively intensified their due diligence disclosures in Form ADV II brochure filings. More specifically, an increasing number of SEC Form ADV II brochure filers included investor due diligence disclosures since 2010. However, the number of filers who include those disclosures has remained relatively even between 2012 and 2014.

The intensity of investor due diligence mentioning relative to total SEC Form ADV II brochure filings, however, has increased substantially; the due diligence count exceeded the total ADV II filings for the first time in 2014. The data suggests that SEC Form ADV II brochure filers take investor due diligence disclosures in Form ADV II much more seriously since the year 2010 and especially since 2012. Filers appear to see a need to increase the quantity of investor due diligence disclosures in Form ADV II between 2011 and 2014.

Moreover, the data on case law between 1995 and 2015 suggests that private fund investor due diligence has reached new and lasting prominence in the court system. The increasing caseload on private fund investor due diligence since 2005 could suggest that applicable legal standards need to be further clarified to protect investors. Madoff-related cases in the aftermath of the discovery of the Madoff Ponzi scheme in 2008 help explain the significant increase in the prevalence and importance of private fund investor due diligence after 2009.

The increasing caseload on private fund investor due diligence since 2005 could suggest that applicable legal standards need to be further clarified. The data shows that between 1995 and 2015 private fund investor due diligence has reached new and lasting prominence in the court system. Madoff-related cases in the aftermath of the discovery of the Madoff Ponzi scheme in 2008 only partially explain the significant increase in the prevalence and importance of private fund investor due diligence after 2009. Private fund investor due diligence is intended for investor protection. My study has demonstrated that the legal standards applicable to private fund investor due diligence are somewhat inconsistent and suboptimal and merit clarification.

Examining the litigation record with regard to expert testimony helps identify prevailing best practices for private fund investor due diligence. Experts are often testifying on behalf of plaintiffs attempting to establish that proper due diligence industry standards should be applied in a given case. Experts provide the court with feedback about the standard due diligence practices and point out specific failings that could make a certain defendant liable. Expert testimony can also provide private fund managers with guidance on how their applied due diligence practices compare with purported industry standards.

Using Westlaw’s Expert Materials tool, I synthesized the applicable cases to identify expert testimony on applicable private fund investor due diligence standards. Westlaw’s Expert Material tool’s coverage begins in 1996  and assesses “selected reports, affidavits, deposition (both full and partial, and trial transcripts from expert witnesses from the state and federal courts of the United States.” I hand-selected relevant expert reports to the court that dealt specifically and in-depth with private fund investor due diligence.

Major failures or “red flags” in private fund investor due diligence among private fund advisers include: the lack of written policy or processes in place to ensure compliance, little to no experience of the individual conducting the due diligence (especially on the particulars of hedge funds), use of basic spreadsheet formulas unable to account for subjective data or systematically update information, not checking paper statements or election records to confirm trade data, not checking credentials and background checks on fund staff, dealing with firms with no third party controls (broker-dealer, custodian, administrators) or substantive auditors (with no auditing history), failure to assess fund performance against common benchmarks  and assess how a fund could make money in declining markets.

Commonalities in expert testimony and expert consensus on applicable standard private fund investor due diligence industry practices, as stipulated in the examined litigation record, include: qualitative review of firm marketing materials, offering documents, subscription documents, manager track records, onsite manager meetings, detailed due diligence questionnaires, monthly portfolio analysis- regression analysis, style drift analysis, qualitative reviews of fund employees including background checks, assessment of fund processes (including buy sell disciplines, risk management, investment research, team approach, technology and infrastructure), assessment of management fees, review of public documents such as SEC Form ADVII, confirmation and assessment of an independent auditor and the fund having an extensive audit record, and regular peer reviews and benchmarking. Specifically, in addition to testifying experts, the SEC has also pointed to Form ADV as a major step in creating sufficient transparency to conduct due diligence effectively.

The heightened emphasis on private fund investor due diligence as demonstrated in my study could foreshadow the possibility of standardization of private fund investor due diligence. Lacking standards for private fund investor due diligence can partially be attributed to private funds’ unique position in markets – unlike mutual funds, private funds evolved as unregistered entities, free from most regulatory oversight. Accordingly, the private fund investor due diligence evolved without regulatory oversight. In analogy to banks’ risk evaluation, 15 years ago banks operated with general risk evaluation strategies but no uniformity and no applicable standards, whereas today bank’s risk evaluation is heavily regulated and turned into a science. Private investment fund due diligence may follow the same evolution. Private fund advisers will likely pass associated costs through to their investors.

BEPS project remains the main focus


The Organization for Economic Cooperation and Development (OECD) has gradually carved for itself a central role in global tax matters over the past two decades. Today, its many initiatives impact global economic activity in a variety of ways. “OECD Watch” summarizes and analyzes the organization’s recent activities relating to international finance and tax matters.


Base Erosion and Profit Shifting

The BEPS project remains the primary focus of the OECD’s tax-related activity. In November, negotiations were concluded on a multilateral instrument – called the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent BEPS – which will “transpose results from the OECD/G20 Base Erosion and Profit Shifting Project into more than 2,000 tax treaties worldwide.” A signing ceremony will be held June 2017 in Paris.

The new Inclusive Framework – whereby small and low-tax jurisdictions are given the appearance of having meaningful input in the project – held its first regional meetings for Latin America and the Caribbean in Montevideo, Uruguay, on Sept. 21-23; for French-speaking countries in Tunis, Tunisia on Nov. 22-24; for the Asia-Pacific region in Manila on Nov. 29-Dec. 1; and for Eastern Europe and Central Asia in Vilnius, Lithuania, on Dec. 14-16.
Andorra, Panama, Macau, Mauritius, and Ukraine all recently joined the Inclusive Framework, giving it a total of 91 members as of early December 2016. Five new jurisdictions – Brazil, Guernsey, Jersey, the Isle of Man and Latvia – joined the Multilateral Competent Authority Agreement for exchange of CbC reports.

New documents were released relating to BEPS Action items 13 and 14. The documents included a list of jurisdictions and their domestic legal frameworks for Country-by-Country reporting (Action 13), as well as additional interpretive guidance on the CbC standard.

According to the OECD, “The additional guidance relates to the case where a notification to the tax administration may be required to identify the reporting entity within a MNE Group (as provided in Article 3 of the Model Legislation in the Action 13 Report). The guidance confirms that if such notifications are required, jurisdictions have flexibility as to the due date for such notifications.”

Also released were documents which will form the basis of the Mutual Agreement Procedure (MAP) peer review and monitoring process under Action 14 (Making Dispute Resolution Mechanisms More Effective). Stage 1 of the peer reviews will be conducted in batches, with the first (consisting of Belgium, Canada, Netherlands, Switzerland, United Kingdom and United States) beginning December 2016, and a new batch following every four months. Review has been deferred until at least 2020 for the following developing nations: Benin, Costa Rica, Egypt, Gabon, Georgia, Jamaica, Kenya, Pakistan, Paraguay, Senegal, Seychelles and Uruguay.


Global Forum meets

The Global Forum on Transparency and Exchange of Information for Tax Purposes met for its annual meeting in Tbilisi, Georgia, on Nov. 2-4. The Forum announced the completion of the first round of the exchange of information on request peer review process with the qualification of Peru, Lebanon, Nauru and Vanuatu for Phase 2 review. Of the Phase 2 reports released, the following jurisdictions were assessed as “Largely Compliant”: Azerbaijan, Brunei Darussalam, Burkina Faso, Lesotho, Morocco, Romania, Bulgaria, Barbados and Israel.

Dominica and the Dominican Republic were rated “Partially Compliant,” while the Marshall Islands and Panama were given “Non-compliant” ratings.

Rather than reject the process for the hypocritical farce that it is, the two newly minted non-compliant jurisdictions prostrated themselves and begged for mercy. Or as the OECD says, they “announced that they had already taken or were taking steps to address recommendations made in the review process.” A fast-track process was agreed to that would allow the Global Forum to recognize progress made by mid-2017 from non- and partially compliant jurisdictions in time to meet the deadline set for the G20 Summit in July.

The Global Forum also reported that its budget has run in the red for the last two years. It tapped into its available surplus to make up the shortfall, but will apply an inflation adjustment to membership fees starting in 2018 and “re-examine the membership fees as a whole in 2017 taking into account the financial situation at that time.” That’s a fancy way of saying that they’ll soon be charging jurisdictions more money for the pleasure of browbeating them into adopting counterproductive fiscal policy.


Preparing for automatic exchange

With the automatic exchange of information set to begin in 2017, the Global Forum notes that 101 jurisdictions have made a commitment to implement the AEOI Standard. Fifty-four jurisdictions have pledged to begin exchanges in 2017, including Bermuda, BVI and the Cayman Islands. Another 47 are set to begin exchanges in by 2018, including Hong Kong, Panama and Switzerland. The Forum now intends to shift focus to “the delivery of the commitments made in order to ensure a level playing field.”

The ongoing monitoring process reports that almost all jurisdictions have both the international legal framework and domestic laws in place for automatic exchange. The Global Forum called for a monitoring report to be delivered by the end of 2016 on the progress made by committed jurisdictions in order to “identify any gaps at an early stage.” Once sufficient data has been exchanged, the Global Forum “will carry out comprehensive reviews of the effectiveness of the implementation of the AEOI Standard.”

More nations have joined the Convention on Mutual Administrative Assistance in Tax Matters. Pakistan, Panama, Cook Islands and St. Lucia signed The Convention, while Switzerland announced its ratification, bringing the total number of participating jurisdictions to 107. The Convention can be used for both the sharing of rulings under BEPS Action 5 and of CbC reports under Action 13, as well as to implement the automatic exchange standard. It is slated to go into effect in 2017, though almost half of the signatories – including the United States – have not yet ratified it.


Politicization continues

In July 2016, the OECD laid out its plan to move toward seeing tax decisions through the lens of “inclusive growth.” Under this rubric, the organization would put less emphasis on “the impact of taxes on economic growth from an efficiency perspective,” and pay more attention to “equity outcomes,” like “redistributive goals” and the “progressivity of tax systems.”

The politicization of the OECD has since only gotten worse. In a publication called Revenue Statistics in Asian Countries, the OECD not only suggested a need for Asian countries to raise taxes, but came to the jaw-dropping conclusion that a nation is not developed unless its government consumes at least 25 percent of GDP through taxes. This is particularly ironic given that the OECD had just recently published a working paper from two economists which acknowledged that “larger governments are associated with lower long-term growth.”
In addition to its increasingly ideological view on taxes, top OECD officials inserted the organization into the U.S. presidential campaign in unprecedented fashion. Secretary General José Ángel Gurria said that “the word racist can be applied” to then-candidate Donald Trump, while Deputy Secretary General Doug Frantz called Trump a “lunatic” and likened his rise to that of Hitler and Mussolini. Regardless of whether one agrees with these sentiments or not, their expression by top OECD officials demonstrates that it is not the neutral, consensus driven body it still pretends to be.


Future trends

Mr. Frantz has also expressed rather disturbing views toward multinational businesses. Namely, he asserts that they are “greedy” for undertaking the common sense “search for the best tax opportunities available to them.” More tellingly, he said: “I think that the idea that your only responsibility as a CEO is to the shareholders is wrong. I think you have social responsibilities, I think you have responsibilities to your workforce and I think that those responsibilities mean you should pay your own fair share of taxes …We need to make it less palatable for multinational enterprises to engage in these legal tax avoidance measures.”

On that front, the OECD released the first edition of a new annual publication called Tax Policy Reforms in the OECD. It provides an overview of the tax reforms implemented, legislated or announced by OECD member nations during the course of the year. The report noted – much to the agency’s chagrin – that 2015 saw reductions in corporate income tax rates as more nations focused on pro-growth policies. BEPS and other ongoing OECD efforts to undermine tax competition will unfortunately make such trends less likely in the future.

Their Global Forum meeting also provided yet more reason to expect sanctions or other aggressive actions against holdout jurisdictions which have not adopted a sufficient number of the OECD’s “recommended” policies. There, a “constructive discussion” was held “against a backdrop of calls for preparation of lists of non-cooperative jurisdictions.” Ominous words for those who support tax competition and fiscal sovereignty.

Landscape changes for reporting impairment losses in financial instruments

The global financial crisis generated several criticisms of the accounting standards that guided the financial statements of the period. Two of the most salient criticisms were the undue reliance on fair value and the failure of existing frameworks to create sufficient credit loss buffers to absorb the losses arising from the crisis.

Both the International Accounting Standards Board (IASB), the authors of IFRS, and the Financial Accounting Standards Board (FASB), the authors of US GAAP, undertook to jointly review the accounting for financial instruments. Initially, this was part of their convergence program, but failure to agree on key components resulted in the parties developing divergent approaches to the issues of financial instrument recognition and measurement, impairment and hedging.

This article will focus on the key issue of the changes in the accounting for impairment for financial instruments as, while the details differ, both standards share a common objective of bringing forward the recognition of potential impairment losses in an entity’s holding of financial instruments.  While no accounting framework could have created sufficient loan loss buffers to absorb the exceptional level of credit losses arising from the GFS, the experience did illustrate the weaknesses in the existing frameworks. This justifies the revision of the previous impairment framework.

While the intention of the review of impairment provisioning is to advance the timing of creation of provisioning, one must consider their net effect in conjunction with the changes in recognition and measurement criteria. Despite the criticism of the role of fair value in the severity of the global financial crisis, the revision of IFRS 9 now makes fair value through profit and loss the default criteria, replacing available for sale. The net effect may be to increase rather than reduce the role of fair value in financial instrument valuation, thus reducing the level of impaired provisions required. The net effect will not be apparent until entities start reporting under the new IFRS 9 that becomes compulsory as from Jan. 1, 2018. Within US GAAP, US ASU 2016-01, the modification to the recognition and measurement criteria broadly retain the framework existing at the time of the financial crisis.

Under both US GAAP and IFRS, the main change in impairment loss reporting has been a move from an incurred loss (backward looking) to an expected loss (forward looking) perspective. This change should have a material impact on banks operations and governance frameworks.


Similar objectives, different details.

While both sets of standards adopt a prospective loss approach, important differences exist between them.  The biggest difference is in the timing of credit risk recognition. The revised US GAAP uses a current expected credit loss (CECL) based on the lifetime default risk to accrue the expected loss. It applies this test from day one of origination. The IFRS 9 expected credit loss (ECL) approach adopted by IFRS uses a three-stage approach to recognizing credit risk losses.  This starts with a 12-month expected credit loss on asset origination that moves to the lifetime expected credit loss approach on a “significant increase in credit risk.” The third stage involves recognition of an impairment event and roughly equates to the existing incurred loss of IAS 39.

The two standards assume different minimum level of initial credit loss recognitions. US GAAP allows an initial recognition of zero for certain high-grade securities, while IFRS 9 expects the initial 12-month expected credit loss to be greater than zero.  The scope of the US GAAP excludes debt securities classes as available for sale and is thus narrower than the IFRS 9 span that includes the AFS equivalent of fair value through other comprehensive income (FVOCI). Also, the two standards apply different treatments for purchased or originated credit impaired assets.

After 2018, these differences will reduce the comparability of financial statements produced under the two frameworks. The level of expected impairment losses that each generates will differ, and the progress of provisions through the credit cycle will vary. However, these differences should not be seen to disguise the common issues that face financial institutions in their implementation of these new frameworks.


Implementation challenges

The main issue required by both standards is that financial institutions must now have formal systems that model and calculate expected credit losses over the life of its financial assets, both on and off balance sheet. These systems cannot rely solely on historic data but are expected to include the results of the asset portfolios performance under different economic scenarios. While the standards make allowance for different levels of a bank’s sophistication and caveat the standards with remarks such as “without undue effort and expense,” the clear expectation is that existing credit risk management practices will not suffice beyond implementation.

This is requiring material efforts to create systems and processes that meet the new credit risk framework requirements. This is not just a matter of accounting, it is a pan-entity project. Hence, the implementation requires a proper project management. Implementation requires participation from at least the following units within the bank:

  • Accounting
  • Information technology
  • Risk management
  • Credit departments
  • Internal audit

Several elements make the project worthy of board oversight. As described above, the project involves resources from across the whole entity. Second, the implementation of the prospective credit loss framework will have financial implications for the entity’s balance sheet. Finally, the standard requires materially expanded disclosures regarding the assumptions and methodology used in the estimation of credit losses. Each of these factors warrant oversight of the project at board level. In many cases the audit committee has identified this as a standing agenda item, while others have set up specific subcommittees to ensure successful implementation of the project.

Four specific areas require detailed attention for this project:

  • Data management
  • IT systems
  • Modeling
  • Reporting
Data management

Prospective credit loss models rely heavily on historic data sets of sufficient longevity and granularity to provide a basis for modeling.  Many banks, especially in emerging and transition economies, lack this data. Multiple data sets include instrument data, macro-economic data, historical performance, customer credit information, customer personal data and collateral.  Any project needs to perform a gap analysis to identify data gaps. The BCBS had 239 sets of potential risk data aggregations.

IT systems

Banks need IT systems for data management, modeling, measuring and reporting. These systems need to aggregate the different data types and interface with the various requirements of the framework. The project should ensure the integration and scalability of the IT environment to provide the functionality the framework requires to function effectively.


The new frameworks require banks to be able to model expected credit losses under a range of economic scenarios. Hence, looking at historic loss levels, while a starting point, is no longer sufficient of itself to justify any projected credit losses. Banks need to analyze existing credit risk management methods and assess new modeling options to meet the new requirements. The proposed frameworks recognize that banks and their markets are at different levels of sophistication and allows them to make their plans within the context of that environment. However, it seems a reasonable reading of the standards, especially IFRS 9, that there is an expectation of a continuing improvement in a bank’s credit risk management environment.

As with any forward-looking model, there is a large degree of judgment required when arriving at final positions. Any development of the modeling framework should reflect this and identify how the bank plans to factor the judgment into the modeling and what steps it will take to ensure its ongoing integrity. This is important as it becomes part of the reporting process and will require acceptance by the banks external auditors.

Finally, the modeling needs to cover a range of scenarios that capture material non-linearites in potential economic outturns. Such scenarios may include base, upside and downside scenarios that are appropriate for the bank’s asset portfolio, exposures to credit risk and level of sophistication.


The disclosures requirements regarding impairment follow the expanded requirements of the Enhanced Disclosures Task Force (EDTF) established by the Financial Stability Board following the GFC. The element of judgment involved in prospective estimates of future credit losses requires materially expanded quantitative and qualitative disclosures in the financial statements. The disclosures cover both on and off balance sheet exposures and include such issues as credit risk profile, credit policies, concentrations, impairment policies and risk mitigation policies. Disclosures are at a level of granularity that facilitates a substantive balance sheet analysis. These expanded disclosures, which include an expanded management commentary, require careful management to ensure they are consistent with the bank’s business plan and overall communication strategy.



IFRS 9 adoption deadline is 2018 while US GAAP adopters of ASU 2016-13 have until 2020 or 2021, depending on their status. The experience of early adopters provides valuable insights into the challenges

The standards have a strategic impact on the bank. They impact the bank’s business model and balance sheet structure and so require understating at board level.

The implementation process requires formal project management. The standards are not just a change in accounting. Their implementation will have an impact across the bank and hence require strategic impact on the bank’s business model.

The identification of data gaps is critical. Regardless of the level of sophistication, the new standard requires an enhanced risk modeling process that is data intensive.

Modeling the quantitative outcomes of the process is difficult but must be done to identify the potential balance sheet impacts. Any material increase in expected credit losses will impact the bank’s public profile and capital requirements. Hence, it is important for the bank to understand the potential impact and develop a strategy to manage the public disclosures.

Prospective credit loss modeling is highly judgmental. Banks need to develop practical policies and guidelines to inform these judgments. Appropriate monitoring and governance mechanisms of the judgment process are important elements.

The standards have material impacts throughout the bank. The need to document and disclose credit risk management policies and processes has impacts beyond just reporting. The impacts flow back through lending, credit risk management, accounting, underwriting and pricing.

The implementation is sufficiently material to provide opportunities for reconfiguration of processes to realize internal efficiencies. Changes to IT systems, policies and operating processes are offering opportunities to reconfigure the organization to comply with the standards. A reorganization may provide the opportunity for effective implementation of the standard without necessarily incurring excessive cost.

International sanctions checking – by no means as simple as it seems

We are often asked how regulated businesses can reduce the cost of ensuring that their client portfolios are free from sanctioned individuals and entities.

Checking a new client against various sanctions lists at onboarding is not sufficient to protect your business from unwittingly assisting a sanctioned individual or entity in the future because such  lists are frequently and regularly updated. A client you onboarded three years ago could very well have been added to a sanctions list last month, and if you’re not checking regularly, you could very well be helping them and thus be in breach of those sanctions.

For those unfamiliar with sanctions lists, they are lists of individuals and entities that have been identified by the UN, the U.K., and the U.S. (and other governments) as from, or owned or controlled by, specific countries or individuals or groups that are participating in terrorist activities or narcotics trafficking.  There are many sanctions-checking service-providers (sometimes known as “list-providers” or “risk-screening solutions”) on the market on to whose platforms you can upload your client database to “batch-check” your clients’ names against those on their lists. The service provider will then provide you with a list of possible name matches. Sounds simple enough, but this is where the real challenge begins.

Larger businesses with thousands of clients will often receive a long list of so-called “possible name matches,” but often these are the result of false positives: for example, if you find yourself with a client with an identical or similar name to one on a sanctions list. Your compliance team is then tasked with reviewing your files and documenting sufficiently the review they performed that led them to determine that your client and the sanctioned individual are not the same person.

Even a small firm with only a few hundred clients is unable to check sanctions lists manually against all its clients. To do so would be to overwhelm its compliance staff (usually one person); and that, of course, in turn risks slowing down the day-to-day operations of client onboarding.

Cost is also a major consideration: the more lists you check, the more it costs. Obviously you want to ensure you are not breaching international sanctions, but many regulated businesses tick the “check-them-all” box when they sign on with a service-provider – and some of these service-providers generate lists that are much more than just sanctions lists. Although it’s commendable that you want to ensure your clients are not up to no good in areas not necessarily connected with international sanctions, the more lists you check, the more false positives your staff will have to investigate.

Some regulated businesses check third parties to transactions. Although not their clients, they feel the need to mitigate the risk to their reputation should they be assisting their client with a sanctioned person on the other side of the transaction. Again, while perhaps a good idea from a reputational standpoint at the time of the transaction, there is no need to continue to monitor the third parties after the transaction.

Your compliance staff are not alone in the process. Your IT team also need to ensure they are aware of the importance of international sanctions. If they have developed their own sanctions-checking system, they should have to prove to you at inception, and then regularly re-prove, the effectiveness of that system and its procedures. Another tricky aspect of the sanctions-checking process can be calibration. If you have bought a “fuzzy matching” feature to cover misspellings and phonetic similarities to your match-screening process, your false positives can go through the roof.  Conversely, if your batch sanctions check is responding to too few alerts, you may be missing real matches. Too many and you’re overloading your compliance analysts and risking human error with information overload and a slowdown in compliance operations.

The basic means to reduce risk of being an unwitting party to a sanctioned person’s transactions, while at the same time also reducing some of the workload and risks that come with international sanctions checking, are these:

  • Automate – The days of paper files for client due diligence and Excel spreadsheets to track higher risk clients are over. You need to organize your client data into a system and automate the process. For those already in a system and ready to move toward a more automated process of sanctions-checking, start by ensuring your client data is complete and accurate. Check for misspellings, accurate dates of birth, and nationality.  These can all help reduce false positives (or achieve real hits) in the name matching process.
  • Batch-Check – Sign on with a trusted, well-known service-provider and start batch-checking your entire client database. And identify who in your database is to be checked regularly; it’s no good batch-checking long-inactive clients or third parties after the transaction is complete. Once the possible name matches are reported to you, make sure your compliance team is taking immediate steps to conclude whether your client is the one listed on the international sanctions lists; and if not, to document the justification for its conclusion.
  • Calibration – Control and know which lists you are checking; and, just as importantly, which lists you are not, and why. To reduce cost, opt out of non-international sanctions lists for regular screening. Although you can batch-check your negative news/media lists less frequently,  you still need to do so regularly.

It is a good idea to make sure that everyone understands the importance of international sanctions. Therefore include, at a minimum, awareness training for all staff, not just for your compliance and IT teams. Include in your AML compliance policies your international sanctions-checking procedures on possible name matches and how to review and document false positive reviews. If a name-match review comes up with a  positive hit, set out the steps which the compliance analyst must take to report to your MLRO and those that the MLRO must take to file a SAR; also, how ongoing communications with any affected client must be handled.

Finally, retain the record of your batch-checking name results for your regulator. Be able to show them how often you perform sanctions-check reviews and as well as the results of those reviews.  Importantly, be aware of and sensitive to the workload your compliance staff are struggling under.

International sanctions checking will never be an easy process and the costs of list checking will only increase as time goes on. But failing to check its client database against sanctions lists is no longer an option for any regulated business that wants to stay free of penalties and reputational risk.