From what I have presented so far, there can be little doubt that the four so-called initiatives launched by the developed countries against offshore financial centres (OFCs), especially those operating in small states, pose a clear and present danger to the continued operation of OFCs in these states. Personally I find this somewhat ironic, as this industry has been spawned in the present age of burgeoning financial liberalisation, and is perhaps the most striking evidence of a positive small states' response to the opportunities afforded by globalisation.
So far I have examined three of these initiatives in these columns: those against harmful tax competition, money-laundering, and the loopholes and weak links the operations of OFCs constitute in the global system of financial regulation. Fundamental as these are, however, they cannot match in level the threat that is posed by the initiative against the financing of terrorism. In this arena much is at stake, as the combination of national security concerns, politics, organised transnational crime, and highly mobile financial fortunes is particularly deadly in the present global environment. It has propelled very strong direct interventions by the US and other OECD governments, which feel threatened by international terrorism. Indeed it is so deadly that concerns in this arena have spilled over into the other initiatives, fuelling a great sense of urgency.
For small states, the sad aspect of their position is the strong public perception that to date their OFC operations have thrived on secrecy. In an age of transparency, this does not sit well with public belief and confidence, particularly as there have been several unwelcome revelations. For example, the collapse of the big US transnationals, notably Enron, has brought to public awareness the extent to which these OFCs are used to mislead the public, governments, and investors and perpetuate systematic financial fraud on a mammoth scale.
Recent revelations also that Halliburton and General Electric have been using these OFCs to trade with states named in President Bush's 'axis of evil' have fuelled considerable concerns in the USA, particularly in light of the links between the first-named firm and the US administration. Also, Oxfam in a paper published in 2000 had estimated tax avoidance by TNCs through their OFCs offshore dealings at the whopping sum of US$50 billion annually. This amount was as large as the total value of all OECD aid programmes to poor countries at the time!
The Dutch disease
The present threat to the OFCs operating in small states has generated a great deal of debate in the development literature. Much of this has centred on the phenomenon of 'the Dutch disease' as economists term it. It would be useful therefore at this stage, if I attempt to present the essential core of this concept.
Some readers may be old enough to recall the Dutch discovery of offshore natural gas in their territories in the 1960s. What followed from this gave rise to the phenomenon of the 'Dutch disease.' As one of the earliest nations to industrialise and a traditional importer of its energy requirements, the unexpected wealth from the natural gas discoveries turned out to be so great that this sector became the leading producing and exporting one in the country. Furthermore, because energy is a key input into all production process, its availability and consequent relative cheapness in the Netherlands led to the adoption by all sectors of the Dutch economy of highly energy intensive production methods. Then came the oil-boom of the 1970s as a result of joint action taken by the oil-producing countries, which led to a tremendous spike in oil prices and along with it all other substitute forms of energy.
The dramatic rise in energy and natural gas prices in the Netherlands had multiple effects. It led to higher wage payments in the natural gas sector, which spilt over to higher wage payments in the non-natural gas sectors of the economy. The rise in the cost of energy per unit of output also led initially to a general rise in the cost of production in these non-natural gas sectors. The combined effect led to a decline in the competitiveness of the non-natural gas sectors and a squeeze on their profitability. In effect therefore, as the primary producing sector benefited (natural gas), the spillover effects into other sectors (manufacturing, services and agriculture) were negative. So strong was this negative effect that economists began to write about the 'de-industrialisation' of the Dutch economy.
There were also several related developments. Thus, because of high-energy prices, as a producer of natural gas, investors favoured the Dutch currency leading to its appreciation in world currency markets. This currency effect compounded the cost increases indicated above, making the non-natural gas export sectors even more uncompetitive. In a similar fashion, the strong trade-union movement in the Netherlands prevented employers from driving down wages in their effort to reduce costs, with the result that unemployment rose.
In summary, therefore, the 'Dutch disease' may be described as a situation where a boom in one sub-sector of exports (and in this case a primary product that was previously imported) leads to a decline in the competitiveness of the other export sub-sectors and the non-traded sectors of a national economy. The negative effects of this decline in competitiveness are so strong that they outweigh the positive gains from the boom in the export items under consideration, thereby undermining the national economy.
The applicability of the notion of the 'Dutch disease' is of course wider than the Netherlands. Similar experiences have occurred in several other countries and may have occurred at the time of the sugar boom in Guyana in the early 1970s. Based on this description, one can anticipate why this phenomenon has been considered as relevant to the predicament that small states could face, if the threats to their OFCs materialise.
Next week I shall continue to explore this issue.
Is it all dollars and no sense (cents) once again!
2004-02-08
This week's article wraps up the discussion on small states that have diversified their economies by establishing themselves as offshore financial centres (OFCs). As I mentioned last week, there is a growing concern being expressed in the development literature that these OFCs may repeat the bad experiences of natural gas in the Netherlands, which produced the phenomenon known as the 'Dutch disease.' The study by Hampton and Christensen, 2002, to which I have referred several times over the past few weeks is a good example of what I mean. If readers recall, put simply, the Dutch disease refers to a situation where there is a boom in certain exports in a country that generates substantial increases in wealth over the short to medium term. And, unwittingly, this in turn sows the seeds for the reduced competitiveness of all other industries and sectors in that economy, and in the end hurts, rather than helps, the national economy.
As was also mentioned in previous articles there might have been a similar transitory experience in Guyana following the boom in commodity prices (especially sugar) in the early 1970s. However, perhaps the best example of this phenomenon in the Caribbean is the case of Trinidad and Tobago where the gains from the massive oil and natural gas price increases of the 1970s and 1980s, seemed to have been frittered away. This was of course the same period when the Dutch disease started in the Netherlands. At that time Trinidad and Tobago was referred to in the region as having all dollars (petrodollars) and no sense (cents)!
The central point
This brings me to the central point I wish to make, which is the Dutch disease is not a natural ailment, but in essence a policy failure. It is for this reason that discussion of it at this stage is so pertinent to furthering our understanding of the vulnerability of small states. Small states suffer from severe disadvantages in the global market, but traditionally, wherever there has been an export boom in one item (as with the case of the OFCs), it has been very easy for them to become over-dependent on the production and sale of that item. Almost without exception the tendency of all governments has been to promote uncritically and reflexively whichever is the booming industry. This was the case with the OFCs, which governments in small states embraced with extraordinary zeal and little prudence.
Much of this can be attributed to their drive to diversify away from the narrow production base and high dependence on primary activities like agriculture, fishing, and cottage industries at the time. Moreover, they no doubt figured that offshore finance would complement the other activity many of them were turning towards with great enthusiasm - tourism. Both these industries depend on rapid and easy communications, local rental accommodation for visitors, as well as certain types of shops and local services, for example taxis, entertainment and sport, so that synergies could be anticipated.
It has also been suggested by some writers that certain cultural and social characteristics of small societies naturally encourage their preference for involvement in ventures like offshore finance with its secrecy and non-transparency. Indeed, so strong was this pre-disposition to favour OFCs as an attractive option, that in the case of the dependent territories, the pertinent metropolitan power encouraged its growth. And, in the case of independent small states, the IMF and World Bank, as well as regional development banks pushed this industry. It was the hope of all concerned that coming out of this confluence, there would be scope for attracting selective FDI flows encouraged by the flow of wealthy visitors and business persons and their growing familiarity with the small state in question.
The data show that by the 1960s and 1970s in several small states the OFCs provided the major and growing share of their foreign exchange earnings, capital inflows, government revenue, jobs, and domestically generated expenditure. However, as this development occurred, the sectors on which the small state relied before the OFC boom was neglected, labour shortages emerged, wage rates rose, and labour productivity declined in several instances. Some small states had resorted to importing 'contract' labour to maintain their pre-existing industries.
Cultural and social factors
In the economic literature this process is sometimes referred to as one where the new industry crowds out the established ones. In their study Hampton and Christensen, 2002, cite Jersey (the British dependency) where the pressure on land prices and labour costs, led to its agricultural land prices and construction costs being among the highest in Europe, while its famed tourist industry went into retreat in the face of the rapidly expanding OFC business. If such export booms continued forever there would of course be no cause for concern. The difficulty arises because such booms are not indefinitely sustainable. As we have already indicated, the threat posed by the rich countries' initiatives to offshore jurisdictions in small states is real, as this could amount to effectively removing the offshore/onshore distinction on which this industry is based.
There is the further problem to consider in the context of a broader political economy, that the OFCs in small states stand at the meeting point of several global titans, each of which is jockeying for influence and position in the new global economy. These are big trans-national businesses, very wealthy individuals, international organized crime, and global terrorism. Given their small size, it is hard to see small states emerging from this predicament as anything but losers. This is ironic, as several small states when they started their OFCs had thought that they were manipulating and exploiting their colonial ties and positions of dependency to their own national advantage. This gave rise to the notion of their 'managing' their dependency. If, however, the OFC bubble bursts, it might very well in retrospect be seen as a 'mismanaged' dependency relation.