Offshore financial centres

inSight

29 Apr 2004

Offshore financial centres

Offshore financial centres sometimes have a bad name in the international financial community. There are, however, reasons for their existence, and not all of these reasons are dishonourable.

I am sure readers have come across the use of the term "offshore centre" or "offshore financial centre". Because of our desire, when circumstances permit, to play an active role in Hong Kong in the intermediation of renminbi funds, this term has come to be recognised in Hong Kong as a desirable status. This is in contrast to the general perception of the international financial community, in particular among the regulatory authorities. They consider offshore financial centres to be a problem in international finance, in that the standard of financial regulation in those centres is generally inadequate. In fact, there has been quite strong pressure exerted by the international financial institutions, such as the International Monetary Fund and the Bank for International Settlements, and by national regulatory authorities, on offshore financial centres in the past few years for improvements in financial regulation. The pressure has been strongest from the Financial Stability Forum, which in 2000 went as far as to name and shame them by publishing a list of jurisdictions, and giving them this doubtful label as offshore financial centres. Although I am a member of that Forum, I do not fully agree with the criteria against which jurisdictions were included. Regrettably, Hong Kong was on the list, along with a few significant international financial centres (Singapore and Switzerland, for example) and a larger number of jurisdictions that have variously also been called tax havens or booking centres or other names. Efforts to get our name off the list have been unsuccessful, although we have from the start been honoured with a Group One status, quite separate from those in Group Two and Group Three. Furthermore, there is recognition, on the basis of the very detailed scrutiny by the International Monetary Fund under the Financial Sector Assessment Program (FSAP), that some of the Group One offshore financial centres practise regulatory standards matching, if not surpassing, those of the developed market economies.

Perhaps we do not need to be too concerned about a misleading label. Nevertheless, I think it would be helpful, in our use of the term, to be clear in our minds exactly what we mean by it. There must be reasons for doing things - conducting financial transactions and organising financial businesses - offshore instead of onshore. I believe there are three distinct reasons. The first is regulatory arbitrage, aimed at getting around stringent onshore regulatory requirements, such as disclosure, corporate governance, liquidity and capital adequacy. Given that these regulatory requirements are there for good reasons, because they are necessary for upholding the stability and integrity of financial systems, regulatory arbitrage should clearly be discouraged. One way of doing so is to put pressure to bear on the offshore financial centres for upgrading their regulatory standards and, for those who are slow or reluctant to effect improvements, to name and shame them. We support this. The strategy can be quite effective, given the market discipline associated with it, in that prudent financial institutions would eschew dealing with those engaging in regulatory arbitrage. As a financial regulator in Hong Kong, I am not aware of any significant shortcoming in our regulatory framework that encourages regulatory arbitrage. We do have a lower tax rate than many other jurisdictions, but the low tax rate is universally applied to all activities conducted in Hong Kong, regardless of whether they are considered to be onshore or offshore business. This is quite different from the practice of a few financial centres where offshore financial activities attract a lower tax rate, or are subject to no tax at all.

The second reason for conducting financial activities offshore instead of onshore is very simply for convenience. With globalisation of financial markets comes increasing demands for their operation on a 24-hour basis, ahead of and beyond the operating hours of the onshore market on the same trading or settlement day. Indeed, in one or two markets of the developed economies, the degree of participation of non-residents is now as significant as, if not higher than, that of residents. For convenience as well as for better risk management, there is an increasing need for trading and settlement platforms offshore, in the other major time zones, linked to the onshore platform, for effecting transactions in those time zones when the onshore facilities are closed for business. The efficient allocation and use of international capital under globalisation depend on the provision and linkage of these offshore platforms with the onshore ones. To this extent, the unfavourable connotation now attached internationally to the term offshore financial centre seems inappropriate.

The third reason for conducting financial activities offshore has to do with the existence of controls onshore. Financial markets have a way of getting around controls. While many financial activities are not permissible onshore, this may not be the case offshore; and so there is a tendency for free markets in the controlled financial instruments to develop offshore, perhaps in non-deliverable form, operating along side the controlled onshore markets. Indeed, this often becomes an important incentive for financial liberalisation, and offshore markets are used as testing grounds. This is actually the pivotal role that Hong Kong is playing in the financial liberalisation of the Mainland. To this extent, the unfavourable connotation in the term offshore financial centre is also inappropriate.

 

Joseph Yam

29 April 2004

 

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