Bermuda: Efficient Capital Movement

There have been many studies done to show that International Financial Centers facilitate an efficient flow of capital. IFCs provide this service better than other jurisdictions, which is why IFCs continue to flourish today. Due to the increasing demand for capital by BRIC and other emerging countries, statistics are showing that IFCs are filling a key role in the development of the economies of the emerging markets.

Developing economies typically suffer from inefficient institutions. Local entrepreneurs are unable to locally access the capital they require quickly or at a competitive price.

Table 1: Quality of Institutions – Developed vs. Developing Countries

Institutional Quality This is an index based on data from Political Risk Services. The index consists of an unweighted average of five part-indices:

(i) the degree to which the population of a country accept its law-enforcement institutions,

(ii) bureaucratic quality,

(iii) corruption in government,

(iv) risk of expropriation and

(v) probability that government will honour contractual obligations.

The index goes from zero to one, with zero as the worst institutional quality and one as the best

Source: Norway. 2009. Tax Havens and Development: Status, Analyses and Measures. Report from the Government Commission on Capital Flight from Poor Countries, Oslo.[1]

Table 1 compares the quality of institutions in developed, developing and international financial jurisdictions. It is to be noted that the quality of the institutions in developing countries is significantly lower than in the developed countries and international financial centers.

Entrepreneurs and investors demand: (i) ways to diversify risk; (ii) reduction of transaction friction (red tape/fees/taxes)[2]; and (iii) elegant and responsive tools to facilitate the flow of capital. Economics 101 teaches us that where there is demand, the market will seek to supply. The IFCs respond to the demand by introducing responsive tools that supply capital, reduce transaction friction and diversify risk.

Bermuda’s Response

Bermuda has responded to the demand with the introduction and supply of a number of ‘products’. Some are unique to a specific industry or address a specific need (e.g. financing of Russian aircraft purchases). Others are more universal in their application (e.g. insurance and funds). The following are only a few of the ‘products’ that have been developed to meet international demand for capital, risk minimization and reduced friction.

Insurance:

The Bermuda insurance market began in 1947 when C.V. Starr chose Bermuda as the headquarters for his American International Company. Insurance development accelerated during the 1960s with the introduction of captive insurance, an innovative risk financing solution for corporations. By 1980, Bermuda was by far the world’s leading captive domicile. Beginning in the mid-1980s, Bermuda began to play a broader role in the world’s insurance and reinsurance markets in response to the mid-1980s commercial liability insurance crisis in the United States. Bermuda has become one of the world’s top three jurisdictions in the global reinsurance market.

Bermuda has achieved this success by developing a regulatory system which involves lower regulatory burden in comparison with traditional jurisdictions such as the US and the UK New companies can be formed in a matter of a few weeks in Bermuda, encountering much less regulatory bureaucracy and red-tape than in other jurisdictions.

Insurance companies require significant capitalization, which typically comes from developed economies. Bermuda has been an innovator in raising new capital with new vehicles such as sidecars and collateralized reinsurance structures.

The overall result is the creation of better and cheaper insurance – insurance which is affordable and in some cases designed for the emerging jurisdictions. A loss or regional catastrophe in a developing country effectively results in a capital flow from developed to developing country to rebuild their infrastructure and business resources.

Offshore Companies:

Why are there more Bermuda companies on the Hong Kong stock exchange than any other country?

The answer is simple, risk minimization. In 1832 Scotsmen William Jardine and James Matheson formed Jardine Matheson a trading company based in China. Jardine Matheson was instrumental in creating trade with China and the development of Hong Kong. Today the company is known for the Mandarin Hotel chain, financial services and more. Jardines has experienced the financial impact of war and government expropriation, enduring a significant loss of business assets in WWII and as a result of nationalization by Communist China following the war.

In 1984 in anticipation of the handover of Hong Kong to China in 1997, Jardine Matheson incorporated a Bermuda company to hold its business empire as a mechanism to reduce the risks of the uncertain business environment in Hong Kong. It expressed the view that the Bermuda holding company reduced its exposure in Hong Kong/China from 72 per cent of total assets to a planned 50 percent[3]. Other Hong Kong companies followed suit.

IFCs as conduits for investment:

Emerging economies have significant capital requirements. It can be shown that a country’s economic growth is directly related to the amount of foreign direct investment (“FDI”).

Professor Jason Sharman argues that IFCs have supplied the demand for capital by providing efficient institutions and minimizing the transactional friction on capital transactions.[4] IFCs have developed efficient, timely, risk sensitive, flexible and lower cost ‘products’ designed to meet the demand for capital for these emerging economies.

Table 2: Foreign Direct Investment BRIC & BVI for 1980 & 2011

Foreign Direct Investment expressed in millions of US dollars at current prices and current exchange

Source: United Nations Conference on Trade and Development[5]

The Table 2 demonstrates:

1. the significant increase in inbound FDI from 1980 to 2011, this FDI has been used to fuel the growth of the BRIC economies;
2. during the same period BVI experienced a similar substantial growth in inbound FDI – for 2011 FDI represents over US$12 million per person.
3. Unlike the BRIC countries, BVI’s inbound and outbound FDI in 2011 are almost identical, indicating that BVI is a conduit for investment capital

Table 3 illustrates that the preferred source of FDI for China is via IFCs, with Hong Kong, BVI, Singapore, Cayman, Samoa and Mauritius ranking in the Top Ten sources of FDI, most ahead of the US which ranked 7th.

Table 3: Top Ten Sources of Foreign Direct Investment to China in 2008

While China is the most dramatic success story, similar results can be shown in other BRIC and emerging economies. UNCTAD estimates that IFCs contribution to inward FDI can be as high as 30 per cent for certain Latin American countries (Brazil and Chile), Asian economies (Hong Kong, China) and the Russian Federation[6]. It has been estimated that no less than 38 per cent of direct investment to India in 2006-08 came from Mauritius.[7]

While Cayman is the clear leader in offshore funds, Table 4 shows that Bermuda is also a significant source of FDI from the Latin America and Caribbean region being the only IFC in the top 5 countries.

Table 4: Top 10 Source Countries from LatAm and Caribbean in 2011

Source: The FDI Report 2012[8]

Randall Krebs
Director