Offshore Paradise?

It's probably jut me, but I had always thought that, when people talked about moving money "offshore" it meant putting money somewhere exotic like the Cayman Islands or Bahamas. OK, or Jersey or the Isle of Man. Well, yes, places like that are used as addresses. And they are just about all British Overseas Territories - why will become apparent below. But the "offshore" actually refers to outside the jurisdiction of the United States. And, if I understand it correctly, the money isn't necessarily held in those places.

London is the world's undisputed global centre for foreign currency trading. I've been reading about how this came about in a piece on the BBC website* which was prompted by the publication of the Paradise Papers a few months ago, when details were published of all sorts of financial transactions which the parties concerned would rather have kept secret. Basically, London achieved this position by accident. Yes, I know London has a geographical time zone advantage, being more easily able to communicate with west and east than they can with each other. Indeed, I read recently that London would be concerned post-Brexit about losing its status not to Frankfurt or Paris but to New York. But only if New York could relocate itself east by 5 hours. But that's not why such a high value of transactions takes place in London.

The story of why and how people with dosh go about avoiding taxes by moving money offshore starts, not surprisingly, around the time of World War I. After all, that is when income tax, which had been around since 1799 (that time the war was against Napoleon) and had been made progressive with the introduction of supertax by Lloyd George in 1909, really took off with higher rates of tax reaching 50%. That lead to wealthy people becoming resident in lower tax Jersey, or putting their money in a trust in the Isle of Man. But it wasn't until the 1950s that London's role became international.

Controls on the movement of money over borders were normal then (Mrs Thatcher scrapped them for the UK three decades later) as speculative money flows were considered to have worsened economic crises. So government approval for, say, Tate and Lyle to invest in a new sugar production facility in Jamaica was required. It was normally a formality but, with a run on the pound under way after Britain, financially weakened almost fatally by World War II, had stumbled into the Suez crisis, the government announced in 1957 that, on a temporary basis, it would no longer approve foreign capital investments.  The City's merchant banks were alarmed. Arranging finance for projects in the former colonies was critical to them. How to avoid ruin?

Hearing the banks' complaints in a series of meetings, the Bank of England agreed in late 1957 to allow the commercial banks to continue to lend and borrow to foreign clients on two conditions:  

1. the lending had to be in a currency other than sterling, and 
2. both sides of the transaction - the lender and the borrower - had to reside somewhere other than the UK.

"The decision was momentous in all respects," says one of the leading experts in offshore finance, Prof Ronen Palan of City, University of London. "They simply deemed certain transactions as not taking place in the UK. Where did the transactions take place for regulatory purposes? Nowhere. "I think it wasn't at all by design; it was a mistake. They didn't understand the implications. It was seen as an accounting device." The so-called "Eurodollar" was born - a global offshore financial market, transacting in dollars and allowing unlimited sums to be borrowed and lent, but under the control of no single state. No act of Parliament (or Congress) sanctioned the decision. There was no thoughtful policy-making, no careful debate.

The Treasury was at first left in the dark. But within years the implications were obvious - this could revive the City of London's fortunes. "By the time the Treasury figured it out, they thought, 'this is good business for the City'," said Prof Palan. Banks from all around the world could borrow and lend in dollars without being subject to US tax or banking regulations - making banking in dollars more profitable out of London than out of Wall Street. Offshore banks didn't have to hold money in reserve for every dollar they lent (as they would in the US), which would dramatically cut their costs.

While transactions were arranged in London, the lenders and borrowers could be registered anywhere. But the parties to Eurodollar transactions needed addresses. So, zero-tax jurisdictions from the Cayman Islands to the Montserrat were used by London's investment banks as the official tax residences of their wealthy customers. Clients could avoid both tax and undesirable scrutiny - for example from the US tax authorities.

Don't knock these places - they don't need to have higher tax rates, else they would just run up huge budget surpluses or have to give citizens not just free prescriptions but free Rolls-Royces. In the British Overseas Territories, local laws were passed to attract more registration business, collecting modest fees that mounted up. No need for a bank branch out there - just a drawer in an offshore lawyer's filing cabinet. Again perfectly sensible. And why would they need sackfuls of regulations when there isn't much activity there to regulate?

Nevertheless there were howls of protest from the US government, which were ignored. Between 1960 and 1970, the size of the Eurodollar market went from $1bn to $46bn and then exploded to to more than half a trillion dollars by 1980, driven by countries rich in "petrodollars" from the hike in oil prices.

After the deregulation of the City of London in the 1986 "Big Bang", US banks joined in, setting up in London. And as the 1990s and 2000s progressed, London became the undisputed global centre for foreign currency trading.

So, if I've got this right (and I might not have 100%) "offshore" companies are only using the Cayman, British Virgin, or other Islands as an address. The money doesn't actually ever go there. I suppose it might often stay in London. And it's why London is the centre of "offshore" for the world. Don't knock it: we take a "cut" in the form of taxes on the companies and people doing the work. But it does sound a bit dodgy, doesn't it?

After all, tax-free, light regulation jurisdictions, including the Bahamas, the Cayman Islands (oh and Delaware in the US) became the corporate locations of choice for legitimate hedge funds. But they were also used to incorporate the vehicles at the heart of the global financial crisis - the 'structured investment vehicles' that did not show up on bank's balance sheets and bought billions of mortgage-backed securities, massively increasing the unnoticed risks in the global financial system which led to the crisis of 2008.

The other thing that we read a lot about is hot money coming into London property. It is estimated that there are more than 36,000 properties owned by anonymous offshore companies in London. The rather useless BBC item in which I found this stat didn't make clear how many of these were domestic rather than company offices, but it did say that included 7.3% of properties in Kensington and Chelsea and nearly 10% in Westminster**.

Indeed, in 2016 nearly 18% of completed new build domestic property completions were to overseas buyers. However, nearly half of these were to people buying with a mortgage, with one analyst suggesting that research suggested that buyers are largely "not ultra-wealthy overseas Russian oligarchs or from Middle Eastern oil money." Three-fifths of all overseas sales in London were made by people or companies from just four countries in south-east Asia: Hong Kong, Singapore, Malaysia and China. "It’s the newly emerging middle classes in Asia getting in on this, who are not any wealthier or poorer than those [British] first-time buyers looking to buy." This is partly because of a rising trend of south-east Asian buyers getting mortgages in their home countries to buy off-plan property in the UK.

So just how big an issue people using a company as a front for buying  into the London property market isn't clear to me. I've also read that suggestions many such properties are left vacant is tosh - they are nearly all rented out. But all of this makes me think I understand a bit more about why many countries think London is a capital of money-laundering. And arguably it's London that is, apparently by accident, the offshore capital of the world.

*Paradise papers: Britain's offshore empire, BBC website 8 Nov 2017 at http://www.bbc.co.uk/news/uk-41906470.
**Just who owns what in central London, http://www.bbc.co.uk/news/business-35757265
***http://www.telegraph.co.uk/property/house-prices/almost-no-evidence-london-homes-owned-foreign-buyers-left-empty/