27 January 2023

The World in 2023: Themes for IFCs (Part two)

Geoff Cook, Chair of Mourant Consulting, looks at key themes that could shape 2023 for International Finance Centres

 

Tax and trade disputes

Concerns over global business taxation and trade sustainability will likely continue this year. A flagship initiative of the early period of the Biden administration was US support for introducing a Global Minimum Business tax. Meanwhile, in Europe, a procession of American companies was required to appear before EU competition and state aid authorities following investigations into unfair tax and trade practices.

A three-year-long dispute between the EU and Amazon has only recently been settled, requiring a substantive change in the firm’s business practices and reportedly under threat of a fine of potentially 10% of global revenue.

The EU has recently agreed on a minimum business tax for large corporations at a rate of 15% after the withdrawal of long-standing objections from Poland and Hungary. Still, how this will fit with the American GILTI and Book tax initiatives needs to be clarified.

America moves through the Inflation Reduction Act to stimulate investment and the US have already ruffled feathers in Europe, with calls to extend the benefits to European companies in an emerging spat over transatlantic trade.

World Trade Organisation (WTO) rules don’t allow subsidies only available to domestic producers in the style of the $7,500 consumer tax credit the inflation reduction act permits. However, although the EU are unlikely to break the WTO rules, they will need more central resource if they are to match the US move.

The Operation for Economic Co-operation and Development (OECD) pillar I and II work on Global Business taxation needs to be faster moving with the search for detailed technical agreement failing to materialise, following the ground-breaking high-level accord achieved in the OECD Global Forum. Perhaps the ‘crowning glory’ of the OECD’s recently departed tax supremo, Pascal Saints-Amans.

In Europe, the tax runway is complete, with the new Swedish Presidency confirming its priorities for the first half of 2023. The Swedish Prime Minister, Ulf Krissterson, laid out the programme in a recent speech:

“In the area of direct taxation, priority will be given to measures aiming to prevent tax evasion, tax avoidance, aggressive tax planning and harmful tax competition, such as updating the EU list of non-cooperative jurisdictions.

“The Presidency will also work to ensure greater tax transparency and to reinforce the exchange of relevant information within the EU, mainly working on DAC8. Sweden promises to continue the discussions in the Council on the Energy Taxation Directive, start the work on the VAT in the digital age package, and advance the negotiations on the AML package.”

Work on DEBRA, the proposal for ensuring that equity receives similar tax treatment to debt will also progress, as will the EU’s new Carbon Border tax, and the drive for the EU Commission’s own resources. And the newly revised terms of reference of the EU Business Taxation Code of Conduct Group will undoubtedly lead to a fresh round of reviews of EU countries’ tax systems. In time they will likely move on to revisit third-country equivalence.

 

Regulatory reforms gather pace

In 2023 the primary area of focus most relevant to IFCs will continue to be the fight against financial crime following the years long efforts to clean up the global financial system.

The International Monetary Fund (IMF) will pursue a three-pronged strategy of influencing member countries in economic performance, financial stability and fiscal prudence. Meanwhile, the Financial Action Task Force (FATF) will continue to upgrade compliance with its standards as new guidelines on legal persons and legal arrangements become embedded. The UN will commence work on making a bid for greater involvement in setting Global tax standards, alongside the OECD.

In the US, the recent failure of the Republican party to take control of the Senate will give the Democrats some cheer, and they will take the opportunity to make further progress on central registers of beneficial ownership.

And a new breed of a politically appointed regulator with interventionist instincts will take a much closer interest in acquisitions deemed harmful to consumer interests or anti-competitive, such as Microsoft’s attempt to acquire Activision Blizzard and the recent fines levied on Epic Games. Private equity, take note.

The Court of Justice of the European Union (CJEU) judgement on public access to Ultimate Beneficial Owner (UBO) registers will reverberate throughout the globe with advocates of privacy and human rights claiming a victory, while those championing legitimate interest will lobby to unlock access for as wide a community of interested NGOs and journalists as possible.

The current UK government may ignore the CJEU judgement given its Brexit instincts but that position is likely to be challenged in the courts. The UK, instead, is expected to focus on its ‘Edinburgh reforms’ as it seeks to use regulation as a competition vehicle. The fruits may be elusive given the demands of key trading partners in terms of equivalence when considering trade and treaty arrangements.

And in crypto, recent market turbulence could see a more interventionist approach as many regulators finalise their crypto roadmaps, and respond to the FTX failure.

In Europe, standard setters such as the European Commission, ESMA and the ECB have shown themselves capable of devising sophisticated directives and regulations. They shape not only EU markets but, through an extra-territorial application, also significantly influence the actions and standards of third countries who seek access to the EU. The EU has been particularly adept at wielding this soft power by emphasising investor protection, competition, and high regulatory standards.

2023 will see a continuing drive in the EU to develop regulation in capital markets and banking, and through a strengthened AML package, together with progress on Solvency III. IFCs need to be alert and agile in respect of these and other initiatives, given the propensity of the EU to apply listings to those they do not consider equivalent.

Not to be outdone, Asia will see a reform agenda pregnant with new initiatives that will emerge and/or progress in 2023. In the APAC region, New Zealand has moved forward on its countering terrorist activity plan, including financial aspects, while Singapore has announced their five-pronged strategy to counter the financing of terrorism which will drive further toward implementation during 2023. Similar moves are underway in Hong Kong.

In China, a new focus on greenwashing will result in the appointment of eighteen credit rating and accounting businesses as gatekeepers for the green bond market.

As the global regulatory focus moves from legislation and regulation to implementation and effectiveness, all IFCs should expect searching and demanding inspections by international standard setters.

 

Green energy gets a boost

We identified in 2022 that ESG would hit some bumps in the road, but it is so established as an investor requirement we do not believe nascent opposition will check its progress.

Moves to exclude ESG criteria by some US municipal funds painted a real contrast with the green aspects of the Inflation Reduction Act, and the EU Commission plans to incorporate elements of the EU’s Sustainable Finance Directive into a new Corporate Sustainability Reporting Directive (CSRD). The new legislation is expected to increase the level of sustainability reporting by corporates in their financial statements.

Work on the EU taxonomy, a classification system for establishing lists of environmentally sustainable activities, continues in its journey to set a ‘common green standard’. According to a recent Goldman Sachs bulletin, the taxonomy is already shaping asset management research and decisions around capital allocation, cost of capital and company valuations. The regulatory impetus for ‘greening’ finance, at least in Europe and Asia, is undimmed.

The most significant ESG change in 2023 will be the boost that green energy receives as an outcome of the War in Ukraine. Interest in nuclear fusion, hydrogen and renewables has spiked as the dawning awareness of energy insecurity took its toll in 2022. Fold in the commitments to net zero carbon emissions that many countries have signed up to, and the move to green energy has taken on a new urgency. Investment into innovation and sustainable energy sources will receive a shot in the arm, opening new opportunities for private capital.

Given the importance of financial services to many small state economies and their susceptibility to climate change, the engagement of IFCs and the many firms that operate in and through them will be critical in facilitating the deployment of sustainable capital and a meaningful response to the call for climate action. IFCs and their firms will need to monitor developments closely.

 

Tech frontiers: friend or foe

China and Western tensions signal a deeper malaise. China and the US have seen each other’s interests through a competitive lens – if one wins, the other loses.

The post-pandemic world has seen digital accelerate to become a vital part of the commerce infrastructure, enabling businesses to continue functioning, employees to stay connected, and customers to remain engaged remotely. However, while digital adoption has opened new frontiers for trade, it has also created new battlegrounds.

With technology set to remain front and centre, tech companies have emerged as politically influential powerhouses in a digitally enabled – indeed digitally-reliant – world. A new spotlight has focused on national security, with different trading blocs and divergent economic interests taking opposing stances. Approaches to state aid are evolving, and antitrust lawsuits are increasingly common in the US and EU as the financial muscle of big tech collides with the need to replenish the empty coffers of nations worldwide.

The parlous state of public finances everywhere will spur moves to raise more taxes, and this will combine with demands for higher wages due to the cost-of-living crisis, the like of which we haven’t seen for decades. Firms will respond by rigorously reviewing their business models and will weigh every opportunity to lift productivity and lower costs. Fold into this the West’s urgent need to diversify its energy sources, and this combination of factors will intensify the drive to digital.

With supply chains disrupted, tariff and trade barriers are increasing, and competition for ‘Chip’ technology and production increasingly resembles a race for ‘Chip’ supremacy. The intellectual property and production map of the tech industry is being redrawn. The US is now applying entity lists which are, in reality, de facto deny-lists of Chinese firms. The risks of dealing with China in technology are rapidly escalating as the two great powers slug it out for tech supremacy.

But, of course, there is a positive side to tech innovation and development. All countries, including full employment IFCs facing high demand, will increasingly adopt digital technology to boost productivity and lower costs. Automation, data analytics, reg tech and digital ID should all make real progress in 2023, and the shift to move employees to ever-higher-value work will be relentless.

 

Can private capital weather the storm?

During a decades-long binge on cheap debt, it seemed a rising tide would float all boats, but as Warren Buffet famously said: “Only when the tide goes out do you discover who’s been swimming naked.”

An assortment of adverse events in a roller coaster year – supply and demand issues, tight labour markets, a lingering Covid problem in China, and Russia’s invasion of Ukraine – boosted inflation and triggered a rapid increase in interest rates, creating significant market volatility.

The result is that most real assets have underperformed with a significant amount of repricing of stocks and bonds. A great deal of tightening has already occurred, with the US FED raising interest rates seven times during 2022, moving from a base of almost 0% to the current 4.50%., the fastest pace of increase in the Fed’s modern history.

Chair of the Federal Reserve, Jerome Powell, set the tone for the future direction of interest rates at the 2022 Jackson Hole gathering of central bankers: “Without price stability, the economy does not work for anyone.” He went on to say: “In particular, without price stability, we will not achieve a sustained period of strong labour market conditions that benefit all.”

Stock markets and bonds have taken a battering, and despite a modest rally, equities look set to end the year down by double digits at least. So, what are the prospects for 2023?

Global GDP growth is expected to be flat, with advanced economies predicted to see growth rates of just 1.1% and 3.7% in emerging and developing economies. Recessions are anticipated in the US and Europe, although views vary on whether shallow or deep, short or long. Of course, economies and markets are not always symmetrical.

Some commentators have observed that it is only a matter of time before private equity follows suit and that General Partners will need to revise NAVs downward. Investors, in turn, will need to adjust their expectations. The stellar returns of recent years will become a thing of the past, it is claimed.

Our view is more nuanced and contrarian. With the proviso that central banks manage the transition from ultra-low interest rates to a more conventional monetary policy approach without significant market disruption, we see ‘Alternatives’ providing enhanced returns and a diversification play for public market investors.

Private equity has developed tools that will cushion write-downs in values that will occur for some existing assets. Continuation funds provide a valuable means to address market timing and liquidity issues, providing the opportunity to safeguard high-performing trophy assets from untimely disposal. Tainted initially by the stigma of assets spending time in the recovery ward, they have progressed to become a valuable portfolio management tool allowing companies to grow to their full potential. Liquidity can be created for the limited partner if desired, but in volatile times, many prefer the ability to remain invested in a familiar and proven-performing asset.

For those with committed but undrawn capital, the opportunity for contrarian investment into targets with more attractive valuations and inflation-busting characteristics will support selective deal activity. Investment in energy transition, food security, infrastructure and the re-mapping of supply chains to enhance resilience through diversification will all see significant new commitments. And while banks may be more demanding on terms and covenants, this will open new space for private credit to occupy. So, as we look forward to 2023 and the end of the rate tightening cycle, we see an opportunity for private capital to weather the storm, and, in time, to stage a recovery.

Geoff Cook

Geoff Cook, Chair of Mourant Consulting in Jersey

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