Why isn’t Australia exporting more funds management services?

It’s a good question which the Investment and Financial Services Association (IFSA) had the good sense to ask Lateral Economics. You can take in our answer to the question in under 700 words as they appear in the Fin Review today, or at much greater length in the report we did for IFSA. The report – Other People’s Money was released today. It is in two parts and this is the second part. The first part was released about a month ago.

I think there’s an interesting story in the part released today. As we did the report it occurred to me that there was a strong parallel between what happened with manufacturing in the 1960s and what’s happened so far with finance. In each case, assisted by domestic policies we developed a large and relatively competitive industry. In each case we tended not to focus on exports – why bother when supplying the domestic market was going so well? Of course an important difference between the two situations is that the assistance the industry got from tariffs was itself a direct part of the problem of why we didn’t export more, whereas the policy of compulsory super does not directly impede exports.

The similarity is more a kind of cultural complaisance – an idea that exports are nice to have but not something that it’s worth making a great effort to achieve. Of course in one sense this is true. There’s nothing special about exports. So if firms find exporting hard, then it’s not clear that there’s any problem. (I’m not sure there’s a particularly strong case but there are positive externalities in one Australian firm being the first into an export market so at least in principle one can argue for some export marketing assistance). If exporting is hard the exchange rate will fall as far as it needs to to make it sufficiently easy for us to do as much exporting as we need to to finance the imports we want.

But what if the sector you’re in is so influenced by tax and regulatory systems – both in your own country and elsewhere – that it makes better sense to think of the sector, at least when it exports as a joint product between firms and regulatory and tax systems. If that’s the case then we may be foregoing substantial profitable export opportunities by regulating in a way that’s insufficiently cognizant of the needs of exporters.

The report comes to the conclusion that to succeed we need tax and regulatory systems that are more responsive to the needs of exporters.

I expect it won’t be believed by some readers (I could write their slogans here myself) that this is not a plea for some special favours – special tax breaks etc. In fact the in principle issue is broadly conceded – namely that just as GST is not levied on exports so we should not tax foreigners who happen to have money managed out of Australia. We should on the other hand levy company tax on the profits of the Australian based firms that manage the money. But as a matter of fact, despite substantial efforts to remove what is essentially inadvertent taxation of foreigners’ investment in Australian managed funds, when global firms investigate the situation with a view to domiciling substantial export activity here they discover a range of problems or uncertainties about the way in which our regulatory and tax systems will interact with what they plan. The result is that they do it out of Ireland where these things have been ironed out – or at least ironed out better and with less uncertainty than here.

The column is over the fold.

Thanks to compulsory super, Australias is the fourth largest funds management industry in the world. It manages a trillion dollars. Its sophisticated, capable and cost competitive.

Yet under three per cent of its revenue comes from exports that is, foreigners paying us to manage their money. Why?

Exporting isnt easy.

A global fund is domiciled in one country, holds assets in other countries, and may have investors from several other countries as well. Throw in the network of bilateral tax treaties and the complexities are enormous.

This complexity means that global funds management is best thought of as a co-product between funds management firms and the tax and regulatory systems to which they are subject.

The regulators of the most successful financial exporters pay assiduous attention to their global fund managers tax and regulatory needs. That doesnt mean theyre a light touch. Unlike firms in other industries, global financiers actually demand strong regulation to protect market integrity.

Nor is this a rationalisation for tax avoidance. You see, just as we exempt exports from GST (like other countries) so most countries accept that that global funds should be tax transparent.

In other words, while an Australian based manager should of course pay company tax on their profits on managing a global fund, the investments in the fund should not themselves be directly taxed. After all, income from many of those investments has already borne company tax at source and bears income tax when distributed to investors in their home countries. Taxing the investments in the fund a third time as opposed to the profits on managing the fund simply sends them elsewhere.

Recognising this, our Government has spent the last few years trying to extricate investments in Australian domiciled global funds from inadvertent taxation. But the devils in the detail, with difficult tradeoffs sometimes necessary between tax neutrality for global funds and preventing avoidance elsewhere in the tax system.

Meanwhile were up against small countries like Luxembourg and Ireland hosting huge global funds, whose regulators have specialised in this game for decades. If theres a tension between their financial exporters needs and domestic considerations, guess whose interests win out?

Starting with virtually no funds management sectors of their own, these financial entrepôts offered generous tax breaks to attract global funds. This gave them the incentive and the information necessary to build tax and regulatory regimes that were highly responsive to those funds needs.

For example, when a European court struck down a special holding company structure within Luxembourg for breaching the EU constitution, a new regime was re-introduced within just four months!

Ireland worked with global funds to produce an innovative regime which is more tax transparent than companies and trusts for pooling super funds so called Common Contractual Funds (CCFs). Some firms tell us that with a similar regime wed manage billions more in pension assets right now. But its a chicken and egg problem.

Our industry is chock full of global funds often run by global companies, but theyre busy managing Australias money. The complex regulatory problems faced by global funds are solved first and faster in Ireland and other financial entrepôts.

Were still beavering away on tax transparency. But changes must run the gauntlet of lengthy reviews. The delay and uncertainty is often a show stopper.

Doing due diligence on establishing a global fund, firms get advice on whether some transaction attracts a particular tax. Here theyre often told probably not. Meanwhile Irelands regulators answer no, with precedents to back them up. Guess where the fund ends up domiciled?

Still, at a time of labour shortage more jobs in finance will mostly mean fewer jobs elsewhere. Whats so special about finance? How about the fact that finance employees get paid far more than average wages even allowing for their higher skill levels.

That helps explain why, from about the time Luxembourg and Ireland became financial centres, their economic growth surged. Its never looked back. Ireland the poor man of Europe is now Europes second wealthiest economy. The wealthiest? Luxembourg by a country mile.

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Patrick
Patrick
14 years ago

I substantially agree, which is why my quibbles are so minor.

One quibble is that I strongly dislike any suggestion that we should be jealous of Luxembourg’s wealth. Self-evidently, when over half your citizens are not actually resident you have a unique position. I knew someone who used to drive from Lyon where he lived to Luxembourg (look it up on a map – it is not Sydney-Canberra!) where his companies ‘lived’ twice a week, just for tax reasons. That was because he lived in France and faced effectively 70% taxation on his (substantial) earnings. If Luxembourg was next to Australia, it might not be Luxembourg.

A second quibble is that over 75% of European capital markets activity takes place in London. The money is held through Luxembourg, but not more so than is held through the Caymans, Malta, the Netherlands, the Bahamas, Cyprus, etc.

A third quibble is that the regulator doesn’t usually need precedents – they can simply tell you what position they will take and that is a precedent.

A point which is not a quibble is that the role of franking credits in Australia makes things awkward.

Another point, which is not a quibble, is that there you could (but never publicly) divide tax offices into broadly two classes: the ‘legitimate country’ tax office (including Australia and the UK) and the ‘tax haven’ tax office – Ireland, Luxembourg and the Netherlands all included.

The second categorisation results from the fact that these smaller EU countries have decided to do just what you recommend, and are all in more or less permanent competition to attract ‘holding companies’ and EU entry points. Which brings me to my final quibble: note, eg, the different attitude of Dutch authorities to the proposed takeover of ABN Amro – fundamentally, the only difference between the tax haven-style tax offices and the others is that the others have more to feel ‘protective’ about.

But I substantially agree with you.

David Rubie
David Rubie
14 years ago

Nicholas Gruen wrote:
That helps explain why, from about the time Luxembourg and Ireland became financial centres, their economic growth surged. Its never looked back. Ireland the poor man of Europe is now Europes second wealthiest economy. The wealthiest? Luxembourg by a country mile.

Nicholas, just an observation after having worked in the finance industry (although not at a particularly high level).

Finance is incredibly parochial. Even in countries like South Africa, where the level of sophistication in the trade of derivatives is in a putative stage, the locals are unwilling to allow the direct entry of foreign financial companies into their markets. Quite often the preferred model is to allow joint ventures involving a local financial outfit and a foreign outsider. Even then, movement is glacial. Australia 25 years ago is a good example of what growth finance markets are like overseas. On the other hand, the mature markets like the US are almost impossible to break into unless you’ve got a very specific niche. Cheating by becoming a tax haven is a short term strategy doomed to failure (there will always be a cheaper country somewhere).

This can be mitigated somewhat by a strong brand, but there’s only one Australian company that even approaches a recognisable international banking brand.

Why do finance employees get payed more? They work more. Lots more. They have to travel for extended periods. Pressure to make money can be intense and the axe can fall with blinding speed – job security is not something you can associate with working in a junior position on a trading desk or even a senior position managing funds. IT problems have to be fixed in minutes, not hours or days, and most serious companies trade 24 hours a day in most markets. Weekend work is common and expected for systems that simply can’t disappear during the week (and not just IT systems, the paper shuffling ones too).

Support staff can expect to be abused on a daily basis by staff at the pointy end who are under immense pressure. Burnout is common, although critical employees can limp along with their carefully guarded corporate knowledge as they have little choice but to work in finance due to their self imposed life styles, they self medicate to alleviate this. In short, it’s deeply disfunctional and nobody who wants to retain their sanity or see their children on a regular basis would do it for any period of time.

Patrick
Patrick
14 years ago

Some of that is true, and applies as much to Europe, Australian and the US as much as to South Africa.

But maybe they also earn lots of money because they make lots of its for their clients, and so relatively small takes are absolutely huge?

Fyodor
14 years ago

Nicholas, I’m sorry to say that this is a very muddled piece.

Just to pick up on Patrick’s quibble, which is a lot more material than he states, you are confusing the domicile of investment vehicles with the domicile of the manager of said investment vehicle. Ireland and Luxembourg attract many investment funds/companies/etc. to domicile in those countries due to the obvious tax advantages, but have very small funds management industries. That is, while the funds may be domiciled there, the actual management – and, importantly, collection of fees – takes place elsewhere, e.g. London, Edinburgh, Frankfurt and even Sydney. There are very few fund managers of any size in either Ireland or Luxembourg.

The other big mistake you’ve made, connected to the first, is that you fail to define what you mean by the “export” of funds management services. What is the product exported? Arguably, the product should be the value added by investment selection, portfolio management and trading decisions. This is, after all, what the end client is paying for – tax jurisdiction, custody, etc. are all trivial in comparison to the bulk of fees paid for the actual management of a fund. If an Australian-owned company employs staff in Geneva to manage European investments for US pension fund clients, with those investments held within an investment vehicle domiciled in Ireland, who is the exporter? I can assure you it’s not Ireland. Arguably, it’s the Swiss operation that adds the most value, even if much of the economic return (i.e. the business profit) from the activity accrues to the Australian company owning the operation. If you think that is an extraordinarily complicated and unlikely example, you’re dead wrong. The industry is THAT fragmented.

Why do Australian companies not export funds management services? For the same reason most countries don’t import it: the investor parochiality that David mentions. Why should a US investor pay an Australian manager to invest in US property? Clearly, the expectation will be that a US-based manager will generate superior returns to someone less familiar with the country. So why pick an Australian manager? There are notable exceptions, but the rule is that it is very hard to break into foreign markets and compete against incumbent domestic players unless one can persuasively demonstrate superior investment performance. The idea that tax makes a material difference to the choice of fund manager is, quite frankly, poppycock: managers can choose to domicile their chosen investment vehicle wherever they wish; the crucial barrier to Australian export success is proving competitive advantage in funds management, not tax.

Finally, Luxembourg was wealthy before attracting regulatory-arbitrage business (calling it a “financial centre” is a stretch of Herculean proportions – you might as well label the Cayman Islands a “financial centre”) and Ireland’s wealth was built on the back of EU subsidies, favourable demographics and manufacturing export success, not financial services. Correlation is not causation.

Fyodor
14 years ago

Hang on a minute. I wonder if you might give me credit for having worked out that in principle domicile need not be important.

I would have, if your focus hadn’t demonstrated that you think domicile IS important. I quote: “The report comes to the conclusion that to succeed we need tax and regulatory systems that are more responsive to the needs of exporters.” Tax is largely irrelevant for a fund manager if he chooses to domicile the investment vehicle he manages in a tax-advantaged location.

Furthermore, the fact that you keep comparing Australia to Ireland and Luxembourg demonstrated that you have NOT worked out that domicile is not as important as you think it is. For all of their success in attracting DOMICILED funds, their funds management industries are relatively trivial.

The fact was that the companies we spoke to spoke of it as important.

Really? Where are they quoted in your report?

The trouble with your analysis is that it takes the case were making to extremes. Who said we should try to corner the market of managing American assets for Americans? Of course that will continue to be dominated by Americans.

It’s not an extreme, Nicholas. I shouldn’t have to explain to you that our equity market, to take the prominent example, is only 3% or thereabouts of current world market capitalisation, and foreigners are most likely to invest in the world’s major markets, not the tiny Australian market. That is, material export success requires that we penetrate foreign markets, i.e. manage money for foreigners, in foreign assets.

But how come Australia, which has quite a lot of companies with classy global asset management – Macquarie, Platinum, Barclays – exports so wretched little of its turnover? So much of it is done for domestically provided money.

Jeez, Louise. We don’t “export” that much, because foreigners don’t pay us to manage money. They don’t pay us to manage money because they primarily want to invest in the vastly bigger markets of North America, Europe and Japan, and we don’t compete effectively in these markets. We don’t compete effectively in these markets because, as I noted earlier, we struggle to demonstrate that we can manage money better in those markets than domestic incumbents. BTW, Barclays Global Investors (BGI) is foreign-owned (by Barclays Bank, strangely enough).

Weve talked to a number of companies that are interested in exporting global funds management from Australia – essentially by expanding operations that they already run managing Australian money.

They tend not to do that predominantly for the reasons outlined in the report. The fund ends up domiciled in the Caymans or in Ireland or Luxembourg.

So what? Why should the domicile of the fund matter if the fund manager still operates from Australia?

But the domicile of a fund in Ireland does make a difference to our position in the value chain. It makes it more likely that value will be added to the fund from other locations, particularly European ones. In principle it need not be so – at least for many of the advisory functions. But the companies tell us it is.

Why? As you admit, there’s no a priori reason why it should be so. It sounds to me like the companies you spoke to were engaged in a rent-seeking exercise, and that you’ve been suckered.

Fyodor
14 years ago

I think you know a few things and assume that if people dont painstakingly explain those things back to you, they dont know what you do.

I don’t need them painstakingly explained to me. I need you to be clear and accurate about what it is you’re saying in the first place. And yes, the evidence so far is that you don’t know enough to analyse this industry correctly.

What could demonstrate that more than your thinking that youre pointing out something I dont know when you say that Barclays is foreign owned?

Nicholas, you referred to Australia “having” three “companies with classy global asset management”, then named Platinum, Macquarie and Barclays. We only “have” – i.e. own – two (i.e. Platinum and Macquarie, which are both Australian-owned) of the three, and Barclays Global Investors Australia does NOT have “classy global asset management”; its offshore parent does. The Australian operation is not a material exporter of funds management services – it is very successful at managing Australian and foreign assets for Australian clients, not taking in fees from foreigners for assets managed from Australia. Now you’re going to tell me you already knew it wasn’t a big exporter, right?

Do you think the only way you can export is by having your own nationally owned firms exporting? I guess you think thats what I think – but its not.

And when youre not thinking the report is about Australian owned funds management – its not – you think its about foreign investment in Australian managed Australian assets. Its not. It talks constantly of GLOBAL fund management from Australia.

If you’d actually read my first comment, and the example of the Geneva-based fund manager, you’d know my answer to that question, and that you’re constructing a strawman.

Your report focuses overwhelmingly on the domicile of the funds, thereby ignoring the much less trivial factors that determine whether Australian fund managers earn fees from foreigners or not. You may think you’re writing about global funds management, but your point of focus proves you’re not.

Barclays have global funds management capability here – not just Australian funds management capability.

Really? How much money does Barclays manage for foreigners out of Australia? Please remember in answering the question that managing foreign assets for Australian clients is not “exporting” funds management services. In fact, if the management takes place in BGI’s offshore operations, AS IT DOES, it’s an import.

You say that we got suckered into a rent-seeking exercise. The funny thing is were not seeking much rent. Were not presenting a case for any special tax favours

I’m glad to hear you’re not seeking “much” rent. That’s very comforting, but the recommendations on page V of your report show very clearly both a desire to favour the industry AND to pick winners. It’s rent-seeking.

…only for more fully doing what weve been trying to do for years – extricating the management of foreign assets from Australia from tax on the investment. (As opposed to company tax on profits from fund management). Thats something an Australian manager can already get by locating in Ireland (along with lower company tax as it turns out). So why would they even bother doing the due diligence on domiciling it in Australia?

I don’t have a problem with your proposals on Australian-domiciled funds. I have a problem with your suggestion that such proposals, if implemented, would result in a funds management export industry. They won’t, just as they haven’t for Ireland or Luxembourg.

Fyodor
14 years ago

Thats the beginning of my point and Im suggesting there are a range of (largely inadvertent) barriers to doing so, and that if we remove them we will generate more global funds management exports.

And my point is that the supposed barrier you’re citing, i.e. an unfavourable tax and regulatory regime for funds domiciled here, is NOT a barrier if it is relatively easy to manage funds domiciled elsewhere from Australia. That is, the “largely inadvertent barriers” you refer to are not, in fact, material barriers.

I dont know that a the value added to a fund can come from somewhere other than its domicile. I do know that.

Not really intelligible, but if I’m correct in assuming you mean that you don’t know that “ALL the value added to a fund can come from somewhere other than its domicile”, then your point is weak. Like any export industry, the key is the amount of value added in each stage of “production” process. The costs of domiciling a fund offshore in a tax haven are trivial compared to the fees earned by a fund manager. It is simply not the barrier you think it is. If it were, and domicile made that much difference, then Ireland and Luxembourg would have thriving funds management (as opposed to fund domiciling) industries. They don’t. QED.

As I suggested in my first comment, the key barrier, which you have largely ignored, is the competitive advantage – or rather lack thereof – of our managers in competing for business against foreigners in foreign markets.

Fyodor
14 years ago

The key barrier in not exporting more funds management to the US is that our funds managers (ie the ones located here) are not located in the US.

The point is not that we must base fund managers in the USA to succeed, but that there is a material handicap to our fund managers in accessing foreign markets, just as there is for foreigners entering our market. An Australian manager looking to export funds management must be able to show a competitive advantage (i.e. sustainable investment outperformance) sufficient to mitigate that handicap. If you cannot demonstrate that you can manage money better than the foreigners you’re competing against, you simply should not be competing with them in that market.

Global funds management can be done well – is done well – from Australia. So we should be able to sell more of it to foreigners. Even those in the US, even if well never crack the US market in the sense you seem to imply of displacing funds that are already there on some massive scale. We both agree on the (trivial) point that that wont happen.

True, and I’ll go you one further: I also agree that Australians CAN manage global funds from Australia successfully – but they will have to earn that business just like anyone else.

I even commend you for tackling the subject and looking for ways to improve their export performance. Where we differ is in the conclusions and the setting of expectations. IMO fiddling with domicile and tax arrangements is trivial and will do little of consequence for our funds management industry. Furthermore, the idea that the government has any competence in picking winners or steering such a sophisticated and competitive industry is frankly laughable.