Standard & Poor's: Report Says Rising Regulatory Pressure On Offshore Economic Models Threatens Small European Sovereigns' Creditworthiness

Increasing regulatory scrutiny of offshore economic models is making the future for small European sovereigns (Gibraltar, Jersey, Guernsey, Isle of Man, Andorra, Monaco, San Marino, and Liechtenstein) uncertain, according to a report by Standard & Poor's Ratings Services.

Titled "Rising Regulatory Pressure Heightens Risks To Small European Sovereigns' Creditworthiness," the report points out that the exceptional wealth of these small sovereigns is in part due to their heavy dependence on the high value-added financial services sector. The sector varies in size across the small sovereigns--from 14% of GDP in San Marino to 42% in Jersey. Dependence on this sector served the small sovereigns well prior to the global financial crisis of 2007-2009, and in some cases throughout it, with Gibraltar and the Isle of Man posting consistently positive rates of economic growth. However, dependence on financial services has since left small European sovereigns exposed to regulatory headwinds.

"An important appeal of several of these small sovereigns is their benign tax regime and/or client anonymity," said Standard & Poor's credit analyst Benjamin Young. "However, European and North American regulatory authorities are pressing for increased banking transparency and tighter rules on tax evasion and avoidance.

"It's unclear to us how far regulators will go to curtail the activities of offshore business centers, and to what extent any regulatory changes will affect the small European sovereigns. Although the regulators' focus falls periodically on offshore financial centers, the latest push, partly in response to the financial crisis, appears to us to be more sustained and focused."

We therefore believe that the creditworthiness of small European sovereigns increasingly depends on the extent to which they rely on tax or regulatory arbitrage or bank secrecy and their value to their larger "hosts." Hosts are larger countries with which small sovereigns frequently have historical ties and which often assume responsibility for small sovereigns' foreign affairs, defense, and monetary arrangements.

The regulation currently being discussed could cause some small sovereigns to lose parts of their financial services business to overseas competitors, forcing them to undertake a major reorientation of their economies. Other countries could find that the financial services they provide to their "host" countries' onshore financial sector - such as short-term lending facilities - are too important to be compromised.

This has positive and negative repercussions. On the positive side, some small European sovereigns are likely to become more adept at reinventing themselves to suit the evolving global environment. On the other hand, these sovereigns are on the receiving end of regulatory shocks.

Aside from regulatory risks, the prolonged recession in the European Economic and Monetary Union (eurozone) has weakened a number of small European sovereigns' trade centers, while most have seen their public finances deteriorate. In some cases, this has led governments to introduce unprecedented consumption and personal income taxes.

Therefore one of the key challenges we see for these small European sovereigns is to adapt to circumstances over which their control appears to be diminishing.

The report examines both rated and unrated sovereigns. Besides the rated Isle of Man and the Principalities of Liechtenstein and Andorra, we consider comparable unrated jurisdictions - Gibraltar (a British Overseas Territory), the Channel Islands of Jersey and Guernsey (British Crown Dependencies), the Principality of Monaco, and the Republic of San Marino.