(Bloomberg) -- In Vanuatu, a remote archipelago in the South Pacific, a popular tourist attraction is something called land diving. Villagers on the lush outer island of Pentecost jump headfirst from a tall wooden tower with tree vines tied to their ankles to break their fall. For the divers, the rite of passage is a plunge into the unknown—and that’s not a bad metaphor for where this secretive tax haven is headed these days.
Anchored in the deep seas between Australia and Fiji, this exotic microstate has faced sanctions since last year for not complying with stricter anti-money-laundering standards established by the Financial Action Task Force. The FATF, an intergovernmental body created by the Group of Seven leading industrial countries, has placed the former Anglo-French colony on its “gray list,” which also includes Iraq, Syria, and Yemen. The action effectively turned Vanuatu banks into financial pariahs.
Then in November the island state suffered another hit to its reputation with the unmasking of its offshore corporate clients’ hidden wealth in the leaked Paradise Papers. By then, the nation’s important banking sector was already limping. Vanuatu regulators and local bankers say that France’s central bank had ordered the institutions it regulates to steer clear of the country, while Germany’s Commerzbank AG and New York-based Citibank had dialed back on their correspondent bank relationships with lenders in Port Vila, the nation’s capital and offshore financial center. “It’s much more difficult to do funds transfers in and out of Vanuatu than probably anywhere in the world,” says Martin St-Hilaire, a managing director of AJC, an accounting and advisory firm, and chairman of the Vanuatu Financial Centre Association.
Vanuatu and its 270,000 or so citizens already face 21st century vulnerabilities typical of a remote and tiny island chain in this age of rising sea levels and superstorms. It’s a less-developed country that relies heavily on international aid to survive. Now a key industry is threatened by the regulatory aftershocks of a global crackdown on tax havens.
The nation is a bit player among tax refuges such as the English Channel island of Jersey and the Cayman Islands in the Caribbean. But singling it out for gray-listing poses grave economic consequences, according to Prime Minister Charlot Salwai. “Its effect,” he told Vanuatu legislators in June, “will be felt on imported food, such as rice, and fuel.”
Amid this uncertainty, a debate is raging in Port Vila about the country’s economic destiny. On one side there’s Salwai, a French-trained accountant and ambitious economic reformer, who backs the introduction of an income and corporate tax to generate revenue that can be used to invest in the country’s future. On the other side there are Thomas Bayer, an American banker turned ni-Vanuatu, as local citizens are called, and a gaggle of expat bankers, lawyers, and financial advisers who’ve made nice livings helping the world’s moneyed elite protect their wealth.
Neither side questions the urgent need for investment in some form to sustain the economy of this necklace of 80-odd islands. Vanuatu is one of the world’s poorest countries, with a per-capita gross domestic product of $2,860, according to the World Bank. Only 10 percent of the nation’s population earns more than $40 a month, according to data compiled by the Vanuatu National Provident Fund, the country’s national pension plan. Education levels—about 6.8 years on average—are well below the global average. Severe weather and climate change are a constant threat to health and food security on the low-slung islands. In 2015, Cyclone Pam left 75,000 homeless and wrecked buildings across the capital.
To pay the bills, the Vanuatu government relies primarily on import duties and a value-added consumption tax. There are no personal or corporate income taxes, no estate or capital gains taxes. Until recently the government has been relaxed about requiring companies to disclose ownership details.
The offshore financial sector kicks in only about 4 percent of the country’s annual output of roughly $800 million, but its existence requires an ultralow tax environment that deprives the government of some revenue. The gray-listing by the FATF raises questions about the sector’s future, says Johnson Naviti, a Salwai policy adviser and director general of the Prime Minister’s Office: “Do we need the offshore sector? Are we better off without it? That’s a possibility.”
The inspiration behind James Michener’s 1947 Tales of the South Pacific, Vanuatu is today a mix of old and new, rich and poor. Take a 40-minute flight from Port Vila to the outer island of Tanna, and you’ll encounter a world from another time, with villagers living off the land, answering to tribal chiefs, and some even worshiping the U.K.’s Prince Philip, the Duke of Edinburgh and consort of Queen Elizabeth II, as the son of a local ancestral mountain god.
Port Vila itself nestles alongside a glistening harbor on the island of Efate. Driving through the capital’s winding streets, you see striking contrasts in wealth. Visiting cruise ships regularly drop off tourists for shopping excursions to markets that sell colorful fabrics, tropical fruits, woven baskets, and pearls. Oceanfront resorts, boutiques, and international schools coexist with shantytown settlements, crater-filled streets, and piles of rotting refuse. It’s a city with traffic jams but no traffic lights.
Vanuatu’s offshore financial center dates back to the early 1970s, when the British and French still shared administrative control over the islands, then known as the New Hebrides. The collapse of the Bretton Woods system of fixed-exchange rates, along with financial globalization, made capital far more mobile than it had ever been.
For Pacific island-states such as Vanuatu, Samoa, Niue, the Cook Islands, Tonga, and Nauru, setting up attractive tax and regulatory regimes to promote the offshore financial industry was a way of luring skilled professionals, financial know-how, and hard currency. The expats who found their way here stirred demand for better schooling, health care, and services. That in turn helped some of these islands develop tourism, an industry that now represents 50 percent of Vanuatu’s economy.
Then the haven experiment on the high seas began to unravel. The rise of global terrorism and tax evasion scandals that hit big international banks emboldened U.S. and European regulators to pressure global financial institutions and governments to hand over more information about suspicious transactions and complex money trails.
Over time, some of Vanuatu’s neighbors have rethought the benefits and risks of remaining an offshore financial center. The Cook Islands and Samoa shifted their focus. They moved away from tax-minimization schemes and toward trusts designed for asset protection. Fiji, meanwhile, developed into a regional hub for call centers.
By sticking with the offshore operations that had served it well, Vanuatu increasingly attracted the attention of faraway regulators. The country surfaced in U.S. prosecutions of money-laundering cases. In 2015 it popped up in the leaked Panama Papers that detailed myriad offshore financial transactions worldwide. That year an evaluation by the Asia/Pacific Group on Money Laundering, a regional affiliate of FATF, claimed Vanuatu had been “infiltrated by transnational organized crime groups” and “used for weapons smuggling, as well as for transshipment of illicit drugs.”
The island hasn’t been blind to what’s going on. “If we say there’s no money laundering, we’re not being realistic,” says Naviti, the adviser to Salwai. Floyd Mera, director of the Vanuatu Financial Intelligence Unit that guards against money laundering, says his team keeps an eye on drug trafficking—“It’s mostly cocaine and heroin from South America”—and any activity involving Russian and East European organized crime gangs.
In June, as part of a concerted effort to get back into FATF’s good graces, the Salwai government pushed a series of bills through Parliament designed to better expose and prosecute money laundering and offshore terrorism financing.
Even so, the government will remain on FATF probation for at least a year until it convinces auditors it has the necessary investments in manpower and information technology in place. “It’s going to be expensive,” says Peter Tari, deputy governor of the Reserve Bank of Vanuatu. “It’s not easy for a country like Vanuatu, where you have limited resources.”
Since Vanuatu’s independence from Britain and France in 1980, its prime ministers have dodged a bewildering series of shifting alliances, no-confidence votes, and outright corruption scandals. Enter Salwai, a Francophone who grew up on Pentecost, which, in addition to land diving, is known for its virgin rainforests and kava, which is used to make a popular intoxicating grog.
Salwai came to power in early 2016 after an epic bribery scandal in which 14 lawmakers—about a quarter of the Parliament—were jailed for bribery. He took office as an agent of change, characterizing himself as such in a speech to the UN General Assembly in September 2016, when he described his plan to broaden the Vanuatu tax base as one of the “greatest” reforms since independence.
Standing unapologetically in the way of Salwai’s efforts to transform Vanuatu’s tax system is Bayer, a Pennsylvania native who came to the islands in 1974 to run Pacific International Trust Company, which was then owned by Bank of America, Sumitomo Bank, Westpac Banking, and Montreal Trust, among others.
Bayer is a no-nonsense former U.S. Army captain who was posted to the Pentagon during the Vietnam War. He says he was a top secret courier who traveled extensively. He put that experience and an MBA from the Wharton School of Business to good use, pulling off a leveraged buyout of Pacific International in 1984 and then later taking over another rival in Vanuatu.
Bayer renounced his American citizenship after Vanuatu’s independence and became a ni-Vanuatu. His Bayer Group controls 30 companies, spanning trust services and insurance businesses to exports. At 76, he remains a power broker in Port Vila—president of the Vanuatu Chamber of Commerce, chairman of the foundation that owns the weekly Vanuatu Independent newspaper, and a two-time member of the Reserve Bank of Vanuatu board. “I’m an entrepreneur,” says Bayer. “The people here are nice but lack capital. Luckily, I get along well with them.”
Bayer faults past governments for failing to stay current with global anti-money-laundering laws. “They just didn’t see this as a priority politically,” he says. “Now they’ve rushed through legislation of international standards in an effort to move off the gray list.”
He sees Vanuatu as a victim of the frenzy in postcrisis financial regulation. The international scolding that’s taking place, he says, amounts to rich-world governments trampling smaller players for commercial advantage. “The more powerful money centers are slowly driving out the smaller centers,” says Bayer.
Bayer and like-minded businesspeople say Vanuatu is nowhere near ready for an income tax. Out of a population of 270,000, says St-Hilaire of the Vanuatu Financial Centre Association, “220,000, minimum, aren’t in the formal economy and wouldn’t be taxed.” That would place a disproportionate burden on urban residents and send expats fleeing, he says.
Once the government, already the nation’s biggest employer, hired a corps of tax collectors, more money would leave state coffers than come in, Bayer says. He favors boosting the consumption tax and doing a better job of enforcing current tax laws to harvest revenue.
In June, Salwai welcomed the arrival of two Chinese People’s Liberation Army Navy warships. The following month, China opened a new embassy in Port Vila. The year before, Vanuatu had become the first Pacific nation to support China’s controversial territorial claims in the South China Sea.
No surprise there. China has lent millions to the island-state for infrastructure projects, including a planned upgrade of the country’s major airfield in Port Vila—an obvious boon to Vanuatu’s essential tourism industry.
In Parliament, Salwai is pushing ahead with a plan to introduce an approximate 10 percent tax on incomes of $6,800 to $32,000, and a 17 percent or so corporate tax rate. If he can wrangle the votes, the new tax regime will be up and running in 2019. Though Salwai has survived one no-confidence vote by a comfortable margin, not all lawmakers are on board for his reform agenda. “He has to be careful,” says Anthony van Fossen, a tax haven expert and social scientist at Griffith University in Brisbane, Australia. “If he’s too bold, he may not be prime minister.”
Even if Salwai comes up short this time, Vanuatu’s days as a free-wheeling tax haven are over. The government has committed to joining the Common Reporting Standard, an information-exchange system developed by the Organization for Economic Cooperation and Development and the Group of 20 to fight financial fraud. Once that’s set up, tax authorities will have an easier time tracking down offshore accounts.
St-Hilaire envisions a world in which financial watchdogs reflexively suspect the worst. “Everything that has to do with tax planning or tax minimization is now considered a fraud–a predicate offense deemed to be possibly money laundering and terrorist financing,” he says.
For Vanuatu, there’s no turning back. One way or another, it faces disruptive change today as surely as it did back when James Michener was stationed here as a young U.S. Navy officer during World War II. The noose is tightening on tax havens, and Salwai or his successors will need to find new strategies to attract overseas talent and capital. For this remarkable Bali Hai-like nation of azure lagoons, hidden waterfalls, and volcanic lava-showers, a second act can’t come soon enough.
Bremner is an executive editor for Bloomberg News in Tokyo.
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