Tax Havens Turned Nightmares

image: the picture postcard Singapore skyline

A pair of renowned tax haven economies found themselves on the ropes this week, having discovered that when you don’t have any income you can’t pay your bills. One had to pull out some fancy accounting tricks to make ends meet, a move that rattled Asian currency markets. The other just defaulted.

Singapore ran into problems last week because it’s a trade-dependent economy and in the Asia-Pacific region the currently-economically-wobbly China is everyone’s big trading partner. More accurately, Singapore is growth-dependent, and when the Chinese economy slowed down, so did goods and services flowing through Singapore. Without any other tax base to rely upon, Singapore’s economy was hit almost immediately by rapid deflation. Even with a healthy balance sheet and enviable employment numbers, businesses in Singapore suddenly found themselves faced with declining prices.

Inflation vs. Deflation

For most trade-dependent countries inflation is a good thing. For evidence of that counter-intuitive notion consider Japan, which has been trying to spur inflation ever since Prime Minister Abe took office. A lack of inflation hurts countries like Japan and Singapore because when prices don’t rise neither do corporate profits or salaries. Debt also becomes more of a problem because when corporate income drops, debt payments become a larger burden on company balance sheets. That’s why the most deadly force of nature for a country with no tax base is deflation. Deflation means prices for goods and services decline, so companies are making less money, but their debt payments don’t change.

In a consumer economy like the United States deflation can also be a problem, but it comes with a silver lining. When the price of goods and services drop, we buy more. When consumers are two-thirds of the economy that takes up some of the slack from declining prices. A company might make less on each sale, but it sells more product. That’s why the U.S. suffers less in a deflationary environment than an income- and investment-tax haven economy like Puerto Rico. When deflation shrinks the value of economic activity, it means no revenue is being generated. No revenue means no investment; and no investment mean no growth and, critically, no jobs – all of which leads to the disaster we’re seeing today as Puerto Rico defaults on hundreds of millions in debt.

Desperate Measures

When a country’s faced with deflation and stagnant growth it can turn to spending on infrastructure to spur the economy if, like the U.S., it has a tax base. But Singapore, long priding itself on being a tax haven for the wealthy, operates a trade-dependent economy. So when trade drops, there’s nothing left to support growth. Instead Singapore’s central bank turned to the one remaining trick a trade-dependent country has to spur business: it diluted the nation’s currency, making goods and services lower-priced, hence more attractive compared to other countries in the region. The last time Singapore had to dilute its currency this much was 2008, in the midst of a global recession.

The Race to the Bottom is On

Predictably, neighboring countries didn’t take this currency devaluation lying down. Other trade-dependent nations had to quickly devalue their currencies to prevent Singapore from stealing their business. Indonesia lowered its exchange rate and said it would announce new monetary policy this week. Now the race to the bottom on currency valuations is on in Asia and there’s no telling where it’s going to stop.

Look for smart investors in that region to protect the value of their currency by shifting to liquid hard assets like physical gold.  That will be good for the price of gold on world markets as investors look for shelter from central bank madness. For investors in Asian countries, it’s the only play they have left to protect the value and buying power of their currency. Other hard asset shelters, like income producing property, are already pretty saturated in most Asian cities.

Unfortunately, bad news for Singapore and Puerto Rico is good news for gold investors, as well as retirement investors.