Does Foreign Deposits + Small Economy = Trouble?

If you’re looking for a good example of the not-exactly-symbiotic relationship between global banking and the rest of the economy, then consider Andorra. Yes, Andorra.

For the uninitiated (which would be most of us), Andorra is a sovereign principality located somewhere between Spain and France. It’s one of Europe’s smallest nations, coming in at just over 180 square miles, and the native population is still below 100,000 (by comparison, the New York City borough of Brooklyn has long passed 2.5 million). Andorra is officially headed by two co-princes, the Spanish/Roman Catholic Bishop of Urgell and the President of France. Yes, current French President Francois Hollande (like his predecessors going back a long time) was elected by French citizens to be the monarch of a neighboring country.

In mid-March, following up on concerns cited by the U.S. Treasury Department, the CEO of Banca Privada d’Andorra (BPA) was arrested on suspicion of money laundering. The U.S. agency believes that the bank laundered funds for various organizations as far away as China, Russia and Venezuela. Naturally, in such a tiny domain, there was no chance the problem could be isolated:  The bank’s board was promptly suspended, Spain and Panama also took over the bank’s units in their own countries, and the bank’s Spanish board of directors resigned. Of course, Standard & Poor’s downgraded Andorra’s credit rating, while Fitch gave a similar thumbs down to the bank itself. And in true domino fashion, the government has now imposed a 2,500-euro limit on withdrawals from BPA. That’s a ton of bad news for a small economy.

While this is all surely regrettable, none of it should matter much to the world at large. But in a global economy, it does. In fact, Andorra’s current troubles richly illustrate the problems inherent in a global banking system when there’s a gap—maybe even a chasm—between a given nation’s GDP and the assets it has under management.

Andorra’s version of a domestic piggy bank brimming with overseas coins is certainly not unique. As Reuters columnist, James Saft, astutely points out in a recent piece,  it’s actually in a long line of countries whose economies were artificially skewed by outside money—think Cyprus, or Ireland, or Iceland. Recession followed by regulation has long had the effect of driving money way to more hospitable shores.

The idea of a ‘banking center’ that lures foreign monies and boosts the domestic budget is almost irresistible, but the math doesn’t always work out. In fact, it can effectively distort local markets, leading in turn to lost deposits and nationwide calamity.

Two years ago, Patrick Honohan, Governor of the Central Bank of Ireland, laid out the core issue during a conference organized by Icelandic bankers. “Comparing across countries, the positive relationship between banking depth and economic growth seems to hold at least until the bank-to-GDP ratio gets to about 100 per cent or so,” he noted. “But beyond that, there is little evidence of a growth-enhancing function for having a large banking system per se.  And rapid growth in a banking system’s credit to the domestic economy has been long-known as a risk factor for financial instability.”

But at a time when growth and instability seem to co-exist, if not peacefully then at least side by side, this is not a message that’s likely to break through. The lure of massive foreign deposits is undeniably powerful to any institution; in economies that are struggling anyway, it’s almost impossible to say no.

In Andorra’s case, it’s one relatively small institution in one European micro-state reeling from the double whammy of suspected money-laundering and outsize foreign deposits. With more financial troubles in specific areas and more regulation in the affluent ones, could today’s outlier become tomorrow’s norm? At the very least, anyone want to guess where the next pocket of turbulence might be?

Written by Jack Dougal