Tight fiscal conditions will constrain Bermuda's public investment and tax increases will blunt a recovery in consumer demand, investment and growth.

Those were the findings of an economic overview on the Island by the Economist Intelligence Unit (EUI), which revealed that public debt levels were expected to rise after a poor revenue performance over the 2009/10 fiscal year, while a mild recovery in inflows from services would result in a widening of the current-account surplus to 18.7 percent of GDP in 2010.

The report also said that relations between Bermuda and its most important economic partner, the US, could deteriorate sharply if US President Barack Obama's administration introduces new tax policies clamping down on US companies' use of offshore financial centres.

In addition, it reported that company defections from the Island to other low-tax domiciles had gathered pace last year, undermining the country's pre-eminence in the re/insurance industry at a time when investment business sector was under pressure globally. Without policy changes to maintain Bermuda's attractiveness to international business, this trend was set to continue in 2010/11, albeit at a slower pace, the report disclosed.

"Relations between Bermuda and its most important economic partner, the US, are being bolstered by continued efforts to sign international tax treaties, although relations with the administration of the President, Barack Obama, could deteriorate sharply if the US government adopts tax reforms that prevent the use of offshore tax domiciles by US companies," the report read.

"Mr. Obama is opposed to the use of offshore jurisdictions (such as Bermuda) by US companies to avoid paying domestic taxes on overseas earnings and has promised to clamp down on the practice.

"Relations with the US will also continue to be guided by efforts to improve the supervision of financial services companies, in order to prevent the Island from being used for transactions connected to the illegal drugs trade, money-laundering or terrorism."

The EIU's report said that financial restraints would prevent Government from expanding capital spending during a period of weak economic growth and public debt would climb in order to meet inflexible spending commitments on health care, justice reforms and improved policing.

"Following an economic contraction estimated at 2.5 percent of GDP in 2009, the Economist Intelligence Unit expects only a weak recovery in 2010/11 as both the tourism and international business sectors continue to be affected by weak demand in the US," it said.

"Tax increases announced in the 2010/11 budget will counteract fiscal revenue growth weakness, but a precautionary raising of the public debt ceiling also reflects the fact that revenues may undershoot targets over 2010/11."

The report said that while Government would continue to seek to lure international financial services providers, particularly insurance companies, which are crucial to economic growth, the success of such an approach was uncertain, given the growing competition from other offshore jurisdictions. In light of this, the number of companies leaving the Island to set up in more favourable domiciles had increased during 2009 and was due to carry on during this and next year.

Meanwhile a rebound in the US economy this year would boost demand, allowing Bermuda's economy to return to positive growth after a contraction of 2.5 percent in 2009, according to the report. However, the expectation of a renewed weakening in US growth, which it expects to slow sharply to 1.6 percent in 2011, would act as a further drag on the Island's growth prospects.

"Our forecast foresees real GDP growth in Bermuda of two percent in 2010 and 1.5 percent in 2011," said the report.

"Risks to Bermuda's short-term forecast appear weighted to the upside, should improvements in risk appetite and global markets consolidate and extend through 2010, lifting international business activity more than we currently expect.

"Domestic demand may also prove more robust than forecast, owing to the demand resilience offered by Bermuda's proportion of high-income earners.

"The dominance and strength of the financial services sector, particularly insurance, make Bermuda's external accounts highly vulnerable to any shift in the perceived stability of Bermuda's tax regime towards foreign companies and especially US-based companies.

"Risk aversion is abating but access to finance could become more costly if revenue remains depressed and spending cuts fail to curb the fiscal deficit as forecast."