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Jamaica's debt threat
A Tale of Two Crises - 2003/4 and 2008/9 - Part 2
By KEITH COLLISTER
Sunday Sunday, October 11, 2009
The first half of fiscal year 2008/2009 saw a sharp rise in Jamaica's inflation due primarily to high world oil and commodity prices. On the 9th of January 2008, the Bank of Jamaica interest rates were increased by 1per cent across the board from their near historic post exchange control liberalisation lows of between 11.65per cent and 12per cent for instruments maturing between 30 and 365 days.
KEITH COLLISTER
In an attempt to reduce the high rate of expected inflation, interest rates were raised again in February and again in June, with the Bank of Jamaica's policy rate now ranging between 14 and 15.5per cent for 30 and 365 days respectively. The international capital market was however still open, even for highly indebted countries, as Jamaica managed to place Jamaican Eurobonds with international investors in June for the second time since the new government came to power.
The international financial crisis intensified sharply after the international financial heart attack created by the collapse of US investment bank Lehman Brothers on September 15th. In the weeks after the collapse of Lehman, the prices of Government of Jamaica Eurobonds, along with most other emerging market debt, fell by almost one third as overseas investors shunned emerging market debt of even the strongest countries in favour of "safe" US treasuries.
Over the course of the rest of 2008, net international reserves declined from US $1.88 billion to US $1.77 billion, and Jamaica's currency declined sharply. Virtually all of this decline in reserves occurred in the month of October, when net international reserves fell by $448.5 million to just over $1.8 billion.
The critical macroeconomic point was quoted in my April 10, 2003 paper "The Jamaican Money Market - A Capital Structure Trap" from the 2001 book The Volatility Machine by former Bear Stearns economist Michael Pettis.
Commenting on Brazil, Pettis noted that because of the high leverage used by local players to buy Brazilian Eurobond debt, Brazil was extremely vulnerable to any change in the market. On October 30th, 1997, the Brazilian Central Bank raised the repo rate from 43.4per cent from 20.7per cent. Brazilian Brady bonds fell, with the main C bond trading as low as 59.5 (a similar to discount to par occurred in 2008 for Jamaican Eurobonds). Local experts calculated that the interest rate shock would increase the public sector borrowing requirement by 3per cent of GDP if rates remained high for one year.
"At some very high level of local interest rates, monetary policy can no longer attract US dollars to the country because investors start raising issues about a country's solvency. Standard macroeconomic models for open economies assume that there is a stable relationship between the currency and domestic interest rates. This is also the key assumption for various models, ranging from currency boards to inflation targeting. And yet for highly indebted emerging market countries facing a fragile fiscal situation, this assumption may be unrealistic. In other words, under critical conditions, high domestic rates, without sound fiscal policy, cannot curb currency attacks. Too high interest rates might actually foster currency attacks, like throwing gasoline on a fire."
Pettis's key argument is that, very much like a company, a country's capital structure makes some events almost automatic. Applied to Jamaica in 2008, this means that, just as in 2003, our high debt and overvalued currency (as suggested by our then huge current account deficit of 20per cent of GDP), made a devaluation virtually inevitable. This time around, a leading international securities dealer estimated that pre Lehman there was approximately US$300 to 400 million in margin lending (loans against Jamaican Eurobonds) to Jamaican security dealers, and perhaps another US$300 to 400 million in additional margin being utilised to buy other instruments eg Fannie Mae/Freddie Mac instruments, again on leverage.
It is important to understand that for nearly a decade the famous "Jamaica bid", meaning foreign investors bought Jamaica's debt because they knew they could sell the bonds to locally based Jamaicans, was an essential piece of Jamaica's ability to raise money internationally. However the financial sector of a country running large current account deficits, like Jamaica, could only buy their own debt with money borrowed from the international broker dealers.
This leverage had all been put in place before the international financial crisis began in August 2007. In their October crisis measures, the Bank of Jamaica correctly sold foreign currency and lent US $170 million to support financial institutions impacted by overseas margin calls.
Continued dollar weakness prompted the Bank of Jamaica to raise interest rates sharply on December 1st 2008, ranging from between 17 to 24per cent for 30 to 365 day money.
In an emergency meeting with the PSOJ the next day, followed by a subsequent press release, the PSOJ policy makers were clearly advised by the leadership of the private sector that the current level of interest rates should not be sustained for very long, a matter of weeks at the most, or risk a repeat of 2003. Behind closed doors, the private sector also advocated an early return to the IMF, even before Managing Director Dominique Strauss- Kahn's visit.
As a response to the crisis, the private sector also pushed for the restart of the social partnership talks, which began again in December 2008. Despite very clear signs of an emerging crisis, the heated political environment created by the by-elections, and the apparent absence of a figure like Dwight Nelson, prepared to put his country above that of his party, meant that to many observers the social partnership talks have been of very limited effectiveness so far.
Unlike in 2003, there seemed to be no acceptance of the need to freeze wages. The agreed imposition of a gas tax, as the most efficient short term measure for a country without "a drop of oil", to quote current PSOJ President Joe Matalon, should have been a critical element of the social partnership. The social partnership would also have been a useful forum to discuss a renewed relationship with the IMF, particularly the critical issue of how to achieve lower interests.
The rise in projected interest costs in the initial 2008/2009 budget to $159 billion, an increase of nearly $34 billion over 2008, was driven mainly by the sharp rise in interest rates at the end of 2008. It was the key element in making the budget so difficult to construct, a problem compounded by the governments seeming inability to freeze other expenditure.
The budget unrealistically projected normal tax revenue growth for the new fiscal year 2009/10 of 11.7per cent, or an increase from roughly $246 billion to $275 billion. Including the tax package, total tax revenue was projected to rise to approximately $292 billion.
Jamaica was recently downgraded to CCC+ by international rating agency Standard & Poor's due to their concerns over our fiscal situation and a proposed debt swap, which they interpreted as a sign that the government had loosened its long-standing bias against debt restructuring. Immediately after the cancellation of the debt swap, the government tried to cut expenditure to compensate for a further increase in interest costs to $175 billion. Unsurprisingly, this was very difficult to accomplish.
In the third of this series of articles on Wednesday, following the presentations on the "Fiscal Debt Challenge" at the Jamaica Chamber of Commerce's National Economic Forum on Tuesday, I will present what I regard as the only solution to Jamaica's debt problem.
A Tale of Two Crises - 2003/4 and 2008/9 - Part 2
By KEITH COLLISTER
Sunday Sunday, October 11, 2009
The first half of fiscal year 2008/2009 saw a sharp rise in Jamaica's inflation due primarily to high world oil and commodity prices. On the 9th of January 2008, the Bank of Jamaica interest rates were increased by 1per cent across the board from their near historic post exchange control liberalisation lows of between 11.65per cent and 12per cent for instruments maturing between 30 and 365 days.
KEITH COLLISTER
In an attempt to reduce the high rate of expected inflation, interest rates were raised again in February and again in June, with the Bank of Jamaica's policy rate now ranging between 14 and 15.5per cent for 30 and 365 days respectively. The international capital market was however still open, even for highly indebted countries, as Jamaica managed to place Jamaican Eurobonds with international investors in June for the second time since the new government came to power.
The international financial crisis intensified sharply after the international financial heart attack created by the collapse of US investment bank Lehman Brothers on September 15th. In the weeks after the collapse of Lehman, the prices of Government of Jamaica Eurobonds, along with most other emerging market debt, fell by almost one third as overseas investors shunned emerging market debt of even the strongest countries in favour of "safe" US treasuries.
Over the course of the rest of 2008, net international reserves declined from US $1.88 billion to US $1.77 billion, and Jamaica's currency declined sharply. Virtually all of this decline in reserves occurred in the month of October, when net international reserves fell by $448.5 million to just over $1.8 billion.
The critical macroeconomic point was quoted in my April 10, 2003 paper "The Jamaican Money Market - A Capital Structure Trap" from the 2001 book The Volatility Machine by former Bear Stearns economist Michael Pettis.
Commenting on Brazil, Pettis noted that because of the high leverage used by local players to buy Brazilian Eurobond debt, Brazil was extremely vulnerable to any change in the market. On October 30th, 1997, the Brazilian Central Bank raised the repo rate from 43.4per cent from 20.7per cent. Brazilian Brady bonds fell, with the main C bond trading as low as 59.5 (a similar to discount to par occurred in 2008 for Jamaican Eurobonds). Local experts calculated that the interest rate shock would increase the public sector borrowing requirement by 3per cent of GDP if rates remained high for one year.
"At some very high level of local interest rates, monetary policy can no longer attract US dollars to the country because investors start raising issues about a country's solvency. Standard macroeconomic models for open economies assume that there is a stable relationship between the currency and domestic interest rates. This is also the key assumption for various models, ranging from currency boards to inflation targeting. And yet for highly indebted emerging market countries facing a fragile fiscal situation, this assumption may be unrealistic. In other words, under critical conditions, high domestic rates, without sound fiscal policy, cannot curb currency attacks. Too high interest rates might actually foster currency attacks, like throwing gasoline on a fire."
Pettis's key argument is that, very much like a company, a country's capital structure makes some events almost automatic. Applied to Jamaica in 2008, this means that, just as in 2003, our high debt and overvalued currency (as suggested by our then huge current account deficit of 20per cent of GDP), made a devaluation virtually inevitable. This time around, a leading international securities dealer estimated that pre Lehman there was approximately US$300 to 400 million in margin lending (loans against Jamaican Eurobonds) to Jamaican security dealers, and perhaps another US$300 to 400 million in additional margin being utilised to buy other instruments eg Fannie Mae/Freddie Mac instruments, again on leverage.
It is important to understand that for nearly a decade the famous "Jamaica bid", meaning foreign investors bought Jamaica's debt because they knew they could sell the bonds to locally based Jamaicans, was an essential piece of Jamaica's ability to raise money internationally. However the financial sector of a country running large current account deficits, like Jamaica, could only buy their own debt with money borrowed from the international broker dealers.
This leverage had all been put in place before the international financial crisis began in August 2007. In their October crisis measures, the Bank of Jamaica correctly sold foreign currency and lent US $170 million to support financial institutions impacted by overseas margin calls.
Continued dollar weakness prompted the Bank of Jamaica to raise interest rates sharply on December 1st 2008, ranging from between 17 to 24per cent for 30 to 365 day money.
In an emergency meeting with the PSOJ the next day, followed by a subsequent press release, the PSOJ policy makers were clearly advised by the leadership of the private sector that the current level of interest rates should not be sustained for very long, a matter of weeks at the most, or risk a repeat of 2003. Behind closed doors, the private sector also advocated an early return to the IMF, even before Managing Director Dominique Strauss- Kahn's visit.
As a response to the crisis, the private sector also pushed for the restart of the social partnership talks, which began again in December 2008. Despite very clear signs of an emerging crisis, the heated political environment created by the by-elections, and the apparent absence of a figure like Dwight Nelson, prepared to put his country above that of his party, meant that to many observers the social partnership talks have been of very limited effectiveness so far.
Unlike in 2003, there seemed to be no acceptance of the need to freeze wages. The agreed imposition of a gas tax, as the most efficient short term measure for a country without "a drop of oil", to quote current PSOJ President Joe Matalon, should have been a critical element of the social partnership. The social partnership would also have been a useful forum to discuss a renewed relationship with the IMF, particularly the critical issue of how to achieve lower interests.
The rise in projected interest costs in the initial 2008/2009 budget to $159 billion, an increase of nearly $34 billion over 2008, was driven mainly by the sharp rise in interest rates at the end of 2008. It was the key element in making the budget so difficult to construct, a problem compounded by the governments seeming inability to freeze other expenditure.
The budget unrealistically projected normal tax revenue growth for the new fiscal year 2009/10 of 11.7per cent, or an increase from roughly $246 billion to $275 billion. Including the tax package, total tax revenue was projected to rise to approximately $292 billion.
Jamaica was recently downgraded to CCC+ by international rating agency Standard & Poor's due to their concerns over our fiscal situation and a proposed debt swap, which they interpreted as a sign that the government had loosened its long-standing bias against debt restructuring. Immediately after the cancellation of the debt swap, the government tried to cut expenditure to compensate for a further increase in interest costs to $175 billion. Unsurprisingly, this was very difficult to accomplish.
In the third of this series of articles on Wednesday, following the presentations on the "Fiscal Debt Challenge" at the Jamaica Chamber of Commerce's National Economic Forum on Tuesday, I will present what I regard as the only solution to Jamaica's debt problem.