Scenarios for the Jamaican Economy

Saturday, November 21, 2009 10:06 AM

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Tough choices to secure our future

By Dr Adrian Stokes

Friday, October 30, 2009

Over the last few months, Jamaicans have spent a lot of time debating the causes of our economic problems. In a perverse way, the current crisis reduces the policy options or the degrees of freedom with which we have to operate. To be frank, Jamaica has oftentimes chosen the "muddle through" option because it was easy and the market was willing to fund our bad habits.

Fortunately for the very young and the unborn, the tendency to "muddle through" is no longer among the policy options available to the government. As Aristotle famously wrote, "We cannot learn without pain." I will therefore save readers the agony of reading another Sherlock Holmes type article. The objective of this article is to examine Jamaica's debt dynamics under different scenarios over a four-year period.

Primary surplus

In general, a country has to run a relatively large primary surplus whenever it has a large debt burden. Think about the primary surplus as what the government has to spend after it has covered the wages of public sector workers and other housekeeping expenses. It is tantamount to what a housewife has to spend on credit card payments once she has bought food and paid her utilities.

As a rule of thumb, the level of the primary surplus needed to stabilise the debt burden is given by where r = real interest rate, g = real GDP growth rate and d = . If we assume real interest rate of 7%, real GDP growth of 1%, and debt to GDP ratio of 120%, then the level of primary surplus needed to stabilise the debt level next year is 7.30% (primary surplus as a percentage of GDP). Going forward, given mounting concerns about fiscal sustainability, keeping the debt burden constant is necessary but not sufficient for long term debt sustainability. The government will have to show that it has an aggressive policy stance to bring the debt level below 100% within a four-year period. By our calculations, making less than 100% within a four-year period means that the government will have to run a primary surplus of at least 9% over the period.

How difficult will it be to achieve the threshold level of primary surplus (7.3%) for 2010/11?

To answer this question, we ran several simulation exercises on Jamaica's fiscal accounts over a four-year period.

Our calculations do not account for "exogenous" items, for example, divestment costs associated with Air Jamaica, ongoing wage negotiations and other costs that are not accounted for in the current budget. Table 1 consists of three fiscal scenarios based on different paths of six-month T-bill yields (interest rate benchmark used for pricing government debt). Implicit in our calculations is that the government will sign an IMF deal by the end of 2009 and that substantial (at least $500BN) loans will be received from the other multilaterals that can be used for direct fiscal support or to refinance expensive local debt. This assumption is critical to the interest rate path going forward. See Table 1

As expected, Table 1 shows that the fiscal deficit is very sensitive to the path taken by the six-month T-bill. This is not surprising given the fact that approximately 60% of the local debt is made up of variable rate instruments. The coupon on these instruments will go lower once the six-month T-bill starts to trend lower. In other words, there is a built-in refinancing mechanism in the local debt profile that offers

significant fiscal benefits once the market has confidence about policy implementation. The government saves approximately J$4.5BN for each 1% reduction in T-bill.

Scenario 3 shows that the fiscal deficit for financial year 2010/11 is 5.53% for an average T-bill of 12% throughout the fiscal year. By contrast, the fiscal deficit is 7.64% for the same period if the average T-bill for the period is 15% (see Scenario 1). Timing issues in terms of how the variable debt rate is priced means that not all the benefits from interest rate reductions will be felt in any one fiscal year.

Notice that debt/GDP falls below 100% at the end of the four-year period under the three scenarios chosen for the analysis.

Contrary to what some believe, interest rates cannot simply fall or be talked down by way of fiat or decree. There is also no "chicken or egg" dilemma when it comes to the determination of interest rates. The market-determined interest rate applied to government debt can only be sustainably reduced if the solvency of government improves. Said differently, interest rates will fall dramatically once the primary surplus approaches and exceeds the threshold level of 7.3% we estimated earlier.

So what must be done to achieve one of the interest rate paths in Table 1?

Expenditure Cuts

In all likelihood, we are underestimating the fiscal deficit for 2010/11 in each of the scenarios presented in Table 1. We suspect this to be the case since we have not modeled for the "exogenous" items mentioned before for example Air Jamaica divestment costs. A reasonable estimate is that these "exogenous" items may total approximately 2% of GDP (J$25BN) for 2010/11. We also suspect that the IMF will be encouraging the government to "account" for these "exogenous" costs in 2010/11. This means the government will have to find an additional J$25BN in new revenues or expenditure cuts just to meet our scenarios in 2010/11.

We believe it will be very difficult to obtain higher revenues than what we have programmed in our simulations. We expect that the savings will have to come from expenditure cuts on the recurrent side. And here is the crux of the matter - how difficult will it be to obtain the level of savings estimated from cutting recurrent expenditure?

The government has indicated that it intends to modernise or realign wages and salaries in line with the revenue-generating capacity of the country. Specifically, it intends to bring wages and salaries as a percentage of GDP to 9.5% as against the current 11%. By our calculations, it would need to cut the wage bill by another J$8BN (from J$126BN to J$118) to achieve this objective in 2010/11. If our estimate of the "exogenous" costs is correct, the J$8BN saving will not be enough to meet our 2010/11 scenarios in Table 1. Clearly, the government will have to cut other areas of expenditure to achieve the targets.

In addition to the J$25BN, the government will still need another J$12BN in savings to hit our primary surplus target of 7.3% for 2010/11. However, this might not be necessary if it is able to convince the market that the fiscal accounts will achieve one of the trajectories outlined in Table 1.

The ongoing highlights the tough decisions and the possible difficult adjustments that will be necessary for 2010/11.

Debt Management Strategy

To achieve any of the interest rate scenarios outlined in Table 1 means the government will also have to implement a robust debt management strategy. A robust debt management strategy means achieving and exceeding the minimum primary surplus target of 7.3%. It also means the government "calling" existing high coupon fixed-rate bonds and refinancing them with lower-cost funds obtained from the multi-laterals. A robust debt management strategy also involves extending the current maturity profile of the local debt to reduce "rollover risk".

Credibility Factor

As it stands, the high risk of macroeconomic instability characterised by periods of high interest and inflation rates reduces the incentive of investors to take long-term views on GOJ local debt. Therefore, a sustainable debt management strategy must include a credibility-enhancing device. Said differently, the government will have to communicate a strategy that reduces or eliminates the time inconsistencies associated with government policies.

One way to create a credibility-enhancing mechanism is to institute fiscal responsibility and transparency laws. These laws place constitutional restrictions on fiscal profligacy and set out clear sanctions for ministers and/ or civil servants who break these laws. Fiscal responsibility laws that can be amended by a simple majority are destined to fail.

Benefits from fiscal adjustments

Notwithstanding the very tough decisions to be taken in 2010/11 to achieve the sustainable primary surplus target, there is significant light at the end of the tunnel. Notice that the debt burden falls below 100% at the end of 2013/14 under all the scenarios in Table 1. There would be a material improvement in Jamaica's credit rating if we were able to replicate any of the scenarios presented in Table 1. In fact, we expect a one- notch upgrade in Jamaica's credit rating to B- (S&P) once an IMF deal is signed and a credible medium-term framework is outlined. Scenario 1, the highest T-bill path, shows that we could even run a budget surplus at the end of the period if investors are convinced about the fiscal direction and bid significantly lower rates for government instruments. Based on comparable sovereigns, Jamaica's credit rating could be raised several notches if we were able to achieve any of the Scenarios outlined in Table 1. Scenarios 2 and 3 might be very difficult to achieve given where we are starting from. However, scenario 1 is very doable if the appropriate policy actions are implemented.

Conclusion

For the reasons outlined above, 2010/11 will be a challenging one for all Jamaicans. It is the fiscal year that many of the necessary fiscal reforms will be implemented. By our calculations, we suspect the government will have to find about J$25BN in savings to produce an acceptable fiscal target. Critical to our assumptions is that an IMF deal is inked within a reasonable time period and multi ateral support is received. Achieving the level of fiscal space targeted will be difficult given the already tough economic climate. However, there is significant long-term benefit to be had once the necessary adjustments are implemented.

Our analysis shows that the debt burden falls dramatically after 2014 even if we use scenario 1. A debt burden below 100% would offer the necessary fiscal room for the government to spend more on infrastructure and to invest in education. The adjustments will not be easy, but as Harry Truman said, "To be able to lead others, a man must be willing to go forward alone."

Dr. Adrian Stokes is the Senior Investment Manager at JMMB. He can be contacted at Adrian_Stokes@jmmb.com

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