Tuesday, December 26, 2006

The cost of corruption

On Christmas Eve, Sunday December 24th, the Gleaner published an article confirming what many of us have known for a long time. The report, entitled “Confession of a corrupt cop”, told of the ways the police corruptly made money by protecting criminals and making evidence disappear. It went on to speak about the silent code of not informing on a colleague, as this is seen as support. In my mind this is no different from the same “informer culture” that the police so publicly chastise inner city citizens about, and in the latter case it is more a means of survival rather than protecting wrong doing.

The 2006 Transparency International Corruption Perception Index showed Jamaica at a score of 3.6, out of 10, with 10 being the least corrupt. Other Caribbean countries scoring lower than Jamaica were Haiti (1.8), Guyana (2.5), Dominican Republic (2.8), Trinidad & Tobago (3.2), and Cuba (3.5). Barbados of course was at a score of 6.7. Is it any wonder that Barbados is perceived as the most developed Caribbean country? The fact is that corruption has a significant economic cost, and is a primary reason why economies under perform.

Corruption culture
Many commentators have been saying for sometime that corruption in the police force, and the political support given to it by way of denial over the years, is a fundamental reason why Jamaica is in our economic plight. Whenever a civil servant takes “a smalls” to do a favour for someone, the customs officer takes a bribe to let in a shipment of guns, or a politician awards a contract because of political affiliation, it eats away at our moral fibre and necessitates a premium for persons doing business in Jamaica. The fact is that if one were doing business in the war torn area of the Congo, you would demand a return way in excess of normal profits for the risk.

Similarly, when we create a culture of corruption it means that the return required for doing business in Jamaica is higher than countries such as Barbados. This will have an effect on driving inflation as quicker returns are required. It also discourages any investment in long term asset creation. We therefore end up with a trading and service society, as Jamaica has transformed into over the years.

This is one of the primary reasons why I have always said that Jamaica does not have an economic problem, but rather a social one. We have bauxite reserves, an attractive tourism product, the best coffee, reggae music, and we can go on and on. So from an economic standpoint there are many products that we have a natural competitive advantage in, which means that we have the basic requirements for economic growth. What we do not have is a society that can create wealth from our natural resources. And this is partly because by our actions we have so corrupted rational market behaviour that resources are not efficiently allocated.

When a politician awards a contract because of political affiliation it means that the best person may not get the contract, and because it is not awarded on a competitive bid then what results is mediocre work. The contractor knows that irrespective of the quality of the work performed that he/she will still be paid, and more often than not the price escalates. When a police officer turns his back when confronted with an illegal situation it creates an unfair competitive advantage for the criminal whose only purpose of starting a business is to launder money, rather than create a productive organization. When a member of parliament wins an election because his/her cronies stuff ballot boxes, it means that there is no drive to improve peoples’ lives, as whether people vote or not then he/she will be returned to power.

These examples illustrate clearly that corruption has a significant cost as it prevents markets from working in an efficient manner, and this in turn makes countries uncompetitive. It is this sort of culture that kills entrepreneurialism more than anything else.

Need for rules
In order for companies or countries to grow there needs to be rules, or processes, by which they act. For example, at one extreme if there was no justice system then what results is anarchy. In this case if someone has a commercial dispute then instead of resolving it in the courts then they may seek to do so by strong arm tactic and what’s worst is that the winner may be the incorrect one. If a company does not have guidelines for how they invest, then investments could happen because of friendship or the emotional decision of one person. In both cases, we see that the most efficient solution would not be arrived at, resulting in a corrupt business environment in the first case and possibly significant losses in the latter.

Similarly corruption has the effect of removing predictability from business decisions. We have for example heard of the high cost of doing business in Nigeria as at almost every level someone has to be paid. Only the most daring and those with connections end up doing business in such a country, despite their large oil reserves. Nigeria is proof that even if a country has one of the most valuable resources in the world, the viability of the economy is not guaranteed unless the society is organized in such a manner so as to exploit the natural advantages. This is the primary advantage that developed countries have over under developed and developing countries.

Whatever we may say about the United States, it is this organization and predictability that drives people to want to live there. The result is that the best minds will usually live in such a country, as they do not have to rely on their connections to survive. This points to another effect of corruption. It prevents the development of our human resources. After all why get educated if all I have to do is know a big wig in the government who can send a contract or two my way, when my friend who has wasted years at University, and missed nights of partying does not end up making the same money I do. After all whether he is smarter than me or not will not make me lose the contract.

Companies also compromise their development in this way. The administrative assistant who knows how to befriend the boss or the person who runs personal errands ends up getting the promotion and the most favour. The company will suffer a faster fate than the country; however, as based on this sort of behaviour it becomes inefficient, uncompetitive, and if it is lucky will survive at the bottom of the food chain. If we look at multinationals, or companies that remain on top for the long term, what they do is establish rules of performance
This “Confession of a corrupt cop” should therefore not be glossed over. This is at the heart of our economic and social issues and needs to be given the prominence it deserves. Unless we solve this issue of corruption in the police force then we will not be able to see the type of reduction in crime levels that we so desperately need, and the cost to Jamaica will continue to be tremendous.
and a system of accountability. Without this companies such as Wal-Mart, Microsoft, IBM, and even our very own Grace Kennedy could not remain at the top. On the other hand companies such as ENRON and WorldCom sought to bend the rules and we all know what happened.

Monday, December 25, 2006

Looking to 2007

At the start of each year the cartoonists usually draw an old man handing over to a young baby, depicting the change from one year to the next. Now whether that baby grows up to be a fragile old man or one who is in good health depends a lot on how we handle our economic and social affairs. For a very long time the Jamaican economy has consistently grown into an ageing person suffering from hypertension and diabetes by the end of the year, as we have refused to do the necessary exercise and eat the right foods that will make us full of vim and vigour.

So what is in store for 2007, based on where we are today and what are we capable of achieving? The majority concedes that the economy is showing improving signs and expect that increased growth will take place in 2007, and this will have a positive effect on the fiscal accounts. Agriculture and tourism seems positioned to do well in 2007, and I am particularly excited about agriculture as I believe that this holds the key to an economic turnaround, as I have been positing for a while.

Risks to economic growth
As we go into 2007 though we have to be aware of the risks to economic growth. We have been in this position before where we thought that the economy was poised for growth and this was turned around because of the selfish action of our politicians, who always believe that the party is more important than the country. I trust, however, that our politicians will have learned from the past and have matured enough to realize that if the country does well then everyone will also, including the same party supporters.

The main risks to Jamaica’s economic growth are (1) placing political objectives ahead of the economy; (2) increasing crime levels; and (3) ignoring the need for productivity increases, particularly in the public sector. If we do not address these issues then we will at best continue to see the aneamic growth rates that we salivate at. While we are happy to be growing at 2% to 3%, our competitors are growing at upwards of 5%. So there is a lot more that needs to be done. Assuming, however, that our politicians can control their urge for calorie intake and ensure that Jamaica is fed a healthy diet of good economic and political policies, then 2007 does look good for us.

So going into 2007 the main risks will be our political intentions, especially as we head into an election, and the effectiveness of the police force in addressing our crime landscape. The recent events in Montego Bay show what many of us have been saying for a long time, the first action needs to be that the police force purges themselves of all the criminal minded police. Only then can they be truly effective in solving our crime situation. And corrupt police and politicians should be held to a higher standard than the average citizen.

For 2007, I expect that the growth in the economy will be led by agriculture and tourism. If one looks around, there is not much else that offers us the competitive advantage that we have in those areas. What we must do from a developmental perspective is ensure that we maximize the benefits of these sectors, and therefore I would approach it in the following manner:
Firstly I would seek to substitute many of our imported products with local production. There is no doubt that one of the main problems with the Jamaican economy is that our import content is too high. We can therefore make significant strides if we (i) organize agriculture to replace much of the imported foods used in hotels and consumed locally; and (ii) replace imported clothing with locally produced clothing lines; and
Next I would encourage investments into agro processing enterprises. This would allow us to add greater value to our agricultural production thus enabling us to earn more for each unit of production. If we are able to do this then we would add more high value jobs rather than the low skilled low paying jobs we have been focusing on.

Of course for these policies to really pay off we need to (i) focus on improving our primary road network; (ii) emphasize training opportunities; and (iii) continue the downward trend of interest rates. If we can achieve this then the economy will be on sound footing. The only wild card in my mind remains the schizophrenic tendencies of our politicians as they approach elections.

Individual investor
So what does this mean for the individual investor? This is the question that people tend to ask me a lot. Well at the end of the day it all comes down to the confidence one has that our politicians will take the right decisions for the economy. Assuming that they do then I see a lot of opportunities opening up.

First I would expect that the stock market will continue to improve. My logic is based on the fact that stock prices are based on company performance. If company profits improve then stock prices will increase. Company profits in 2006 were mostly down because of the adjustment to do with reducing interest rates, as many companies were invested in government paper and as rates came down then they had to reorganize their income sources. This included some downsizing but also many companies invested in new activities. The price earnings (PE) ratios are also lower than the average ratios before the market started to decline, which I would expect to go back up. There are certain stocks that will do better of course, and to select these then persons should see their stock brokers (make sure you have a good one).

As an example, if agriculture and tourism are expected to be the main growth sectors then I would look at companies positioned to take advantage of this. Additionally, there is a lot of construction taking place, and with an improved economy the housing market usually does better, which means that companies related to the construction sector will benefit most. This type of analysis should not only serve the individual investor but also should be the approach companies take in determining what they invest in.

Based on the report that consumer loans at commercial banks have increased by 33% ($13 billion) over the prior year, these banks should see an improvement in their bottom line, as they take advantage of higher interest spreads. In my opinion though this market is not sustainable if general income levels do not improve, and so for them to continue to grow profits they have to make a switch to funding small businesses. This in turn will drive economic activity also. Whoever positions themselves to best take advantage of this will see the greatest profits, and consequently the greatest stock price increase.

I also believe that there are creative investment opportunities out there that can provide acceptable risk with higher returns. Real estate will provide opportunities also but I think one should be selective in the type of real estate one invests in. The international market also provides opportunities for good returns and diversification, especially with the increased access to market opportunities provided through the internet and some local institutions. The present position of the US, European and Asian economies also provide opportunities for playing one against the other.

So while I expect that the economy will improve, a lot rides on political will. Even with that concern, however, I believe that there are specific opportunities open to investors who consult with their investment advisors and plan for 2007.

The importance of private sector efficiency

Over the past few weeks there has been much optimism about the Jamaican economy. It is felt that with the lowering of interest rates and increasing business and consumer confidence that the economy is poised for stronger growth, and with much justification. Agriculture and Tourism both seem to be at a point where significant contributions will be made to the economy, and this is good as both sectors have the greatest potential of absorbing our highly unskilled labour force.

In addition to this it seems as if we will be ending close to our fiscal target, and this will further set us up for improved confidence and growth in the following year. When investors make strategic investment decisions they do so for the long term, and so it is very important not to upset this confidence.

With all the emphasis on the government’s policies, however, it seems as if we have forgotten about the importance of the private sector in making this growth happen. After all the government should only create the correct investment environment but it should be up to the private sector to make growth happen. What this means of course is that the private sector should ensure that once the government does what is asked of it then they should be in a position to take the maximum advantage of the growth opportunities. The private sector will have to compete with international standards and this of course means that companies must be efficient else the creation of an investor friendly environment would have been fruitless.

Jamaica Public Service Company
This thought came to mind recently after being confronted with two situations. The first is the Jamaica Public Service Company (JPS), which seems to be still suffering from the monopolistic blues. The fact is that they still behave in many respects like a monopoly and this has far reaching implications, not only for individual consumers, but also the productivity of companies. Electricity is a very important cost component of any modern business and if we cannot keep the generation costs as low as possible then we are behind the eight ball when it comes to competing internationally.

The cry may be that oil prices worldwide are high, and this is true, but isn’t the cost high for everyone around the world. So what we should focus on when competing is not just the absolute costs but more importantly the relative costs. This relative cost difference is caused because one company is more efficient (productive) than another, and this is one of the driving elements of marginal costing.

JPS has in the past lamented the high cost of illegal connections, in terms of lost revenue, and this cost obviously has to be borne by the legal customers, whether directly or because it restricts us from receiving a lower rate. Well one year ago I reported an illegal connection to the JPS, by calling the then President’s office, calling the customer service centre, reporting it to persons who came to inspect the premises, and writing through the complaints section on the website. On three occasions the servicemen visited to turn off the electricity because the bill was not being paid, and each time it was illegally reconnected but the JPS did not have the common sense to see the criminality in this and address the problem.

Well one year, and one administration later, I emailed the five senior managers at JPS. I received a message the next day from one of the administrative assistants to say that the matter would be addressed the following day. Well two weeks later the following day has not yet arrived. Apart from the lost revenue over the year, the cost of generation, the lost man hours, and the fire hazard, all caused from the illegal connection. JPS runs an expensive advertising campaign in the media advising people of the hazards of illegal connections and requesting that we report them. Yet when it is reported nothing is done.

The consequence of JPS’s inefficiency is that these added costs are heaped on the public, thus creating cost inefficiencies in delivering services and products to the consumer, and international market. This makes Jamaican products uncompetitive in relation to other countries.

Business Ethics
The second incident relates to the necessity of maintaining ethics in business, as it leads down to a breakdown of trust, and can affect our international business image. Recently a friend communicated an idea to another company, which the intention was to engage that company’s services in assisting him to deliver a product to the market. What happened was that the company, whose services were being sought, went directly to the supplier in an attempt to steal the deal away from him. Getting a share of the pie was not enough, they needed the whole hog. Information garnered after the fact was that this was not the first time that such an incident occurred with this company, so obviously it is a habit.

Even in competition there must be rules of engagement. In athletics drugs are banned so as not to create an unfair competitive edge and honesty is encouraged amongst sportsmen. Can you imagine if every one sought to stab someone else in the back what the outcome would be? There would be grid lock as ideas would not flow freely and so progress would be slowed.

It is extremely important that not only efficiencies are created in businesses but that trust is established. One of my fundamental principles is that someone’s word must mean more than a contract. It is because of these instances why we need contracts in the first place, thus adding additional costs to businesses.

These two examples illustrate simplistically, how important the operations of private sector companies are to economic growth. We are competing with international companies which every day strive for greater and greater efficiency and so must operate in the same manner if we are to truly compete and grow our economies. This means that high standards need to be adapted for individual performances, as well as operational efficiencies. There are too many examples of companies that fail to grow to their true potential because they are limited by the inefficiencies within their organization.

If we even look at the larger, more profitable companies in Jamaica, the things that are clearly recognizable are (1) good management; (2) high employee productivity; (3) good technology systems; and (4) structured operational processes. Without these the organization reaches a plateau and fails to grow any further. Any attempts at growth above this level often leads to reduced profitability, as the marginal cost of growth outweighs the marginal revenue. So while emphasis is placed on revenue enhancement, just like economic growth, if one does not have the capacity to grow then the cost of achieving the growth will always outweigh the added benefits.
It is therefore very important for us to remember that while the government has an integral role to play in creating the right environment for investment, the private sector must ensure that they are properly organized to be internationally competitive in order to see Jamaica grow.

The role of interest rates in the market

From time to time readers ask me about the effect of interest rates on the economy. This curiosity comes from the fact that interest rates have been a main consideration in the Jamaican economy since the 1990s, and hence have seen numerous commentaries in the press. This is justified, as the high level of interest rates have been the main cause of not only the economic problems we face, but also our social issues.

An easy explanation would be that when interest rates are high enough people will invest in interest earning assets, such as high yielding government paper. The effect this has is that it diverts money from competing investments, such as manufacturing, once the return on the paper is comparable, that is considering the risk-return relationship of each investment type. When interest rates are reduced, so that based on the risk-reward relationship, the return on say manufacturing is comparable to or higher, then the investor will shy away from paper and invest in real assets.

This is similar to the way in which the Fed uses interest rates to manage the pace of the US economy. So regularly we hear of the Fed raising or reducing interest rates to control inflation and growth (economic activity). When the Fed wants to keep inflation low or slow down the growth of the economy, e.g. consumer spending levels, which drives inflation, then they will raise interest rates, usually in increments to gradually slow down the economy. Similarly when they want to stimulate economic activity they will reduce rates, which will encourage consumer spending. This spending may take the form of consumer or business borrowings as interest rates on loans will be lower. This in turn encourages manufacturing to satisfy the increased demand, and leads to more jobs.

Paper investments
This is how every market will operate, given that other factors such as social conditions are stable and is why the suggestion to use moral suasion to reduce interest rates is impractical, as it assumes that the market is not rational. What has happened to Jamaica over the last ten to thirteen years is that the government has kept interest rates on paper investments high, so this has had the effect of diverting money from the real economy. And just as all other markets do the Jamaican market similarly moved money from the productive sector to investments on paper (deposits), which does not create wealth.

This contributed to the decline of the productive economy, and since no wealth was being created we had to borrow money to keep the country going. This in turn aided in the ballooning of our debt and resulted in us having to today use 70% of each tax dollar to service debt, instead of having it to invest in our people and infrastructure. This lack of funds and infrastructural investment has led to the decline in social conditions, as health and other social services are compromised, and real investments declined as monies were transferred from productive enterprises to paper investments, and real investments made difficult with a deteriorating infrastructure.

So if we want to stimulate economic growth, then certainly one tried and proven method of doing it is to reduce interest rates. The marginal interest rate reductions we have been seeing since the start of the year is already having a positive effect on productive investments. As interest rates come down then the relationship between paper and real investments changes. Real investments begin to become more attractive and debt financing becomes a little more affordable. This results in a move of money from investment in government paper to wealth creating businesses.

The varying of interest rates therefore has the effect of increasing or decreasing production, as it affects demand. In turn this also affects the currency markets, and exchange rates, as it means that if interest rates in the US are reduced then holding US$ is less attractive to investors as one would receive a lower return (interest rate) on the US$ when compared to say the Sterling. For this reason when the Fed cuts interest rates then it devalues the US in comparison to other currencies. A weaker US$, however, means that the relative price of US exports is cheaper in relation to exports from other countries, such as the UK. This will in turn have the effect of increasing the demand for US exports, in other countries, and reducing the demand for imports into the US from other countries against which the US$ has revalued.

When Jamaica was increasing interest rates we did not see any increase in value against the US$, however. In fact we still saw devaluations of the J$, although not at the rate it would have been if interest rates were lower. We sometimes got an indication of this as any attempt to reduce interest rates would lead to an increased demand for the US$, which shows that the Jamaican market acts rationally also.

Jamaica’s productive capacity
The reason why we did not see an increase in the J$ versus US$ is because at the base of a currency’s value is the productive capacity. In other words the only demand for J$ was because of higher interest rates, which meant that when persons wanted to convert the principal and interest to US$ there was no increased earnings to pay it from, as our productive capacity was on the decline. This means that we were using paper to pay paper, and not earning new monies to pay the high interest rates, while at the same time using the principal for non-productive activities.

This caused an increase in the “production” of high yielding J$ paper, which was being paid by the Government in turn increasing the “export” of money (high interest rates) not goods. So the behaviour pattern caused from interest rates does work in Jamaica. The problem is that it has the effect of increasing what one has the productive capacity to increase, which in our case was high yielding government paper.

The problem with Jamaica, therefore, has always been productive capacity. Logically when one varies interest rates, the objective is either to increase / decrease demand for goods or services. Our productive capacity was replaced, however, because interest rates were increased so high that non-productive investments provided a higher rate of return than productive activities. In addition, the loss of jobs because of increased interest rates also caused deteriorating social conditions further eroding the investment climate. So the rational behaviour of investors led them to invest primarily in high yielding government paper, rather than productive enterprise.

What has been happening recently, why commentators like myself are upbeat about our economic prospects is (1) interest rates have been coming down marginally, thus reducing the relative return of paper investments versus real investments; and (2) improvement in the crime levels creating a stable environment for investment. The primary threats to this fragile state are that with the upcoming elections (1) there is an increase in crime levels, or (2) irresponsible pubic spending. Both these conditions can have the effect of reducing investor confidence and pulling back any gains we have made.

I hope that this explains to my readers how interest rates affect underlying economic activity and their understanding that at the base of Jamaica’s problem is one of productive capacity.

Thursday, November 30, 2006

Market versus state growth

We can always tell when the silly season of election approaches. At this time the politicians are like men trying to court a woman. Some do so by telling the lady the truth about what their intentions are, but for the most part they will tell the lady what they think she wants to hear to make themselves look good. So if the lady is impressed by fast cars and glitter then they will try their best to acquire a loan to buy the car, or borrow it, and make all the promises about where they will take the lady. The whole plan, of course depends on the vulnerability of the lady and how gullible she is.

In this case, the lady of course represents Jamaica and the fast car and glitter the promises that the politicians will shower on her in order to secure the prized possession, state power. It matters not that after gaining his ultimate goal that the lady is left in emotional shambles and may even consider suicide or develop a cynicism towards all men after that. The satisfaction of the hour, or minute, is similar to a child receiving a lollipop not being concerned of the cavities that may follow.

Opposition announcements
This came to mind in two recent announcements by members of the opposition party. The first is the announcement by the leader of the opposition that he would remove education tax and HEART, if elected to power, and replace these recurring revenue items with low interest loans. Naturally meaning also that we would have annual recurring low interest loans of at least J$20 billion, adding to our mountain of debt. Now doesn’t this seem contradictory to the need to reduce our debt, and is this the way to solve the need to relieve the high burden of taxation on the Jamaican people. I am the first to admit that our tax landscape needs significant reform, in order to ensure the best use of our tax dollar, but if your legs have been torn apart by shrapnel, why amputate the hand.

The second suggestion, with which I take greater issue, is in contradiction to the suggestion of low interest loans each year to replace the taxes mentioned. The statement by the Minister of Finance in waiting, Audley Shaw, that he would use moral suasion with the private sector to reduce interest rates is simply a backward step. If Mr. Shaw has the power to use moral suasion to reduce interest rates then he is an extremely valuable person to the Jamaican people. Why stop at interest rates? That moral suasion should be used to reduce prices on the things that really affect the Jamaican consumer; electricity and telephone bills, and oil prices. This, however, is not known as economics but rather hypnosis and so it seems as if our politicians, having failed to find an economic solution to Jamaica’s challenges, will now be engrossed in the power of the mind.

At the moment the economy is showing signs of being on the mend and poised for greater growth. This is evident in the areas I think, and have always been saying, will drive growth for this country, agriculture and tourism. These two sectors have been the stars performers in the growth numbers over the last one to two years. The fact is that Jamaica’s natural competitive advantage is in our unique flavours (produce) and our natural beauty. In addition to that we also have a relatively high level of unskilled workers. The agriculture and tourism sectors are best suited to absorb the unskilled labour force. So in the adversity of an unskilled labour force we are blessed with the competitive advantage of agriculture and tourism, which can easily take advantage of our disadvantage.

But, just as leading up to the last election, when the economic prospects appeared good we were hit with the “run with it” speech, so once again we look to be gearing up for political promises that could again negatively affect business confidence and push the economy back into the black hole that we only seem capable of peeping out from. Statements from politicians about their intentions in running the country do have an effect on confidence, which is a very important ingredient of what economic viability is made of.

The remark that moral suasion will be used to influence prices (because interest rates is the price of money) can be interpreted to mean state intervention in the running of the economy, as when the Prime Minister or Minister of Finance suggests to the financial sector where rates should be it can be construed as a very strong request given our constitutional arrangements. When Bernanke (not Bush) feels that the US economy is weak he will decrease benchmark rates and see how the market reacts, not go to the market and persuade them to reduce rates.

Interest rate determinants
The level of interest rates is a function of market conditions. So although the government has been marginally reducing interest rates, there are other factors that affect rates, and these primarily have to do with risk. Two such risks include the political and economic risk. So when the market hears intentions of using moral suasion, rather than monetary or fiscal means, to reduce rates, it increases both the political and economic risk of an investment and therefore helps to keep interest rates higher.

One other significant risk has to do with the market that the funds are lent into. Over the last one to two years the commercial banks have recognized the need to shift to consumer type loans, as a result of the falling margins on securities dealing business, which will not get any better soon. They have, therefore, been making the switch to consumer type loans, hence the barrage of advertisements and shows selling car and furniture loans. These are much riskier types of loans and so carry a higher interest rate. This has helped to keep rates high in recent times.

This market will soon stagnate, however, as more and more consumer needs are satisfied and more importantly as many consumers realize that they are unable to repay the payroll advances or car loans they had taken out. So naturally persons will start defaulting, and the banks may end up having more cars than Mack D’s. This will force the banks to get into the corporate finance / business type loans, but not before they have topped out the consumer loans market and have secured the next one year’s payroll of the poor man who bought the fast car to impress the lady.

Eventually interest rates will decrease as more business loans are granted, which carry a lower risk and will not be taken up at the current high rates being offered to consumers. The key to this of course is that the BOJ continues to marginally reduce benchmark rates.

Banks will also have to start lending money, using ideas as capital, as the growth areas will come from small businesses with little or no collateral. My opinion has always been that a sound idea is worth far more than a piece of land or a car, but banks in Jamaica have never had to take on any real risk as their coffers have always been secure by the high yielding government paper and consumer loans. Assuming that the politicians stay out of determining prices in the economy, however, and leave it to the market then the banks will be forced to take more risk if they want to survive. If I were influencing a bank’s policy I would certainly be assembling a team that could assess credit risk based on a business plan, and the principals involved, in preparation for the future.

As history has shown us, the greatest threat to our economic future has not been hurricanes but rather the misguided policies of our politicians.

Wednesday, November 22, 2006

A more productive environment

Last Wednesday, the Gleaner reported two items, which I think should be mentioned, given the persons the news surrounds and the importance to Jamaica’s productivity. The first has to do with a statement attributed to Dr. Davies that “Remittances encourage dependency over productivity” and the second is Mr. Golding saying that the JLP would (1) remove education and HEART taxes, and (2) consolidate statutory payments into a single social security deduction.

The importance of these two statements is because they come from two individuals who have the ability to affect the changes. First of all, Dr. Davies’ statement that remittances encourage dependency is not only true, but is quite a revelation coming from an administration that has always relied on remittances as a part of bolstering the Balance of Payments. The up surge in remittances beyond tourism as the number one foreign exchange (FX) earner occurred during this administration. The fact that Dr. Davies has now admitted that ways should be found to funnel this remittance money into productive activities is therefore very refreshing.

Cause of remittances
The fact though is that remittances came to prominence as a FX earner because the environment was not conducive to productivity, and not a fall in productivity because of remittances. The fact that Jamaicans left to seek employment elsewhere is because the environment did not allow them the opportunities they needed to make a decent living and enjoy it in a crime controlled environment. Thus many had to go overseas, leaving their beloved country, so that they could afford a decent living for themselves and family members, who they would send remittances to. In the process we ended up destroying the family structure, affecting values and attitudes, and sending away some of our most productive minds. The result of course, is not only a society lacking productive thought, but also a degradation of values resulting in indiscipline and crime.

Of significance in creating this dependency syndrome, is not only remittances, but the high interest rate regime. High interest rates had the effect of creating a dependency syndrome for the rich, as well as stagnating any investments in productive activities. The fact is that companies and individuals who could afford to would purchase high yielding government paper and earn virtually risk free returns equivalent to, or more than, the hassle of risky productive enterprises. So that while the remittances of the small man was money from overseas, the equivalent for the rich man was high interest rates.

In order to channel remittances into productive activity then what we need to do is create an environment where people will want to invest in these activities because it creates better opportunities for them. This has been the way of the market economy for centuries and there is no reason for it to change for Jamaica.

This leads to the promises by the JLP that they will slash education and HEART taxes, replacing them with low interest loans, and also consolidate all statutory payments into one social security tax. While I agree with the latter, I think the promise to slash the taxes and replace them with low interest rates loans would be the incorrect thing to do. In addition I don’t know how practical this would be as the need for HEART and education taxes is recurring, that is we will need this funding every year. This fiscal year, for example, we budgeted to rake in $9.7 billion from Education Tax, and HEART would be a similar amount. So effectively what Mr. Golding is saying is that we would borrow an additional $20 billion per annum, which would mean adding to our debt stock each year, instead of reducing it as we should.

My opinion is that debt should only be for a specified period, as it relates to operational expenses, and one off expenditures that will provide a return greater than the cost of the debt. It is because we have been using debt for operational purposes over the years why we are in the debt crisis we are today. I think it would be therefore impractical to slash these taxes unless we can replace them immediately with other non-debt revenue sources, and so in my mind this amounts to nothing more than an election promise.

A more efficient tax system
On the other hand the promise to consolidate the statutory payments into one statutory deduction would be an excellent move. As Mr. Golding rightly says, this would simplify the business operations of companies, and would be especially beneficial for small and medium sized businesses. This would be a move in the right direction, and should be looked at in the context of a wider move to restructure the whole tax system for efficiency, and bring productivity to the highly bureaucratic public sector. The fact is that the tax system is burdensome and inefficient for businesses and is in dire need of restructuring. As I illustrated two weeks ago, even after working through the computations one sometimes faces the difficulty of paying the tax.

I again would like to remind us all of the recommendations of the Joe Matalon Report two years ago, which highlighted the need for a reformed tax system, with certain recommendations being made. As usual, however, we only implemented the part of the report that was beneficial to the fiscal accounts, forgetting that bringing efficiency to the private sector also means greater government revenue.

These two statements bring to the forefront the need for the creation of a more investment friendly environment, which of course includes the further reduction and control of crime. Two nights ago I was watching TVJ news where it was reported that the police are going to concentrate their efforts to ensure that crime is kept at a minimal during the Christmas season. The fact that we even have to talk about keeping crime low during Christmas is in itself a problem. Shouldn’t it be expected right throughout the year that this is the norm. Shouldn’t it be expected that the Noise Abatement Act applies throughout the year. If we have to make a special effort to control these during Christmas then it means that we do not have control over indiscipline.

The need for a more productive environment brings to mind also a very important race that is currently underway, that is the Presidency of the PSOJ. Many Jamaicans may ignore this race but it is very important for Jamaica. If we are serious about growing this economy then it means that there must be proper private sector representation to bring the various associations under one umbrella group to lobby as a unified voice.

It is small businesses that will primarily bring back vitality to the economy. It is therefore going to be very important that the private sector representation bats for these small groupings. This is going to require a personality that will foster trust, as this is going to be a difficult task, but one that is necessary. It is also going to be very important for the leader of the PSOJ to be willing to criticize the country’s governance, as any complacency to do so can lead to a break down in the investment climate.

All these considerations, therefore, point to the need for fundamental change in our investment environment rather than focusing on the symptoms as we normally do.

Friday, November 10, 2006

The business of FX trading

On March 3, 2006, the Financial Services Commission (FSC) raided OLINT’s New Kingston offices charging breaches of sections 7 (1) (a) and 8 (1) (a) of the Securities Act. Section 7(1) (a) prohibits persons from dealing in securities without a licence, while Section 8 (1) (a) restricts involvement in the business of providing investment advice without an investment advisor's licence.

On August 2, 2006, Elaine Warner, personal financial advisor with Sterling Asset Management wrote “FX Trading – a viable investment alternative”. On September 29, 2006, the Jamaica Observer’s Caribbean Business Report reported Michael Lee Chin as predicting “…that foreign currency trading schemes…cannot be sustained and will end in ruin.” On October 4, 2006 the Business Observer reported that the regulated financial industry was calling on the FSC to allow the licencing of mutual funds to level the mutual fund field, as they have to compete with operations such as Cash Plus.

On Sunday November 5, 2006, the Observer reported that OLINT was granted a stay of execution for a stay and desist order from the FSC, with the condition that they not increase their membership pending the appeal by the company to be heard on March 26, 2007.

With all these contradictory reports, and no final decision, the investing public is of course left in a quandary as to what information is correct. On the one hand small investors have been reaping high returns from outfits such as OLINT and Cash Plus, and Sterling Asset Management (a registered securities dealer), through its Sterling Report, stated that FX trading is a viable investment alternative.

On the other hand, a well respected self made billionaire, has charged that FX trading schemes will end in ruin. The FSC has never stated that FX trading is illegitimate or illegal. They have only charged that OLINT was not authorized to carry on securities dealing or give investment advice. This is quite different from saying that the activity is a scheme, which will end in ruin. The FSC’s Brian Wynter has said that the public should be aware of schemes that promises high return and could end up in disaster, as it is his responsibility to do. The FSC is a regulator and must ensure the investing public is protected and has a responsibility to look into any unregulated entity they believe can damage the financial landscape. Our memories should not be too short to remember FINSAC in the 1990s.

So what is the investing public to believe? Is it possible to legitimately receive these high returns or is it just a scheme designed to take away their hard earned cash? I decided that the best way to ascertain the reality was to investigate the matter personally, and trade myself.

The facts
In order for us to properly understand FX trading we should look at some facts. After all FX trading is an international market and has been in existence since the early 1970s. The question then is why has it not resulted in economic financial ruin, and why countries such as the US and UK not shut down these operations to protect investors. The market does not operate under the cover of dark, so it is not difficult to find out who the main players are. In fact, news stations, such as MSNBC and CNBC, report on FX trading activity daily as a legitimate market.

Some of the facts surrounding FX trading are as follows:
The FX market is by far the largest trading market in the world. Trades across the globe currently exceeds US$1.9 trillion per day;

Rank-----------Name----------------------% of volume
--1-------------Deutsche Bank-------------------17.0
--6-------------Merrill Lynch----------------------5.7
--7-------------J.P. Morgan Chase-----------------5.3
--8-------------Goldman Sachs--------------------4.4
--9-------------ABN AMRO-----------------------4.2
--10------------Morgan Stanley-------------------3.9

The top ten currency traders are large financial institutions (see table). The ten most active traders account for 73% of trading volumes and the impact of retail traders is minimal. Retail brokers are estimated at 2% of the entire market.
Currency prices are affected by economic and political conditions. The most significant effects are from interest rates, global trade, inflation and political stability. Traders watch commentary, and the economic calendar, to predict which trend the market will take;
Currencies are traded in pairs. On the spot market the most heavily traded pairs are (1) EUR/USD – 28%; (2) USD/JPY – 18%; and (3) GBP/USD – 14%. The top six most traded currencies are (i) United States dollar [USD]; (ii) Euro [EUR]; (iii) Japanese yen [JPY]; (iv) British Pound Sterling [GBP]; (v) Swiss franc [CHF]; and (vi) Australian dollar [AUD];
There is little or no inside information in FX markets. Fluctuations are driven by actual monetary flows, as well as expectations in monetary flows from economic or political information;
There is no single unified FX market, rather a number of interconnected marketplaces. The result is that there is no single dollar rate but a number of different rates, depending on the bank or market maker that is trading;
The main trading centers are London, New York and Tokyo. As the Asian trading session ends then the European session opens followed by the US session. This results in a 24 hour market. It closes on Friday afternoon (end of US session) and opens on Sunday afternoon (start of Asian session – Monday morning in Asia);
It is estimated that only about 15% of all traders are successful; and
Like many other markets and services the currency market has a lot of scams perpetrated.

It is the size of the market, the number of participants and highly speculative nature that makes the market unique. Over 50% of traders stay in the market for under one week and approximately 20% are estimated to be in the market for one hour or less on each trade.

Trading characteristics
Today one can trade by accessing any one of the many brokers via the internet, who provide their own trading platform. When one accesses these sites you can choose to trade a demo account, which allows access for a specified period of time. When you are ready to trade with real money you can do so through a mini or standard account, with a minimum of US$250, which trades in units of US$100,000 per trade, or mini-accounts, which trades in units of US$10,000.

The question may be asked, how does a retail client access that amount of money? The answer is that brokers provide margins. For example, if a margin of 200:1 is provided then if you put up US$500 you will be allowed to trade up to US$100,000. Financial houses usually trade margins of 10:1 but margins of up to 400:1 are provided for retail clients. For this reason FX trading can be very risky for retail clients, as if the market turns against the retail speculator then it could easily wipe our their capital.

Many retail clients use technical indicators, such as Japanese candlesticks, Relative Strength Index, Directional Movement Index, and Fibonacci to take advantage of trends. The other type is called fundamental analysis where traders predict based on economic and political information coming to the market. Traders use either fundamental or technical analysis based on current market information, or tend to stick to one or the other.

On executing a trade there is no commission charged. Brokers make money on the buy-sell spread. When one buys the EUR:USD pair, for example, you buy at say 1.2889 but the selling price is 1.2886, so the only way to profit is to wait until the sell price moves to 1.2890 and above, which at that time the buy price would be 1.2893. Conversely one could short the currency pair by selling it, at 1.2890 and wait until the buy price falls to 1.2889 or under and then buy to make a profit. Thus one can make money on going long (buying) and short (selling). The broker always makes a spread, which means that the only way that market volumes can sustain themselves is if new money constantly enters the market.

What are the risks?
FX trading, however, is very risky. Because of the highly speculative nature and the number of persons in the market, it is extremely volatile. This volatility means that the market can change directions quite easily and because of the highly emotional state of traders, as revealed by the candlesticks, a sudden change can occur that can wipe out retail speculators, especially with large margins. For this reason all “legitimate” brokers advise to only put up money one can afford to lose, and when trading use what is called a stop loss.

The problem, however, is that it is also very addictive. In fact many persons refer to it as gambling because of the highly speculative nature involved. The odds of winning or losing on a trade, however, are 50-50, that is the market can either go up or down. The odds of winning the lottery are very small and the odds of winning cash pot, for example, are approximately 36:1. So that even if forex is deemed to be gambling the odds are much better. In addition there are technical predictive tools, while the predictive tool with cash pot may be a dream.

Over time one can use fundamentals to predict with some amount of accuracy what rates will more than likely be, just as one predicts stocks and bond prices. It is therefore the high level of speculation, and the very short term nature of trades that makes FX trading so risky, as well as the high levels of margin provided. Similarly, US stock brokers do provide margin for trading stock, which can also be very risky.

Because of the large size of the market, and the interest in the high returns that can be made, the market is also victim to many scams. It is therefore important that retail speculators who may choose to enter the market understand this and ensure that they verify the legitimacy of the broker.

It is also because of the high level of risk, addictiveness and scams that the FSC has to try to protect Jamaicans. On the other hand, recent trends have indicated that Jamaicans are willing to accept this risk, as they have got used to a high return environment and when interest rates began falling it was difficult for many to adjust to the lower, although normal returns.

Is it legitimate?
The question then remains, is FX trading a legitimate activity? And if it is legitimate shouldn’t the regulators be seeking to regulate the industry, as it is evident from the call of the industry for mutual funds, that the market is moving towards higher returns, even if unregulated?

The fear of course is that a lot of money could eventually find itself leaving the shores of Jamaica. If we do nothing about legitimizing it then we will only see many inexperienced persons going online and losing their capital anyway. It may therefore be better to have professionals perform this service under the umbrella of the FSC to ensure regulation.

I don’t buy the argument I have heard that FX trading services have affected the stock market performance. It is known that the stock market is mainly driven by institutional investors. If we assume that FX trading has affected the stock market then it means that institutional traders have also gone the way of placing funds on the currency market. If that is so then they would have recognized the legitimacy of the market also.

Based on these arguments, it seems to me that forex is legitimate. The problem with the market is not its legitimacy but rather the high level of risk involved. Because of the high level of risk it is very similar to gambling in my view. After all any speculative trade is taking a chance, which is what gambling is, whether it is FX trading, stocks or bonds. What makes an activity resemble gambling is the level of speculation involved, that is the odds.

My results
So what did my own personal experience reveal? Well in order to satisfy myself I looked at the various sites and tested around two different demos. After trading the demo accounts for approximately one month, I put up the minimum amount of money to make it more challenging. I started trading real money on October 3, 2006 and at the time of writing this article, November 9th, 2006, which is 27 trading days (there are about 240 trading days per annum), I showed a return of approximately 20%, as an inexperienced trader doing it only occasionally. That is an annualized rate of 178%, however, future losses could easily turn that around. One of the things you learn to do from early is develop your own trading strategy that works for you. As a result I focused on certain tools and followed specific rules I developed, and with my accounting training it was not difficult to adhere to the discipline required. While it may not be probable to make 10% per month, it is highly probable to make much more than 10% in a month. So from a marketing point of view it may be worthwhile to spread the return over a year, so that if one month you make 30% and the next month you make a loss of 10%, then you could make an average payment of 10% for each of the two months.

My knowledge of the market is from reading and practicing with demo accounts. Let me warn everyone though that even though these returns can be made the market is very risky if you do not (1) have the requisite technical skills to understand the tools and market movements; and (2) maintain the required discipline. After all, the market is driven by the same emotions behind most speculative traders, fear and greed, and if one does not maintain discipline then the market can easily turn against you. Because of the risk involved, however, I would not be trading with anyone else’s money.

In my view, however, the market is legitimate and is not a Pyramid or Ponzi scheme. But like any other lucrative business, these schemes exist as fraudsters try to take advantage of enthusiastic investors. The National Consumers League in the US, cited the top ten internet frauds for 2005 as:
Auction items never delivered, average loss of US$1,155 (42% of complaints);
General merchandise never delivered or misrepresented, average loss of US$2,258 (30% of complaints);
Nigerian money offers, average loss of US$6,937 (8% of complaints);
Fake cheque sent for goods and services and victim is told to wire back money, average loss of US$4,361 (6% of complaints);
Requests for payments to claim lottery winnings, average loss of US$2,919 (4% of complaints);
Phishing, at an average loss of US$612 (2% of all complaints);
Advance fee loans, at an average loss of US$1,426 (1% of all complaints);
Internet access services, at an average loss of US$1,262 (1% of complaints);
Information/adult services, average loss of US$504 (1% of complaints); and
Work at home plans, average loss of US$1,785 (1% of complaints).
The department of Homeland Security has also made predictions about the top frauds for 2006, and this list does not include forex. They have pointed to the emerging risk of hackers accessing on-line brokerage accounts, however.

This list has never included forex trading schemes, even though there are forex fraud schemes. What it shows, however, is that there are greater risks in other areas, which may be even more accessible and difficult to trace. Investors need to be made aware of all the risks, and warnings should be issued by the regulators.

I cannot say enough, however, that it is very risky and does require some amount of formal training, and wit. Some of the rules to follow are:
Only invest what you can afford to lose. A mortgage on the house or using your savings to invest in forex is not only very risky, but also stupid. Portfolio management is key, and while there is a place for high risk investments, one should also have low risk and long term investments such as fixed income and the equities market;
Ensure any advisor is a trusted source, with a good track record, just as you would with any other investment. Regulatory oversight is very important;
If you do not have the requisite skills to do the proper analysis then it is best to stay away because of the risk involved. Not because you have access to a computer and high speed internet does that mean you are a trader; and
Finally but very importantly, remember that under section 5 of the Income Tax Act, once you are resident in Jamaica for tax purposes you must pay taxes on any income earned, whether earned in Jamaica or not.

E-mail: dra_chung@hotmail.com

Tuesday, November 07, 2006

An environment encouraging success

Each time I go to the United States (US), I always wonder, as many Jamaicans do, why it is that Jamaicans go overseas and become very successful, but find it so difficult to do the same here. It is as if we are deliberately holding back the potential that would give this country the opportunity to grow at enviable rates.

The infrastructural support and assistance provided to US citizens is done with one thing in mind; to encourage development and success. On the contrary the way Jamaica operates is that we put every stumbling block in the way of persons trying to move forward. Is it any wonder then that we find ourselves in an economic quandary, where per capita income is a mere US$4,500 compared to countries such as the US at US$41,600, Trinidad at US$16,800, Barbados at US$17,300, Singapore at US$28,600, and Ireland at US$41,100. This of course is no surprise as education and income is directly linked, and while we are struggling with a literacy rate of under 80% these countries have rates in excess of 95%.

Is it any wonder that we find in excess of US$1 billion invested by Jamaicans in other countries, as stated by the World Investment Report (WIR), when so much more development is needed at home? Is it any wonder that Trinidad receives more Foreign Direct Investments (FDI) than we do?

Neglected infrastructure
The truth is that we have neglected to provide an attractive infrastructure, both in terms of capital development and human resource skill levels to woo much more investments into the country. Over the past two to three years we have been celebrating the fact that FDIs have been significantly up. This, however, is primarily because we have been benefiting from the global explosion in FDI flows over the past two to three years also. The WIR shows, however, that the flows to developing countries, such as Jamaica, have been slowing and is expected to reduce even further. We can therefore expect that the levels of FDI we have been experiencing may fall over the next one to three years.

My view, however, is that it is better to grow organically, that is from locals investing, rather than rely on FDI. And we certainly have the capacity to do so with some support. Whether investments are from foreign companies or locals, however, it is still necessary that we develop an infrastructure and processes that will assist them to be successful rather than feel as if one is fighting a losing battle, because as you push the cart up hill you feel as if the system is pushing against you.

Now that we have finally started to reduce interest rates and tackle the crime problem “intelligently”, we need to now go one step further. We need to ensure that the environment in which people have to invest, work and live in is geared towards assisting them to succeed rather than fail. It is not enough for us to be satisfied with growth rates of 2% to 3% when we have the potential to grow at faster rates if the proper investment in our people and infrastructure is made.

I have always said that one can determine the state of a country’s environment just by driving on the roads. In the US there are strict laws against speeding and many police on the roads to ensure that one adheres to the speed limit; there are many signs on the road that tell you of the various exits and destinations; there are many pedestrian tools on the roads; there are school speed zones, where if you go over the prescribed 15 miles per hour you could end up in serious trouble; the lanes are clearly marked with directional signs; and motorists respect the rules relating to traffic signs.

In Jamaica on the other hand, the police will generally only stop someone speeding if they deliberately set up a speed trap, and sometimes they will ask if you are going “write” or “lef”; the instructive road signs are few are far between; even when there are pedestrian tools, which are far from adequate, the pedestrian better give way to the driver; school speed zone – what’s that; the only thing that the lanes are clearly marked with are potholes; and motorists try to beat rules relating to traffic signs.

This comparison is symptomatic of the way in which we have set up our environment for people to succeed. So because we have made it so difficult we end up with a comparatively low literacy rate and run down infrastructure. The WIR states that the new FDI trend is being driven by R&D investments. Countries that attract R&D investments have a well developed infrastructure and educated work force. If this is the new trend in FDI then where does that leave us with our low literacy rate and less than adequate capital spend. The fact is that we may see short term financial benefits from spending less than budgeted capital expenditure, but what is the long term effect, if this is the global trend.

Misinterpreting debt
The focus a balanced budget has led us to believe that the be all and end all of financial management is to come out with a short-term positive financial position. Just as companies focusing on short-term profits may find itself in difficulty over the long run, so it is the same for a country. I have always said that the real problem with debt is not the level in relation to GDP, but rather what is the return in relation to the cost. If the return on debt far exceeds the cost then there is nothing wrong with it. In theory it is efficient to acquire as much debt as possible to the point where the marginal return is equal to the marginal cost. The problem with our debt is that we have, and continue to, use it primarily for consumption purposes. Therefore the marginal return has been below our marginal cost for a long time. This is the reason why we find ourselves spending so much of our earned dollar to service debt. If on the other hand the marginal return on our debt was still greater than the cost then we would not be faced with spending so much of our revenue on debt servicing.

If instead we had used the almost J$900 billion debt to focus primarily on capital development we would find that we would have been in a much better position to (1) attract investments; and (2) see greater returns for each investment dollar spend. For example, if we were truly focused on infrastructural development then we would not have the situation, as reported in the Gleaner, where cruise ships have to be turned back because of inadequate ports, thus resulting in much needed lost revenue. We would not have to contract overseas companies to build highways and in turn charge Jamaicans, resulting in increased transportation charges, and possibly net remittances outside of Jamaica through repatriation.

If we are truly to benefit from exceptional levels of economic growth then we must do everything to create the environment for investment. Of necessity we must focus on developing our infrastructural support for investments to take place, which means improving our distribution networks, not shutting down our only inland airport in Kingston. We must focus on improving our skill level, not just isolating the children better able to deal with GSAT pressures from the rest of the pack. We must make our roads a more disciplined environment. We must make it easy for small businesses to grow, not pressure them with coping with an inefficient tax system.

In short we must provide the infrastructure for people to want to do business and live in Jamaica. If not then we will always be looking for (1) FDIs rather than having the real development of home grown world class organizations; and (2) being satisfied with aneamic growth rates in relation to the global environment.

E-mail: dra_chung@hotmail.com

Wednesday, November 01, 2006

Government revenues and corporate earnings

The fiscal numbers for the six-months to September 2006 are out, and in my opinion there are no surprises. My own view, which I had written and commented on, is that the $219.2 billion revenue targets are going to be difficult to achieve, given the past performance in the economy and the fact that there was no fundamental change in our economic arrangements.

The September numbers show that revenues are some $2.7 billion behind budget, driven by tax revenues underperforming budget by the same amount. The forecast is for tax revenues for the last six months to be higher than the first six-month period, with tax revenues projected to be $18.0 billion, $17.4 billion, and $26.3 billion in December, January and March respectively. This in my opinion is going to be difficult to achieve, compounded by revenues being behind already.

My reasons for saying this are what I have always been saying. The cement crisis had a significant effect on the economy and corporate earnings, tax collections in the first six months was biased by cash accounting and the collection of arrears, and the economy was not capable of growing at rates of 3% based on the arrangements at the time. I believe, however, that the changing economic climate will see a fundamental shift in the way we produce and will see improvements in real investments, driven primarily by agriculture and tourism. This will be the catalyst for real growth to take place at 3% and more in the future, but the effect on the current fiscal year will not be fully felt.

Fragile economy
With that said though, the economy is in a fragile state and any disruptions caused by (i) an upsurge in crime; or (ii) irresponsible fiscal spending can once again change our course. It is therefore going to be very important that the upcoming election, and the desire to win, is not given primacy over our economic arrangements.

As it relates to current fiscal year revenues, instead of the $219.2 billion projected, we may see actual revenues being achieved between $210 billion to $215 billion for the year. Revenue projections will be adversely affected by the following lines:

- Profits taxes from companies, projected at $20.1 billion for the year, are currently $576 million behind budget, and will continue to be marginally behind budget given the downturn in corporate earnings. This line may end up being $1.1 billion behind budget for the year;

- PAYE, projected at $43.4 billion for the year, is currently $1.5 billion behind budget. With the recent and expected lay offs from companies restructuring to adapt to the changing economic environment, we can expect that this line will under perform, and may come in at $3.5 billion under budget for the year;

- Tax on interest, projected at $13.0 billion for the year, is currently $1.3 billion ahead of budget. In September 2006 this line was over $800 million behind budget because of refund payments to pensions, which are expected to continue into the final six months. This line may come in on target, as pension payments reduces the surplus; and

- Consumption taxes (GCT and SCT) are currently $1.2 billion behind budget. These have been affected by the reduced consumption caused by the cement issue, which has seen some resolution. This will continue to be affected by the corporate restructurings, however, and may come in $2 billion behind budget.

Based on these lines we could see total revenues coming in at between $6 billion to $7 billion behind budget, resulting in the $210 billion to $215 billion range.

With that said, however, the government should easily meet its fiscal target by continuing to spend less than budgeted on programmes, wages and salaries, and capital projects. Interest expenditure will continue to be higher than budgeted, as loans have been higher than projected. The result of this expenditure savings, of course will be that less monies will be available for social programmes, public sector workers will continue to hold strain, and improvements in the capital infrastructure generally, and for schools and the police in particular, may be delayed. It is obvious, however, that the government is committed to maintaining fiscal discipline, and this is the reason for the ability to reduce interest rates and force a shift to real investments in the economy.

Revenue performance
This underperformance in revenues is to be expected given the corporate results over the last six months. This may continue until the end of the calendar year, after which I expect that we will start to see an upturn in corporate activity, as (i) lower interest rates, coupled with the recent lay offs, means that more entrepreneurial activity will take place; (ii) disposable income increases with an upswing in construction, with the return of cement and projects continue; (iii) corporate earnings come off the lows they have been experiencing, as the restructuring initiatives start to take effect; and (iv) world cup 2007 approaches. This of course is dependent on ensuring that fiscal spending remains responsible and confidence is not reversed by virtue of factors such as crime. It is therefore very important that good governance practices are adhered to.

The situation, therefore, is that the economy is at a cross roads. If we maintain control of the social conditions and continue to improve the investment climate then we will see more private investments taking place, and more importantly from small local entrepreneurs. The continued reduction in interest rates will have a positive effect on the real economy and will be a cornerstone to the turnaround in our economic fortunes. Over the next three to six months companies will continue to see the benefits of their restructuring effort, and corporate earnings will begin to increase, resulting in greater government revenues. The real benefit for government revenues will fall into the next fiscal year, however.

The expectation, therefore, is that if we continue on our current path, and not allow political euphoria to undermine our efforts, then we could see growth in excess of 3% next year, but there is a slim chance of achieving that this year. In any event this adjustment is necessary and the important thing is that there is improvement.

It remains a concern that net loan receipts are $20 billion higher than projected. The question I continue to ask is, if we are within our fiscal target then what is the need for the greater than projected loan receipts? With a lower than projected fiscal deficit we should be expecting to see a lower loan receipts instead. This is important as a higher than projected net loan receipts means that interest payments will continue to be greater than budgeted. If we are to remove our fiscal deficit then it is important that we also seek to reduce interest payments, which is a significant portion of our expenditure (40%).

Going forward then revenues is not expected to surpass expectations, especially given current corporate earnings. The fiscal targets will be met, however, by suppressing expenditure. As the fiscal deficit reduces this will allow for further reductions in interest rates, spurring further economic growth. Again I repeat, however, that good governance is going to be essential going forward.

Wednesday, October 25, 2006

Adapting to a changing economic climate

The way with which Trafigura has monopolized the press and commentary was predictable because of the enormity of the scandal in many ways. In fact it certainly would have competed with the soaps on television, as it had all the intrigue of a made for television story. The commentary must continue as it is important that there is a full investigation and revelation of what happened so that we can have the purging necessary to move forward.

One of the inadequacies it has shown up is the inability of some persons to focus on more than one issue at a time, as it seems that some commentators cannot understand why we should also address the confidentiality issue, while at the same time addressing the more important issue of the acceptance of the gift by the government.

The incident has also derailed our continuing discussions on the economy, and the fiscal accounts. The Finance Minister recently held a press conference where he fielded questions on the economy and seemed pretty up beat about the prospects as relates to the fiscal targets being met. He stressed that the “inflation scourge” was being brought under control, as the twelve month point to point as at September 2006, showed an annualized inflation of 6.5%. Recently the confidence numbers also showed an upswing in business confidence. There has definitely been a less tense criminal atmosphere year over year. Other indicators show interest rates being reduced marginally, the exchange rate being pretty stable over the so-called “tamarind” season, a rebound in agriculture, and the industrial climate settling down.

On the negative side, the greater than projected increase in the debt of J$26 billion is of concern. This is especially so as we continue to boast of record NIR levels, which in my opinion is not necessary to be so high. If we maintained an NIR of US$1.5 billion, then this would allow for us to retire J$55 billion worth of debt. The lower than targeted capital expenditure is also a concern, as this is what has resulted in a lower than projected fiscal deficit and this type of spend is necessary for future development.

Changing economic environment
What is evident though is that there is a change taking place in the economic environment for the better. Growth is no longer being driven by the financial and retail sectors, but rather by agriculture and tourism, and this is reflected in our improved current account position year over year. The problem with the trade balance remains that even when we increase exports, we are so import dependent, even in our production that imports naturally increase also. In my opinion, this changing economic climate has resulted primarily as a result of the focus on making cheaper funds available to the market and reducing crime through intelligence gathering rather than brute force.

What this has done, however, is caused firms to strive to become more efficient in order to survive. The truth is that even though we have liberalized our economy (certainly foreign exchange flows) since the 1990s, we had not really removed the protection for companies from the globalization effects. This may not seem like a logical argument, but my reason for saying this is that even though there was a significant amount of liberalization in the economy, local firms have had the false protection of high interest rates. In other words there are many companies, not just financial institutions, which did not have to produce real goods and services to increase profitability year over year. All they would do is invest their cash resources in high yielding government paper to make money. Thus what the government did was to liberalize the foreign exchange movements, and removed some protection for the manufacturing industry in particular, but the protection was afforded to companies with cash resources as they could earn almost risk-free income by investing in government paper, thereby protecting them from the competition in the operational business.

With the fiscal situation improving, interest rates trending down, and greater competition coming to the market it has resulted in corporate earnings slowing down generally. Companies must now change their business models in order to continue to grow, as it now calls for efficient organizations.

Consequently, we have been seeing moves by companies to deal with the changing environment. BNS has made an offer to acquire DBG, Grace Kennedy has announced major restructuring in their operations as they seek to become a world-class organization by 2025, Issa transport has announced that they will be merging eight companies into three, Capital Solutions is offering equipment, and Mainland will be importing 200,000 tonnes of cement annually. All of this is happening no doubt because companies realize the changes that are taking place in the economy, and returns from paper instruments are decreasing.

Preparing for the change
It is a good thing that this change is taking place, as it is impossible for us to continue sustaining an economy without growth in the goods producing sector and economic activity in general. It is the lack of growth in these areas that is at the heart of our increasing debt levels, as the economy was being financed by debt. What is going to be important, however, is how as a country we prepare for the changes that are taking place. For example, we have to ensure that we create a much more productive and efficient public sector. Over the past two weeks I have been making every attempt to pay property tax on behalf of a strata, only to be told that they will not accept the “much needed” tax payment because the strata does not have a TRN number. The solution therefore is not to collect the tax rather than assist to get a TRN number for the strata and collect the taxes.

What this implies is that many persons may be unprepared to face the changes that are coming. It is going to be very important that we have a productive and educated workforce if we are to meet the challenges ahead of us. This is what many commentators have been speaking about for a while. As usual, however, we wait until the changes have occurred and then we try to prepare for them.

As normally happens when economies go through a fundamental shift in the way business is done and profits are made, there will be some fall out. We saw that this was coming with the fall off in the stock market and so it should come as no surprise. This sort of shift happens regularly in developed markets, where based on trends and internal reasons, the company finds that its sales and profits are down and have to restructure the organization to adapt. Because in those countries they normally have many new companies being formed the job fallout is usually replaced by the new jobs.

Based on the shift that is happening in the economy, I do expect that there will be more restructuring in many companies. In fact many companies may be going through the restructuring exercise but without any publicity.

The government has an integral role in ensuring that this needed shift in the economy, from earning profits based on paper to real goods and services, is successful. Primary among these responsibilities are (1) to avoid affairs such as Trafigura to ensure that confidence is maintained; (2) continue the intelligence based approach to fighting crime; (3) improve the access to and quality of education; and (4) develop an efficient public sector. If these are not done then we can easily reverse the benefits that we have started to see, and I pray that the election will not cause irrationality to set in. As I have always said, the government must provide the right environment to allow the private sector to be the main engine of growth.

Wednesday, October 18, 2006

Governance – the real Trafigura lesson

After enduring Trafigura for the past two weeks, the question all Jamaicans must ask is how have we benefited? Have our leaders dealt with the issue in a manner that will significantly reduce the risk of it ever happening again, and more importantly than preserving a political party, will ensure that Jamaica maintains a good image.

The way we have handled the Trafigura issue brings to mind the 90/10 principle, written by well known author Stephen Covey. The 90/10 principle tells us that we cannot control 10% of things that happen to us, but the other 90% we can. The example he gives is as follows:

You are eating breakfast when your daughter knocks over a cup of coffee onto your shirt. You have no control over what just what happened. What happens next will be determined by how you react. You curse. You harshly scold your daughter for knocking the cup over. She breaks down in tears. After scolding her, you turn to your spouse and criticize her for placing the cup too close to the edge of the table. A short verbal battle follows. You storm upstairs and change your shirt. Back downstairs, you find your daughter has been too busy crying to finish breakfast and get ready for school. She misses the bus. Your spouse must leave immediately for work. You rush to the car and drive your daughter to school. Because you are late, you drive 40 miles an hour in a 30 mph speed limit. After a 15-minute delay, and receiving a speeding ticket, you arrive at school. Your daughter runs into the building without saying goodbye. You arrive at the office 20 minutes late and find you forgot your briefcase. Your day has started terribly. As it continues, it seems to get worse and worse. You look forward to coming home, When you arrive home, you find a small wedge in your relationship with your spouse and daughter.

What happened is completely determined by your reaction to the spilling of the coffee. Alternatively you could have said nicely to your daughter not to worry about it, go upstairs and change the shirt and everything would have worked out fine.

Political conduct
Similarly the Trafigura situation occurred. I am among the first to say that the accepting of even a donation from Trafigura is poor governance, and am pleased, though not surprised, by the comments attributed to Dr. Davies that accepting the donation was an error. But what followed the incident further compounds the poor state of governance. The reaction by the government, and the opposition to a lesser extent, showed us how sorry a situation Jamaica is in with respect to leadership.

The fact is that the display by both political parties is in breach of the political code of conduct as on both sides party paraphernalia is clearly hanging out even more than the flags along Mountain View a few weeks ago. This hanging of “party colours” climaxed for me on Tuesday night in Parliament when both garrisons were at each others throat in defense of their object of worship, the party. Clearly both the government and opposition forgot that they were supposed to be sitting in Parliament representing the interest of Jamaicans, as they unashamedly drew the line in the sand, daring each other to cross it while snarling and gnashing their teeth in defense of their colleagues in the pack.

And after over seven hours of debate, and electricity and media costs, can Jamaica truly say that we have got one step further to finding out what went wrong and learning from it so that it will never happen again. And can we say that we have taken appropriate action where it needs to be taken, to ensure that anyone involved in such an unethical breach does not purport to represent Jamaica again.

The opposition brought a motion against the government, but it must have failed, as it is uncertain whether the PNP members are even fully aware of all the circumstances. Still they continue to support the tribe and jeer the opposition, and many could find themselves apologizing as the Attorney General did. But in all fairness one could not have expected them to support the opposition even if their conscience would have moved them in that direction, because they may not even know what happened.

It is ironic though that even without the benefit of full knowledge, on either side, they all carry on like a set of school children, consistently talking when a member was on the floor. The prime minister commented on this, as clearly she was incensed by it, giving some amount of hope of it being arrested.

A different approach
Let us assume a different approach had been taken. The opposition leader came across the information and immediately brought it to the attention of the finance minister and prime minister, and alerted them to the fact that he would be bringing it to the attention of the political ombudsman and police commissioner if necessary. He then gives them two weeks to investigate the matter and make a public statement on it, after which he will be going public.

The prime minister investigates and finds that some members of government are implicated and takes appropriate action, and communicates it to the opposition leader. The opposition leader then goes public with it after agreeing what happened with the prime minister. He still calls for the resignation of the government and puts it to Jamaica that such an arrangement is scandalous. The prime minister makes the findings of the investigation public and the matter is discussed in parliament with all the facts and debated without heckling from both sides, so that Jamaicans are not treated to this sort of display by our leaders in the highest body of the land.

The result would be that the public is made aware of the facts, a proper investigation might have been done, the banking act would not have been breached, and the world would not have to sit by and watch the lack of substance of our leadership. The private sector leaders, who have spoken out may not be wondering if they are to consider further investments in Jamaica.

Wouldn’t this have been a better option for Jamaica, and it may not have been necessary for members to stand in Parliament and defend one unethical action by saying that the other side does it also. In all of this did anyone remember that it was more an explanation for Jamaica rather than trying to keep the other party quiet by accusing them of the same thing, or is Parliament a place for political “knights” to jostle. I guess a good defense of a crime is that everyone else does it. I am again heartened by the report that Dr. Davies said he would be fully investigating the income tax leak and taking action. A glimmer of hope.

What Trafigura has shown is not that our politicians are capable of errors. What it has shown is that Jamaica has a weakness in governance. After all is said and done it is the way that we deal with our problems that make us seem like a developed country with proper leadership, not the fact that we have issues.

This is no different from a company that is in crisis. It is the reaction to a crisis that determines if you continuously remain in crisis mode or are able to rise above the tide and swim to shore. That in my view is a mark of good leadership.

Tuesday, October 10, 2006

The Trafigura effect

This year, blessed with a quiet hurricane season, Jamaica has created our own category 10 hurricane, Trafigura. The issue has been the subject of hot debate over the last two weeks, with charges and counter charges being laid. It is of both national and commercial importance, making it very easy to forget the underlying issue for Jamaicans.

When news first broke, it was posited as a reason for the current PNP government to resign en bloc, by the JLP. The PNP denied anything illegal or immoral about it, and at first seemed to deny that the account name, CCOC, had any particular meaning and then back tracked. They then stated that Trafigura made the contribution as a political donation, but then Trafigura described the $31 million as a commercial arrangement with CCOC, no doubt influenced by the investigations against them in Holland.

In all of this I am heartened by the statements from the JCC and PSOJ, as for the first in a very long time the private sector is not only showing a unified voice, but is actually making public comments in the interest of the country. This inspired by a newly elected, and more importantly, younger generation business leader, Mark Myers.

Public trust
This matter led to the resignation of the Information Minister, Colin Campbell, and the JLP is calling for more heads. The way the PNP handles this one can determine their foreseeable political future, and they should ensure that it is dealt with in Jamaica’s interest and not with the party as primary concern. I trust also that both parties will have campaign reform included in their manifestos for early implementation, although neither has shown any real commitment to campaign reform as yet.

Even if there is nothing illegal about the contribution, it is unethical to have accepted it, under the cover of darkness from a company the government has negotiated a commercial arrangement with. What would be government’s position if a government agency accepted a significant Christmas gift from a company it was in a contract negotiation with?

While serving on the board of the Betting, Gaming and Lotteries Commission, one principle the then Chairman insisted on was that no commissioner should accept any gift from a licensee, including lunch. The fact is, even if the donation was legal, on the face of it it appears to be wrong, and the reality of perception is very important for our persons publicly elected or appointed. It is very difficult for (1) Governments to rule without moral authority; and (2) for foreign and local investors to have confidence in an environment where trust is minimal. We are only two familiar with the effect confidence has had on our economy.

The 2006 Global Competitiveness report states that amongst the 1st Pillar needed in a country to provide a foundation for competitiveness and growth are the state of (i) Ethics and corruption [Diversion of public funds and Public trust of Politicians]; (ii) Undue influence [Judicial independence and favouritism in decisions of government officials]; (iii) Government inefficiency [Wastefulness of government spending and Burden of government regulation]; (iv) Corporate ethics [Ethical behaviour of firms]; and (v) Accountability [Efficacy of corporate boards, protection of minority shareholders’ interests and Strength of auditing and accounting standards].

This illustrates a need to maintain transparency, especially if we are serious about attracting foreign investments, which is a deliberate strategy of this administration. This also supports the argument against the breach of customer confidentiality. The banking sector has its foundation in the principle of confidentiality, as do lawyers, doctors and accountants. This alleged action by an FCIB employee, if true, would be a fundamental breach, and the passing of documents even more damning. The bank has realized this and has taken swift action, and must be commended, but must go further to ensure that preventative systems and controls are in place, rather than react, as must be done by all financial institutions.

From Trafigura’s point of view they are already mired in controversy. Formed in 1993, they are commodity traders and charges have been made of linkages to Marc Rich. Trafigura’s group equity stands at US$600 million (J$39.7 billion), and has 35 offices in 36 countries. The group manages its commercial activities through Trafigura Beheer BV (Parent company in Holland); Trafigura AG; Trafigura Pte Ltd (runs group petroleum trading in the Far East); Puma Group (operate group’s world-wide oil storage and distribution assets and investments); and Galena Asset Management (based in London and FSA registered. This is the subsidiary through which Trafigura established and operates fund management).

In May 2006, the US Department of Justice released a statement that Trafigura AG was convicted of falsely representing that more than 500,000 barrels of Iraqi oil was obtained in compliance with the Oil-For-Food Programme. The company, which Trafigura bought the oil from, Ibex, charged that the scheme “had been cooked up by Trafigura”. Trafigura was ordered by the United States to immediately pay a fine of US$8 million, and forfeit US$9.9 million, representing proceeds of the two implicated oil shipments.

In September 2006, Trafigura was accused of dumping toxic chemicals in Abidjan, Ivory Coast, that caused the death of seven persons and 40,000 to be treated in hospital for nausea, breathing problems and nosebleeds. Ten persons, including two French Trafigura executives, Claude Dauphin and Jean-Pierre Valentini, were charged in connection with this. It also led to the dissolution of the Ivory Coast government “to ensure that those who have a hand in what happened…take full responsibility and are removed…”

Interestingly, the BBC reported that Trafigura tried to dispose of the waste twice before Abidjan. First attempting to discharge the waste in the Dutch port of Amsterdam, but the company that was to do the disposal suddenly increased its charges by 40 times. Trafigura then tried to offload the waste in Nigeria, but failed to reach an agreement with two local firms. The question is, what did those companies become aware of?

Although charges of the second incident would have arisen after them meeting Colin Campbell in August 2006, surely any slight attempt at due diligence would have shown the conviction in May 2006. The responsibility of government must be to ensure that in all their dealings they are very transparent and careful to ensure that it stands up to public scrutiny and maintain public trust.

It is regretful, and distasteful, that certain government representatives have personally attacked the JCC president. This is not what I expect from the new politics brought by Patterson and promised to be continued by the current Prime Minister. Come on let’s all start thinking about Jamaica’s interest as it is only through unity that we can move forward.

At the heart of all of this are the possible effects on the moral credibility of our leaders and the business and economic climate. It is therefore of utmost importance that as a country we are seen to deal with this problem effectively, so that we send the right message to the international community. I am confident that the Prime Minister’s nature will result in the matter being addressed in Jamaica’s interest. The unity of criticism from the private sector, social groups and media underscores its importance.