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.


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.


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.