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.