Thursday, January 25, 2007

Developing financial markets

Last week I wrote about the importance of regulations, and referred specifically to OLINT and Cashplus, which have been the focus of many discussions over the past few months. The debate around these investment schemes have heightened over the past week and seems to have climaxed with statements from David Smith, explaining that he does not guarantee 10% per month, and Errol Ennis, stoutly defending his right to operate and lambasting the Financial Investigations Division.

This is exactly what I saw coming, and why I wrote the article last week. The fact is that if we do not (1) have a proper regulatory environment in place; and (2) rule quickly on contentious issues then there will be contradiction. This does nothing more than waste our energies on matters that should be solved by preset structural processes. I drew a parallel with a company, where the HR structure and rules are not in place. What happens is that you end up managing multiple personalities and hence waste precious time dealing with HR issues, which really are not solvable without a defined set of acceptable behaviours, while the competition focuses on making money.

This is precisely what will happen to us as a country. While we debate, through our emotions and self interest, whether or not OLINT or Cashplus is legitimate, our international competitors are busy developing their own financial markets and raising their productivity levels. The fact is that we take much too long to make rulings one way or the other on issues because we fail to objectively analyze and put the proper rules in place to deal with them.

Creative ideas
Financial markets do not develop by maintaining the same products and services for eternity. We have seen the development of our own capital markets through the introduction of commercial paper and money market transactions. Internationally also when derivatives were developed many thought that these may be a problem simply because it was not fully understood. So if we want to develop markets we must continue to encourage creative thought. Every successful company starts with an idea, and for every successful company there are five failures. What we must never do though is discourage creativity, or what the Americans refer to as invention.

As this creativity is being encouraged though, the regulators have a very important balancing act to play. While they must not interfere to the extent of killing creativity, they need to ensure that new ideas do not have the intention of defrauding investors, and that all relevant information is made available to the public. Even after all of that, however, investors will always be free to make their own decisions and take as much risk as they want once they have all available information and understand it. For example if I want to gamble all my money on a donkey running against stallions in a race, and I understand the risks, then it should be my business to do so.

It is therefore a very delicate tightrope that regulators must walk, but they must do so. In other words instead of fuelling the debate by not ruling on the matter, let us put it to rest. In any event, while we wait there are many persons who are putting their monies into currency trading, and risky hedge funds, and even fraudulent internet schemes, by just turning on their computer. Are we going to protect these persons by taking away their computers and banning DSL connections? What we must do is understand the risks, document it, and communicate it to the public, and where we believe that further protection is needed, legislate it. Investors can also protect themselves from risky investments through portfolio diversification, but there is always a place for high risk investments.

Even if the regulators choose to legislate against certain activities, however, this is no guarantee that the public will not participate. Today we have something called the internet. This has opened up access to global markets and makes the job of regulators difficult in protecting the investing public. The only way to really address this is by education. This was a point referred to by Errol Ennis in an interview on Nationwide News.

Internet access
While I was a Commissioner at the Betting, Gaming & Lotteries Commission, I was charged by the chairman with the responsibility of looking into the then new advent of Internet Gaming. One point the regulators found difficulty with was, when doing a transaction on the internet, in what jurisdiction does it occur. Does it have jurisdiction (a) where the server is located, which could be in a different location from where both parties to the transaction are; (b) where the payment originates or terminates; (c) the location of the buyer; or (d) the location of the seller? And where does the acceptance of the offer occur, forming the binding contract? Which regulator therefore has jurisdiction over the transaction?

The United States spent years looking at this, as they sought to ban Internet Gaming in their country, without much success. Until the president recently signed legislation outlawing the provision of Internet Gaming services in the US, these organizations flourished, and with the signing of the legislation into force one company was reported as writing off US$350 million, having to sell the company for US$1. In my opinion though this will still not stop the average American from gambling on internet sites. All it will do is force the activity underground but it will still happen. Just as law enforcement has realized that the best way to fight drug use, including the legal drugs, is by education to stem demand, so too they will eventually have to educate to control Internet Gaming.

If we intend on carrying on a market economy then we must understand that it is important for capital markets to develop. That development, however, will not happen by becoming complacent with what we have, but always looking for that next new idea that will spur greater growth. Last week comments were made by Milton Brady that there is no reason why financial institutions should today be saying that falling interest rates have reduced their profitability. He lamented the fact that the Finance Minister gave the sector two years warning that rates, and margins, on GOJ paper would be coming down. He further stated that some financial institutions have failed to wean themselves off GOJ paper and still invests an average of 35% of assets in it. Naturally therefore net interest income and profits must fall.

The Jamaican public, like every other national, rationally continues to seek higher returns. In the US this has led to the explosion of hedge funds and private equity schemes. These hedge funds have lost and earned a lot of money, and have made upwards of 40% in 2006, playing with billions of US$ on bets such as where oil prices will go. What the regulators ensure is that they play by the rules and investors are aware of the risks. It is through the creation of new ways of thinking that capital markets expand making way for much needed equity for new businesses.

My main concern remains that we do everything to protect the Jamaican market while developing it. What I do know is (1) the world is not waiting on us to sort out our challenges, just as they have leap frogged us in economic development while we tried to grapple with globalization and our politics; (2) we cannot afford another “FINSAC”; (3) we must develop our capital markets with new ideas; and (4) regulators will not be able to forcibly protect investors against themselves with the internet. The ball is in the court of the regulators.

Friday, January 19, 2007

The importance of regulations

About two weeks ago someone referred to me as the marketing manager for OLINT. Around the same time a friend called me to ask if I was the owner of Cashplus, as that is what they were told. In the latter case I don’t even know who the principals are, but as usual Jamaicans care little for fact in many instances and more for sensationalism, so that whenever something is said they would rather hold onto it if it encourages gossip.

These comments no doubt originated because I have been calling for the regulation of these entities and some persons have seen this as a push for legitimization. Never mind the fact that Brian Wynter also called for the regulation of these entities, else they will fail, but I am not aware of anyone saying that he is the marketing manager. I don’t share the opinion that they will fail because they are not regulated, but regulation is important to reduce the risk to the investing public.

Need for regulations
The comments on my position are unfortunate as it illustrates the inability to see beyond the emotions of our own positions. The fact is that it shows how easily we forget the past and is a concern that we do not learn. In the 1990s, because of the lack of a proper regulatory environment, we suffered probably the greatest setback to our economy ever – FINSAC. My argument for regulation of these entities is therefore because if anyone of these entities were to fail it would have a contagious effect, greater than malaria, throughout the financial sector and would negatively affect the confidence contributing to the current growth trend. It is therefore within the interest of the players within the financial sector to regulate these entities rather than continuously debate whether they are legitimate or not. I cannot understand the short sighted approach of some of our more sophisticated thinkers.

I am happy to see that Brian Wynter was reported as calling for these entities to be regulated, and is indicative of the positive influence that the FSC has had on monitoring our financial sector. We cannot like regulation when it suits us but disagree with it when it does not.

No one can argue with the fact that the financial market in the US is probably the most developed. Additionally it is through the development of financial markets that other sectors are able to expand as it creates capital for businesses. Capital markets are not developed by shutting out new ideas but by bringing them under regulation and ensuring that they complement the existing financial structure.

This is the importance of regulations. If we do not abide by regulations then we have nothing but chaos leading to failure. If we do not have laws to regulate our daily lives and commercial transactions then we cannot have progress; we will not have investments; and more importantly there will be no justice and crime will increase. Similarly within markets and companies, if we do not have regulations then we will not have predictability; we will not have protection for investors, employers and employees. In short we would have a free for all system where investors and employees are taken advantage of, vigilante justice will prevail, and there will be no development.

This of course brings to mind the use of monies for purposes other than originally intended, and I speak specifically to the use of the National Insurance Fund and the Capital Development Fund (CDF). When we communicate to the public, or participants in any fund, that the funds will be used for a specific purpose, we establish a trust relationship. When we betray that trust by using the funds for other purposes then we create animosity.

Use of funds
In addition there is a reason for rules being established around the use of funds. When the rules were originally established it would be because it is on this basis that the funds could be raised and the uses would have been thought to be for maximum benefit. This is no different from the use of money in private pension funds that the government will correctly strictly regulate. The change in the use of the monies from these funds therefore fly in the face of the regulatory environment that the government is trying to strengthen, and doing a good job at. If the government is going to lead in this area, however, it is very important to do so by example.

There is no need for another bureaucratic body to be established to monitor the CDF, as recommended by the Opposition Leader, as we already have enough rules to govern this fund. There must be documentation surrounding the objectives of the fund; there are the rules of fund accounting, which governments should adhere to; and there should also be greater parliamentary oversight, which is what they are paid to do. What we must do is enforce the rules.

This lack of the enforcement of regulations results in a lack of structure and prohibits growth. Nowhere is this more obvious than in a company, where this can be seen more readily. If one looks at large multinational companies there is a common thread; they all have standard rules to govern every policy. So the determination as to disciplinary matters, reporting, charitable contributions, expense accounts etc. are all guided by standard rules. If this was not so then there would be no controlled expansion and where growth is not controlled then it is difficult to know when any part of that company is in trouble; in other words it takes away the predictability and control. This is one of the reasons why I always say to small business owners that it is very important to report your correct profits and pay the right taxes. If you setup your accounts to be unstructured to make it difficult for the tax man you also make it easy for the person wanting to commit fraud and will prevent expansion and early retirement.

What happens also is that human resources become unmanageable, costs are not controllable, and productivity inevitably declines. The company then finds itself unable to compete effectively as they do not have enough control to adapt quickly to changes. No where is this more true than in the military. The rigid discipline enforced in the army is necessary as any weakness in the field could contribute to a defeat and the substantial loss of lives, and maybe the fall of a government. It is important that when the General gives the command that it is not only communicated effectively but also that the command is followed without question. That way the only risk is that the wrong command is given but there is no confusion as to what is to be done.

There is no doubt that regulations are very important and we must try to regulate all the areas that provide risk to the public. If we do not do so then we are being irresponsible in our approach to managing the economy. It is not enough to say that there is justification for bending the rules, as there will always be justifiable reasons for flouting the rules depending on who has the power to do so at the time. Today we may find ourselves in the position of benefiting from the compromise of rules and tomorrow we can find ourselves on the other side. So it is very important that we develop a culture of strictly applying rules and order.

Thursday, January 11, 2007

Maximizing growth

Any objective assessment of the Jamaican economy will show that there has been improvement in our growth prospects. These signs include (1) growth in the agricultural sector, and particularly non-traditional exports; (2) record tourist arrivals, and the expansion of rooms; (3) revitalization of the construction industry, following the unnecessary cement crisis; (4) reducing interest rates, spurring interest in small business; (5) increased business confidence; and (6) the fact that, behind mineral and fuels, the machinery/equipment category is the second highest import, implying new investments.

Despite these signs, however, we have to bear in mind that the growth is still in a very fragile state, and can easily be reversed in the blink of an eye. So while we recognize these positive signs, we must still put careful management is in place to ensure that (a) the positive trend is not disrupted; and (b) growth is maximized.

I have been saying since last year that the main threats to this fragile growth remain political actions, crime and corruption. It is against this background that I say that Jamaica does not have an economic problem but rather a social one. The fact is that if we were to positively address our leadership and political issues, corruption in the police force, enforce discipline, and improve training opportunities, then we could seriously address the economics.

Improved confidence
My opinion is that the only real difference between the current upbeat perception and a few months ago is primarily one of improved confidence. There has been no substantial change in infrastructural support; there has been no change in the goods and services we have a competitive advantage in; and there has been no change in literacy standards. The main changes have been (1) improved business confidence; (2) a reduction in reported crimes towards the end of last year (positively affecting perception); (3) improved consumer confidence, as a result of Sista P becoming Prime Minister; and (4) a gradual reduction in interest rates and continued stability in the exchange rate. In short it is the perceived improvement in the will of the leadership to address issues such as high interest rates and crime that is driving confidence and a willingness to invest.

This is what many of us have been arguing for a while, that is, government should not be involved in determining economic policy and investments, but rather should just create a positive environment and leave it to the private sector to grow the economy. If we had an economic problem then even with a positive environment it would be difficult to show economic improvement. What we must do is keep on top of the social issues of responsible governance, crime, corruption and education, thereby reducing the cost of delivering the final products and services. If we are able to deal with crime and governance then we could almost immediately improve the growth in agriculture and tourism. The point is that we have latent potential in these sectors that is being stymied by the social issues, and once the social factors are fixed we can see effortless growth.

What we must do is therefore ensure that we maximize the growth prospects. No doubt Jamaica is benefiting from the improved global environment, and no doubt based on economic cycles this global growth will eventually come to an end. It is therefore very important that we maximize the benefits from global growth and therefore prepare for any downturn that may come in the future. As an example, last year we did not have any significant natural disaster, but we managed to create our own, the cement crisis. Can you imagine if the cement debacle did not occur what sort of economic expansion we would have seen? This again speaks to the issue of governance, which again is a social/political, not economic issue.

It is also against this background that the surprise postponement of the increased income tax threshold is damaging to the economy. Such a move not only damages confidence but is a short sighted approach to managing the fiscal accounts. The Finance Minister has in the past responded to concerns of the public and I am confident that he will again correct this situation, as he has shown a commitment to doing what is necessary to improve the fiscal situation. The cost of the threshold increase is approximately J$5 Billion, but the effect from the loss in confidence and economic activity could be more over a longer period. We must be careful that situations like these do not recur as it could upset our fragile growth.

Trade numbers
The trade numbers also show exports increasing 31% over the first nine months of 2005. However, the trade deficit widened by 14%. This was primarily because of the bill for minerals and fuels (oil), but also the import of machinery/equipment was over 20% of the import bill. Thus both categories accounted for over 50% of imports. The positives from this is that there has recently been a reduction in oil prices, and the pundits are expecting it to decrease further, and importing machinery means an expansion of investments and future exports. If this trend continues then we should see a positive effect on the trade deficit in 2007.

Even so we cannot have a hands off approach to managing this. We must maximize this potential by ensuring that incentives go to ventures producing for export and food for local consumption, which can replace imports. Import substitution is important as a part of our problem is that we have such a high import content that even when exports and tourism grows we see a corresponding increase in imports. If we strategize around ways to substitute local production for imports in certain areas this will be a big positive.

This is the type of management needed to maximize benefits from growth. It is not enough to be satisfied with growth of 2.5% to 3%, as we have a greater potential. In order for us to realize that potential, however, we must ensure that we take the necessary actions to improve the social and physical infrastructure to ramp up the capacity for greater growth.

This is similar to a company seeming prosperous when inefficiencies are masked by favourable market conditions. In other words, growth occurs because everyone around is growing (global economy), not recognizing that growth is occurring primarily because of the market rather than internal efficiencies. So when market conditions become unfavourable the operational and human resource capacity is insufficient to cope. It is therefore important not to be misled into believing that everything is going great guns and not work on the inefficiencies, for example the public sector.

We therefore cannot become complacent about the positive signs. Now more than ever we must ensure that we (1) address the inefficiencies in the system; and (2) not fall into complacency and too much “chest beating”, as any slip can result in a fall and a concussion.

Again I would like to remind everyone that we have been in this position before and because of political decisions, taken a few steps backward. Only last year we saw where crime statistics were improving only to be hit with a startling increase in the murder rate this year. This is illustrative of the need to remain on top of the issues.

Thursday, January 04, 2007

Strategic planning is important

The government recently released the fiscal numbers for the eight months ended November 2006. The overall fiscal deficit shows better than projections, as it was J$28.0 billion versus a projected J$29.6 billion. In order to fully appreciate the outturn, however, we have to go behind the numbers to see what it is telling us. In fact a closer analysis shows that we are in fact behind on our development targets, even though the absolute number appears to be better than projected.

The fact is that the deficit currently stands at over 3.0% of GDP versus a projected 2.5% of GDP. There are still four months to go but based on the growth rate it seems unlikely that this target will be achieved. As I have been saying since the start of the fiscal year, given the cement crisis and the infrastructural support, the economy does not show the capacity to grow at 3% to 4%. We did not have any natural disasters this year so in true Jamaican style we created our own, the cement crisis.

Tax revenues
My projection is that for the fiscal year the deficit will come in at over 3% of GDP simply because GDP growth will not be at the 3% to 4% projected. Because of this tax revenues will also come in below target, which already was very difficult to meet, as a 20% increase in tax revenues was always going to prove challenging. My own projection remains that we will achieve tax revenue growth of approximately 10% to 15% at most. My reasons are (i) the MOU will restrict growth in income; (ii) single digit inflation will keep prices relatively stable, meaning little growth in company profits, if any; (iii) the reduction in interest rates has affected company profits negatively; (iv) the first three months was positively affected by tax arrears collection; and (v) the planned increase in the income tax threshold would have negatively affected payroll taxes.

Many would argue that tax revenues are just J$2.7 billion (2%) behind budget with eight months gone. However, the last four months represents 39% of total tax revenues, and relies heavily on increased payroll, profits and interest taxes. Companies have shown less than expected profits; the savings rate has declined, and companies have laid off staff in order to deal with lower profitability. In addition lower profits means less Christmas bonuses. This translates to less tax collections, and may be a reason behind the government’s late decision to postpone the increased tax threshold until other allowances are removed to neutralize the effect.

This postponement can only negatively affect business and consumer confidence. We must bear in mind that the only real difference between today and a few months ago, when economic prospects did not seem so upbeat, is increased confidence. It is confidence that will lead persons to invest and spend monies. If we continue to make decisions that adversely affect the confidence in government pronouncements then it will only serve to restrict our growth. After all when taxes are to be increased the legislation is always hurried through, and in many cases not put into law until months or years after. It seems as if only when there is to be a credit given to the public that the administrative preparation has to be perfect. The cost of this decision could be more than the potential loss in revenues.

The fact that we always seem to struggle to meet our tax revenue and growth targets is symptomatic of the way we plan and approach budgets. As an example, each year we prepare budgets as if natural disasters are an exception rather than the norm. So when the hurricanes and the floods happen the government always seems surprised at the extent of the damage even though this occurs almost every year.

Strategic planning process
This is not a problem only to be found in the government budget, as private companies face this issue also. Budgets are seen as the beginning and end of the planning process when in fact they really should just be used to support the strategic planning process. Unless we understand this then each year we will be surprised that we miss the budget targets, and will also place the blame at the wrong feet. Whenever budget targets are not met we tend to focus on the Finance Minister as failing when it is because the operational objectives were not met why the budget was not achieved.

Looking at the annual budgetary process it seems as if there is little or no strategic planning. And if it is actually happening it seems to be overshadowed by the actual budget. The budget should be the outcome of the strategic planning process, thereby supporting the objectives set for the year. These strategies should be driven by the operational ministries, such as Education, Security, Health etc.

The strategic planning process should be as follows:
The Cabinet (Executive) should sit each year (maybe 6 months before the budget is presented) and set broad objectives for the coming fiscal year, e.g., to reduce unemployment by 1% or improve per capita income by $500. The important point here is that high level objectives should be set and measurements must be carefully selected so that they can guide growth objectives;
Each operational ministry should translate the high level objectives to achievable tasks, based on their operational capacity, and set timelines for each. Measurable targets should be set and at this stage each Ministry should prepare their own blueprint as to how the targets will be achieved;
The various ministries / departments should next put realistic costs to each operational strategy. Each task should have documented (i) the assumptions for meeting the target; and (ii) the impact it will have on meeting the high level objective for the ministry / department;
The executive team should meet to go over the plans of all Ministries. The strategic plans of the Ministries should include all departments and statutory organizations that falls within its accountability;
The Finance Ministry should consolidate the budgets and prioritize expenditure based on the value added to overall objective and resource availability. At this point the budget will be finalized and presented to the nation along with the strategic objectives.

It is important to understand that the budget is merely a support for the strategic plan, so that if the operational objectives are not met then the budget may not be met. Once we start focusing on the budget then we lose sight of the strategic objectives, which is really what will drive growth.

Unless we can approach our annual budget in this way then we may end up meeting our fiscal targets but not making any real progress. Because of this we get preoccupied with the absolute fiscal target when we should be concerned with whether or not our strategic objectives have been met. So at the end of 2006/07 fiscal year we may meet our absolute fiscal target, but productivity, per capita income and the quality of education may have all declined. Maybe we need to change the name to the fiscal strategic plan and in that way hold ministries responsible for achieving the targets they set at the start of the year.