What determines investments?

Last Wednesday the Fed Reserve chairman, Ted Bernanke, reported on US economic outlook at Capitol Hill. The global investment market zeroed in on any indication about inflation and the direction of interest rate movements. The movement of interest rates is of course one of the most fundamental factors affecting investment decisions. If rates go up, then the currency becomes more attractive to hold relative to another, as the returns on holding the currency is greater. On the other hand, a rise in interest rates is unfriendly for real investments as it means that as an option, borrowing money becomes more expensive, and consumers will have less disposable income. Similarly, if rates decrease then it means that financing for a business becomes less expensive, and this will encourage business activity.

From the consumer’s perspective, lower interest rates means that mortgages, and other consumer loans become cheaper. Consumers will take advantage of the less expensive money to improve their life styles by buying new houses and motor vehicles.

Here in Jamaica, one concern expressed is that even though interest rates are declining, we have not seen a corresponding increase in commercial investments. This of course is cause for concern, as if there is no increase in real investments then foreign assets are more attractive, which will place some amount of pressure on the exchange rate. It is therefore critical to understand what factors affect new investments, as clearly declining interest rates is not enough.

Jan-06 Dec-06 Change
T-Bill 12.47% 11.60% (0.87%)
Installment credit 23.07% 21.65% (1.42%)
Mortgage credit 20.26% 13.09% (7.17%)
Personal credit 29.19% 27.64% (1.55%)
Commercial credit 13.72% 13.36% (0.36%)
Local Govt & Other Public Entities 12.09% 12.12% 0.03%
Central Govt 16.49% 13.83% (2.66%)
Overall A/W Rate 17.50% 17.59% 0.09%

Average interest rates
The table shows how average interest rates have moved, between January and December 2006, on various types of loans (www.boj.org.jm). Average Treasury bill rates have reduced by 0.87% over the period. The most substantial reduction has been in mortgage credit, and this is evident in the aggressive rates that are being offered by institutions such as BNS and Jamaica National. The other areas that have seen a fall of more than 1% are installment credit (hire purchase included), personal credit (which would include motor car loans), and loans to central government (which would be impacted by the reducing rates on government paper).

What we find is that commercial credit has not seen any significant reduction in rates. The question is what would have caused such significant reductions in consumer type loans, but in the area where it is needed to fund business expansion (commercial credit) the rate reduction has been marginal in comparison. The two main factors in my opinion are (1) there is a much greater demand for consumer borrowing, influenced by the advertising and loan facilities made available by banks; and (2) banks consider commercial loans more risky than consumer loans, as spreads are lower and venture capital is not readily available from banks.The low demand for commercial loans, and the accompanying risk-averse nature of banks, results from a perception developed out of the FINSAC era and the lack of confidence in the ability of the authorities to administer law and order. One of the main negatives of the high interest rate policy Jamaica pursued, leading to FINSAC, was not the loss of investments, but rather the damage done to our entrepreneurial spirit.

The fact is that even if interest rates were to be reduced by 5%, there would still be limited uptake in corresponding investments. The reason for this is that investment decisions are affected by much more than interest rates, and other monetary policy. We have to remember that economics is a social science, and consequently is a study of the behaviour of people. When we change monetary policy to influence economic outcomes, what we are hoping to do is influence the behaviour of individuals. So reducing interest rates does not by itself improve economic performance.

When interest rates are reduced, it is expected to have the result of affecting people’s investment decisions, as it is hoped that an individual will want to borrow money at the lower cost and invest it in real businesses, which gives a higher return than the cost of the funds borrowed. And this is what happens in countries such as the US and UK. The reason why a rate reduction will have the intended effect therefore is because individuals will react in the desired way. What we need to ascertain then is what is it that influences this reaction from individuals?

In the US, for example, when the Fed wants consumers to increase economic activity and drive new investments they will lower interest rates. Lower rates will mean reduced funding costs for businesses and consumer purchases. Thus demand for debt financing will increase. When these funds are accessed then individuals will look at the investment options available and invest in ventures that will give them a consistently higher return than the cost of the borrowed funds. Lower rates will also cause the currency to devalue against that of major trading partners (assuming their rates do not change), resulting in the relative price of goods produced being cheaper, thus increasing exports.

Social factors
The problem we have is that the social factors are a challenge for us. The expected effect of interest rate movements assumes that investors are indifferent between investing in financial products and real investments, and whether they do or not depends on the level of interest rates as one factor. This of course also assumes that people have the necessary confidence in the economy that they will want to make real investments, which is the issue for Jamaica.

The confidence of Jamaicans is affected by (1) the memory of FINSAC; (2) the level of crime, and in particular extortion, which is an unpredictable cost of business; (3) the level of government bureaucracy; (4) the unpredictability of tax policy; (5) the competence of our workforce; and (6) the time it takes to resolve commercial transactions in the courts; as some examples. If investors cannot have reasonable confidence that the environment will remain suitable for business, then irrespective of how low interest rates are, we will not see any significant increase in real investments. Instead we will see investments in ventures that provide quick returns, as one is not sure how much time is available for investment recovery. This is certainly one reason behind the choice of some Jamaicans to invest in high risk alternative investments, as it is their right to do. After all it is not as if we have moved out of real investments to paper investments. We were mainly invested in government paper before, so all we have done is moved from one paper investment to another.

If we are serious about increasing the number of real investments by Jamaicans, we must encourage an environment where people feel safe to invest. Our crime problem, government bureaucracy, and the way we handle development work in our tourist capital does not leave one with a lot of confidence in the investment environment.