Friday, May 20, 2011

That FINSAC issue

IT seems as if the Finsac issue will never settle down, as it has been debated by both sides of the political divide and civil society since the 1990s. This is why I strongly supported the need for some study/ commission, as it is necessary to understand the causes of the greatest financial collapse in Jamaica. After all, this was the era that reversed Jamaica's economic improvement, as all data shows that up to the mid-1990s, the economic indicators were looking good and entrepreneurialism was strong.

In my view, it was therefore very important to do a proper study of the period and understand what went wrong, not to cast any blame but to understand fully an era that resulted in the beginning of our economic stagnation and debt crisis. And so I welcomed the commission of enquiry, but have always felt an objective, academic study of the period was necessary before any testimonies were taken.

This approach is essential in order to avoid what is happening now — a lot of crosstalk and blame being thrown around. For at the end of the day, what do we really achieve apart from political and other point scoring? Will we truly find out what went wrong, and even if we do come up with the truth, the whole truth, and nothing but the truth, will it be believed by most people? The sad truth is no. As we are seeing today, this Finsac issue is going to be argued along party, business, and banking lines.

It is therefore going to be even more difficult for us to arrive at the truth of what happened, and my prediction is that whatever report the enquiry comes up with will be believed by 50 per cent of the country, while the other 50 per cent will disagree. So at the end of the day we will have ended where we started.

There is, in my view, some truth in what is being said by all sides to the story, but there are also half-truths and lies. The only way for us to salvage some objectivity and arrive at an answer, at this juncture, would be to set up a group to do an objective study, made up of the members that are acceptable by government, opposition, business community and civil society. And this group must not include anyone who was affected by the meltdown, as it is too emotional a subject.

I will attempt to provide a synopsis of what went wrong, based on the research I did while writing my book.

The platform for the financial meltdown was created with the premature move to liberalise the Jamaican economy, as stated by Ralston Hyman. The fact is that the economy and our resources were not ready for the onslaught of global competition. One reason we were able to achieve growth towards the end of the 1980s was the protection provided to the economy. It is not that our economy was much more efficient than today, but we were at the time restricting foreign exchange movement and therefore local producers were protected. This is why a fixed exchange rate regime could work then but couldn't work today.

With the coming of the 1990s and freer world trade, there was a push by organisations like the WTO and the IMF for countries to liberalise their trade policies and foreign exchange movement. In fact, one can remember that the mantra of the IMF was always to get competitive through currency devaluation. This, however, was never going to be easy for a country like Jamaica that had a broken market economy and an internationally uncompetitive private sector. Our labour force was also relatively unskilled and unproductive. So in the 1980s, for example, the only way to attract the garment industry to Jamaica was through cost incentives.

The liberalisation policies in the early 1990s, therefore, resulted in significant exchange rate depreciation followed by high inflation. Faced with high inflation, businesses, including banks, would invest in assets such as real estate and land that rose significantly in value each year, and when these assets were revalued on their balance sheets, the equity would always increase even without doing anything else but just holding them. Business owners borrowed money from banks at rates in the high-teens to low-twenties, and purchased real estate and US dollars, or if put into the business they would just increase prices every year and recoup from the poor consumer.

This, of course, was unsustainable and would have come to a stop either from government policy or deflation, as disposable incomes would have fallen in real terms sooner or later.

Faced with this situation, the government correctly used monetary policy, through high interest rates, to halt inflation and bring the exchange rate under control. The problem the government faced was that if it reduced interest rates, then the inflationary cycle would take hold again. So what should it do? And so it continued with the policy of high interest rates. This was against a background of inadequate foreign exchange supply and reserves, low productivity, and an uncompetitive private sector. The correct move would be to reduce money supply, reform the public sector bureaucracy, and in the interim attract foreign exchange (borrow or FDIs) to stabilise the economy. The choice was to continue with the high interest rate policy, and the following were the resulting factors:

* Persons who borrowed at around 20% now saw loan rates of up to 90% and there was no way that businesses could support that interest cost, and it was therefore just a matter of time before the businesses started to collapse; and

* Asset values started to stagnate or decline, resulting in much tighter liquidity and declining capital reserves on the balance sheet of banks. Banks also faced much higher interest cost on overdraft facilities at the BOJ, which they needed to support the worsening liquidity situation.

There was a liquidity crisis and so the government had no option but to step in, through an entity such as Finsac, to provide liquidity support for the banks. So the truth is that it was the continued high interest rate policy that resulted in the liquidity drain, but there were other factors that set the platform for this, such as (i) poor financial regulations; and (ii) bad business practice, in terms of balance sheet, and more specifically debt and risk management both at the level of the business and banks.

But what happened after Finsac exacerbated the problem. Finsac should never have taken control of the assets and businesses in the way that it did. What should have happened is what occurred in the US, after the recent financial crisis, which is that the government through Finsac should certainly have provided the liquidity support for the banks but should have (i) allowed control of the operations to remain with the private sector, if even a new management team was hired, which would deal with the assets instead of Finsac; and (ii) if the government was going to sell the debt it should have been offered to local entrepreneurs at that price, through an objective body.

There is a lot more that could be said, but space does not permit and any more details require financial analysis. What is clear, though, is that without an objective study we will never have significant acceptance of any findings, and that things not only went wrong with government policy but there was bad management practice in both the businesses and banks.

Friday, May 13, 2011

The role of fiscal policy

FISCAL policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy.

Coming out of Jamaica's recent budget presentations, and globally since the recession, some have asked the question, what is the role of fiscal policy? In fact, there has been a sharp division between those who support the Keynesian model and those who oppose it, particularly in the US, where the Republicans, Tea Party members in particular, have questioned Obama's use of fiscal spending in creating hundreds of jobs instead of allowing the free flow of the market.

The downside of fiscal spending is of course an increase in public debt, and the upside, it is argued, is the need to stabilise the economy, especially in a recession, to ensure that the decline is not so significant that it leads to poverty and possible social unrest. The results of this fiscal spending in the US have been (1) significant increases in the fiscal deficit and public debt; and (2) a reprieve for many households and a halt in the slide of the global economy.

Because history does not reveal its alternatives, one cannot with certainty argue what would happen if this fiscal spending did not take place. My own view is that the US economy would have declined further, like in the 1930s, thereby exacerbating the global crisis, and we would have seen much greater global suffering. In fact, we see what has happened in countries such as Greece, UK, and the Middle East, where the lack of fiscal spending has resulted in social unrest.

What is evident is that two similar forces cannot repel each other. So it is general consensus that in order to stop a recession then what is needed is an opposing force, such as private investments, job creation, or fiscal spending. In a declining economy, it seems logical to me that when private sector or consumer spending is in retreat, then one has to have fiscal spending in order to repel the force of recession. There is no doubt that economies cannot free-fall or rise forever, and will always adjust from strong growth or decline, as the survival instinct of people will always cause an adjustment. The challenge that governments face is how to smooth out these adjustments, so one does not have excessive overheating of an economy that causes inflation and rapid pull-back, or there is not prolonged decline.

This effort by governments is done through fiscal policy. It seems logical therefore that when an economy is growing fiscal policy should be mildly applied, and should be geared towards encouraging the continuation of an environment that prolongs the growth period and very importantly ensures that the wealth created is not concentrated in the hands of a few. This can be done through policies such as subsidised health and education, or tax incentives. When an economy is in growth mode the use of monetary policy is always more effective at smoothing out growth periods.

When an economy is in decline, however, monetary policy should take a back seat to fiscal policy. In other words, fiscal policy should be the counter-cyclical force to the recessionary environment. If this does not happen, then the economy will decline much further than if fiscal intervention is used to halt that decline, as business and consumer spending and investments will naturally be in retreat. This is because the natural behaviour of private individuals is to retreat when there is economic danger.

This has been the failing of the IMF programme and the previous budgets to this current one. This is also the reason why the economy went through 14 quarters of consecutive decline. The fact is that if an economy is in decline and all sectors retreat, including government (and government should be the savings account for the country), then obviously it will decline further unless some opposing force causes a sudden stop. In the Middle East, for example, that sudden stop was social unrest. In democracies like Jamaica, that sudden stop would have come after much prolonged suffering, when new injection comes in the form of aid, loans, or at a much slower pace, private investments and economic activity.

This is why the recent budget's direction, along with the PIOJ growth-inducement strategy, has been a significant positive change in the fortunes of the economy, as it shows that fiscal policy is now being used to create that enabling environment and inducement for economic growth. If this was done up to a year ago then we would have started to see growth already, as the global economic conditions had improved some time ago.

On the other hand, fiscal policy should not be used to facilitate welfare spending, which was the problem of the budget and economy prior to even the 2008 recession. This is why I have kept saying that Jamaica has always been a welfare state, and is the reason why the economy has struggled to grow. Our use of fiscal policy over the years has not allowed for the market to be efficient, and we have been no different from the archaic and inefficient economies created by the former socialist states.

It is for this reason that the recent budget presented by the government has been correctly welcomed by private sector groups, and understandably so. Government must now go further and eliminate all incentives and allow the entire private sector to play the game on a level playing field. If this is done then the more efficient companies will survive and the economy will grow. If we seek to protect inefficient companies then the economy will continue to experience stagnation or relatively slow growth.

Even while this change in the budget direction is welcome and necessary, including the upcoming tax measures, it is not sufficient. What will be needed is for a sustained move in this direction. We need to ensure that the government is held to account to continue moving fiscal policy in this direction, as it is the only way to get the market efficient and confident enough to maximise the value from private investments and spending, and ensure high levels of growth in the future.

What I am fearful of is that because of elections this trend might be reversed, just as we have in the past reversed positives in order to “run with it” for an election. If the government sticks to its commitment of preferring policies for economic growth over political expediency then we will get to the “promised land”. If, however, political expediency raises its ugly head again then we will be back on the track to nowhere.

It is therefore critical that when we are analysing the budget presentations, and policy proposals being put forward by the government, opposition, and other parties or independents going into election, we pay careful attention to the effect of the policy proposals and not be distracted by the hype and fever around election platform speeches. This is the role of those in civil society that have the capacity to understand the true effect of the policy proposals, and those persons should facilitate the education of the masses in this respect.

After the courtship leading up to the election, or even the wedding on election night, we have to live with the government for at least five years.