Friday, December 09, 2011

What are our options?

In answering the question of what are Jamaica's options, let's look at three scenarios. In both John Brown has income of $100 of which he spends $70 on necessities, $20 on discretionary items, and $10 he saves.

The following actions are taken by John:

o Scenario 1: accumulates debt of $25, which he uses to purchase a luxury item for consumption. Debt to Income ratio of 25%.

o Scenario 2: accumulates debt of $150, which is used primarily for luxury items for consumption. Debt to Income ratio of 150%.

o Scenario 3: accumulates debt of $150, which is used primarily for productive/investment purposes. Debt to Income ratio of 150%.

If John wants to reduce his debt, then he may do the following.

Scenario 1: this is a simple solution, as all John needs to do is cut back on the discretionary spending, and if his savings has a lower return than the cost of the debt then he could forego the savings and pay down the debt.

Scenarios 2 and 3: these are not as straightforward as 1, because the questions of survival and comparing return on investment versus debt are relevant decisions.

In 2 for example, John could not just cut out discretionary expenditure, savings, and necessities to pay back the loan. Even if he could use all his income to pay back the debt, he still would not have enough money available. In any event it is not possible to use all his income because a substantial part of his income goes towards keeping him alive ($70/70%). And therefore if he were to just keep cutting back on expenditure to pay the debt, then he would at best become destitute and could end up in an early grave.

In 3, what he must do depends on the return he makes on the investment he uses the debt for. So if the debt cost him $5 per annum and he makes $10 per annum (after taxes and all costs) from the investment, then it may be worthwhile to keep the debt and pay down the debt from the investment while maintaining his current lifestyle. However, another important consideration is cash flow from the investment versus that of the debt, as cash flow is the most important consideration. A company never goes out of business because of accounting losses, but because it doesn't have net cash inflow. It is important to understand this point, because this relates to Jamaica's situation.

Some analysts continue to point to the debt to GDP ratio as our major problem. However, if I had a debt to GDP ratio of 500 per cent but I didn't have to make any debt payments until 10 years in the future, and someone else had a debt to GDP ratio of 150 per cent but had to make all the payments within a year, which one is better off today? The fact is that cash flow is more important than the ratios, which should really be used as a guide for policy and action and not the reason why one acts.

So in John's case it is important to understand the debt repayment terms, and this is why in the restructuring of the debt the timing of the cash outflows is so important. But all debt restructuring does is give more time to make adjustments, and so if John gets a reprieve in terms of timing of cash payments, he must ensure that he has a plan to adjust either his expenditure or income in order to ensure that when the payments start again he is not in the same position because he has not made the necessary adjustments.

It also seems obvious that John cannot resolve his debt problem (scenario 2) by just cutting back on expenditure, and so the only real option is for him to increase his risk in a very calculated way, in order to reduce his debt in the long term. Seaga did this in the 1980s, when the debt to GDP ratio increased to 212 per cent in 1984: this additional borrowing helped to result in average growth of 6 percent per annum towards the end of the 80s and a debt to GDP ratio of 90 per cent in 1990. This is a countercyclical approach, as opposed to the current IMF agreement which is procyclical, which could not help John in solving his debt problem without landing him to penury or death.

Even if John were to reduce his debt through forgiveness, cutting back on expenditure, or returns from investment, he would not solve his long- term problem without developing the discipline to live within his means. And he will not be able to get persons to continue to support his business if his service level is not consistent (low productivity), access to his business is difficult because of crime impact, or when doing business with him you are frustrated by an inefficient automated telephone system (bureaucracy).

I am sure that you have by now drawn the parallel between John and Jamaica. Jamaica's situation is about 80 and 20 per cent of scenarios 2 and 3 respectively. What this illustrates is that the real problem with Jamaica is not the debt to GDP ratio, which is just a symptom of the underlying issues.

Like John, if we are to solve Jamaica's long-term problems we must address the root causes of:

o Discipline and productivity;

o Bureaucracy;

o Energy and food import costs (more efficient spending on necessities); and

o Cash flow - matching inflow to outflow.

The Prime Minister in a recent speech indicated that the government must adopt a mix of policies to include countercyclical approaches, which is in contrast to the IMF agreement. One such project is the JDIP, of which I am really disappointed about the current circumstances, but it is important that it continue for the health of the economy.

It is critical that when we listen to the debates we are not caught up with terms that sound nice but that we try and understand the fundamental issues and how the proposed solutions will solve the problem. There are some analysts who in the past were not prepared to do the proper analysis and were very much in support of the IMF agreement, and today I am surprised to hear them saying that the terms need to be relaxed or renegotiated. The purpose of analysis is not to predict an event after it has happened. Predictions are made before an event. It was incorrect analysis that resulted in the global financial crisis, so we must be very careful about what we digest. Apparently it is not only politicians who "flip-flop".

I may not be able to listen to the live economic debate next Thursday, because of a previous engagement, but would implore everyone to do so and take careful note of the substance of the proposals rather than the surface issues. This is especially so as I do not believe that, whoever forms the next government, there are any different policy options that will work.

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