High interest rates as a financial solution
Last year was the most dysfunctional since the great financial meltdown of 1996 when the banking system sunk into a blackhole. Whether this year, 2010, will see a turnaround from darkness to light will depend on the same banking industry.
From the depth of despair of 1996 when over 40 financial institutions crashed, almost wiping out the entire industry, the surviving banks have become stellar performers riding high as superstars on super-charged interest rates. But this is not a success story, except for the banks whose achievements stand out in the landscape of a decaying economic environment.
The basis of the mounting profits in the banking system is the excessive commercial interest rates charged. These rates are now much lower than they were in the 1990s when interest rates hovered between 46 to 50 per cent between 1992-1995, during the height of the financial meltdown. But the prime lending rate is still far too high to promote business activity. This is particularly so when rates among Jamaica's business partners in exports, imports and the cost of money are largely low double figures. This comparison is not restricted to our major trading partners in Europe and North America; it is true also of the regional CARICOM partners where commercial rates are far less than in Jamaica.
Prime Lending Rates 2006
The Bahamas 5.5
Trinidad and Tobago 11.06
The consequences of excessively high rates reduce economic activity, among other things, producing anaemic economic growth. Such conditions could be tolerated for short periods. But nearly two decades of no growth, little growth, and negative economic growth, have taken their toll on the fiscal burden which the economy has to bear in borrowing more and more at high costs to make up for the budget shortfalls in the revenue of the stunted economy.
To close this gap, either more revenue (mostly taxes), or less expenditure, is the standard recourse. But less costly interest rates would also be a successful prescription.
All three of these options are being pursued now by the Government as part of a package to satisfy the International Monetary Fund (IMF) that Jamaica is worthy of its assistance not only because it is in need but because it is helping itself.
The first option, to increase tax revenue significantly, was implemented in 2009 when two tax packages totalling an unbelievable $40 billion were imposed, the last being just before the end of the year. This would lift revenue proceeds but hardly enough to close the gap of what is now said to be more than $110 billion, and could eventually be higher. The original fiscal gap was $78 billion.
The second option, to cut expenditure, is to be tabled in Parliament in April 2010, for presentation in the new Budget when significant staffing cuts of public service employees are expected.
The third option deals with lowering interest rates which would, in effect, reduce the amount paid by government to service its enormous debt. The ratio of debt service to GDP in Jamaica is one of the highest in the world, making it impossible to pursue a successful rescue mission of the economy if the debt service is not considerably reduced.
Each one of these options will make a valuable contribution to closing the huge fiscal gap of $110 billion in the economy. But there are some drawbacks.
Expenditure cuts to reduce staffing will require payout of a substantial redundancy package which could absorb most of the surplus generated by cuts. On this basis, the true surplus would not be realised until 2011. This would assist in closing the future, not present, gap.
These two options aside, it is the reduction of interest rates, the third option, which promises substantial yields on a sustained basis. Government indebtedness includes some J$750 billion in local bonds. Of this amount, roughly 50 per cent, or $375 billion, has been issued at variable interest rates based on movements in the Bank of Jamaica (BOJ) 180-day treasury bill rate.
Draconian tax measures
Theoretically, if the BOJ rate was reduced by an average of five per cent, the saving over one year would be some $19 billion. This is very close to the $21 billion raised recently by additional taxation. But if this solution was so easy and painless why was it not the chosen option to raise the financing required to assist in closing the financial gap instead of imposing draconian tax measures?
There are many ways to answer this question, the principal one being the presumed fear that if interest rates were lowered significantly there would be excessive consumer expenditure which would put pressure on the inflation and exchange rates to the detriment of the economy.
This view was put forward by the former governor of the Bank of Jamaica, Derek Latibeaudiere. But, under pressure from the finance ministry, and the IMF negotiating team position, roughly two percentage points were clipped off the BOJ rate last year, in two rate cuts. This effort did not cause any adverse movement of significance to the inflation or foreign exchange rates and the reason is understandable.
The financial compression which the economy is currently undergoing and, indeed, which is expected to deepen this year, after the higher taxation package of nearly $20 billion recently announced (and a similar package at the beginning of the current financial year in last April) left little appetite for consumer borrowing or spending. A surge of expenditure at this time is, therefore, very unlikely. Accordingly, the time is ripe for reducing commercial bank rates to generate substantial savings that would be of great value in the struggle to produce a balanced budget and generate economic growth without adversely affecting the economy.
The banks, of course, are not going to make the move to cut rates for more than one reason:
(1) Lower interest rates chargeable on loans to clients would, presumably, reduce bank profits, although in light of the mammoth profits being made by some banks, this would be a weak argument. Furthermore, lower interest rates could attract increased business. Smaller businesses with marginal profit-ability could find a way forward with lower cost of credit and established firms could reap better returns which could be used for expansion or new investment;
Are they genuine?
(2) Banks in Jamaica operate on a very high base cost of an average of 11 per cent of average total assets which is considerably higher than the much smaller cost of operations in the CARICOM group of nations and is said to be the highest in the world. If these figures on Jamaican banking cost are genuine then there would be a limit to the extent of rate reduction which the banking system could tolerate without prejudicing its own viability.
But are the figures genuine, given the similarity of banking operations in the CARICOM region and more than likely the higher wages and salaries which should prevail there. What could be the basis for Jamaican costs of operation to substantially exceed those in Trinidadian banks?
The question of cost differentials in banking operations in the CARICOM group cannot be lightly dismissed. Understanding it is a necessary prerequisite before rates are driven down further. The banking system is too critical to be made to undergo radical change without relative certainty of proceeding on a safe course. This is precisely why I have been pressing for a survey of interest rates and costs to determine what room exists for further reduction in the bank rate without endangering the industry.
Data on the Jamaican side in the Bank of Jamaica, are available to accomplish such a study. As far as comparable data from other selected CARICOM countries are concerned, figures are again available in the regional central banks. Why then is there a reluctance to move forward on a sensible basis to test the waters given the considerable resulting benefit which is possible?
Too big to tackle
Perhaps it is felt that the banking industry is too big to tackle particularly on the question of level of profits, assuming that lower interest rates mean lower profits. But is this so? Lower rates also mean more loans which, in time, could translate into more profits.
Interest rates are the key to unlocking the future. This problem has to be tackled early or all else that is being done will be in vain because high rates will only allow partial adjustments of the economy leaving the country stranded only a short distance ahead of where it is now and has been for most of the past few decades.
Scotiabank Centre - File