Delroy Hunter | An alternative to derivatives-based hedging of oil risk
Jamaica, like the rest of the world, is facing a sharp increase in inflation arising from supply chain constraints due to the ongoing pandemic and war.
There is a lingering concern that this spike in inflation could be permanent, rather than transient, especially for a highly import-dependent country like Jamaica. Undoubtedly, higher oil price and the ‘exchange rate pass-through’ inflation, due to the secular decline of the Jamaican dollar, account for a substantial portion of inflation over time.
Given recent heated arguments about hedging oil price risk between members of the government and the opposition, it is clear that oil-induced inflation is a major national concern.
In this article, I propose an approach to aid in the fight against oil-induced spikes in inflation, with the added benefit that it could contribute to more stable exchange rates and, possibly, lower interest rates. The proposal partly addresses the recent call by Dr Gene Leon, president of the Caribbean Development Bank, who urged Caribbean governments to consider the management of various risks in a more integrated framework.
The integrated framework proposed herein reflects the fact that high domestic inflation not only robs residents of the purchasing power of their incomes and savings, but also elicits interest rate increases by the central bank, and is likely to be a major driver of the depreciation of the Jamaican dollar over time.
In an article in The Gleaner on April 10, I discussed the use of oil derivatives to provide protection against large oil price increases. I noted that paying the call option premium, but then allowing the option to expire without exercising the right derived therefrom when oil price remains lower than the strike price of the option, creates political risk for the government. This is because the opposition could claim that the premium was wasted.
An alternative proposal is that the government allocates the ‘hedge’ tax collected from the sale of refined petroleum products to a fund that is dedicated to the purchase of common stock, or equity, of the best globally based oil-related companies. This is akin to creating a sovereign wealth fund, though different from the way they are typically funded. Since Jamaica has no oil of its own, acquiring equity in oil producers allows us to participate in the benefits — and share the risks — of being an oil producer.
There would be three possible benefits to Jamaica from purchasing a portfolio of oil-related stocks over time. First, in periods when there are large increases in oil price, we would be able to dispose of a part of the portfolio to subsidise the price of refined petroleum products locally or to procure a derivative-based hedge. This is because, in general, the market values of oil companies are positively correlated with changes in oil price. That is, when oil price goes higher, oil companies’ stock prices tend to increase, as is their ability to pay dividends. This implies that a portfolio of oil companies would be likely to pay off more when we need a pay-off the most.
Second, Jamaica’s ownership of a US-dollar-denominated portfolio of stocks would serve as a buffer for the Jamaican dollar in the foreign exchange market. This is because a growing portfolio value would strengthen the signal of government’s capacity to, if necessary, intervene in the foreign currency market through the disposal of a part of the portfolio.
Third, under specific conditions, the portfolio could serve as collateral for the government in certain credit market transactions. While collateralising government loans with assets in the portfolio would be somewhat inconsistent with its primary purpose, a benefit of doing so is that the government would be able to obtain better credit terms, possibly including lower interest rates, on its foreign loans.
If the funds from these loans were then loaned to local institutions, or if the interest rates on such funds were to serve as benchmark rates for transactions in the local market, then the lower interest rate paid by the government would benefit the economy by reducing local interest rates.
There may be concerns about adopting this proposal. A stock investment does not guarantee an increase in value to meaningfully subsidise gas price at a given point in the future. Correct. But unlike the derivatives strategy that provides protection over a relatively short period of time, stocks of companies that remain a going concern always retain some value, and generally increase over time.
Concerns that adopting this strategy could place a strain on the local foreign exchange market and would not provide immediate relief from inflation can be addressed by making smaller periodic investments instead of, say, large year-end investments, and focusing on the medium to long term, as oil price risk will be with us for a long time. That the portfolio would be concentrated in one industry could be addressed by diversifying into alternative energy and other commodities.
If there is a concern that the hedge tax is not large enough to be worth the effort, recent annual estimates are about US$47 million at current exchange rate. This could be augmented with proceeds from a future sale of the government’s shares in Jamaica Public Service Company Limited, JPS, or bauxite-related assets and other future windfalls.
Finally, the notion that these funds should be invested locally rather than in foreign companies warrants some discussion, but it is my strong view that the benefits of the above proposal exceed those from the local investment. However, if adopting the proposal would be too large a political liability, a possible local investment would be to use the hedge tax — and future proceeds from JPS — to aggressively fund the use of solar energy to reduce our dependence on imported fossil fuels.
Overpricing for depreciation
A commonly held street view is that local importers overprice their goods to reflect a substantial expected depreciation of the Jamaican dollar by the time they are required to make payments to foreign suppliers or import the next shipment of goods. If so, this would exceed reasonably expected ‘exchange rate pass-through’ inflation.
Consider an importer owing a foreign supplier US$1 million due in 90 days. If it had the liquidity, it could purchase the US dollar obligation with about $150 million today. By doing so, the local-currency cost of this particular shipment would be locked in at $150 million, which would be the basis for the importer’s pricing, subject to other business expenses and markups.
In contrast, assume the importer needs to sell the goods over the 90 days to obtain the funds to purchase the US$1 million. This importer faces exchange rate risk because of the uncertainty of the amount of local currency that will be required to purchase US$1 million.
If the importer has a strongly pessimistic view of the future value of the Jamaican dollar, it might price the goods to reflect the US dollar obligation costing, say, $190 million. This would imply that the importer believes that the Jamaican dollar would depreciate by more than 20 per cent over 90 days. This aggressive pricing, and the inflation it generates, could be moderated if the importer employed an exchange rate hedging strategy.
Actually, the importer can relatively easily hedge this risk using a 90-day working capital loan, providing there is a willing lender and liquid currency market. In essence, the importer could borrow $150 million immediately and simultaneously use it to purchase the US$1 million and settle the foreign currency obligation. At the end of 90 days, having sold the imported goods, the importer pays off the loan. Assuming 5.0 per cent interest rate over the 90 days of the loan and an additional 3.0 per cent of the loan for the cost of pledging collateral and other loan fees, the total cost of the US$1 million in imports would be $162 million.
Hedging allows the importer to know this with certainty on the day it takes the local currency loan to pay for the US dollar obligation. This means that the importer can reflect that known cost in its pricing and in the process, aids in the moderation of inflation.
My point is less about the mechanics of the hedging, which some local companies currently employ. Rather, it is to point out that the government can increase the hedging capacity in the economy. If the central bank estimates that the minimum incremental cost of the inflation that arises from the pricing process described above is greater than the cost that would be incurred by society to have government establish a special liquidity window to fund currency hedging, then the government should consider doing so.
Now, you might ask how is the suggestion to encourage a simple currency risk hedging strategy related to the proposal that the government use the hedge tax to procure a portfolio of stocks in energy-related foreign companies? Owning a portfolio of foreign oil stocks can signal a more robust local currency and reduce the huge forward discount on the local currency that importers are accused of building into their prices.
Delroy M. Hunter, PhD, is the Serge Bonanni Professor of International Finance at the University of South Florida. He is currently on a Fulbright Research Scholarship at the UWI Mona School of Business and Management.