Sunday Business presents a new series courtesy of the Bank of Jamaica that will appear on the last Sunday of every month. It will concentrate on central banking issues and matters pertaining to the management of the economy. This week we take a look at interest rates. In Jamaica's best interest: what will it take to achieve low interest rates ?
"... proceeds from this bond issue [May 2001 euro-bond] will allow the Government to reduce its presence in the domestic market, thus accelerating the downward movement in interest rates."
- Finance Minister Omar Davies, May 2001
A SIGNIFICANT REDUCTION in interest rates is a paramount objective of the central bank, and the Bank of Jamaica is well aware of the benefits to be expected from such a reduction. Cheaper funds made available from lower interest rates should be a big incentive to investment activity, thus stimulating economic growth. A low interest rate environment will not only accelerate the reduction of present debt obligations, but also reduce the possibility of the country ever again encountering such a massive domestic debt problem.
The central bank, however, is also aware of its own constraints in attempting to progressively lower interest rates, and is also aware that interest rates do not exist, and therefore cannot be managed, in a vacuum.
Interest rates are typically very high in a context of high inflation. The higher the rate of inflation, the higher the interest lenders will demand as compensation for the decrease in the purchasing power of the money they will be repaid in the future.
The fact that interest rates in Jamaica are still relatively high in the face of the six-year run of single-digit inflation that the central bank has been able to achieve, is indicative that the current interest rate situation is not exactly typical. In order to understand how and in what circumstances domestic interest rates can be lowered to more acceptable levels, therefore, one needs to first understand what factors are now keeping them high.
DEMAND AND SUPPLY
An interest rate is a price the price the lender charges the borrower for borrowing money, and price, of course, is determined by demand and supply.
The Jamaican Government does not at present collect enough revenue to cover its committed expenses, and so has sought to borrow to finance its budget deficit. The fact that this deficit has widened considerably in recent times means that Government faces an ongoing cash-flow problem and is in more constant need of borrowed funds. The size of the deficit means as well that Government is by far the single largest source of demand for financing in the domestic market, and high demand equates to high price, especially since the market is fully aware of the Government's acute cash crunch. Because of this awareness, it is a natural consequence that investors will hold out for the highest possible price they can ask for. Investors have choices as to where to place their funds, and all logical investors want attractive returns on their investments that's the point of investing.
INVESTOR CONFIDENCE AND THE RISK PREMIUM
Interest rates are also determined by the lenders' assessment of risk. In addition to accounting for possible inflation risk, the lender of funds is taking a risk that the borrower may not repay, and interest is the compensation for taking that risk. The price one charges to lend, therefore, in addition to being influenced by the forces of demand and supply, is also a reflection of the amount of confidence the lender has in the soundness of the prospective borrower. The greater the perceived risk, the higher the price.
Theoretically, Government instruments are usually regarded as having a very low element of risk, but local investors are aware of the fragility of the foreign exchange market and the sensitivity of inflation to possible exchange rate movements. Inves-tors are also aware of the Government's fiscal difficulties, and these factors combined inhibit strong investor confidence. Unless tangible steps are taken to restore confidence and credibly assure the market that the economy is back on track, investors will have no reason to lower the risk premium they are inclined to levy on Government debt instruments.
WHAT SHOULD NOT BE DONE
The very high risk-premium currently being placed on Government debt is especially significant in the face of recent pronouncements in some quarters indicating an apparent belief that interest rates should arbitrarily be lowered.
Calls for drastic interest rate cuts are being made in an attempt to indicate ways out of the country's debt crisis, but these calls, for the most part, ignore the connection between interest rates and Government's borrowing activity. Interest rates cannot be talked or wished down, and in a modern society, artificial rate reductions will not deceive the market. Every investor would like a higher price for his or her money, so a central bank can easily hike interest rates above the current level of market expectation.
Doing the opposite, however, is never easy, and it is essentially impossible for a central bank to significantly push interest rates down below the natural equilibrium level of demand and supply. The market will simply not accept it. The prescription of a sudden and unsubstantiated drop in interest rates would be a lethal blow to the patient, because the move would most likely precipitate a major depreciation of the exchange rate. While the heavy ratio of domestic to overseas debt means that the current debt stock is more sensitive to interest rate than exchange rate fluctuations, the dilemma is that the lesser impact of exchange rate fluctuation is still large enough to be detrimental.
As investment firm Bear Stearns indicated in its Novem-ber 2003 analysis of Jamaica's debt situation, using July 2003 figures, a 10 per cent devaluation of the exchange rate would impact the country's debt service to the tune of approximately 0.7 per cent of GDP. Suddenly an-nouncing a drastic cut in interest rates below the current equilibrium of demand and supply would not somehow convince sceptical investors in the market that Government is suddenly in better control of its fiscal affairs, especially since much of the state of those affairs is very public knowledge.
The inevitable consequence of this move would be that investment funds would shift towards more attractive US-dollar instruments, creating renewed pressure on the foreign exchange market, yet another upward push in inflation, and the subsequent need to drastically reverse such a slash of interest rates, perhaps to even higher levels than the rates they were lowered from.
WHAT NEEDS TO BE DONE
Simply stated, Government needs to remove itself from the domestic market as quickly as possible. Only when this happens will the subsequent drop in demand pressure lower the asking price on interest, and so allow the central bank to aggressively push interest rates down much further.
But how can the Government remove itself from the market when it is still in dire need of financing?
The answer to that question is neither easy nor simple, but two steps will be required from Government: 1) Reducing its appetite for financing, so it will not be in such dire need of funds. 2) Taking steps to restore international investor confidence to enable it to again seek financing on the international market instead of at home.
This financing would be at lower rates than could be obtained locally, and would further cement its ability to stay away from the local market and so allow domestic interest rates to keep going down. The fortunate thing is that the action required to fulfil step one will simultaneously achieve step two. The obvious imperative is for central government to meaningfully, drastically, and comprehensively, restructure its affairs in order to reduce its expenditures and maximise its revenue collections.
In addition to continued tax evasion by some of those already in the tax net, the estimated 20-40 per cent underground economy is much too large, and means that Government is actively starving itself of badly needed revenue by consistently failing to address gaping holes in its collection net. There is a lot of money out there that rightfully belongs to the Government, and Government must make itself efficient enough to collect it.
Surgically cutting expenditures where most appropriate and carefully but meaningfully exploring the offer of the private sector to restructure some of its current debt obligations will also allow the economy some breathing space to wriggle its way out of its current conundrum.
Tangible action and a credible plan is also a prerequisite to restoring and maintaining investor confidence, which is an inextricable component of any sustained drop in interest rates. This plan should fully incorporate the next budget presentation, as the very costly bout of instability last year was triggered partially by the fact that in the face of already waning investor confidence about the fiscal slide, the budget presentation was not viewed by the market as credible, and was not accompanied by a tangible plan of action.
However, given the gravity of the worsened fiscal situation and the public concern it has understandably generated, plus other underlying economic conditions, the Government may be well advised to prepare and present the expected action plan well ahead of the budget exercise in April.
Against the background of a small, open, vulnerable and import-dependent economy, the central bank does not have the luxury of focusing only on interest rate policy, as critical as it is. In addition to being mindful of financial system stability, the Bank of Jamaica also has to simultaneously keep on eye on the exchange rate, because significant depreciation will increase the overall debt stock, push inflation out of control, and foster general economic instability.
If, however, local investors can be convinced to have more confidence in the economy and therefore its currency, then the exchange rate will remain stable, and the central bank, ceteris paribus, will be able to keep moving interest rates down.
