Jul 2009 Financial News

BOJ interest rate cut welcome, but much more needed

Jul 27, 2009

On Friday, the Bank of Jamaica (BOJ) reduced the interest rate it offers on its open market instruments by one per cent across the board. The new rates vary from between 16 per cent for its 30-day instrument, 16.5 per cent for its 60-day instrument, 19 per cent for its 90-day instrument, 19.2 per cent for its 120-day instrument, all the way up to 20.5 per cent for its key 180- day instrument.

In the press release accompanying the cut, the Bank of Jamaica noted: "This action comes against the background of positive trends in key monetary policy indicators. Notably, the 12-month point-to-point rate of inflation as at June 2009 fell to 9.0 per cent, from 12.4 per cent at the end of fiscal year 2008/09 and 24.0 per cent as at June 2008. This outturn has been underpinned by continued stability in the foreign exchange market. Additionally, the BOJ's gross foreign reserves have stabilised at US$1.6 billion."

Critically, BOJ noted that "The prospects for continued stability in money and foreign exchange markets have been strengthened by the government's decision to secure a stand-by arrangement with the International Monetary Fund. Finalisation of an agreement will pave the way for additional inflows from other multilateral institutions and a reduction in the government's reliance on domestic financing."

Jamaica's planned return to the IMF is the key factor

There should be no doubt whatsoever in anyone's mind that the key factor behind the BOJ's decision to cut interest rates was Finance Minister Audley Shaw's announcement in Parliament on Tuesday that Jamaica plans to return to the IMF. Minister Shaw stated that in addition to a US$320-million allocation of SDRs coming out of the G20 summit (likely to be approved in September), Cabinet had authorised him to seek to borrow up to 300 per cent of Jamaica's IMF quota, or $1.2 billion over two years, by way of a stand-by arrangement. According to Minister Shaw, at least US$400 million of the IMF borrowing was to be "up front", and combined with a further US$400 to US$500 million in borrowing from the other multilaterals (dependent on the IMF's seal of approval), would represent total borrowing of just over US $1.2 billion in the second half of the fiscal year (this assumes one treats the SDR allocation as a loan, and not a gift).

In a short Wednesday morning report on the IMF announcement, Oppenheimer's Dr Carl Ross noted that the Golding government has obtained about US $1 billion in funding commitments from other multilaterals already.

Ross argued that, assuming the IMF loan is approved, Jamaica now has multilateral commitments of roughly US$2 billion or 20 per cent of GDP over the next few years, which he describes as "very positive for the balance of payments", and that it "should reduce the credit risk on the external debt."

In short, the planned IMF and multilateral borrowing would be more than sufficient to plug even Minister Wehby's most pessimistic scenario for our balance of payments, namely a foreign exchange gap of US$800 million this fiscal year. In any case, the gap is almost certain to be less, if for no other reason than imports will be weaker than forecast (the strong implication of the recent stability in our foreign exchange reserves), unfortunately reflecting the much poorer than expected state of our local economy. The IMF agreement should therefore allow Jamaica to avoid the prospect of a devastating devaluation that would normally accompany a balance of payments crisis.

Perhaps even more importantly, from the perspective of the sustainability of our enormous debt burden, the clear intention for a very heavy shift to multilateral borrowing would sharply reduce what is currently an excessive level of borrowing from our local market, allowing interest rates to fall much further.

To quote Dr Ross again, "Our Jamaican investor base has been quiet recently for a few reasons: First, risk has been pulled back from the foreign (mainly Canadian) owners of the Jamaican banks; second, the government has been inundating the local market with J$ (20 per cent+) and USD (10 per cent-ish) issues in the local market; and third, the IMF talks have been telegraphed and locals have had a wait-and-see approach."

As unpalatable as it may be for some, the Jamaican population should welcome a return of the IMF, as after more than a decade of having suffered to generate unusually high primary surpluses (fiscal surpluses before debt interest), it should now be understood by everyone that it is our interest bill that is the albatross around Jamaica's neck.
Jamaica's interest costs as a percentage of GDP are the highest in the world. Combining our need with our extreme effort should therefore make us the world's number one candidate for debt relief, as Minister Shaw no doubt told his counterparts in Chile.

Some elements of the local financial sector clearly recognise the need for lower interest rates. In its local market commentary on Thursday, Pan Caribbean noted: "At yesterday's six-month T bill auction, which was 155 per cent oversubscribed, the average yield fell to 20.60 per cent relative to 21.05 per cent in June. Of note, the current yield is 90 basis points (bps) below BOJ's comparable rate. We expect BOJ to respond positively to this development.

Investors should seek to lengthen maturities in expectation of lower rates over coming months. The GOJ's pending agreement with the IMF, although without full disclosure of the details, suggests that IMF resources will be available to supplement currency demand as we head into the third quarter where demand slows and FX flows are less vibrant.
While the fiscal deficit remains a concern, we have seen heightened interest in bonds and expect as rates fall some interest may redevelop in the stock market."

The key point, as noted by Pan Caribbean, is that the local financial sector has accepted the BOJ Governor's challenge to lead interest rates down after the Chris Zacca-led PSOJ meetings with the government in late February and March. The key 180-day T-Bill rate, which is normally above the BOJ rate, has fallen every month from 24.26 per cent in January to 20.6 per cent in July, despite the higher risk represented by Jamaica's deteriorating economic fundamentals and the government's increasing demand for funds.

Every 1 per cent fall in interest rates cuts the government interest bill by $4 billion, reducing the risk that an unsustainable budget deficit will lead to fears of default, capital flight and a collapse of the currency. Just as important, the central bank of an economy in a severe recession should cut its real interest rates (the nominal interest rate minus inflation) to zero or even negative levels to save its small business and overstretched consumers, as the US is trying to do now. Businesses and consumers faced with bankruptcy can't pay taxes. Lower interest rates mean that more companies will stay in business, pay taxes, and therefore reduce the demand for borrowing. With an inflation rate of nine per cent, investors would still break even in real terms after tax with a 180-day T-bill rate of 12 per cent, making this the minimum target for the 180-day open market operations rate after an IMF agreement is signed.

However, the BOJ should not wait for an agreement to reduce interest rates further, but take advantage of the forward-looking nature of financial markets to get at least half the benefit of an IMF deal up front, reducing rates by at least another four to five per cent on any good news over the next couple of months.

Article by: Keith Collister
Source: Jamaica Observer
http://www.jamaicaobserver.com/magazines/Business/html/20090725T210000-0500_156124_OBS_BOJ_INTEREST_RATE_CUT_WELCOME__BUT_MUCH_MORE_NEEDED.asp
Publiushed: Sunday, July 26, 2009