For Barbados, Staring into the Abyss can be Scary, but Somehow Reassuring

A steady stream of rumors and speculations has been sweeping the public and not so public forums in Barbados lately about the state and fate of the economy. The intensity of the speculation has been ratcheted up significantly following the release last week of the much anticipated Central Bank’s 6-month economic review, whose bleak assessment of the current situation (and most troubling, the future outlook) helped feed the growing suspicion and fear that things may have come unhinged once and for all. Talk of an IMF financial rescue program, complete with harsh conditionality and possibly a voluntary devaluation of the local currency, now sounds as imminent and inevitable as Kadooment after Cropover. While there is plenty of reason for concern, policy makers in Barbados should not succumb to the panic and should instead let their heads cool down in the gentle Caribbean breeze, and prevail with poise and wisdom, for the time for reckoning is finally upon them.

In his latest review, Governor Worrell didn’t mince words, and instead painted a bleak picture of anemic growth, dwindling foreign reserves, widening fiscal deficit, growing (domestic) debt, weakening external sector, and a drop in tourism receipts. While the news itself did not come as a big surprise to most as some of trends highlighted have been progressively observed and predicted for a while now, I was rather surprised with the more direct (read honest) tone of the language, and especially with the realization and communication, for the first time in such reviews, of the need for a major adjustment, and a quantification of that adjustment (around $ 450 million according to the Governor). To illustrate this point, I prepared below 2 word cloud visualizations for the transcripts of the latest 2 quarterly economic reviews, to examine, via side-by-side comparison, if this change in tone and urgency can be visually observed. If you’re not familiar with word clouds, the bigger the size of the word, the more frequently it appears in the transcript. Click on picture for enlarged view.

barbados word cloud

Sure enough, while the March 2013 review focused more on issues of debt, taxes, and spending, the June review saw words like reserves and growth take further prominence. The most interesting finding I observed was the creeping up of the word “major” in the June review in much higher frequency, like a sort of a subliminal message to the readers alerting them of the fact that the situation is on the verge of something dramatic, both in realization and in the scope of the solution needed. This marks a departure in tone and style of communication that tended previously to downplay major risks and offer a reassuring tone to readers, almost to the point of false security. To be fair, the job of Governor Worrell as gatekeeper of macro stability and bearer of the message (no matter how bad the message) is not an easy one: One has to balance between an accurate transmission of a message in a way not to cause undue worry or panic. In this case, I was glad to see a deliberate shift towards more honesty and transparency, as required by the rapidly deteriorating situation.

I was most particularly troubled by three deteriorating indicators: negative GDP growth, a widening fiscal deficit, and a rapid loss in foreign exchange reserves.

macro

With a high public debt burden of over 100% of GDP, Barbados simply has to “grow out” of debt and start deleveraging by stimulating growth and reducing its fiscal deficits, and hence its future funding needs. The fact that Barbados has been running increasing budget deficits and not able to grow will act as an accelerator for debt accumulation, which will knock the debt trajectory further outside its sustainability zone. As for foreign reserves, they constitute Barbados’ last line of defense for the much prized fixed exchange rate regime against the USD.
I’m worried about these two trends because, with further deterioration, they both lead to the same outcome (financial insolvency), albeit via different paths: as I said above, spiraling fiscal deficits, coupled with low or no growth, will increase the future borrowing needs of Barbados, which will force the country to seek financing outside its domestic market (due to its saturation). This external financing will become increasingly more costly both relative to domestic financing and to previous external financing, as the perception of loose fiscal discipline get cemented in the mind of international (non-multilateral) investors, who would then require a higher premium on their lending to compensate for the increased credit risk. This would ultimately start a downward spiral of rising borrowing rates and rising borrowing needs, similar to what Greece and Portugal experienced, leading to financial bailout to starve off bankruptcy. Similarly, a rapid loss in foreign reserves will force the government to do one of two things: seek financial assistance or abandon the currency peg, both unsavory solutions.

But let’s take a quick diversion and talk about currency devaluation, something that pundits both within and outside Barbados have been identifying as a possible (or inevitable) solution. Devaluating the local currency can be achieved either by adjusting the rate at which the currency is pegged to the foreign currency of choice, or abandoning the fixed exchange rate regime altogether and allowing the exchange rate of the local currency to float and be determined by supply and demand. For Barbados, both cases will likely result in a significant loss of purchasing power of the Barbados dollar, since it will be worth less in foreign currency terms. Would this be a good or a bad thing for Barbados? First, in a country that relies on importing the majority of its basic necessities, the price of these imports will be higher in local currency terms. By contrast, Barbadian exports will be worth more, but we all know Barbados does not produce and export many goods besides rum and pepper sauce. However, Barbados does “export” a valuable service to the world in the form of tourism: a weaker Barbados dollar will make the tourism industry more competitive and could attract more tourists, especially from the US. The hope is with a more revitalized tourism sector, more employment can result and growth can be spurred again. The question then becomes, will the effects of an improved tourism sector outweigh the higher import costs associated with a weaker currency? The answer to this question would determine if Barbados comes out a net winner or loser from devaluation. One thing is sure though: the immediate effects of devaluation include higher short-term, uncertainty-induced inflation, which could cause large economic distortions before things settle down again.

All is not lost for Barbados however, and every problem has a solution out there. I don’t doubt for a second that policymakers in Barbados are able to pinpoint the problems and devise solutions. The problem, as is often the case in public policy, is the social cost of implementation and political leadership. So what would a reasonable roadmap for the immediate and longer-term future look like? Concerning fiscal management, and just like when one needs to tackle high credit card balances, one needs to work extra hard at work in hope of a promotion, or even get a second job to supplement income, while reducing discretionary spending and limiting the use of the credit card to bare essentials. Savings generated will allow for faster repayment of debt. The situation is analogous in the case of governments: restoring fiscal discipline requires measures both on the revenue and expenditure side, and there is room for both in Barbados. Here, the usual culprits spring to mind: on the revenue side, there is a clear need to stem the revenue leakage emanating from VAT and tax discretionary waivers and loopholes, which by some conservative estimates account for about 25% of total tax revenues, and in a country where tax revenue represent 95% of total revenues, the stakes become significant. In essence, it’s the whole tax framework that needs reviewing (and this does not necessarily translate into higher tax and VAT rates as most people think). The bigger battle resides in the expenditure side, with much room to reduce spending on stalwart silos of financial waste as the transportation board, public pensions, the public wage bill, and the tertiary education sector. Like it or not, these spending areas are generous by any standard, and would need to be adjusted in one form or another. Again, the common misconception is that this would translate into loss of jobs in the public sector, which is not necessarily true. For example, the size of the public workforce can be allowed to shrink by natural attrition without replacing retiring public servants with new ones, and pension benefits can be harmonized and re-allocated in a more efficient manner.

A quick look at the government’s recent Growth and Development Strategy 2013-2020 confirms that, indeed, these and other beginnings of solution are currently being investigated and programmed. The Government is not as blind or irresponsive as one would like to think, as one would seem to think that this time, the adjustment effort is radical and for real. In fact, the government is proposing a fiscal effort that would effectively half the current fiscal deficit from over 9% to 4.4% in 2013/14, which would seem on the face of it like a herculean effort. Can it be done in one year? Surprisingly, it has been done the same way not once, but twice in the past 7 years (see graph on fiscal balance above): immediately before the 2008 crisis and again in 2011/12. The effort was however inconsistent and short-lived. A major prerequisite for the success of this roadmap is thus a high level of consistency and discipline, coupled with higher than usual political leadership to enhance political ownership of the roadmap, and help “sell” what amounts to a tough medicine pill to swallow to a weary and skeptical audience. Additionally, a rather high level of frontloading of fiscal adjustments and broad-based reforms is needed to provide the system with a sizeable positive jolt.

What do you do when the day of reckoning is upon you? Well, you reckon. Staring into an abyss can lead you to do two things: panic and jump, or pause and assess your options knowing that what’s coming can be infinitely more devastating and painful. Staring into the abyss can be somewhat reassuring if you somehow believe you can fly, but you have to be honest: in a world of lies and liars, the most dangerous lie is the one you tell yourself.

BIG BANKS GETTING BIGGER … AND THAT’S NOT EVEN HALF THE STORY

After the crisis of 2008, global finance, starting in the United States, plainly needed better regulation and supervision. Lots of institutions had turned out to enjoy taxpayer backing because they were perceived to be too big to fail. Huge derivatives exposures had gone unnoticed. Supervisory responsibilities were too fragmented. The Dodd-Frank act came into life in July 2010, and attempted to address these issues under four axes: securitisation, compensation, liquidation and systemic risk (too big to fail). Two years now since Dodd-Frank, how has the situation evolved?

Several analysts, using data from the FFIEC, recently picked up on the very verifiable story that America’s big 5 have in fact gotten even bigger compared to pre-crisis levels. see here and here. I reworked the numbers using the same source data and came up with a slightly nuanced outcome: big banks are indeed as big or even bigger than what they were prior to Dodd-Frank (depending on what your base comparison year is), but the ratio of the top 5 bank holding companies to real US GDP (most other analysts use nominal GDP) has been steadily decreasing since 2009. It currently stands at 65% of real US GDP, or $8.7 trillions (see below), compared to 68% at end-2009. So, to be fair, if we’re trying to answer the question of whether Dodd-Frank brought about positive changes to the “too big to fail” dilemma, the comparison should be between today and 2010, not 2007.

This said, I personally think that the emphasis should be placed more on the soundness and stability of a bank rather than its relative size, the simple argument being that if a bank is well capitalized, liquid, and overall sound in its credit positions, then the “fail” part of “too big to fail” would be taken care of, and the “too big” part would become irrelevant. Krugman and I seem to be in agreement, and he further adds that “the pursuit of a world in which everyone is small enough to fail is the pursuit of a golden age that never was.” Regulate and supervise, and do it right and airtight.

Speaking of banking stability and soundness, are big banks today any more solvent (and, by direct consequence, less leveraged) than they were pre-crisis?  Hardly, judging by the latest data, again from the FFIEC. See for yourself below. Granted, the Tier 1 leverage ratio is hardly a comprehensive assessment of bank stability and soundness (I should know, I’ve been drafting banking sector stability reports for the IMF for 10 years), but it is a fundamental measure of solvency, hence potential bankruptcy and failure. This is what the Fed’s stress testings are all about: will the banks have enough capital to sustain operations and pay back shareholders and creditors in severely adverse scenarios? The news was conveyed last month in the resultsof the Federal Reserve’s latest bank stress tests. As presented by the Fed, most of the news was good. Some large financial institutions were judged likely to have sufficient equity capital even if the U.S. economy were to experience a significant downturn. With that, banks such as JPMorgan were allowed to increase their dividends and even buy back shares. But there’s a problem, and it’s not a small one. If you buy the Fed’s view of what is likely to constitute stress, there is some justification for its action. But why would we let banks reduce their capital in the face of so much financial and economic uncertainty around the world (re: Europe)? We all know that lower equity at big banks means higher expected losses for taxpayers down the road: The disaster of 2008 caused about a 50 percent increase in U.S. debt relative to gross domestic product — the second largest shock to the country’s balance sheet after World War II.

On these stress tests, the Fed’s assumption in the stress scenario that Europe would have a mild recession seems too benign given the latest developments re: Spain, Portugal, Greece. How much faith do we have in these stress tests? a combined 96 percent of North American financial services professionals were “not at all confident” or only “somewhat confident” that the Fed’s stress testing addresses all of the important risks to the banking system, according to a recent Sybase survey.

So we’ve established that big banks are as big or even bigger than they were pre-Dodd-Frank, and possibly as thinly capitalized and over-leveraged as ever, but are they more prosperous?  you bet, not quite as rich as 2007, but getting there quickly and steadily. See below.

The financial system it seems hasn’t become safer since September 2008. We are not in a strong position to weather any financial storm that starts gathering on the horizon, and that should be ample cause for concern.

-Samer