The Model is Broken

Feature address by Ronald F. deC. Harford
Chairman, Republic Bank Limited

at the 41st CAB Conference
“The Changing Face of Caribbean Banking”

Radisson Grenada Beach Resort
12 November 2014

The Model is Broken

In the year 2014, the economies of the OECS, and without a doubt, the wider Caribbean, stand with their backs against the wall, thrust into that position by behemoth forces. To be specific, the region’s development to this point has been hamstrung by an unsustainable economic model and the uncompetitive nature of its key sector, tourism. Let me be clear from the onset, the main cause of the region’s struggles is not the global financial crisis, which started in 2007, although it has stifled the flow of capital to the region. Neither is it the resultant global economic recession, which we could all attest, constrained demand for tourism and Caribbean exports. No, these events merely exposed the region’s Achilles’ heel, namely the broken model on which the economy is based.

For a greater appreciation of the unsuitability of the region’s economic model, one only has to review key trends in governance and fiscal management that developed over the years.

One of the greatest shortcomings of the Caribbean’s political system is that it allows successive administrations to focus too much attention and resources on appeasing the electorate, at the expense of activities that are beneficial to the future common good. Equally damaging, is the low level of accountability of our leaders, who are permitted to avoid hard questions such as those related to corruption, expenditure and unrealized budget plans. The sad reality is that our political structure in some ways impedes the region’s long-term development.

Fiscal management in the Caribbean is severely deficient. Many governments run perennial deficits and create debt, the proceeds of which go to unproductive uses. These unproductive uses have neither consistent nor self-sustaining sources of revenue to repay debt. Governments therefore tend to fill revenue shortfalls with deficit financing and lengthy delays in paying for goods and services. This is basically servicing debt with more debt, a perfect recipe to allow debt to accumulate to unsustainable levels.

For years, buoyant economic activity masked the true effects of the profligate fiscal policies adopted by many regional governments. During this period, the state used the funds from deficit financing to employ an ever-increasing proportion of the labour force and direct scandalous amounts of public resources to unproductive means in the form of transfers and subsidies. For political reasons, governments establish these expenditure patterns and they become entrenched. For instance, St Lucia’s 2014 Budget allocated 74% of expenditure to recurrent spending and was based on a fiscal deficit of 5.7 % of GDP; 94% of Trinidad & Tobago’s 2015 budget was dedicated to recurrent expenditure, with a deficit of 2.3% of GDP. In December 2013, the IMF indicated that Barbados had the highest relative wage bill in the Caribbean, equivalent to 10% of GDP. Its fiscal deficit is expected to reach 12.4% of GDP in 2014. The country’s wage bill consumed 39% of recurrent revenue in the 2013/2014 fiscal year, compared to 33% for St Kitts & Nevis, 41% for Jamaica and 16% for Trinidad & Tobago. Grenada’s wage bill is expected to reach 55% of recurrent revenue in 2014. During the same period, Barbados current expenditure was 141% of current revenue, while the ratio was above 92% for both Jamaica and Trinidad & Tobago. Grenada’s current expenditure was 106% of revenue.

This pattern of spending serves to crowd out the private sector, and thus impedes the dynamism of the economy. Worse still, it leaves the affected countries with onerous debt and fiscal balances for generations to come. Consequently, Antigua & Barbuda, Grenada, St. Kitts & Nevis, Barbados and Jamaica all have debt levels close to or above 100% of GDP, while several regional governments are now confronted by double-digit or high single-digit fiscal deficits. The deterioration of public accounts to such an extent undermines growth, as countries now have to direct significant resources to repay debt. According to the Eastern Caribbean Central Bank, debt service payments averaged 22% of revenue in the OECS in 2013 (financed largely by deficits as pointed out before.)

The regional financial sector has a long history of funding government’s fiscal deficit and buying public debt. Here then is the problem.

Insurance companies by law are mandated to purchase government debt to cover long term liabilities. Banks and insurance companies are now financing Sovereigns with 100% to 200% debt to GDP. This debt is of course, unsecured. The opportunity costs of holding government debt can be significant for banks, since they may be able to generate greater rates of returns in an open currency market by investing in gilt-edged securities or lending to the private sector. Of even greater concern, are losses incurred when governments default on debt payments or require banks to take “haircuts” on outstanding debt because of insolvency. This jeopardizes the long-term and short-term savings of the population. It is one thing to have a defaulting Sovereign but it is a catastrophic event when this is coupled with financial institutions’ default. As we speak, Grenada is trying to convince private sector creditors to forego repayment of a portion of debt already issued to the government. Be mindful that government debt usually funds civil service activities and other non-revenue generating endeavours. Anaemic economic conditions and high exposure to public sector debt, has undermined the financial sector’s profitability and depleted its capital base in the OECS. It is estimated that the banking sector needs to be re-capitalized with US$600 million.

For some time now, the region has had to make do without grants and aid. We should put the days of deficit financing behind us. Going forward, rigid budget controls will cause the money supply to contract. The consequence for the OECS then, is a severely overbanked region. Scotiabank announced plans last week to close 35 of its Caribbean branches and retrench 1,500 employees. This follows some restructuring activities by the Royal Bank of Canada earlier this year. The 1970s saw the exodus of the American Banks from the region, while British banks were out by the early 2000s. HSBC sold its last branch network in Cayman this year. Now that the American Banks (Citibank) are exiting Central America, it is appropriate to ask, “is it now the turn of the Canadians?” The stronger regulatory environment and the more onerous reporting requirements that exist today have made it difficult, I am told, to manage branches from the Metropolitan centres, making them unattractive and reduced their competitiveness, resulting in poor performances.

 

All things have cycles and our wave has long crested.

Ladies and gentlemen I would now like to draw your attention to the challenges of the regional tourism sector. It is clear that the mass-market tourism model is unsustainable in the Caribbean given our small scale and high operating costs. To enhance the viability of the sector, operators should focus more on niche markets and the high-end segment. In the current environment, great occupancy levels are being reported primarily by the high-end operators such as Sandals Resort and Spice Island [Beach Resort], while the mass-market operators continue to struggle. With high labour costs and expensive energy supplies, the regional tourism sector — which is energy intensive — is finding it difficult to remain competitive. Most destinations in the region rely primarily on oil for energy generation purposes, rather than the much cheaper gas fuelled power generation grids found in Trinidad and Dominican Republic. In a situation where tourism destinations around the world derive electricity from cheaper and more efficient fuel sources or have scale, the Caribbean, using the current model, is likely to remain relatively uncompetitive. According to the Caribbean Centre for Money and Finance, the Caribbean market share, compared to the rest of the Americas, has been in decline. On the other hand, Central and South America have seen their market share grow between 1990 and 2011. When we look at CARICOM countries, in the context of the entire Caribbean, the trend is the same. In 1990, CARICOM nations received 34% of all international visitors to the Caribbean. By 2000, this figure fell to 28%, before slumping further to 22% in 2011. Conversely, Cuba and the Dominican Republic experienced significant market share growth during the period.

Weighed down by surging energy costs, several Caribbean nations sought refuge in PetroCaribe, an energy-assistance programme for the Caribbean and Central America launched by the late Venezuelan President, Hugo Chávez, in 2005. The programme allows Caribbean states to take fuel from Venezuela, but only pay a portion of the cost up front, with the remainder being converted to long-term loans. This consistently adds to the region’s stock of debt, which is already at unsustainable levels. The Economist Magazine revealed that Jamaica, Guyana and Haiti deferred payments to Venezuela that were equivalent to 4% of GDP and greater than 10% of government revenue annually, between 2011 and 2013. During the period, Antigua and Barbuda deferred payment equivalent to 2% of GDP, while Grenada and Dominica added just below 2% annually to their respective debt figures under the programme. Since PetroCaribe permit these regional states to consume a level of fuel they ordinarily could not afford, policy makers have not felt a significant sense of urgency to address the woes of the energy sector. With Venezuela now finding it difficult to supply basic goods to its citizens and with the country facing severe and deteriorating fiscal deficits, the PetroCaribe programme has been called into question. One suspects that President Nicolás Maduro will face mounting pressure to wind up the programme until the situation in Venezuela drastically improves. From a Caribbean perspective, many regional states now find that their economic prospects are dependent on what is essentially a failed or failing state. I think we can all agree that this is a less than ideal situation, which is deeply disturbing, to say the least. In light of the recent fall in the price of oil to US$77 per barrel, after averaging over US$100 for an extended period, the IMF has advised Caribbean countries to put contingencies in place to cater for possible interruptions or a complete halt of PetroCaribe.

Ladies and gentlemen, the world is constantly changing. Nowhere is change more evident than in the way business is conducted. Innovators have now become disruptors and have transformed (disrupted) many industries including banking, newspapers, telecommunications, and entertainment. As an example, one disruptor, Uber, has significantly impacted the taxi business in over 200 cities around the world. The company was launched only in 2009 and connects commuters with nearby pre-registered cab drivers through a mobile application. Usually, passengers are picked up within minutes of confirming a ride. They are in the process of disrupting taxi industries the world over. Innovators/disrupters have disrupted book publishing and the music industry. They are succeeding in getting more and more households to abandon hard-wired telephone services, and steady improvements in mobile and internet phone technology make it a matter of time until traditional phones become a quaint relic. Hydraulic Fracturing (fracking) technology has disrupted the oil trade. By driving down transport and communication costs, they have transformed the clothing, furniture and untold other industries. They have virtually wiped out the travel agency business, replacing them with something called APPS. Netflix is about to disrupt the cable and satellite providers of television. Our own credit card industry is even about to be disrupted with the like of Apple Pay. Such changes are part of the natural evolution of economic activity. The Caribbean is used to economic changes, having moved from mainstay industries such as Sea Island cotton, cocoa and sugar. What is important is that the region recognizes we are in a tumultuous period of rapid disruptive change and the need to re-invent itself before it is too late. We all know change is coming but then all of a sudden it happens.

It will be remiss of me not to mention some of the good things that are taking place throughout the region. One example is the Cayman Islands’ foray into medical tourism. In February this year, the 104–bed hospital known as Health City Cayman Island (HCCI) was officially opened. The facility is the fruit of the vision of Dr Devi Prasad Shetty, renowned cardiologist and founder of Narayana Health (NH), who has opened many similar institutions in his native India. Health City will provide cardiac, cardiology and orthopaedic services at competitive prices to international and local patients. The hospital is expected to eventually expand to 2,000 beds. In five years time, they expect 15,000 persons, in doctors, patients, nurses, care giver etc. to be on island benefiting from this. Cayman has a population of approximately 50,000. This has relevance for islands with sizeable medical schools where such venture would be a natural fit providing a teaching hospital and research facilities. Yachting, particularly luxury yachts, hold much potential for tourism development when an adequate number of large mariners are in place.

In energy, several nations in the region have begun exploring renewable energy alternatives. Aruba is well ahead of its peers in this regard, benefitting from significant cost savings by investing in wind energy. The country’s has seen its fuel consumption cut in half since 2012. Others are exploring the potential of geo thermal energy.

Perhaps the most frustrating thing about the region’s challenges, is that much of what is required to effect meaningful change is within our control. For instance, it is by no means impossible for Caribbean governments to implement initiatives to reduce the role of the public sector in the economy. We have far too much government in these islands. Of course, this policy must be complemented by significant incentives to encourage private sector-led growth. What about fiscal neutrality? Is it too much to ask elected officials to manage public funds more prudently and thus, turn away from deficit financing? Why can’t the Caribbean focus on niche market tourism and IQ-intensive industries? Is downstream diversification too hefty a goal for Guyana and Trinidad & Tobago? If we revise the interest rate regime and in particular, eliminate minimum deposit rates that exist in some jurisdiction, will not some the shackles the bind the financial sector be broken? Buying high and selling low is a very ancient prescription for the demise of a business. Not one of these things is beyond our capabilities, yet we perpetuate the philosophies and activities that maintain the status quo. We have become quite adept at identifying the underlying causes for the region’s structural deficiencies, but less competent at taking credible, sustained action to put things right. For this reason, the region continues to be blighted by unsustainable fiscal accounts and growth well below potential. Within the financial sector, investment by foreign banks in the Caribbean is receding, while indigenous banks are left holding on to stocks of non-productive loans and have inadequate capital to fill the void. In view of this, it is not surprising that the OECS banking sector, is as stated, in need of US$600 million to be re-capitalized. The model is indeed broken. I hope for the region’s sake that our will to take corrective action is not as well.

Thank you.

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