UAE or IMF way?
Closer look at Estwick proposal
Barbados is at one of the most significant crossroads in our history. Our fiscal deficit, due initially to the fall-off in business we experienced after the 2007/2008 worldwide financial meltdown, has been compounded by the rapid build-up of debt required to service said deficit.
Some of the choices and decisions made in the past by both administrations have contributed to our current situation. I will not be addressing those issues, as they are not pertinent to the solution recently proposed by Dr David Estwick, my main focus in this article.
I first saw the article about the UAE proposal in Barbados TODAY on the morning of Saturday, February 8, and below are my initial thoughts that I immediately shared on Facebook with some of my colleagues:
“I have a couple of quick observations. As structured, this loan would create an asset of US$5 billion and corresponding debt of the same amount. He [Dr Estwick] is recommending that we pay down existing debt as it comes due from these funds. At four per cent [interest], it adds about US$289 million a year to our debt service cost. However, since it would be on deposit with interest paying institutions or invested in series of instruments that match the maturity profile of existing debt, the effective borrowing rate is zero.
“This means that we can immediately cancel the Credit Suisse facility and pay off all existing debt falling due this year, and replace that component of our debt with new debt, which costs us a maximum of four per cent, and over a much longer term.
“Just to be clear, this also means that any debt owed to National Insurance falling due in this period would be settled by this facility and we would have a net inflow of foreign exchange. Based on his [Dr Estwick’s] comments earlier this week, we have interest payments of 25 per cent on current expenditure to meet, or around US$350 million for this year. This structure adds that amount to our reserves.
“He [Dr Estwick] indicated that amortization of the loan principal was another US$350 million. This structure seems to support his position. It will give the Government space to properly restructure the Public Service and rationalize it in the long run. It would allow for the reduction in the Public Service through attrition, as well as the consolidation of a number of agencies. It would create a positive investment climate and it should ensure that the private sector put money on the table to undertake projects in which the public sector should not be involved.”
The strategy as proposed is bold, somewhat counter-intuitive since the typical first reaction would be to pay off at least all of the outstanding international debt. However, those of us working in the finance field, and the financial sector in general, understand that it is sometimes necessary to restructure and refinance debt to create the capacity to turn your business around.
The following table from the approved Estimates for the 2013/2014 financial year clearly demonstrates the strain that current debt service places on our country. The $1.3 billion in debt service cost represented 34.3 per cent of the planned expenditure of Government for the year.
Extract of Table 6 from the approved Estimates 2013/2014.
Table 9, the projected Statement of Financial Position as at March 31, from the approved Estimates for 2013/14, breaks the national debt down as follows:
This table demonstrates that $10.1 billion of the total liabilities of Government need some form of refinancing or restructuring. Nearly 30 per cent of this amount, or $2.93 billion, would have to be repaid within 12 months after the end of the 2014 financial year. When we combine this information with that in the table above, we see that the average cost of financing Government activities is around 6.34 per cent.
As presented, the amounts do not include the impact of the recent Credit Suisse loan and other borrowings which the Government has been forced to undertake since the Estimates were presented in March 2013. This level of debt translates to a debt service cost of around US$697 million per year over ten years, which is the approximate maximum term of our existing debt.
Hence, adding the existing facility and using it to pay down higher cost debt as it comes due would save us around US$408 million a year. The savings would be less than these high level Estimates due to the cash flow impacts of servicing existing debt and the new debt components.
Many have asked why anyone would want to lend to us at any rate, given our current debt rating. Earlier last week, the newspapers carried the story about the Chinese funding the Almond Beach capital programme, a sum estimated to be some $500 million. This suggests that there is at least one Government still willing to provide funding to us.
We know from history that funding from the Chinese government usually comes with a Chinese labour force component attached to it.
I believe that the UAE (United Arab Emirates), which is a somewhat westernized country, is looking to build relationships worldwide as the Chinese have been doing for some time. As far as the interest rates are concerned, I believe that the UAE is applying the general principles of Islamic finance to the proposal. The International Finance Magazine described Islamic finance thus: “Islamic banking and conventional banking differ in certain aspects: while conventional banking follows the interest-based principle, Islamic banking is based on interest-free principle and principle of profit and loss sharing and in performing their businesses as intermediaries. An Islamic bank is essentially a partner with its depositors and also a partner with its entrepreneurs. This agreement is done to avoid the payment of interest.”
With the current below-investment credit rating, the Government can no longer raise debt from regulated financial institutions. In fact, some of the holders of the existing debt have to divest themselves of our debt in an orderly manner. This means that some of these debt holders are taking capital losses as they dispose of our debt, as a result of our credit rating downgrades last year, combined with our increased borrowing costs.
The local commercial banks are somewhat exempt from these investment restrictions, since they have to hold local Government debt as part of their reserve requirements. They are currently holding more reserves than they are required to, but I expect their risk managers will not let them increase their exposure further, unless so mandated by legislation.
This, therefore, leaves the Government with the option to sell its debt to private equity funds, hedge funds, sovereign wealth funds, governments, international agencies or the IMF. Each of these institutions has its own risk restrictions. Governments like the UAE, with surplus cash, are the best candidates to lend funds to a country like Barbados with our current constraints.
The proposal has a number of challenges which are offset by what I believe are substantial arguments for it to be accepted and implemented. The principal challenges are:
1. It will increase the national debt by between 60 and 100 per cent.
2. It assumes that the sinking fund could be structured to earn interest at the same rate or higher than that at which we are borrowing from the UAE.
3. It assumes that the repayment of principal on the UAE loan would be deferred for at least three years, which provides the upside that the majority of interest earned on the sinking fund for the UAE loan, in this period, would be used to retire the foreign debt as it comes due.
4. There is a risk of inflation if access to these funds results in the economy expanding too rapidly.
5. There is the temptation to use these funds for expenditure purposes rather than investment and debt retirement.
There are significant benefits to this proposal, which are:
1. We will have an immediate inflow of ten times our existing foreign reserves which will be invested in foreign currency assets.
2. We will be able to immediately retire the Credit Suisse loan.
3. The elimination of the high interest cost short-term loan will result in a positive revaluation of all outstanding Barbados debt held by foreign institutions.
4. It provides additional support for our fixed peg to the US$, as it does not simply replace existing debt, but is supported by an asset-backed sinking fund.
5. It should reduce the country-specific premium used in determining the local bank lending rates in Barbados as the country’s exposure to currency rate shocks is reduced.
6. It should lead to an expansion of credit in the local economy, both at lower rates and for longer terms. This would allow for businesses and individuals to fund more of their obligations to their creditors and Government as well.
7. It would allow Government to meet its obligations to its creditors, as well as to settle Value Added Tax (VAT) and other tax refunds, which would free up additional cash flow to the private sector enabling it to meet its obligations and to make additional investment.
8. Repayment of existing foreign debt will be repaid from the sinking fund rather than being funded by new borrowings.
9. It will not create a market distortion by attempting to repurchase all outstanding foreign debt, which would allow for a diversified borrowing profile.
10. Some of the treasury bills and treasury notes owed to the Central Bank of Barbados (whose value has decreased due to its open market operations to contain interest rates) would be repaid in US$. This would directly shore up our official reserve position.
11. Some of the debt due to the National Insurance Scheme (NIS) would be repaid with foreign currency, which would allow the NIS to expand its foreign investment portfolio and earn direct foreign investment income. It would take further pressure off our reserves since the NIS would not have to compete with the rest of the market to purchase foreign currency for investment purposes.
12. It should lead to a two- to three-point upgrade in our investment rating over the next 18 to 24 months.
13. The change in the structure of existing debt and the cash flow impact allows Government more room to restructure its spending profile.
14. It would allow the Government to better implement the reduction in the size of the Public Service in a more orderly and structured manner. This would ensure that the economy would not further slip into recession due to the sudden reduction in business and consumer activity. Further it would ensure that relevant Government agencies continue to be properly staffed to provide business facilitation services.
15. It would take pressure off the NIS to fund unemployment and severance costs resulting from the staff retrenchment programme.
16. It should make the country more attractive for foreign direct investment as investors would no longer question our capacity to release profits to them as earned.
17. It would promote a climate for further liberalisation of our exchange control regime.
18. It provides space for the government to push income-producing statutory corporations to come to the local debt market to raise National Development Bonds in their own right rather than seek foreign debt funding or funding from the NIS. This would result in the mobilization of low return bank deposits into higher return investments.
19. It will educe the costs of financing government and allowing it to lower both indirect and direct taxes and broaden the tax base.
20. The Barbados Stock Exchange (BSE) has been waiting for the publication of the rules for the International Stock Exchange which has been discussed publicly over the last couple years. The stabilization of our country-specific risk would create a more fertile environment for a positive launch of this exchange, than that of a country which is constrained by International Monetary Fund (IMF) monitoring or structural adjustment agreement.
21. Allows the Government to shift away from a regime of direct and indirect tax concessions to attract investment towards a regime of tax credits and accelerated tax deductions which will bring more certainty to the decision-making options of both local and international investors.
22. At any point, we can transfer the assets in the sinking fund back to the UAE to repay the outstanding balance of the debt that we owe them.
They are several areas in which my thoughts differ from Minister Estwick’s proposal:
• I would rather see a structured sinking fund consisting of a mixture of sovereign, corporate and super-national debt instruments, rated A or better, than a fixed deposit. This would allow the investment manager the ability to generate returns higher than the interest rate on the debt.
• I would argue that there could be a limited investment of equity securities included in the sinking fund, but this may create a risk portfolio that would not be compatible with the desired end result.
• I would rather borrow up to the original US$5 billion suggested than the US$3 billion amount stated in the leaked Cabinet paper.
• I would not reverse the retrenchments that have already occurred. However, as the restructuring process continues, I would seek to better match skills with needs by drawing first from the pool of retrenched staff.
I am concerned that there are a number of areas of external interference which have previously come into play (and may do so in the future!) stopping Cabinet, as well as the Social Partnership, from properly considering all of the benefits and challenges of this proposal.
(a) The leaking to the public of the presentation to Cabinet before that body has had the time to fully consider its merits and challenges.
(b) The focus on Dr Estwick’s motives and that he did not publicly disagree with his colleagues earlier, rather than on the substance of the proposal.
(c) Possible pushback from the unions on the reinstatement of severed staff and renewed resistance to the restructuring of the Public Service.
(d) The push to restore full funding to UWI and other statutory agencies because the money would be there to do that from the proceeds of the UAE loan
(e) The inability to say “Here is an alternative to what is already on the table.” This current action does not mean that decisions taken earlier were incorrect, as there was no other path to take at that time.
In general, there seems to be an inability to understand that in order to fix the long-term structural imbalance in our economy, we must make sacrifices. At the end of the day, while we treasure free education, free medical service and a fairly secure social safety network, we fail to understand that as part of our maturing as a country, those of us who can afford it must give up our reliance on Government. We cannot expect to enjoy low effective tax rates, as well as a range of free services, which are in fact expensive to provide, without having to pay the price at some time.
There are risks in the proposed transaction. If we don’t earn the yield we are looking for on the sinking fund, then it would not be a cash-neutral or cash-positive solution. The biggest negative is the doubling of the current national debt, which would be offset by increasing our holding of foreign reserves by BDS$10 billion, less the immediate repayment of the Credit Suisse facility.
The sinking fund itself would be the security for the loan, since it would not be used to pay down 100 per cent of the existing debt. The other side I am seeing is a gradual increase in our credit rating over the next 18 to 24 months, back to investment grade. This would reduce the current yield demanded on the outstanding Barbados debt and move its current market value upward. The danger of repaying the debt in full is that no lesson is learned. There would be a current account surplus created almost immediately which I guarantee would be wasted in the short term.
Some of the near-term debt coming to maturity owed to the NIS would be paid to them in US dollars which would allow them more capacity for international investments, creating a larger pool of total foreign holdings over the long term. It removes the devaluation fear and creates an overall positive climate for foreign direct investment.
The biggest challenge is to ensure that there are mechanisms which reduce the risks of inflation. The period after the existing debt is repaid (in the next ten to 12 years) needs to be carefully considered. However, with the sinking fund in place it is conceivable that it could be used to retire a significant portion of the UAE debt immediately after the existing foreign
debt is retired.
This proposal warrants close examination, since it could substantially reverse the downward trajectory we are currently on, and place us on a path of growth, as well as increased long-term stability of our currency peg. We would be able to make investments in our country, which should have been done pre-Independence, from the wealth accumulated by our colonial masters from our canefields, cassava and cotton holdings.
Let us not drop the ball because of egos and politics.
(Colin Daniel is the principal of Strategic Consulting & Advisory Services, and has worked in Barbados, Bermuda, Canada and the Cayman Islands. He is a fellow of the Certified General Accountant Association of Canada, having gained his designation in 1990.)