Reining in Jamaica's fiscal management

Ralph Thomas, Gleaner Writer

In everyday life, we assume many risks, beginning from the moment we awake to the moment we go to sleep and throughout the night. The fact that we get out of bed safely without breaking a leg, or cross a busy street without getting hit by a motor car, does not mean that these risks did not exist. Risks are often invisible and continuous, and, when identified, are not to be simply ignored, but managed 24 hours per day and seven days per week. Our ability to act normally and avoid disaster is predicated on habits developed over a lifetime, to recognise possible dangers and to take evasive or other actions to avoid the risks becoming a reality. Similarly in conducting a business, survival and success is dependent not only on recognising risks and taking defensive action, but on profitably managing the identified risks. Those businesses that do a better job of risk management are more likely to survive and thrive in the long run.

In developed countries, the essence of good management requires that highly trained professionals who fully understand the risks they are undertaking on behalf of the enterprise be put in charge of critical decision-making that can make or break the business. Risk management and the related capability to properly execute treasury-management transactions to offset risk are trainable skills that are in short supply in Jamaica and is a factor affecting our ability to grow our economy.

Risk and treasury functions are not jobs for amateurs, no matter how highly placed the individuals are in the enterprise. Persons who are employed in jobs that place them in decision-making positions involving financial and other risks must be properly qualified and possess the necessary expertise, experience and sound judgement to make decisions that can potentially create multimillion-dollar losses. Guessing is never good enough.

Risk-strategy decisions

In the public sector, there is an evident need to equip high-level persons with the necessary skills and capabilities to rigorously apply the tools of risk analysis and make informed risk-strategy decisions. Alternatively, such individuals must be quickly replaced with capable persons who are able to properly carry out the functions at this critical stage of our development. The complex and specialised world of risk management involves not only putting the correct policies in place, but also successfully executing the transactions necessary to accomplish the risk-management strategy. Indeed, treasury products once reserved for large multinational companies operating across the globe, such as derivative products, currency and interest-rate swaps, option contracts and other esoteric products are now widely used by corporations and, of necessity, the Government of Jamaica in its debt management and other programmes.

These instruments of treasury management are very effective in managing interest rate and foreign exchange risks when properly used by experts, but can prove as deadly as a loaded gun in the hands of a child, when used by persons without the required training and expert knowledge.

It is in this vein that I again raise the issue of the bungled attempts by the GOJ to hedge the foreign-exchange risks arising from a €204-million loan extended by Venezuela's Banco Desarollo y Social de Venezuela (BANDES bank) in 2008, to the Government of Jamaica, through the Development Bank of Jamaica (DBJ). Reportedly, the financial losses on the ill-fated attempts to hedge the loan and change its denomination from euros to US dollars through a foreign-exchange swap, a type of treasury product, exceeded US$50 million. This is not a trivial sum if you translate this amount into how many lives could have been saved in our hospitals with better funding, the number of students that could be educated, policemen equipped to improve our security, or roads built or jobs created to alleviate unemployment.

If ever there was a case study for bungling and making the worst possible choices at the worst possible time, this is it. The scenario is very simple: a loan denominated in euros, the widely traded currency of the European Union, is placed on the books of the DBJ by the Government, the proceeds of which were intended to be used to support the national road programme. At some point it was noticed that the trend in exchange rates between the euro and the US dollar, to which the Jamaican dollar is aligned, was one where the euro was strengthening rapidly against the greenback. The consequence of this movement in exchange rates was that a large gap was developing that would, if it continued unabated, result in the debt repayments and the actual debt in Jamaican dollars being increased significantly.

Ill-timed trading

The decision-makers conducted a series of inappropriate and ill-timed trading and debt-management transactions to hedge the debt that left Jamaica out in the cold, when the direction of euro to USD exchange rates again moved in the opposite direction from the previous trend, locking in huge financial losses for the GOJ. The irony is that if no action had been taken, the trend in the financial market would have quickly reversed itself and it may have cost significantly less to repay the original loan in Jamaican-dollar terms.

Other transactions followed that compounded the initial mistake, as the interest rate on the loan obligation saw an increase from 7.25 per cent to some 8.29 per cent when a one-year US$ loan was put in place, followed by a bond issue to replace this loan with longer-term financing. The actual costs, if they were to be calculated, would include the fees paid by the GOJ to various counterparties for arranging hedging transactions, the swap losses that accrued and the differential in cost resulting from refinancing the debt on worse terms than originally agreed, such as the inclusion of the requirement for a GOJ guarantee, when none was attached to the original loan. To this must be added the opportunity cost of a 'do-nothing strategy', which meant that if the GOJ/DBJ did nothing, they may have actually made some money for Jamaica.

It shouldn't take a well-trained professional to observe that markets go both ways - sometimes they go up and sometimes they go down - and, therefore, hedging strategies should never only deal with one direction of movements of rates, but both up and down oscillations and seek to limit losses within a band of values reflecting the risk tolerance of the GOJ. The art of the game is to so position oneself in the market by appropriate trading and hedging, that whichever way the market moves, whenever it moves and in whatever direction it moves, the trading position of the government institution remains neutral and protected from the consequences of exchange rate losses. Had this been done properly, in the case of the BANDES loan, losses, if any, would have been minimised and contained within acceptable levels.

Future conduct

This debacle evidences the continuing absence of a robust capability to utilise treasury products to manage financial risks in the affairs of our Government. Could this fiasco happen again? Yes, I believe it could! Have we learnt any lessons that can inform the future conduct of the financial affairs of the Government on behalf of the people of Jamaica? What steps have been taken to strengthen our risk-management capabilities? Have the inept decision-makers been replaced with competent persons? Have the necessary risk-management policies controlling risk tolerances been created? Were these policies written by the same individuals that made the mistakes? Have state-of-the-art technical and computerised market and risk-valuation systems been put in place to support future decision-making in similar circumstances, to avoid repetition of the BANDES blunder?

These and other questions should be publicly debated to ensure that the necessary follow-up is done to improve our risk and treasury-management capabilities. It is of national importance that the decision-making processes by which the bad decisions were arrived at are closely examined and the contributing factors be dealt with to prevent recurrence of similar financial disasters.

Modern businesses in various industries embrace a new and expanded version of risk management, referred to as enterprise risk management (ERM). I would argue that governments such as ours in emerging economies must embrace the practice of ERM, as the operation of many aspects of government now involves the same types of risks and decisions faced by other types of institutions. Advisers on significant transactions must not benefit from trade execution based on their advice, as this is a conflict of interest. Since various elements of risk are sprinkled throughout our public-sector institutions, there is need for consolidated identification and oversight of such risks and the fragmented institutional resources to manage those risks must be brought under a unified command, staffed by highly skilled professionals and backed by the necessary execution capability to prudently manage the risks of the Government of Jamaica.

Clear policies for risk governance and risk tolerance must also be developed and implemented by the GOJ in a consultative process with those with the insights, experience and skills to contribute meaningfully to the debate, across party lines, locally and with the underutilised diaspora.

Ralph S. Thomas is a senior teaching fellow and joint appointee of the Mona School of Business and the Department of Management Studies, UWI. He is a financial consultant, and was a vice-president of the Bank of New York-Mellon. Email feedback to columns@gleanerjm.com and ralphthomas003@yahoo.com.