What the Government Should Do Now

Ask any businessman and they’ll sing you the same song about how important interest rates are. They’ll tell you about how interest rates affect their cost of acquiring capital; making it more expensive to produce their goods and services. They’ll tell you that this high cost of production affects their ability to compete with companies in other countries. They’ll even tell you that this high cost of production brought about by the high cost of capital, affects even the businesses that they sell to as a portion of their output becomes the input of other firms in the economy. If they told you all this they would be telling the truth. High interest rates make it more expensive to invest in new businesses and more expensive to operate existing businesses.

With all this though, this is not the major reason why high interest rates are really bad for the economy. No. For that you need to look at the impact on consumers. The fact is, while investment expenditure accounts for less than 10% of the island’s total output, consumer spending accounts for close to 82%. This of course means that consumer expenditure (as is the case with most economies) is the major driving force in the economy.

Therefore, anything that stifles consumer spending is actually negatively impacting more than 80% of the gross domestic product (GDP). High interest rates have a huge negative impact on consumer spending and hence the overall economy.

For instance, take a look at the impact of high interest rates on home and motor car purchases. These are two so-called big ticket items that are pre-dominantly financed with loans. They are also two sectors that have a significant interrelation ship with the rest of the economy.

So for example, when a sharp rise in interest rates force the cost of mortgages higher, this has the immediate effect of reducing the volume and value of mortgage loans. This is clear and easy to see. But what does it really mean?

For one, it means that there will be less activity in the financial services sector; a major contributor to overall output in the economy in terms of investment and employment. Lower profits in the financial services sector will normally translate into lower levels of spending in other areas such as branch openings and the level of advertising.

In addition, the decrease in mortgage loans would lead to a fall in housing construction which has a serious knock-on effect on the retail/wholesale sector through reduced sale of hardware and building material. The lower level of mortgage loans will also negatively affect the transportation sector as there will be less hardware items being bought and therefore less to be transported. This multiplier effect on home construction will also extend to the furniture retail sector, restaurants and a host of other sectors. The same is true with motor car purchases when interest rates rise.

The long and short is that the sharp rise in interest rates in the past three months has dealt a terrible blow to the economy; both in terms of increasing the cot of capital and making it harder for businesses to finance their operations, but also in terms of making it more difficult for consumers to finance the acquisition of important assets such as houses, cars and furniture. The net effect of course is that the reduced spending means lower sales for the very companies that are struggling with the direct impact of the higher cost of capital.

The risk of course in trying to mitigate this is that if you lower interest rates sharply, this may cause a further run on the Jamaican dollar; with individuals and companies better able to afford loans that may be used to purchase U.S. dollars in the hope that if the dollar slides even lower they will be able to sell their recently acquired stock of U.S. dollars at a significant profit.

However, lowering interest rates would not have to happen overnight. A structured and properly communicated programme of interest rates reduction could and should be implemented.

In addition, there are other policy tools that could and should be employed to boost economic activity, slow the rate of losses at the island’s financial institutions and shore up employment.

Firstly, the government should increase the minimum wage tomorrow morning. They should do so before noon as there is no time to waste. Here’s why: there are approximately 200,000 persons earning minimum wage in Jamaica (about 16% of the employed labour force). Increasing the minimum wage by say, J$400.00 per week would mean a higher cost of operation for the island’s companies to the tune of approximately J$80 million extra per week. That’s true. However, it would also mean J$80 million in additional spending on their goods on services; which would translate into a total weekly boost to the economy of over J$300 million when the multiplier process is complete. That’s a lot of additional spending in the economy for an J$80 million increase in the wage bill. Put differently, most of the hundreds of millions of dollars in additional expenditure would be earned by the very companies that had to pay the increased wages. They would be significantly better off if the Government were to increase the minimum wage.

After they increase the minimum wage, the Government should also increase the income tax threshold (the announcements should probably be made at the same press conference). Why? For precisely the same reason that it makes sense to increase the minimum wage. he fact is, the typical worker who is positively affected by increases in the minimum wage and the income tax threshold are not earning high salaries and are therefore, very, very likely to spend any increase in salary that they earn as soon as it is earned.

While the Government may not be able to reduce interest rates at the pace that is needed, they should increase both the minimum wage and the income tax threshold as soon as is physically possible.

Trillions of dollars in wealth

Here are the facts: (a) over 200,000 houses were built in Jamaica over the past two decades, (b) the average value per house is at least $10 million. Here’s what this means: the 200,000 houses at this $10 million dollar average value translate into at least $10 trillion in wealth. That’s a lot of money.

This $10 trillion in real estate wealth is not likely to lose value over the next 30 years; in fact it’s more likely (notwithstanding the current state of the economy) that the value will outpace the inflation rate during this period.

What this means is that when the last of these mortgages are paid off in the next 30 years, there will be tremendous wealth held by a group of Jamaicans that just a few generations ago were working 18-hour days as slaves. The significance of this is often ignored.

The sharp increase in real estate wealth in the past two decades is important for another reason. With the birth rate tumbling over the same period, the average family size is less than four persons per household. This means that there are fewer people in each family who are likely to lay claim to this new wealth.

This real estate wealth may not translate into cash, but it means is that there is now significant ability to access capital through the use of the real estate as collateral .

The discussion then, about economic crisis, job losses, the rising foreign exchange rate and the high price of oil while important, fails to notice one very important fact: there is now significant wealth in the hands of the average Jamaican.

For a people that have not known financial wealth in centuries, this is both a significant reality and a significant challenge. For one, it’s of crucial importance that this wealth be preserved during this current economic downturn with large-scale re-possessions to be avoided at all cost.

In addition, it is important to ensure that this wealth is passed to the other generation in an organized and structured manner through the use of proper wills, provisions being made for the payment of transfer taxes and due thought given to how the houses will be held (by individuals or through trust funds etc.)

Much has been said about the stock market with its billion of dollars in market value and approximately 50,000 investors. This is obviously commendable, but so too is the newly created real estate wealth with close to 200,000 families and more than $10 trillion in value. There needs to be a shift in the dialogue.

Rethinking Retirement

Let's say that you do exactly as told: you do a sensible budget; live within your means; save a significant portion of your monthly income and invest in stocks in your youth and gradually shifted your portfolio toward bonds as you grew older. Let's say you did all of this for 40 years until age 65; it would be reasonable after all this sacrifice and discipline to expect at least a comfortable retirement.

It would be a reasonable expectation but it if the 40 years were the ones up to 2008, then you may be in for a great surprise. During this period, Jamaica's inflation averaged 17% per annum a rate that eclipsed the yield of most investment options. Let's put this in perspective: an annual inflation rate of 17% over a 40 year period means that on average, prices would have surged more than 53,000% (yes, this is a real number) over the four decades. An annual average inflation rate of 17% over a 40 year period would leave investors hard-pressed to earn real returns. An item that cost $100 in year 1 would end up costing more than $53,000 at the end of the 40 years.

Financial Analysts define a Real Return on an investment as a rate of return that is greater than the inflation rate. Therefore, if your investments earned an average of 17% per annum over the past 40 years then your real rate of return would have been 0%. This may not be as bad as it sounds as almost no form of investment earned an average annual return of 17% over the past 40 years.

For one, fixed income investments have not yielded this kind of return, but then, no one real expects fixed income investments to yield superior returns. No, for that eyes tend to gaze expectantly at the stock market. There is good reason for this. Since its inception in 1969, the stock market index has skyrocketed from 100 points to its current level of approximately 82,000 points. This is remarkable when it is remembered that at current levels, the index is well off its peak of a just a few years ago.

The only problem with this though is that most investors do not invest in the index (though there are investment vehicles that allow this). Instead, they invest in individual stocks and the results of this have been far more checkered than investing in the performance of the market as a whole. Furthermore, stock prices can be particularly volatile.

There has been an undisputed saving grace during this 40 year period though: real estate. Here’s an example: a 2-bedroom, 1-bathroom house in Portmore went for $20,000 in 1980. The same house (unimproved) now sells for at least $6 million. This an average increase of over 1000% per annum over the 28 years period. Of course this gain only becomes available if the home is sold and therein lies the problem: the wealth cannot be truly unlocked unless the home is sold. In many instances, this is the residence of the owner and sale is not a viable option.

The next best option is therefore rental. While rental income has not grown in the way that property value has, the gain has still been remarkable. Take this example: a studio flat in Mona Heights rented for $500 per month in 1989. The same flat would rent for at least $25,000 today. This is an annual gain of 245% over the 20 year period. Not as dramatic as the surge in property value but enough to provide a significant cushion against inflation , with more than enough left over to fund retirement.

This is not to say that real estate is the only good long term investment option. No, the point is that when planning your retirement funding strategy, real estate and its ability to tame the effects of inflation should not be far from your thoughts.