Barbados: UAE way or the highway

Colin W. Daniel

BRIDGETOWN, Barbados, Thursday February 27, 2014 – Barbados is at one of the most significant cross-roads in our history. Our fiscal deficit due initially to the fallout we experienced after the 2007/08 worldwide financial meltdown has been compounded by the rapid build up of debt required to fund the fiscal deficit. There are choices made by both administrations in the past which have contributed to the situation we are in. I will not be addressing those issues as there are not pertinent to the solution recently proposed by Dr. Estwick. 

The following were my initial thoughts which I shared with some of my colleagues on Facebook on the morning of Saturday February 8th when I first saw the article about the proposal in Barbados Today. “I have a couple quick observations. As structured, this loan would create an asset of US$5 billion and corresponding debt of the same amount. He is recommending that we pay down all existing debt as it comes due from these funds. At 4% 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 debt 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 4% and over a much longer term.”

“I believe that the UAE is applying the general principals of Islamic Finance to the proposal” 
–Colin W. Daniel

“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) comments earlier this week, we have interest payments of 25% on current expenditure to meet or around US$350 million for this year. This structure adds that amount to our reserves. He indicated 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 and 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 that the public sector should not be involved.”

The strategy as proposed is bold, somewhat counter intuitive since the typical first reaction would be pay off at least all of the outstanding international debt. However, those of us working in the finance and the financial sector in general understand that it is sometimes necessary to restructure and refinance debt to create the capacity to turn our business around. 

The following table from the approved estimates for the 2013/14 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% of the planned expenditure of government for the year. 

Extract of Table 6 from the Approved Estimates 2013/2014

 

2013/14 Estimate

Revised 2012/13

Approved 2012/13

Actual 2011/12

Debt Service

 1,334,399,792

985,412,231

995,580,150

861,304,349

Interest Expense

608,435,219

565,656,418

551,460,279

527,213,136

Expenses of Loans

 4,367,174

3,542,347

3,585,007

3,596,403

Debt Amortization

721,597,399

416,213,466

440,534,864

330,494,810

Table 9, the projected Statement of Financial Position as at March 31, 2014 from the approved estimates for 2013/14 breaks the National debt down as follows: 

 Current liabilities                                                     $ 0.65 billion

Treasury bills                                                             1.57

Current portion of long term debt                                 0.72

Total payable in under 12 months                                2.94

Domestic debt                                                            4.80

Foreign debt                                                              2.82

Other long term obligations                                         0.15

Total long term obligations                                          7.77

 

Total liabilities                                                          $10.71 billion

This table demonstrates that $10.1 billion of the total liabilities of government need some form of refinancing or restructuring. Nearly 30% of this amount, or $2.93 billion would have to be repaid within twelve months of the end of the 2014 financial year. When you combine this information with that in the table above, we see that the average cost of financing government activities is around 6.34%. 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 we 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 will 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 would anyone want to lend to us at any rate given our current debt rating? Earlier last week the news papers carried the story about the Chinese funding the Almond Beach capital program which has been estimated at $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 which is a somewhat westernized is looking to build relationships worldwide as the Chinese is doing as well. As far as the interest rates are concerned,. I believe that the UAE is applying the general principals of Islamic Finance to the proposal. The International Finance Magazine defines Islamic Finance as follows: “Islamic banking and conventional banking differs in certain aspects, while the 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 debt rating, the government can no long 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 loses as they dispose of our debt as a result of our debt 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 currently holding more reserves that they are required to do, but I expect their risk managers will not let them increase their exposure further unless 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 their 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. 

CHALLENGES

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: 

It will increase the national debt by between 60% and 100%. 

It assumes that the sinking fund would be structured to earn interest at the same rate or higher than we are borrowing from the UAE. 

It assumes that the repayment of principal on the UAE loan would be deferred for at least 3 years which provides the upside that the majority of interest earned on the sinking fund for UAE loan would be used to retire the foreign debt as it comes due. 

There is a risk of inflation if access to these funds results in the economy expanding too rapidly 

There is the temptation to use to funds for expenditure purposes rather than investment and debt retirement

BENEFITS

There are significant benefits to this proposal which are set out in the following bullet points

1. We will have an immediate inflow of 10 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 back 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 are 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 VAT and other tax refunds which would free up additional cash flow to the private sector to meet its obligations and for 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 which has increased 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 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 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 it room to restructure its spending profile. 

14. It would allow the government to better structure 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 agencies continue to be properly staffed to provide business facilitation services. 

15. It would take pressure off of the NIS to fund unemployment and severance costs emerging from the staff retrenchment program. 

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 National Insurance Scheme. This would result in the mobilization of low cost bank deposits into higher return investments. 

19. Reduce the costs of financing government and allowing it to lower both indirect and direct taxes and broaden the tax base. 

20. The BSE has been waiting for the publication of it 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 positive environment for a positive launch of this exchange than a county which is constrained by an IMF monitoring or structural adjustment agreement. 

21. Allows the government to shift more from a regime of direct and indirect tax concessions to attract investment to a regime of tax credits and accelerate tax deductions bring more certainty to the decision of both local and international investor. 

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. 

CONCERNS

They are a couple areas where I differ on Minister Estwick 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. It would allow the investment manager the ability to generate returns higher than the interest rate on the debt 

I would argue that they could be limited investment in equity securities included 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 $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 first from the pool of retrenched staff. 

EXTERNAL INTERFERENCE 

I am concerned that they are a number of areas of external interference which have and could come into play stopping Cabinet as well as the social partnership from properly considering all of the benefits and challenges of this proposal, these include:

a. The leaking of the presentation to Cabinet before it has had the time to fully consider it 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 push back from the unions on the reinstatement of served staff and renewed resistance to the restricting 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 that here is an alternative to what is already on the table. It does not mean that decisions taken earlier were incorrect as there was no other path to take at the time. 

In general, there seems to be 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 pay the price at some time. 

CONCLUSIONS

Colin DanielThere 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 cash neutral or cash positive solution. The biggest negative is the doubling of the current national debt which is offset by increasing our holding of foreign reserve by BDS$10 billion less the immediate repayment of the Credit Suisse facility.

The sinking itself would be the security for the loan since it would not be used to pay down 100% of the existing debt. The other side I am seeing is a gradual increase in our credit rating over the next 18-24 months back to investment grade. This would reduce the current yield demanded on the outstanding Barbados debt and revalue 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$ 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 FDI. 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 10 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 is retired. 

This proposal warrants close examination, it could substantially reverse the trajectory we are on and place us on a path of growth as well as the 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 generated to our Colonial masters from our cane fields, cassava and cotton holdings. Let us not drop the ball because of egos and politics.  Click here to receive free news bulletins via email from Caribbean360. (View sample

The opinions expressed in this commentary are solely those of Colin Daniel. Colin Daniel (FCA, FCGA) works in Strategic Consulting & Advisory Services and is a Non-Executive Director of the Barbados Entrepreneurship Foundation.