THE Bruce Golding Administration has received kudos for taking the bull by the horns and tackling the country’s crippling debt burden head on. Its newly launched Jamaica Debt Exchange (JDX) programme and medium-term economic plan are stepping stones toward sustained economic growth. However, investors have been jolted by the widely perceived, but often misconstrued impact the debt exchange will have on local financial institutions — the biggest holders of Government paper.

Already there has been a sell-off of financials on the local stock market but with low volumes, as investors scurry to dump the stocks they expect will feel the most damaging effects of the JDX. As a result, financial powerhouses like National Commercial Bank of Jamaica Ltd (NCBJ), Scotia Group Jamaica Ltd (SGJ) and Pan Caribbean Financial Services Ltd (PCFS) have seen their stock prices plummet by at least 12 per cent since the start of the year, helping to drag the JSE Main Index down by approximately 10 per cent.

However, many investors are missing the bigger picture — the strength of Jamaican financial institutions as well as the longer-term benefits of the programme, specifically a boost to loan creation as businesses and entrepreneurs take advantage of lower interest rates. Not to mention that the JDX drastically lowers the possibility of the biggest risk facing financial institutions’ business models: a Government of Jamaica (GOJ) default.

Certainly when financial institutions unveil first-quarter earnings this May, the results will not be as robust as they have been especially in the past several quarters. The most immediate blow will be to financial institutions’ balance sheets, which will take a one-time hit in the form of a reduction to capital. In other words, once the JDX transaction is completed on February 16, 2010, these firms will likely have to mark down the value of the domestic debt instruments held as assets on their balance sheets and incur fair value losses on their capital base.

However, the good news is that local institutions for the most part are well-capitalised and able to withstand these losses. Prior to embarking on the route of a debt exchange, the Government conducted a series of “stress tests” to ensure that the financial condition of these institutions would not be significantly compromised and that there would be no “systemic” risk. Additionally, for those institutions that may face liquidity problems, the Government has committed to use US$400 million from the International Monetary Fund (IMF) and other multilateral funding to “create a Financial Sector Support Fund to provide a source of liquidity to eligible financial institutions that may be affected by the issuing of new bonds in the exchange”.

Apart from financial position, financial institutions’ profitability may also be impacted from the perspective of Net Interest Income, given that a large portion of these Firms’ income is derived from interest earned on securities. For example, for Scotia Group Jamaica Ltd’s (SGJ) year ended October 31, 2009, interest from securities accounted for 43.22 per cent of total interest income, an increase of 4.85 per cent over the prior year. On the other hand, Jamaica’s other top bank, National Commercial Bank of Jamaica Ltd (NCBJ), has maintained interest income from securities as a percentage of total interest income at 60 per cent or more in 2009 and 2008. Of note, however, is the fact that not all earning assets held by these institutions will be impacted under the debt exchange. For example, financial institutions will still reap significant gains from those instruments such as global bonds, which are exempt from the JDX.

In addition, one must bear in mind that financial institutions are in the business of managing spreads, and thus have the ability to mitigate a fall-off in profit by adjusting their liability management accordingly. Given that financial institutions will be earning less on their investments, it follows that they must reduce interest rates offered to clients on repurchase agreements (securities dealers) and on deposits (commercial banks). This will be a relatively easier task to achieve for those institutions such as securities dealers that hold more short-term liabilities on their books.

Though commercial banks also have liabilities that come due in the short-term, they will likely have a more limited ability to make the appropriate adjustment given the fact that deposit rates are already significantly low. In other words, banks’ cost of funds (deposit rates) will remain relatively stagnant while their lending rates will be significantly reduced, resulting in shrinking spreads.

It is expected that the insurance industry may be most affected due to the fact that companies under this umbrella hold longer-term fixed liabilities as part of their portfolios. For companies like Sagicor Life Jamaica Ltd (SLJ), it may become more difficult to service these obligations such as annuities, which are fixed over a period of years, given significantly reduced income from investments.

Ultimately, the main benefits of the initiative include a dramatically reduced probability of default of the GOJ and breathing room for the development of the private sector. In addition, these firms’ should be able to boost earnings as the flow of more affordable credit in the economy will spur increased borrowing. In particular, Jamaican businesses and entrepreneurs will be encouraged to borrow funds to facilitate start-up businesses and the expansion of existing operations. Furthermore, financial institutions will have the opportunity to become more innovative, by providing improved and more competitive products and services to clients. In turn, deposit-taking institutions may see an expansion in their loan portfolios and other financial institutions, a growth in their client base, which will likely help boost interest income and net earnings.

Another positive aspect is that a lower interest rate environment, coupled with an improved economy should help spark renewed interest in equities as the year progresses. Financial firms that have an equities division under their belt, stand to enjoy increased fee income, which can be used to counter-balance the initial impact arising from the debt exchange.

All in all, though the Government has taken a difficult decision it is one aimed at reinforcing the building blocks of the Jamaican economy. Financial institutions will not only be forced to keep a closer eye on their spreads, but should also return to the drawing board to find more creative means to bolster earnings and shareholder value.

Kimberly Thelwell is a Research Analyst at Stocks & Securities Ltd. You can contact her at kthelwell@sslinvest.com.