TWO weeks ago, in a brilliant presentation, one of Jamaica’s leading economists, Bank of Nova Scotia’s Jason Morris, addressed the very timely issue of Jamaica’s budget and the global environment at the Jamaica Chamber of Commerce’s post-budget forum, jointly sponsored by accounting firm PriceWaterhouse and Bank of Nova Scotia.

Morris began by observing that the global economy is divided into a two-speed recovery, with emerging markets continuing to grow faster than developed markets. The most important developed market, the US, has seen strong growth in corporate profits (78% of quoted companies beat earnings estimates in the most recent quarter), but most of the profit increase is coming from emerging markets. Moreover, the profit increase is still slower than required for a recovery in private sector employment growth in the US, which at its peak had lost nearly 9 million jobs, and still needed to regain 6.7 million jobs to reach pre-recession levels.

There was a sharp decline in both US and Euro ten year bond yields just before quantitative easing two (QE2) in July. This “flight to safety” reflected concerns that the world faced a prolonged near- depression scenario of extremely low growth as experienced in Japan after its financial crisis.

The start of QE2, when the Federal Reserve bought made huge purchases of financial assets e.g. bonds, injected a lot of cheap money into the market driving the rise in the price of commodities such as oil, gold, and silver over the last nine months in a process of “re-risking”.

In the developed world, the markets are not currently worried about future inflation because of labour market slack, and weak housing and overall growth prospects. In the US, Morris argued, Federal Reserve President Ben Bernanke was not intending to increase interest rates because the U.S. economy remains weak. In contrast, the stronger growth in emerging markets meant that higher commodity prices were driving higher expected inflation and rising interest rates.

The ending of the Fed’s asset purchase programme (QE2) means that there is likely to be upward pressure on U.S. interest rates. However, in his view, the market has already priced in most of this, and expects rates to remain low due to the slow recovery and consequent low inflation expectations.

Morris observes that both the US and Europe have growth and fiscal problems, with the US having been put on negative watch by rating agency S&P due to its huge fiscal deficit, and the ongoing problems of the so called PIGS (Portugal, Ireland, Greece and Spain). Worryingly, the acronym now appeared to include Italy.

The European debt crisis was a key risk going forward, with the markets pricing in a 57 per cent chance (based on credit default swaps) of a Greek default at the time of his presentation (it has since risen further). Some European banks have balance sheets larger than countries, so that a default involving a haircut (a reduction in loan principal) of the sovereign debt (of say Greece) would decapitalise the exposed banks. This situation is unlike that of what happened with the Jamaica Debt Exchange “JDX”, where the banks only lost interest that they couldn’t collect anyway. This means that the European Banks face significant “headline risk”, in terms of possible margin calls, freeze on capital, etc in such a debt restructuring scenario.

Partly as a consequence of these concerns, international investors were currently moving money from developed countries to emerging market countries. As a consequence, the extra interest to hold emerging market debt, expressed as a “funding” spread over London Interbank offer Rate (LIBOR), was a mere 0.7% above pre-crisis lows reflecting their strong balance sheets and better economic growth.

The Jamaican economy

Morris believes that over the past year, Jamaica has achieved “a whole lot”, and the economy was “heading in the right direction” as a result of the success of the JDX and the overall IMF programme. He expects this to continue in the very near term for the key macro variables. However, like a recovering alcoholic that had only taken step one of a ten step programme, we now need to focus on steps two to four (which in his view includes comprehensive tax reform) of our reform agenda to avoid backsliding.

The continued slow US recovery meant there was upside potential for increasing Jamaica’s economic activity in 2011/2012.

A critically important step for business confidence was the proposed two-year extension of the IMF programme. Morris argues that the fiscal deficit without the IMF would have been very negative, and the extension gives Jamaica more, albeit limited, freedom to implement the necessary reforms. Even after the extension, this was still a short window of three to four years to turn the economy around. Economic growth must come from the private sector. As Morris notes “We continue to fool ourselves that government can spend money to drive economic growth”.

Referring to Jamaica’s just completed 2010/2011 budget, Morris observes that both tax revenues and expenditure came in slightly below budget. For the current fiscal year, there was a huge real increase in capital expenditure relative to last year (particularly when taking out last year’s extraordinary items such as Air Jamaica).

Despite meeting their overall fiscal target, with a deficit of 6.1% of GDP, the government failed to meet their primary surplus target. It is only a primary surplus, meaning an excess of revenue over non -interest expenditure, that allows one to pay back debt.

Morris noted the sharp reduction in the global capital markets perception of Government of Jamaica (GOJ) sovereign credit risk, with our sovereign credit spread of about 3.5 per cent now only 1 per cent away from the 2007 lows of 2.5 per cent, or less than a quarter of the nearly 15 per cent at the height of the crisis in late 2008. Jamaica’s long recession, after 13 consecutive monthly declines, appeared to be nearing an end (subsequent first quarter GDP was 1.5 per cent). However, credit growth, which had gone negative in March 2010, was only marginally positive in the current quarter due to high default rates and a slow reduction in interest rates. Finally, Morris observed that despite the JDX, the one to five year maturity profile for Jamaica’s debt had not improved dramatically, and that Jamaica still required growth (and continued low interest rates) to deal with our debt trap.