In October 2008, Standard and Poor's maintained its 'B" rating of Jamaica's external debt but changed its outlook for this rating from 'stable' to 'negative'. This change in outlook raises a very real prospect of a full downgrade in Jamaica's external debt rating.
Because markets respond quickly to changing economic information, it is important for the authorities to carefully weigh the content of this rating, and respond quickly in ways that will reassure and calm financial markets.
This change in outlook has occurred in a context of a less than favourable international economic environment of elevated commodity prices and global financial market crisis.
These factors add to the urgency for an appropriate policy response.
There are three main credit rating agencies operating in juxtaposition with international financial markets: Standard and Poor's, Moody's and Fitch.
interest payments
Their analytical reach is effectively global. Any borrower, nation state or corporation, that establishes a large or repeated presence in these markets, will have their debt issues 'rated'.
Rating agencies assess what is referred to as 'credit risk'. Essentially, they advise on the likelihood of a borrower making repayments of the amounts borrowed and the interest payments committed, according to the agreed schedule.
Rating agencies initially focused on the risk of corporate debt instruments. As international financial markets opened to sovereign debt issuers, however, they have expanded into the assessment of 'sovereign risk'.
Rating agencies are paid by the borrowers, the issuers of debt instruments. As borrowers make large and repeated forays into international financial markets, rating agencies will offer their paid services for their (compulsorily) published assessment of the quality (credit risk) of the issuer. If the issuer declines, the issuer may still be subject to the less welcome prospect of what is sometimes referred to as a 'hostile credit rating'. Usually the issuer pays.
credit risk
While the issuer usually pays for the rating to be conducted - to facilitate access to credit - the service provided is arguably of even more significance to the creditor.
The rating advises of the risks and prospects of the issue/issuer and by extrapolation the approximate interest rates that are necessary to compensate for the assessed level of risk.
It is worthy of note that rating agencies pride themselves on being objective in their assessment of credit risk. Their professional reputation and therefore their ability to sell their services, depends on this objectivity.
Their effort to be 'right' in assessing credit risk is amplified by the reality that errors have been made and underestimated credit risk has cost investors including in the current global financial crisis.
As a result, sentimentality and cordial interpersonal relations are not relevant in rating financial instruments. Nor are rating agencies so concerned with causative origins as with effective solutions, going forward.
When Grenada's economy was decimated by hurricane, rating agencies immediately moved their rating of its debt to 'default'.
What the ratings mean
Ratings run the gamut from AAA (S&P) and Aaa (Moody's) to C for bonds on which interest is being paid.
Any lower rating reflects default, that is, non-payment or inability to pay.
The highest ratings - not common nowadays - reflect highest capacity to repay principal and interest.
Ratings of B reflect concerns about long-term payment sustainability and susceptibility to adverse external shocks, for example, adverse weather or changes in international market conditions.
Ratings of BBB (S&P) or Baa (Moody's) and above are regarded as 'investment grade', while lower ratings are seen as 'speculative'.
A 'stable outlook' means that a rating is expected to be sustained for the foreseeable future; 'positive outlook', the prospect of an upgrade; and 'negative outlook', the prospect of a downgrade.
Positive and negative outlooks are sometimes referred to as "half-upgrade" and "half-downgrade" respectively. Stable is a reaffirmation that the current rating is likely to be maintained.
Assessment of country risk
For a company, the credit rating assesses its financial statements for factors such as solvency, liquidity and profitability. For country or sovereign risk, the assessment will include the following:
Fiscal balance and capacity. Sustained fiscal deficits contribute to macroeconomic dissaving and undermines the capacity of a government to service its obligations. Even where payment of local currency obligations is supported by abuse of the money creation capacity of the central bank (this has not been a factor in Jamaica in the last several years) there will still be foreign currency constraints.
The burden of the public debt. There is a strong interdependence between a heavy burden of public indebtedness and fiscal imbalance and incapacity. A heavy public debt burden diverts significant fiscal resources to debt servicing, creating strains on the provision of essential social and economic infrastructure and services and on the attainment of fiscal targets. At the same time, failure to meet fiscal targets results in unprogrammed additions to the burden of public indebtedness.
The adequacy of official international reserves. These are the primary warranty of official external debt payments. Even where the country's external inflows are strong and the fiscal accounts are in balance, the possibility of negative internal and external shocks makes a cushion of official external reserves desirable to external creditors. There is no absolutely scientific measure of "adequate". Whereas there are "rule of thumb" benchmarks (e.g. reserves equivalent to 12 weeks of imports of goods and services) the requirement would increase with an assessment of increased economic vulnerability (susceptibility to shocks).
Buoyancy of foreign exchange current inflows and foreign direct investment. As discussed above, these are the factors that underpin foreign resource availability in the economy, including the adequacy of international reserves. Inflows may be current (merchandise and service exports or remittances) or capital (foreign direct investment).
The insulation of monetary policy from fiscal incursion. Failure to insulate can lead to money creation to finance fiscal deficits. This can result in inflationary destabilisation, undermining of productive economic activity and the diminution of official external reserves. One means of insulation is the enhancement of legal central bank autonomy, properly defined. In the absence of legal autonomy, Jamaica has not been abusing its central banking function over the past several years
Economic diversification and resilience to external shocks. Credit is rated more positively, the greater the degree of economic diversification. An economy that is dependent on only one or two sectors may suffer significant losses in the context of adverse shocks to any of those sectors.
The more diversified the economy, the more likely it is that the economy can maintain its normal functions, including debt payments, in the face of an external shock.
Economic growth. The medium to long-term capacity to service debt is dependent on the size and buoyancy of its economy, that are dependent on the sustained rate of economic growth. While the burden of economic debt may be superficially eased by the inflation of nominal Gross Domestic Product, this has implications for increasing nominal interest rates, increased domestic demand for foreign exchange and exchange rate depreciation. It is real economic growth centred on foreign exchange earnings that guarantees the payment of debt.
The S&P Rating of Jamaica and its Proper Interpretation
The S&P rating finds positives in Jamaica exceeding its primary surplus targets (for the first half of the current financial year), the quick (monetary) policy response to the sharply deteriorating external environment, and in what S&P perceives as private sector and trade union support for Government policies.
They, however, find negatives in a "weak fiscal position", a narrow economic structure, and rising external liquidity risks and "deteriorating asset quality of Jamaican banks".
Without repeating the analysis of S&P, it is worthy of emphasis that about half of the summary is taken up with elaborating on the perception of rising external liquidity risks.
S&P says it will downgrade its assessment of Jamaica's debt if external pressures add to fiscal uncertainty, increase capital outflow and impair external liquidity. It could restore its 'stable outlook' if Jamaica avoids significant reserve loss and "adjusts in an orderly fashion".
The current negative outlook should however be taken as an indication that S&P expects to lower its rating.
The Policy Implications of the S&P Ratings
Strangely enough, a superficial extrapolation from the S&P analysis would suggest that Jamaica should hope for the best in terms of a benevolent external environment. A deeper reading may suggest more active policy options.
For the near term, monetary policy has to remain conservative. The degrees of freedom in further tightening monetary policy are however constrained by the impact of monetary tightening on public expenditure for debt servicing, the fiscal deficit and the public debt.
S&P, despite approval of the strong primary surplus has also cited a "weak fiscal position" and does not appear to recommend further fiscal tightening. The juxtaposition of strong primary surplus with weak fiscal position may suggest an appreciation of limited room to manoeuvre with revenue and non-debt public expenditure.
The constraint of public debt means that there are no easy choices. Public policy however, cannot afford the luxury of being passive in the face of unfavourable external influences.
Difficult fiscal choices need to be made to help insulate the public finances and external reserves against S&P's "rising external liquidity risks".
These difficult choices may include postponement of capital and recurrent programmes and consideration of advancing implementation of efficiency and revenue enhancing tax reform. Given concerns about deviations from the assumed underpinnings of the budget, a strong and clear statement of policy appears necessary to the bolstering of economic confidence.
The citation of the asset quality of banks is not particularly meritorious, especially in the context of developments in the international financial system. I expect that the regulatory authorities would have dealt with this appropriately.
For the medium term, the concerns about narrow economic structure must be taken very seriously. While we correctly support tourism and rely on the fidelity of remittances, public policy needs to chart a path towards economic diversification by strongly promoting other sectors.
A diversified economic structure contributes significantly to economic confidence.
The Imperative Not To Be Passive
The 'half downgrade'negative outlook may already be having a negative effect on Jamaica's public debt and financial markets. Official debt is trading at sharp discounts (related in part to the global crisis) and strong yields.
Any downgrade in this context will further inhibit access to markets or make it prohibitively expensive, further compromising our capacity to resolve our negative fiscal and public debt interaction.
Multilateral and international initiatives may contribute but may not be a complete substitute. In any event, the "price" of any such assistance will be externally supervised fiscal adjustment. Is that easier than doing it for ourselves?
Stronger real economic growth is necessary.
This may be neither attainable nor sustainable in a context of a correlation of a heavy debt burden and unresolved fiscal deficit pressures. Jamaica may have to accept the sequence of resolving the fiscal problems first to facilitate sustainable growth later. In this context, it is important to mange and moderate near term socio-economic expectations.
Colin Bullock is a former central banker and former financial secretary in the Ministry of Finance. He is now attached to the Department of Economics, University of the West Indies, Mona.
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