THE DOWNGRADE of Jamaica's sovereign credit ratings by rating agency Standard & Poor's (S&P) in quick succession, first on August 5 to CCC+ and, more recently, on November 2 to CCC, both with a negative outlook, gives a glimpse of the challenging headwind facing the Jamaican economy. On both occasions, the rating agency expressed concern about the long-run sustainability of Jamaica's J$1.27 trillion debt, citing the possibility of Jamaica entering into a "distressed debt transaction", or to put it bluntly, the possibility of "default" or a "debt restructuring".

One may argue, with good reason, that such imminent debt restructuring concerns by S&P were a bit premature and unwarranted on both occasions, given there was, and still is, no official announcement of any such consideration by the Jamaican authorities despite the challenging budget and debt dynamics being faced. In other words, 'willingness to pay' seemingly was not in question, given official pronouncements. However, one cannot argue that Jamaica doesn't face challenging ability-to-pay issues, given falling tax revenues from seven consecutive quarters of negative growth.

acute challenges

These challenges have become so acute, that as Jamaica enters the latter stages of negotiations with the International Monetary Fund (IMF) for a US$1.2 billion standby loan agreement (SBA), for balance of payments support, various commentators have echoed sentiments that perhaps it is time for Jamaica to restructure its debt as a possible solution to the challenges being faced, given its unsustainable trajectory. There is the argument that one of the virtues of such a policy option would be to equitably share the burden of economic pain by transferring more of it to holders of capital, who are more able to bear it.

In fact, one of the primary reasons for calls to go the 'debt restructuring' route from various quarters is the argument that undertaking such a policy action would reduce the debt overhang and free resources to spend more now, given the current harsh economic climate. In other words, undertaking a debt restructuring seems to be synonymous with increased public spending (or the reduced need to cut public spending) on major items such as wages and salaries, infrastructure, education, crime, and health.

These seem like logical arguments for a debt restructuring, given a debt burden that is running 15 per cent larger than the total value of goods and services produced (GDP) last year. Further, 58 per cent of the budget is allocated to interest and principal repayment, resulting in either very little discretionary spending or increased borrowing to fund spending, which is self-defeating. However, such logic may be incomplete because it does not take into consideration the net present value of the effects of the policy action. Said differently, the 'logic' may be ignoring the negative possible outcomes which could outweigh the positives, and could lead to an even worse outcome than debt restructuring was trying to prevent in the first place.

What is debt restructuring?

Strictly speaking, debt restructuring implies a change in the contractual agreements of the debt, such as reducing the original principal to be repaid (for example, from J$100 to J$80) and issuing new debt with lower interest rates (for example, from 20 per cent to 10 per cent) and longer maturities (for example, from five years to 20 years) - usually at a cost to holders of the debt (an outright default) and by extension economic agents.

For example, Argentina in 2004 restructured US$100 billion owed to domestic and foreign debt holders, by proposing to repay only 25 per cent of the value of the debt owed, that is, a 75 per cent reduction in the net present value of the debt. Such a restructuring is termed 'NPV negative', given the loss borne by debt holders and economic agents (which equals the interest and principal savings to the government).

Other forms of 'debt restructuring are 'NPV Positive' or 'NPV neutral', which do not involve any net present value loss to bondholders and economic agents (other than foregoing interim cashflow), but provides much-needed breathing room by changing the composition and interim cost of debt for governments to take appropriate policy actions to improve their ability to pay. Such transactions, though strictly defined as restructuring, are usually part of a menu of features of debt management strategies aimed at lowering and smoothing government debt service payments, reducing the vulnerability of public debt to unexpected shocks and maintaining efficient capital markets.

The distinction between prudent debt management strategies - an everyday feature of public finance all over the world - and a default is important, because the two forms of restructuring have substantially different outcomes when implemented.

ECONOMIC LINKAGES AND DEBT

A partial direct positive consequence of Jamaica's 'home bias' regulatory framework - where the local financial sector, by design, is required to have a large exposure to Jamaican assets - has protected the local financial industry and, by extension, local economic agents, from the brunt of the global credit tsunami that ravaged financial markets worldwide.

However, an unintended consequence of this home bias, which in retrospect was clearly a good thing, is that Jamaica's financial industry is inextricably intertwined with the local economy.

Said differently, Jamaica's government debt, both local and foreign currency, is mainly held by local economic agents.

The domestic debt, which is the subject of any discussion around restructuring, is almost 100 per cent owned by local economic agents, while between 44 per cent and 50 per cent of the external debt is held locally. Overall, an estimated 75 per cent of Jamaica's total public debt is held by local economic agents, including pension funds, the national insurance scheme, banks, securities firms and insurance companies. This compares with less than 15 per cent in Russia, 46 per cent in Argentina, and less than 20 per cent for Caribbean neighbours Dominican Republic, at the time of their 'restructuring' exercise.

To further cement the linkages with the real sector of the economy, household deposits represent 42.8 per cent of GDP, while credit to the private sector represents 19.4 per cent of GDP. Household deposits and credit to the private sector emanate from the financial services sector, which owns an estimated three quarters of the domestic debt.

The capital base supporting these activities is estimated at J$150 billion with exposure to approximately J$378 billion of domestic government debt alone. Hence, an NPV negative debt restructuring would likely not only impact the holders of capital but could spread to general economic agents as well.

The point is, the depth of domestic economic linkages did not exist in countries that have successfully restructured their debt in an NPV negative way. For example, Russia had household deposits of seven per cent of GDP and credit to the private sector of four per cent of GDP at the time of its 'restructuring'. Despite this small exposure, small depositors took significant losses of between 37 per cent and 58 per cent for domestic deposits and between 50 per cent and 60 per cent for foreign deposits during the Russian restructuring exercise.

Jason Morris is senior investment strategist at JMMB. He can be contacted at jason_morris@jmmb.com.