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Fiscal Rule Urged To 'Maintain Credibility'

By NEIL HARTNELL

Tribune Business Editor

nhartnell@tribunemedia.net

The Government’s US consultants called for the Bahamas to implement a ‘fiscal rule’ to “maintain credibility” with bondholders and the international capital markets, given the switch to a lower revenue-yielding Value-Added Tax (VAT).

Explaining why it recommended that the Government set a maximum debt-to-GDP ratio ceiling of 65 per cent, and annual debt reduction targets, Compass Lexecon said it was vital to maintain confidence on Wall Street and among the credit rating agencies.

“To maintain credibility with bondholders even as the Government enacts a VAT at a different rate than it initially proposed, it would be advisable to establish a ‘trigger’ that raises rates on the VAT if specified fiscal goals are not met,” the US consultants suggested.

Expanding on this theme, Compass Lexecon added: “We recommend that the Government also establish a new, permanent fiscal rule. Fiscal rules have been found to help governments shift to sustainable fiscal policies, while enhancing the Government’s credibility with credit markets.

“The issue of credibility is especially important for the current government, since our recommendation would represent a change from the Government’s announced VAT policy.

“Changing the VAT policy at this point may be seen by some market actors as an indication of a lack of commitment to fiscal sustainability, and enactment of a fiscal rule like that suggested here could help offset this effect.”

The Government last week largely heeded the joint advice of Compass Lexecon and the two New Zealand consultants, Dr Don Brash and John Shewan, and adopted the 7.5 per cent VAT model they were jointly urging - one with a low rate, few exemptions and much simplified.

The rate slash, from 15 per cent to 7.5 per cent, will likely be perceived as generating lower revenue yields, hence Compass Lexecon’s call for the Government to send further fiscal prudence and austerity signals to its international audience via expenditure side measures.

These suggestions, though, were rejected last week by Prime Minister Perry Christie, who said that while they sounded fine in theory, they were more difficult to implement in practice for a small country susceptible to natural disasters.

Credit rating agency reaction to the 2014-2015 Budget has thus far been muted, Moody’s telling Tribune Business yesterday it was sticking to its ‘negative’ outlook and watching brief announced at 2013 year-end.

“At this time we are not going beyond what has been published,” a Moody’s spokesman said.

Explaining its ‘fiscal target’ recommendation, Compass Lexecon recommended a 65 per cent debt-to-GDP threshold “above which the debt will not go under any circumstances”.

And, while a minimum annual debt reduction target would have been set, this could be ‘waived’ in emergencies.

“In particular, under this target, we would recommend that the central government’s debt-to-GDP ratio should begin falling by fiscal year 2015-2016, as deficit reduction phases in, and then fall at a rate of no less than 1 percentage point of GDP per year in the years thereafter, until that ratio is below 50 per cent of GDP,” Compass Lexecon said.

“This should be seen as a minimal target. Faster reduction in the debt-to-GDP ratio over the long term would be beneficial. The target could be waived if the economy were in recession (the unemployment rate were above a certain percentage) or in any year in which the government affirmatively declared a natural disaster.

“Such safety valves would provide the Government flexibility in the face of economic downturns and natural disasters. This target provides the government sufficient time to implement its proposed deficit reduction measures before a higher VAT rate may be implemented.”

And, explaining how an automatic VAT rate increase could be triggered through missing these debt reduction targets, Compass Lexecon said: “For instance, the VAT rate could automatically rise 2 percentage points (producing in the range of 0.8 percent of GDP in additional revenue with the VAT tax base the Government has proposed) every year that the fiscal targets are missed.

“That is, the VAT rate may permanently increase from 8 to 10 per cent if the debt-to-GDP ratio target is not met. If, in the following year, the target had not been met again, the VAT rate could be increased again by 2 percentage points. That process would continue until the target is met.”

Placing the Bahamas’s current fiscal position in context, Compass Lexecon said that while the Government’s finances were on “an unsustainable trajectory”, its direct debt-to-GDP ratio was below 60 per cent and “not in any danger zone” yet.

“About three-quarters of the debt, including all short-term Treasury Bills, is held domestically, and capital controls limit the ability of Bahamian financial institutions, public corporations, and pension funds to invest in alternative assets,” the report added.

“Refinancing risk is therefore low in the near-term. Maturities on Bahamian long-term debt are spaced relatively evenly over the next 24 years, so no fiscal shocks are anticipated from obligations to pay large lump sums.”

However, absent any fiscal reforms and restraint, the Bahamas’ deficit would remain above 4.5 per cent of GDP over the next four years - averaging 5 per cent and pushing debt-to-GDP over the 65 per cent mark.

The Bahamas was ‘three notches’ away from having its credit rating moved from ‘investment grade’ to ‘speculative’ by Moody’s, and just two places away from a similar fate with Standard & Poor’s (S&P).

“The Bahamas enjoys a good reputation in international markets, but that could change in light of the current fiscal trajectory,” Compass Lexecon said.

“And the rating agencies’ assessments reflect both the Bahamas positive history and its current risk.....

“To be clear, even with a further downgrade from the ratings agencies, the Bahamas could still have adequate access to outside capital markets, but, as the previous literature suggests, it tends to increase borrowing costs,” the report added.

“Furthermore, further downgrades would increase the risk of a more dramatic cutoff from external financing. All of this suggests that, while the Bahamas does have credibility based on its history, there is a danger of that dissipating, and the Bahamas should take action not just to put forward a plan to achieve long-term fiscal sustainability, but also to do what it can to bolster the credibility of that plan.”

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