Thursday 6th March, 2008


Biting the inflation bullet

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By Ian Narine

The year is 1998, ten years ago and a while before, T&T started to see the record levels of oil and gas revenues which have been the hallmark of our more recent past. At that time the Central Bank’s reserve requirement was 21 per cent on local currency deposits and nine per cent for non-banks. For the record, the reserve requirement is the portion of deposits that banks must themselves deposit with the Central Bank. These deposits earn no interest return and therefore serve the purpose of reducing the amount of funds available to a bank from which they can lend to customers.

A higher reserve requirement means that banks will need to increase rates or see a fall in income. Back in 1998 with a 21 per cent reserve requirement, the prime lending rate was as high as 17.5 per cent and the interest rate spread between deposit and borrowing rates was around ten per cent.

The Memorandum of Economic and Financial Policies of the Government of T&T for 1999/2000 indicated that high lending rates are an impediment to the development of small and medium-sized firms which are (or at least should be) the main source of new jobs given the capital intensive nature of the energy sector.

The recent presentation by the Governor of the Central Bank at the T&T Petroleum Conference provides some data to support this point. The energy gross domestic product (GDP) as a percentage of Total GDP is estimated at 43 per cent for 2007 while energy sector employment to total employment is just four per cent.

Further, we are expecting the energy sector to show growth of just 4.4 per cent in 2007 compared to 21.4 per cent in 2006 while the non-energy sector growth is expected to be consistent year-on-year at 6.6 per cent.

If high lending rates are an impediment to growth in the non-energy sector, why is it then that the likely outcome from the February 22 repo rate announcement by the Central Bank is a rise in interest rates? The bank indicated that they have raised the repo rate to 8.25 per cent and also increased the reserve requirement from 11 to 13 per cent. The increase in the reserve requirement marks what for all intents and purposes has been a failed policy initiative.

Fiscal vs monetary policy

It was in 1999 that the policy of reducing the reserve requirement was articulated with the intention being to reduce the figure to bring it in line with the reserve requirement for non-banks which is nine per cent. It was the pursuit of this measure that resulted in the sharp declines in interest rates that the country has enjoyed over the decade. This trend is now being reversed but the policy objective was never achieved.

The reason for the increase in the reserve requirement and general tightening of the liquidity position by the Central Bank is clear and understandable. Inflation continues to rise and what is now most worrying is that core inflation which excludes food and other volatile elements has risen to 5.7 per cent up from 3.9 per cent in December—the highest monthly increase since this indicator was established in 2003. Isn’t it now time for the politicians and those in authority to treat this issue of inflation with the seriousness that it deserves and effectively deal with the issue instead of trying to deflect and window dress?

Core inflation is at 5.7 per cent, headline inflation is at ten per cent. To put it into perspective the Vision 2020 document which is supposed to guide our progress to developed country status puts a headline inflation target of five per cent. Core inflation now exceeds this target. The last time we were above ten per cent the Governor of the Central Bank described us as being on a slippery slope, clearly he was right then and the evidence is there for us to see now.

The objective of the latest move by the Central Bank is to reduce the level of demand (consumption) in the economy. The trends are clear with the median home price now standing at $1.1 million up from $425,000 in 1999 and imports of consumer goods representing 15.5 per cent of total imports in 2007 up from 11.8 per cent in 2006.

More than understanding what is happening we must also go a step further and try to understand why it is happening. One of our challenges speaks to the shift away from a manufacturing and production emphasis to one of import and distribution.

Increasing interest rates should help to curb consumption (demand) and so reduce the level of imports. All of this is being done in an attempt to control inflation but it will also negatively impact expansion in the non-energy sector. Recall as well that it was the steady rise in interest rates in the US over the past couple of years which saw property prices peak, then fall and the level of foreclosures increase.

Easier to import

We need to understand the underlying reason for a shift to import and distribution from the more indigenous productive sectors in order to appreciate the problem we are trying to solve. Let’s take a simple example and bear in mind the constraints of trying to explain this issue via the limited space of a newspaper column.

We have two people selling coconuts around the Queen’s Park Savannah. One sources his coconuts from an estate in Cedros and the other imports his coconuts from, say, Brazil. In January 2007 both vendors sell at the same price of $6 a nut with the importer making slightly less profit because of shipping costs.

Fast forward to January 2008 and the inflation rate in T&T is ten per cent but in Brazil let’s say it is five per cent. It means then that the cost of the coconut will move to $6.60 since the vendor who is sourcing locally has to pay a higher price. His price increases because the owner of the estate in Cedros has to pay higher wages, finds it difficult to source workers, the workers that he does find are transient so there are frequent errors and output is of low quality. In addition it now costs more to transport the goods to Port-of-Spain and traffic congestion means that it also takes more time to do so.

Roads in this rural area are in a state of disrepair which means that vehicle maintenance costs are also higher.

However, the vendor importing the nuts has no such problems. His costs have only increased by five per cent ($6.30). However, he can afford to charge the same $6.60 since this is what his competitor is charging. The 30 cent differential is now a further profit for him.

Eventually the vendor who is sourcing locally will get wise to the situation and maybe seek to import as well. The price is not going to come down though, since it was clear that consumers were able to afford the $6.60 price in the first instance. If you see this as price gouging as some have argued then appreciate that it is being facilitated by misaligned policies.

The customer gets the product, may complain about the price but is still prepared to pay. The vendor makes more profit than originally intended so those two parts of the equation are happy. The real loser in all this is the owner of the coconut estate who is finding it more difficult to compete because of circumstances outside his control.

Substitute the coconut estate for any other type of agricultural produce, for these same factors are contributing to the high food prices.

Go a step further and look at it from the perspective of any local manufacturer and you will appreciate the problem of competitiveness.

The simple point to all of this is that we have not managed our fiscal resources so as to maintain our competitiveness in the non-energy sector. The reality is that there are always checks and balances to every system and in the long term there is really no place to hide. Every economist will tell you that you should not have an inflation rate that exceeds that of your trading partners. The above example clearly explains why that is so.

Our target inflation rate four years ago was 5 per cent. We have consistently exceeded that and there is a price to pay for such extravagance.

In the final analysis we can either increase interest rates or adjust our currency in order to influence demand. However, if we continue to operate a non-energy deficit then we are not addressing the supply of money. This is where the real problem lies. We have been lead to believe that the solution lies in increasing the supply of goods as this will cause a reduction in prices. The truth is that the solution lies in reducing the supply of money in the economy.

The Central Bank has attempted to do this through many different avenues, however, so long as their policy objectives are not supported by the fiscal authorities then they are fighting a losing battle. The fact that the reserve requirement never got to nine per cent after ten years is testament to that.

Ian Narine is a stockbroker registered by the SEC. Please send comments to

[email protected]


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