#BTColumn – Dilemma of variable interest rates and mismatched funding

Disclaimer: The views and opinions expressed by the author(s) do not represent the official position of Barbados TODAY.

By John Beale

Recently Bajans were informed by the Barbados Government of a substantial increase of about $150 million in interest rate cost of Barbados’ foreign debt. This interest rate cost is forecast at an alarming 15.7 per cent of total Government expenditure for 2023/2024 financial year compared to a low of 8.8 per cent in 2019!

The reasons for this have been superbly explained by economist Justin Robinson, Professor of Finance and the Pro Vice-Chancellor of the Board of Undergraduate Studies (UWI).

In a nutshell, when the Barbados government negotiated the loans, they came with attractive long-term maturities, “low effective variable rates” and a favourable increase in our foreign exchange reserves.

The government, in its enthusiasm to show how much better they were to the previous administration and to show how good they had improved the Barbados debt position, pronounced to the nation all the positive sides of the negotiations. This is typical of any government that invariably likes to bring good news to the public and in so doing they almost never give a balanced overview. As a result, the Bajan public was caught by surprise about the significant increase in interest payments that will pose an additional burden to our debt service.

While the government probably did the best that they could do under the circumstances, the underlying risk of the debt negotiation was with the variable interest rate for the duration of the loan. The reason being that the rate was not a fixed rate but a variable rate which means it can go up or down over time as the rate is subject to change at periodic reset periods.

The loan was indexed to the London Inter-bank Offer Rate (LIBOR). This represents the cost of funds to the lender who would then add a credit risk spread (margin) to the cost. The “spread” over the cost of funds is what allows the lender to get a return on their loan. In other words, if LIBOR was 0.75 per cent and the credit risk was 1 per cent the total interest charge would be 1.75 per cent. If however LIBOR rose to 5 per cent, the total cost would be 6 per cent (5 per cent for LIBOR and 1 per cent for the credit risk).

I assume that the “expert” negotiating team for the government knew of the risks associated with variable rates but that they assumed or hoped that while the rates could go up or down, that over time it would not be too significant. Perhaps they also tried to get the lenders to agree to a cap (maximum increase at any interest rate change) not to exceed an agreed given percentage. Maybe they can still get the additional burden of the interest cost to be financed at concessionary rates.

Professor Robinson is correct in saying that Barbados’ increased debt payment following a surge in interest rates is likely to have a significant negative impact on development plans over the next fiscal year because the increased interest expense will erode funds that could be used for productive projects. This situation could also occur in following years as well, if interest

rates remain elevated. Likewise, Professor Robinson’s advice for the government to strike a better balance between its foreign debt and domestic financing is also commendable.

DANGER OF FORECASTING INTEREST RATES AND FUNDING EXPOSURE

Predicting interest rates (as well as foreign exchange rates) is a very complex challenge, especially over the long term. Moreover, these rates can also be influenced by unexpected events such as an election, a war, an epidemic. Even the best professionals can make huge losses that can lead to banks going bankrupt.

1. THE SILICON VALLEY BANK (SVB), CALIFORNIA 2023

Inexplicably, in order to earn an extra 1/2 per cent in yield the management of SVB invested in long-term treasuries and mortgage-backed securities to boost earnings. Perhaps they thought that cheap money which was 0.07 per cent in 2021 would exist forever. However when interest rates reached over 5 per cent due to the substantial interest increases by the Federal Reserve in order to reduce inflation, some banks suffered huge losses and were de facto bankrupt. Management had created a significant duration and liquidity mismatch with the bank’s depositors and this led to a run on the bank.

2. CHASE MANHATTAN BANK ( CHASE), BARBADOS 1979

When CHASE came to Barbados in 1970, they did not acquire a bank. Hence they had no clients with deposits to fund their operations. They funded the branch with six-month sterling

LIBOR that cost about 5 per cent. The funds supported their loan portfolio for short and long-term facilities, at rates of about ten per cent. Initially this was very attractive because CHASE had a spread over their cost of funds of 5 per cent. However, CHASE unfortunately had many loans, (including mortgages) at a FIXED interest rate for a long term. The bank was in a mismatch situation – namely short-term variable rate deposits funding long-term fixed rate assets!

Needless to say when six month LIBOR in London reached a high in 1979 of 17 per cent the profitable loan spread of 5 per cent suddenly became a negative spread of 7 per cent resulting in serious losses!

NEED FOR TRANSPARENCY AND DISCUSSION

Despite PM Mottley’s excellent and sustained efforts to get the developmental institutions to better assist developing countries like Barbados obtain more attractive loan arrangements, I agree with Professor Robinson that it will be an exceedingly difficult battle to win to get them to give relief to these countries facing higher than expected debt service costs. While we can wish her well, I expect that the development institutions will say that they have no control over the cost of funds and that their cost of funds is also the lowest in the market.

The reality to date is that the criteria of the World Bank of only using per capita income as the basis for giving concessionary interest rates is outdated and inappropriate. The technical staff at these developmental institutions know this but the decision is politically determined by the powerful countries. Senator Crystal Drakes’ wish to see a greater level of transparency and open discussion around the true nature and structure of the national debt is commendable, given the high level of our debt. Moreover, any additional debt that Barbados contracts should be carefully analyzed, especially regarding identifying the source(s) of repayment.

Barbados should not be tempted by “cheap” interest loan payments because even an interest-free loan can be a problem. If the loan funds are not employed in a productive manner that will generate funds to repay the debt, we will be flirting with danger.

John Beale is a former deputy director of CHASE, Brazil, Vice President of Banco Internacional, Brazil, CEO of RBTT, Barbados, and Investment Officer, International Finance Corporation, Washington ]]>