September 11, 2002

THERE has been quite a lot of public debate with respect to balance of payments deficits and devaluation, some of which I'm afraid has been somewhat misleading. As someone who, in a former life, was integrally involved in the compiling of Bermuda's balance of payments statistics, perhaps I can give some clarity to this public debate.

First of all the term "balance of payments deficit" is itself a misnomer, because the balance of payments (BOP) can never have a deficit, it always balances, just like a company's balance sheet always balances. The BOP consists of two sections: the Current Account and the Capital Account.

The Current Account aggregates all transactions for goods and services by Bermuda with entities outside Bermuda. Imports are considered a negative flow while exports are considered a positive flow. Thus if a shopkeeper imports a sweater from Scotland the BOP Current A/C is negatively impacted by the value of that sweater. If the shop sells the sweater to an American tourist then the BOP Current A/C is positively impacted by the sale value of the sweater.

The so-called Balance of Payments surplus or deficit is really the surplus or deficit of the Current Account, i.e. the net of all current transactions of goods and services between Bermuda and the rest of the world. The Current Account BOP balance is an important measure of a country's trading performance and is one of the most important of all of Bermuda's economic indicators, but we'll get to the importance part later. First the structure.

The Capital Account is equally important. Just like in financial accounting, BOP accounting is a double-entry system: debits and credits. Let's look at the sweater again. When the shop imports the sweater it is a BOP negative or debit, the other side of the transaction is that he has to pay out money, money that belongs to him and Bermuda, to someone in Scotland.

That payment out of our banking system to Scotland is a credit in BOP accounting to the Capital Account. Almost every transaction that takes place in the Current Account has its mirror image in the Capital Account. The export of the sweater to the tourist while resulting in a credit to the Current Account causes a debit to arise in the Capital Account.

There are, however, transactions that are strictly Capital Account transitions. If I took $1,000 from my local bank account and invested it in a US Treasury bond, this transaction would not impact the Current Account at all. Both the debit and credit would be to the Capital Account. So in the example I read in your newspaper where a Bermudian land owner sells land and uses the proceeds to invest abroad, the impact on the BOP is strictly to the Capital Account and therefore has a zero effect on the so called BOP deficit/surplus because the BOP surplus/deficit is strictly a Current Account balance.

Even if the Bermuda land were to be sold to a foreigner it would not impact the Current Account as land is in its very nature a capital asset. The outward investment would not even impact Bermuda's foreign currency assets. When a Bermuda resident takes Bermuda dollars and invests overseas that investment is considered a part of the island's foreign currency assets and not a drain on reserves. You have merely switched your type of foreign asset, from cash to securities. Consumption of goods or services overseas is a drain on foreign exchange reserves.

Now this whole discussion has arisen because Bermuda is currently running a deficit on Current Account. Now that we know what exactly this means, let's look at the importance of the Current Account balance and it's connection to the US/Bermuda dollar peg.

Bermuda is an economy with virtually no indigenous natural resources except for its people. We import over 95% of consumed goods and a similar percentage of capital goods. The capital goods we don't import we assemble or fabricate from imported materials. We are dependent on imports like no other country I can think of.

We export services to visitors under the aegis of tourism and to corporations and high net worth individuals under the aegis of international business. We have been in the fortunate position for decades of having these exports far exceed our imports.

These Capital Account surpluses have accumulated in an almost invisible pool of capital, known as foreign exchange reserves. On page 5 of the BMA's latest Quarterly Notice there is an item called "Foreign Currency Position (consolidated)". These funds ($666 million) form a significant part of the island's foreign currency reserves, but not all.

Before the dismantlement of exchange control most of this pool was in the local banking system, albeit held in US dollars. Since that time a portion of it has been placed in all kinds of investment vehicles, stocks, bonds, mutual funds, hedge funds, etc. Before it was largely under the control of local banks, now it is under the control of both individual and local banks.

The BMA Quarterly Notice shows the island recorded a Current Account deficit of $43 million for Q1/02. The first quarter is most often a weak one due to obvious seasonality. The deficit of $26 million in Q4/01 was also of note, but the position for the entire 2001 was a surplus of $145 million, sharply down from previous years.

If Bermuda had a prolonged period of BOP deficits this pool of capital could be depleted and could pose a problem for the island to finance the imports it desperately needs. Make no mistake, this reserve pool of capital is not small, for an economy our size. Its exact size is very difficult to estimate but public sector financial mismanagement, poor private sector performance in tourism or international business could drain this pool over time. One thing is certain, devaluation, or the removal of the US/Bermuda dollar peg, would not be a solution to a Current Account deficit problem. The only reason we can maintain parity between currencies is because behind every BD$ there exists a US$, held either by the BMA or a local bank. If the peg were removed and, say, the value of the BD$ were halved, imports would immediately cost twice as much.

In view of our reliance on imports it would represent a huge reduction in the disposable income and standard of living for every Bermudian. The labour force would immediately move to increase BD$ salaries to compensate for the loss of purchasing power and there would be unleashed a powerful round of inflation. And what about BD$ savings accounts? Their purchasing power would also be sliced in half.

Currently BD$ and US$ are freely interchangeable, but if the peg is removed, no one would want to hold BD$; everyone would want to be paid in US$, from taxi drivers to management companies. What exempted company worker would settle for being paid in BD$?

Would those people working for Government and major domestic firms be satisfied receiving dollars that are worth half as much as they were a day before? How would this situation improve our BOP Current Account performance? It wouldn't. It would only make our situation worse.

Bermuda's BOP Accounts are denominated in Bermuda dollars, so if you assume the island imported the same physical amounts as the year before, a 50% devaluation would double our recorded value of imports. Exports would also double leaving no effect on the Current Account.

In a country that does not manufacture a significant value of goods locally, devaluation is useless. Our exports are not priced in our own currency. Take Japan, for instance, if their currency is devalued it makes their exports cheaper in other currencies and they will then have a competitive advantage in trade.

Most of our exports are not priced in Bermuda dollars, they are priced in US$. If we manufactured a significant amount of consumer goods locally these would look relatively cheaper to local and foreign consumers after devaluation.

But because we don't produce anything much locally and import virtually everything, a devaluation achieves nothing positive at all, only creating economic chaos, dislocation and plummeting purchasing power on the part of locals, particularly the so called man in the street who has the fewest options.

With a huge jump in inflation, interest rates would have to be hiked very sharply to attract capital to BD$ and help stave off a capital flight that would certainly ensue. Without the reimposition of exchange controls defenc of the BD$ would be impossible.

One thing that has been overlooked in the discussions I have read is that there has been a very large inward investment flow into Bermuda in the last few years, represented by hotel renovations and the construction of new office buildings.

These inward investments flows appear in the Capital Account of the BOP not Current Account, so even if you are running a deficit on Current Account, new capital can still be formed on island. That is why it is misleading to draw sweeping conclusions on the overall economic situation from looking solely at the Current Account section of the BOP.

Most of the mechanisms used by other countries as economic policy tools such as devaluation, interest rate changes, exchange control, and public sector deficit finance won't work in Bermuda.

Interest rate changes

We don't have a real central bank. The BMA doesn't operate a fractional reserve system, neither do we have the capacity for open market operations. Without that the Government can't influence interest rates other than using moral suasion.

Exchange control

We used to have exchange control to enforce the fixed 7% system. That whole structure penalised small investors and also trapped money in Bermuda. The wealthy were always able to hire lawyers to figure out ways to get around the system. Ordinary folk didn't even know there was a way around it.

Today, the BOP Current Account shows an item called "Investment Income", relating to income from foreign investments. That income is a direct result of the relaxation of exchange control. Now that it's gone people will never accept exchange control again.

Public sector deficit finance

Economics 201 teaches us that the Keynesian model of deficit financing to increase local spending and thus GDP and personal incomes. Unfortunately, this is a favourite of our present Government.

This model was not meant to apply to an economy that imports 95% of what it needs. It was meant to apply to one with a large indigenous manufacturing base. The model involves Government borrowings being circulated in the community and stimulating the economy. In short, the proceeds of the Bermuda Government deficit financing is mostly spent as imports which is a drain on the Current Account, foreign exchange reserves and GDP thus largely neutralising the enhancing effect of the whole exercise.

At the end of the day all you have is a bigger Government loan to foreigners that needs to be repaid. And where will the foreign exchange for that come from? From reserves or the export of services: tourism and international business.

What can we conclude from this discussion? The economic gimmicks commonly practised by many countries would be either ineffective or disastrous when applied to the unique Bermuda economic paradigm. Talk of devaluation is scary but I don't know any Bermuda Government that would be reckless enough to enact such a policy. It certainly would guarantee that Government's replacement at the ensuring election. The Bermuda dollar would sooner disappear than be devalued.

To remedy BOP deficits on Current Account we need to concentrate on improving the things that made the Bermuda miracle a reality:

1. A thriving tourism sector and a thriving international business sector.

2. Practical prudent Government finances.

3. The continuation of a consumption-based tax system, and

4. Policies that encourage the golden goose to stay within our shores.

We must all understand the economic factors that make those sectors profitable and seek to foster those factors.

E.T. (BOB) RICHARDS