Economic report: The Commonwealth of the Bahamas

ECONOMIC REPORT

THE COMMONWEALTH OF THE BAHAMAS

Prepared by : Anh Ho (120005724)

Dorothy Kiew (120003293) Helen Ling ()

Word Count: 1,992

The Commonwealth of the Bahamas – ‘an archipelago of 700 islands and islets’1 covering 5,382 square miles of land in the Atlantic Ocean.

With US$11.04 billion GDP and US$31,300 GDP per capita,2 the Bahamas holds the ranks 151 and 42 respectively in the world and is ‘one of the wealthiest Caribbean countries’.3 Tourism and financial services (offshore banking, specifically) account for 96% of the country’s GDP, 60% of which are owed to tourism including tourism-related construction, and the 36% to financial services. About half of the country's labour force of 191,455 is employed directly or otherwise in the tourism industry, and the country is experiencing an unemployment rate of 14.7%.

The Bahamian economy experienced solid GDP growth until 2006 due to stable growth in tourism and increases in the construction of hotels and resorts.4 However, the economic downturn in late 2007 took its toll on the economy mainly through a significant fall in tourists during the final quarter of 2008.

In 2000, the renewal and reinforcement of financial regulations made international businesses including offshore banks relocate elsewhere to escape the strict regulations, contracting the financial sector of the economy and causing a decline in the country’s competitiveness.5

The above table shows a similar proportionate change of the United States’ and Bahamas’ real GDP6 because as the latter has little domestic resources to exploit and limited primary and secondary industries, nearly all food and manufactured imports are from the U.S. This greatly exposes the Bahamian economy to instabilities in the U.S. All the countries above except Japan who had no general price level increase saw their inflation increase at a slower rate in 2012; the U.S. and Bahamas saw their annual percentage change drop to 2.0%. The only country which had no change in unemployment rate in 2012 is China. The UK’s unemployment rate showed an incremental increase in 2012 while that of the Bahamas and US fell in 2012.

1, 3, 4 & 5 https://www.cia.gov/library/publications/the-world-factbook/geos/bf.html 2 The measures of GDP are made using the purchasing power parity method. 6 Real GDP is Gross Domestic Product after taking into account the effects of inflation

The government’s tax revenue for 2011/2012 totalled B$1.30 billion while its accumulated revenue and grants totalled B$1.43 billion; both figures were around B$100 million short of budgeted figures. Tax revenue is the largest contributor to the economy’s revenue, followed by non-tax revenue, capital revenue and grants.

When the recession initiated in late 2007 Bahamian yearly tax revenue fell in 2007/2008, 2008/2009 and 2009/2010 before increasing to B$1.30 in 2010/2011. Tax revenue is expected to rise to B$1.41 billion for the year 2012/2013.

The largest portion of the tax revenue is the taxes on International Trade & Transactions which accounted for B$712 million in 2011/2012. Property tax and business and professional license fees are major components too.

In contrast, total yearly expenditure has been increasing since the year 2007/2008. Total yearly expenditure in 2011/2012 was B$1.90 billion, comprising mainly of current expenditure amounting to B£1.55 billion; budgeted expenditure for 2012/2013 is B$2.08 billion. The increased spending can be largely attributed to increases in consumption, particularly personal emoluments. General administration together with public order and safety make up the general public service function of consumption which is the largest. Transfer payments include interest payments, subsidies and other transfers – subsidies paid are the greatest.

As the increase in yearly revenue since 2009/2010 was not as large as its expenditure, there has been an increase in the Government Finance Statistic’s (GFS) deficit. GFS deficit was B$448 million in 2011/2012 and is expected to be B$547 million in 2012/2013. Yearly internal borrowing carried out in Bahamian Dollars (net treasury bills, loans/advances and government securities) has been increasing since 2007/2008 and in 2011/2012 it was B$354 million.

Yearly debt repayment has been increasing since 2007/2008 and it peaked in 2010/2011 at B$269 million before falling in 2011/2012 to B$84 million which is still around B$30 million greater than expected. Below is the debt distribution for the Bahamas for the next 10 years. Total debt for the next 10 years including interest over 136 issues is B$1.30 billion. According to Moody’s Investor Services, government debt rose to 53% of GDP last year from 32% in 2007 while Standard & Poor (S&P) stated that Bahamian budget deficit in 2012 rose to more than 7% of GDP due to increased capital expenditures.

Source: Bloomberg Terminal

Credit rating agencies Moody’s and S&P have given the Bahamas a negative outlook. In the last year alone, they both cut their ratings after concluding that the country has limited revenue and increasing fiscal deficit and government debt.

Source: Bloomberg Terminal

On March 11, 2013 the government approved offshore oil exploration as they seek a new line of revenue to reduce its debt burden. However, there is no guarantee that there is ‘enough oil to be commercially viable’5. The next month, the government announced that value-added tax (VAT) at 15% would be introduced on July 1, 2014 ‘as part of a fundamental reform of the tax system’7. They have also proposed to:

• ‘effect the eventual reductions in import duty rates that will accompany The Bahamas’ accession to the World Trade Organization (WTO);

• reduce excise tax rates to compensate for the VAT; • eliminate Business Licence Tax as currently structured; and • eliminate the Hotel Occupancy Tax.’8

7 & 8 Press Release from Ministry of Finance, Bahamas on February 14, 2013

VAT has a regressive impact on the economy as low income groups pay a higher proportion of their income, leading to a rise in inequality among its population. Bahamians would have a lower disposable income and theoretically this would lead to a fall in consumption and investment depending on the marginal propensity to consume9. VAT also makes domestic goods and services more expensive, affecting Foreign Direct Investment and further repelling tourists. The tax would be ‘revenue neutral’10 for the first few years of implementation as it offsets the changes to other taxes on goods and services. On the flipside, it is expected to contribute up to 6% of GDP annually by 2016.11

The eliminated Hotel Occupancy Tax and 15% reduced excise duty will, however, positively affect tourists especially those from countries with high excise duties like the U.S and EU. A zero rate for exports and international transport of goods and passengers such as food and agricultural products can increase the level of Bahamian exports while reducing prices of necessary imports.12 This would also improve the economy’s net exchange position13. Bahamas is currently experiencing a trade deficit, where the level of exports is lower than imports – in 2012, it was a negative net exchange of 14.1.

2010 2011 2012 2013 2014

Exports of goods and services 4.4 7.6 6.6 5.8 4.0 Of which: Travel receipts (gross) 6.6 5.0 8.1 7.2 5.0

Imports of goods and services 1.1 12.9 7.3 4.6 2.5 Current account balance -10.5 -14.0 -14.1 -13.6 -12.7

Source: IMF

Another way to raise funds is to implement a withholding tax as suggested by Phillip Galanis, managing partner at HLB Galanis. The withholding tax taxes ‘dividends of funds repatriated outside of the country’14 and could be up to 30%. This tax is paid by employers directly to the government and applies to income earned by non-residents of a country. Foreign commercial banks operating in the country are known to generate more than $100 million in profits annually and most of it is repatriated to Canada.

The above suggestions are instruments of fiscal policy, a demand-side policy which aims to increase and maintain:

• equality among the people; • standard of living through growth and employment rate; and • stability of the government budget.

Monetary policy, another demand-side policy can be used to influence the economy. The main instruments which include interest rate and quantitative easing are aimed at directly controlling the rate of inflation and hence, stimulate economic growth in the country. The stability of its exchange rate (mainly between Bahamian and U.S. dollars) and credit surrounding the economy are also fundamental objectives of the policy.

Changes in the base interest rate can influence market rates, asset prices and confidence of the population. In turn, this affects aggregate demand, creating ‘domestic inflationary pressure’. Due to little time lag, effects on the economy can be seen almost immediately after a rate change is introduced. This process is known as the interest rate transmission mechanism and a flow chart is presented below.

9 Marginal propensity to consume is the proportion of a dollar of household income that is spent. The greater the marginal propensity to consume, the greater the household will spend and this adds to an increase aggregate demand. 10 & 11 http://www.thenassauguardian.com/index.php?option=com_content&view=article&id=38006:moodys-bec-debt-to-impact-rating&catid=40:business&Itemid=2 12 http://www.tax-news.com/news/Bahamas_To_Introduce_Value_Added_Tax____59784.html 13 Net exchange or balance of payments on current account is the difference between exports and imports. 14 http://www.thenassauguardian.com/index.php?option=com_content&view=article&id=38002:govt-urged-to-impose-withholding-tax&catid=40:business&Itemid=2

Source: http://www.bized.co.uk/virtual/bank/economics/mpol/mpc/theories1.htm

Most countries choose to lower their interest rate in a recession to stimulate consumption and investment which shifts the aggregate demand (AD) curve outwards, leading to an increase in real GDP and reduction of cyclical unemployment15. As shown on the diagram, by shifting AD1 to AD2, real output increases from Y1 to Yfe, indicating an increase in GDP and employment rate. However, when lowering interest rate can no longer affect the economy or it cannot be lowered any more, quantitative easing can be used. Japan has seen success in eliminating deflation by adopting such a practice. Quantitative easing involves creating money electronically to buy toxic government bonds from financial institutions such as banks, insurance companies and pension funds, increasing the price of bonds and lowering its yield. Banks are theoretically incentivised to lend more, boosting the economy.16

Figure 1 Figure 2 Change in any policy will have an exaggerated effect, dubbed the multiplier effect on the economy which eventually shifts AD even more. Although fiscal policy can be used to support monetary policy, there usually exists a conflict between the two. By applying both deflationary monetary policy and expansionary fiscal policy, and taking into account the multiplier effect, a rise in inflation will occur when resources are fully employed (Figure 1 – price level reaches P3 but output is constant). A negative multiplier effect carries the risk of recession and lower confidence levels. Demand-side policies customarily stimulate growth by increasing components of aggregate demand which then lowers cyclical unemployment but raises inflation. Empirical evidence brought forward by A.W. Phillips and illustrated on the Phillips curve (below) reinforces the existence of a trade-off between inflation and unemployment. Even when taking into account expectations and augmenting the said curve, the trade-off is still argued to hold but only in the short run.

Source: http://tutor2u.net/economics/content/essentials/phillips_curve.htm

15 Cyclical unemployment occurs when the economic cycle is in a downturn. 16 http://www.bbc.co.uk/news/business-15198789

In conclusion, monetary policy has been successful in maintaining stable exchange rate through the time. Albeit the country makes little use of this policy in terms of stimulating growth using interest rates as the main tools, real GDP growth has remained positive at 2.5% in 2012 despite the effect of the recent recession.

However, increasing fiscal debt (53% of GDP in 2012) and narrow revenue stream (7% budget deficit in 2012) continues to be problematic. The government recently announced VAT at 15% beginning in July 2014, reduction of import duties and excise tax, and elimination of the Business Licence Tax and Hotel Occupancy Tax. Furthermore, Phillip Galanis proposed an introduction of withholding tax to curb the repatriation of funds out of the country by offshore banks.

Although it is advisable that the government focuses on monetary policy due to a short time lag while allowing automatic stabilisers to correct fiscal matters, due to the fact that “constant rate still serve the country well” , fiscal policy should remain the main policy. By introducing various forms of tax such as the VAT and the withholding tax, the government can improve its accounts and allow a much needed improvement of economic outlook and credit ratings. In the future, this can encourage cash inflow to the country by foreign investors. On the other hand, the government can lower unemployment benefits to motivate the unemployed to seek work, reducing both frictional unemployment and fiscal deficit.

In the long run where there is no trade-off in the Philip Curve, due to the fact that the economy is highly sensitive to external shocks, it is suggested that the country should adopt supply-side polices, which increase efficiency in markets and industries and achieve a higher underlying rate of growth of real national output (Figure 2).17 For the Bahamas, it is possible to strengthen supply-side policies because they can combine the needs of its industrial especially this time when the government approved offshore oil exploration; as well as its long term societal development.18. However, increasing labour mobility can be time-consuming and costly.

17 http://www.tutor2u.net/blog/index.php/economics/comments/unit-2-macro-revision-notes-on-supply-side-policies 18 http://www.academicjournals.org/ijpds/pdf/Pdf2011/Apr/Karagiannis%20and%20Madjd-Sadjadi.pdf