CAN FINANCIAL LIBERALIZATION COME TOO SOON? JAMAICA IN THE 1990s

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  • CAN FINANCIAL LIBERALIZATION COME TOO SOON? JAMAICA IN THE 1990sAuthor(s): James W. DeanSource: Social and Economic Studies, Vol. 47, No. 4 (DECEMBER, 1998), pp. 47-59Published by: Sir Arthur Lewis Institute of Social and Economic Studies, University of the WestIndiesStable URL: http://www.jstor.org/stable/27866184 .Accessed: 10/06/2014 19:52

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  • Social and Economic Studies 47:4 (1998) ISSN: 0037-7651

    CAN FINANCIAL LIBERALIZATION COME

    TDD SOON?

    JAMAICA IN THE 199?S*

    James W. Dean

    ABSTRACT

    This essay argues that Jamaica's woes were triggered by premature

    liberalization of her internal and extenl financial markets. It argues further

    that liberalization in the long run can serve Jamaica well, but only if coupled wth a wide range of stabilization and prudential measures to avert further

    crises.

    The countries of the Caribbean...may gain from orienting their reforms to

    wards a more competitive domestic financial sector and a more open

    external financial sector. This should not mean that countries should rush

    towards the liberalization of their financial sectors... a liberalization programme

    should not be undertaken until a large measure of macroeconomic stability has been achieved, including careful and effective management of the money

    supply and the fiscal account. This should be followed by the liberalization of

    trade and the domestic financial sector and finally [emphasis added] the

    liberalization of the capital account (El Hadj, 1997, p. 28).

    The author acknowledges with gratitude informative interviews with Jamaican government officials and ministers, central, commercial and merchant bankers private sector economists, and academics. Without their information and insights this paper would not have been possible.

    Pp 47-59

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  • 48 SOCIAL AND ECONOMIC STUDIES

    LIBERALIZATION AND ITS CONSEQUENCES

    The political economy of financial liberalization in developing countries

    Financial liberalization that began in the UK and the USA during the 1970s was followed by a world wide lifting of controls. Such controls typically in

    cluded interest rate ceilings, restrictions on entry by both domestic and foreign financial institutions and on exit by the former, and barriers to the inward and

    outward movement of capital. This was often accompanied by an overvalued

    exchange rate. Liberalization usually meant a lifting of interest rate ceilings, a

    relaxing of barriers blocking domestic financial institutions from establishing branches and subsidiaries abroad, allowing domestic residents to hold foreign securities and bank accounts and perhaps also to invest abroad directly, and a

    loosening of restrictions on external payment of dividends, profits, capital

    repatriation and disinvestment by foreign firms. As well, it often meant a

    relaxing of restrictions on the inward flow of capital, such as those on entry of

    foreign financial institutions, sale of securities to foreigners, borrowing abroad

    by domestic banks and non-bank firms, access by foreigners to domestic equi

    ties and real estate, and foreign direct investment.

    The spread of liberalization to developing countries was sporadic and

    often serendipitous. Small island economies were frequently induced to open

    up their external and financial sectors by the twin carrots of membership in

    free trade agreements and potential for offshore banking (Dean, 1993; Dean

    and Felmingham, 1997). Others were prodded or even panicked into liberal

    ization by balance of payments crises (Haggard and Maxfield, 1996). Jamaica falls into the latter category.

    On the surface, the rapid and early deregulation undergone by certain

    developing countries is puzzling, as it proceeded further than most developed countries at the time, and in retrospect was premature. For example Argen

    tina, Chile and Uruguay all liberalized during the late 1970s, and later suffered

    dire consequences (Edwards, 1984; Edwards, 1987; Edwards and Wijinbergen,

    1986; Corbo and de Melo, 1985). More recently, in late 1994 and early 1995, Mexico's liberalization seemed to some to be premature. Although the lessons

    for sequencing economic de-control are by now well documented (for example,

    McKinnon, 1991; Sachs, Tornell and Velasco, 1996), both Mexico and Jamaica

    appear to illustrate that these lessons are subject to pressure from the forces of

    realpolitik.

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  • Can Financial Liberalization Come Too Soon? 49

    Of course realpolitik often operates in opposing directions. Freeing up capital flows stands to harm private sector lenders and dealers in black market

    foreign exchange whose rents would be eroded by foreign competition (Grosse, 1994). Governments often have even more to lose, benefiting as they do under

    capital controls from the ability to run fiscal deficits financed by monetary creation without discipline from international lenders. Governments also stand

    to lose powers of patronage toward sectors of the economy that they may, for

    good reasons or bad, care to favour.

    On the other hand as liberalization in the developed world proceeds, with the consequent increase in global economic integration, the balance of

    realpolitik begins to shift. The opportunity cost of controls on the private sector increases, as do opportunities for evading such controls. Increased ex

    ternal trade leads to greater incentives and occasions for under- and over

    invoicing. Banks in their turn see opportunities for tapping international sources

    of savings, and are tempted to open branches or subsidiaries abroad, particu

    larly in New York and in the London Eurocurrency market. Governments find such operations increasingly difficult to monitor, difficulties that are exacer

    bated by enhanced communications and travel possibilities. Indeed cheap air travel alone has made the enforcement of capital controls on individuals al

    most impossible. Finally, foreign firms and financial institutions see opportu nities for profit in markets that are as yet relatively closed, and begin to lobby for looser controls on entry.

    Although these trends might ultimately lead to liberalization in and of

    themselves, their force has typically been strengthened by a balance of pay ments crisis. This might seem paradoxical, since a crisis should surely prompt government to tighten capital controls rather than loosen them. Yet between

    1985 and 1990, when much of the developing world was mired in sovereign debt crisis, developing countries consistently and increasingly liberalized their

    capital accounts: the number of liberalizing measures increased from twenty two in 1985 to a peak of sixty-two in 1988 before falling off to forty-nine in 1990 (Dean, 1992; IMF, 1992; Bowe and Dean, 1997). To be sure, in some cases (for example in Argentina, Mexico and Venezuela) the initial response to

    the debt crisis in 1982-83 was to tighten controls against capital flight, but these responses were soon reversed. Prompted by this evidence, Haggard and

    Maxfield (1996) undertook to examine the history of capital account policy in

    four countries: Chile, Indonesia, Mexico and South Korea. They found that between 1970 and 1988, these countries revised their financial policies signifi cantly in eleven instances, of which eight involved loosening rather than tight

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  • 50 SOCIAL AND ECONOMIC STUDIES

    ening. Of these eight episodes, all except one originated in a balance of pay ments crisis.

    By "balance of payments crisis" is meant, loosely, a sharp reduction in a

    country's stock of international reserves that is not readily reversible by bor

    rowing from abroad. Such a crisis might be precipitated by unsustainable do mestic monetary, fiscal or exchange rate policies, or by external developments

    such as a sharp increase in international interest rates, a drop in demand for

    exports, or a deterioration in the terms of trade. The crisis typically takes

    shape as a speculative attack on the exchange rate, rapid capital flight, and withdrawal of voluntary private lending from abroad (Krugman, 1979).

    Why should a balance of payments crisis prompt loosening, rather than

    tightening, of capital controls? The answer is that the political position of those interests that favour liberalization is suddenly strengthened. Such inter ests include holders of foreign exchange, exporters, foreign creditors and in

    vestors, foreign financial intermediaries, and the international financial insti tutions (IFIs): in short, the owners, earners and potential lenders of foreign exchange. Only if the capital account is liberalized will foreign exchange hold ers desist from (illegal) capital flight, exporters desist from false invoicing, and

    potential creditors be prepared to resume lending.

    Why Jamaica liberalized

    Jamaica's rapid removal of capital controls in 1990 can be put in the context

    just described. Throughout the late 1980s, Jamaica underwent a series of bal ance of payments "mini-crises." She was repeatedly bailed out by the IFIs, in

    particular the IMF, which in turn pressured for liberalization. That this oc

    curred fitfully at best can in part be explained by the continuing gratitude of

    developed country lenders, particularly the USA, for Jamaica's fortitude under

    the Seaga government in face of the socialist example set next door by Cuba. In

    short, generosity from USAID and other bilateral lenders helped relieve heat

    from the IMF: one measure of this is that the exchange rate actually appreci ated between 1987 and 1989. But in 1989, with the collapse of Soviet aid to

    Cuba, bilateral G-7 loans and grants to Jamaica began to dry up. Jamaica was

    sufficiently starved for foreign exchange that she submitted to pressure from

    the Inter-American Development Bank (IDB) to dismantle capital and foreign

    exchange controls, in return for a fast-disbursing trade and finance loan.

    Thus at least one interest group, the IDB, became sufficiently critical to

    Jamaica's short-term financial health that it succeeded in pressuring her to

    remove capital controls, precipitously and in haste. It should be added that by

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  • Can Financial Liberalization Come Too Soon? 51

    1990, a second and crucially important interest group, the Central Bank of

    Jamaica (BOJ), also stood to gain from the rapid removal of capital controls.

    Under capital controls, the BOJ had established the practice of borrowing US

    dollars and other foreign currency abroad, buying Jamaican dollars domesti

    cally at the current exchange rate, lending these to Jamaican importers and

    others as suppliers* credits, and finally collecting repayment from these suppli ers in Jamaican dollars after 30-90 days. Once the exchange rate began to

    depreciate rapidly, this practice left the BOJ with massive losses, since its for

    eign currency borrowing on behalf of private sector suppliers translated into

    greatly increased Jamaican dollar costs once the loans came due. Just as the

    BOJ had profited from this practice when the Jamaican dollar was rising, it was

    losing from it once it began to fall. The BOJ therefore was happy to cooperate with exchange rate liberalization, which would force the private sector to bear

    its own losses on foreign exchange obligations.

    Why Jamaican liberalization was premature

    Wisdom with hindsight may be suspect. Nevertheless extensive and world

    wide experience with liberalization over the last two decades has taught us a

    number of lessons. Central to these are three preconditions. Firstly, trouble

    free liberalization must be preceded by macroeconomic balance and stability.

    Secondly, it must be preceded either by an exchange rate that is close to its

    long-run equilibrium, official foreign exchange coffers that are full, or, prefer

    ably, both. Thirdly, it must be preceded by well-capitalized and well-supervised financial institutions, as well as well-understood regulations governing the emer

    gence of new institutions and new financial practices. None of these precondi tions held in Jamaica in 1990.

    By 1990, Jamaica was running loose fiscal policy as well as loose mon

    etary policy, a combination that was surely unbalanced. Moreover the overall

    macroeconomy was verging on instability, in the dual sense that the fiscal

    deficit was close to a Ponzi scheme, and monetary creation was beginning to

    accelerate the rate of inflation. The fiscal deficit had risen to record heights and was rising further and faster, in small part due to bailout efforts stemming from the 1988 hurricane, but more fundamentally because external indebted

    ness had been transformed into internal indebtedness.

    This is a pattern common to many developing countries that incurred

    foreign debt during the 1970s and early 1980s which then became unservice

    able. Typically, central banks in such countries gradually assumed responsibil

    ity for outstanding private sector debt in return for payments in local currency

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  • 52 SOCIAL AND ECONOMIC STUDIES

    or in local-currency denominated bonds. Thus the central bank of Br...

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