Financial Sector Liberalisation in Jamaica

8/2/2019 Financial Sector Liberalisation in Jamaica

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Chapter 1

Introduction and Overview

(1) Project Aim

The Jamaican financial sector saw rapid growth in the 1980s. By the mid-1990s,

however, the system collapsed resulting in a massive government bailout to the

tune of some J$80 billion. Many argue that the process of financial sector

liberalisation that commenced in 1985 is largely to be blamed. The aim of this

paper is to examine the process of financial sector liberalisation and the role it

played in the demise of the Jamaican financial sector.

(2) Liberalisation Defined

Liberalisation, in the general sense, means making less strict. From a financial

perspective, liberalisation, often used interchangeably with deregulation, is the

freeing up of established government rules and a move towards an environment

determined more by market forces. Market discipline is substituted for the hand

of the government with the aim of creating a more efficient marketplace.

Liberalisation is achieved by deregulation and through the process of

privatisation; privatisation being the exposure of the public sector production

process to free market forces. The emphasis of this project is on the process of

deregulation of the Jamaican domestic and Foreign Exchange (FX) market

designed to remove market distortions and improve efficiency.

(3) The General Contents of the PaperTo put the paper in proper perspective, liberalisation that commenced in 1985 is

contemplated against the historical background of the financial sector going

back to the 1960s. Close attention is also paid to economic environment

preceding liberalisation and its evolution over the years.


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The process of financial sector liberalisation was embarked upon with good

intentions in mind but today the debate rages on as to its role in the collapse of

the Jamaican financial sector. While there are compelling arguments linking

liberalisation to the decline of the financial sector, others argue that other

factors, such as the ineptitude of managers and directors were solely responsible

or played just as important a role.

The purpose of the study is to examine whether the objectives of the Financial

Sector Reform Program (FSRP) were achieved, to outline the impact of

liberalisation on the system and to look at other factors that could havecontributed to its decline.

The massive fallout in the financial sector saw the intervention of the Jamaican

Government through the Financial Sector Adjustment Company (FINSAC). With

the important role played by this organisation, its projected impact on the

Jamaican economy and its budgetary resources in the years to come, the

paper would not have been complete without an appreciation of

Governments bailout plan.

Many other countries (developed and developing alike) have undergone the

process of the financial liberalisation. To establish some parallel with the

Jamaican experience, similar reforms in other regions (mainly Japan) have been

examined.

(4) Reasons for the ResearchPresently, there is very little literature documenting in a very structured way, the

liberalisation process. Further, since the collapse there has been no formal

investigative structure to look into the crisis and the causative factors. The

research will not only prove useful in providing a better understanding of

financial sector liberalisation in Jamaica and its role in the banking crisis, but also


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in developing appreciation of current trends in the sector and broader macro-

economic environment. The information will prove useful to academics, bank

personnel, and even to the regulatory bodies.

(5) Focus on the Banking Sector

Finally, the paper contemplates financial sector liberalisation from a broad

perspective and its impact on financial intermediaries and markets. However, for

focus and clarity, particular emphasis is placed on the analysis of its effect on the

Jamaican banking sector. The emphasis is on its state prior to liberalisation, its

subsequent growth, the collapse and the aftermath.

(6) The Organisation of Financial Systems

The essence of financial sector liberalisation is dependent on how financial

systems are organised and their structural characteristics. Chapter 2 examines

financial systems and it also takes a more detailed look at liberalisation. It closes

with a historical perspective of the Jamaican financial system.


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Chapter 2

Financial Systems

(1) Introduction

The paper as outlined in the first chapter examines the collapse of the Jamaican

financial system and the role played by liberalisation in its demise. This chapter

puts financial systems and the role of its functional units into perspective and

describes briefly the regulation process. Oftentimes, financial systems are

regulated to the point where they prevent free interplay of market forces. The

process of economic liberalisation, which is used to free these forces, is also a

focal point of this chapter. Liberalisation of the finance sector in Jamaica

commenced in 1985. The latter half of the chapter looks at its historical

development going back to the 1960s and up to 1991.

The year 1991 is used as a marker, as the second phase of the liberalisation

process (as will be shown) commenced at just around that time.

(2) What is a Financial System

A financial system essentially serves to move funds from those with surplus funds

to those with a shortage of funds. In developed countries, such as the United

States, the financial system typically comprises lenders (savers), financial markets,

financial intermediaries, and borrowers (spenders). This structure is represented in

Exhibit 1.


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Financial Systems

Indirect Finance

FinancialIntermediaries

FUNDS FUNDS FUNDS

Lenders (Savers) Borrowers (Spenders)1. Households Financial 1. Business Firms2. Business Firms FUNDS Markets FUNDS 2. Government

3. Government 3. Households

4. Foreigners 4. Foreigners

Direct Finance

Exhibit 1Flow of Funds through the Financial SystemSOURCE: Frederick S. Mishkin, An Overview of the Financial System, Chapter 3, Money, Banking, andFinancial Markets, 1989 (Scott, Foresman and Company, 1989), p. 43.

As shown in Exhibit 1, funds flow from lenders to borrowers either directly or

indirectly. In direct finance, funds are borrowed directly from lenders by selling

them securities (claims on the borrowers future income or assets). The indirect

method involves a middleman or financial intermediary that stands between the

lenders (savers) and borrowers (spenders).

(3) Financial Markets and Intermediaries

Financial markets and intermediaries are two of the functional units making up

the financial sector. These include Debt and Equity Markets, Primary and

Secondary Markets, Exchanges and Over-the-counter Markets, Money andCapital Markets and Depository, Contractual and Investment Institutions. Exhibit

2 below illustrates differing types of units.


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Financial Systems

Types of Financial Markets Types of Financial Intermediaries

Debt and EquityPrimary and Secondary

Exchanges and Over-the-CounterMoney and Capital

Depository Institutions (Banks)Commercial BanksSavings & Loan Associations

Mutual Savings BanksCredit Unions

Contractual Savings InstitutionsLife Insurance Companies

Pension FundsFire and Casualty InsuranceCompanies

Investment IntermediariesFinance Companies

Mutual FundsMoney Market and Mutual

Funds

Exhibit 2Financial Markets and IntermediariesSOURCE: Frederick S. Mishkin, An Overview of the Financial System, Chapter 3, Money, Banking, andFinancial Markets, 1989 (Scott, Foresman and Company, 1989), Portion extracted from p. 51.

(4) Regulation of Financial Systems

Financial systems are usually tightly regulated by agencies under specific

legislation. In the United States, for example, the financial system is among the

most regulated sectors of the economy. Regulation is designed to accomplish

the following:

Provide information to investors so that they are able to determine how safepotential investments are.

Ensure the soundness of the financial system to protect investors anddepositors and funds they have invested.

Improve control over monetary policy such as in the control of money supplythrough reserve requirements.


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Financial Systems

Encourage home ownership to develop a more politically involvedelectorate, more responsible citizens and, ultimately, a more stable society.

(5) The Process of Economic Liberalisation

Economic liberalisation is the act of reducing government-imposed constraints

on the behaviour of actors in the economy. It concerns:

Programme and sector aid that promotes policy and institutional changedesigned to free internal and external markets for goods and services;

Improving the efficient operation of markets; Correcting market distortions; Restructuring enterprises and institutions in the public sector; and Strengthening public revenue and expenditure planning and management

Liberalisation is achieved by privatisation and deregulation. The main features of

the liberalization process, opinion formers and policy makers and

implementation agencies are shown in Exhibit 3. The highlighted features are the

subject of this paper.


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Financial Systems

Features of Liberalisation Opinion Formers and PolicyMakers

Implementation Agencies

Liberalise Trade and Promote

Exports

Politicians Government Departments

Deregulate industry andcommerce

Ministries or Agencies The Central Bank

Reform finance sectorinstitutions - removal of ceilingson interest rates and selective

credit controls

Political Parties Commercial and Investment

Banks

Reduce subsidies Non-Government

Organizations (NGOs)

Agencies

Free Prices Representatives of externalagencies

The Stock Exchange

Restructure and/or sell offstate-owned enterprises

The Central Bank Managers in State Enterprises

Reduce the budget deficit, by

cutting public expenditure andmaximizing tax revenue

Government Advisors Private Sector Managers

Reduce the numbers of civilservants

Academic Institutions Financial and Regulatorybodies responsible for market

supervision

Devalue the currency andliberalise foreign exchangedealing

The Press Economic development

agencies

Taxation Authorities

Private ConsultancyCompanies

Ministries of Agriculture and

Rural Development and NGOs

Ministries and other agenciesconcerned with social safetynet provision

Exhibit 3Features of the Liberalisation Process

Privatization and DeregulationPrivatization involves the exposure of the public sector production process to

free market forces. The most commonly understood meaning is the sale of

state-owned enterprises, but it can also refer to the contracting out of a

service. While, deregulation is the easing of rules under which a firm or an

industry operates, allowing expansion within the sector or diversification into

other sectors and opening the sector to other entrants. Fewer restrictions on

price is another recurring theme.


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Financial Systems

Internal vs. External LiberalisationThe liberalisation process can either be internal or external. With internal

liberalisation, reforms are concentrated on freeing local markets while;

externally, the process may involve the removal of exchange controls to

allow locals freer access to foreign markets and foreign investors, the same

freedom with local markets.

Financial sector liberalisation in Jamaica basically had two phases. Phase

one dealt with the internal markets; while phase two was both internally and

externally focused.

(6) The Structure of the Jamaican Financial System

By 1991, it was the financial intermediation aspect of the Jamaican financial

system that was well defined with varied financial intermediaries active in the

areas of life insurance, commercial and merchant banking, and mortgage

financing. There were also credit unions, development banks, and a unit trust.

(see Appendix 5 for information on financial intermediaries operating in Jamaica

in 1985).

These institutions, falling under the jurisdiction of the Ministry of Finance and

Planning, had sprung up to facilitate increased financial intermediation despite

developments that led to instabilities in the international financial system during

the early 1970s.

Specifically in 1971, the Bretton Woods system of fixed exchange rate began to

unravel. By 1973, the system finally collapsed with the more widely traded

currencies allowed to fluctuate in line with market forces. The international

financial system was further shaken by the OPEC oil crisis in 1974.


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Financial Systems

While the financial intermediaries were very active in Jamaica in the mid-1980s,

financial markets were virtually non-existent. To give an idea, the Jamaica Stock

Exchange which offered an opportunity to trade stocks, only operated for two

trading days. Further, the simple process of transferring stocks was cumbersome.

The process was badly in need of simplification in terms of the length of the

process and the steps involved, such as adjusting stock registers and issuing new

certificates.

(7) Historical Perspective (1960s to 1991)

The Financial System in the 1960sFrom even before the 1960s, the Jamaican financial system was already

taking shape (See Exhibit 4). The first institutions to emerge were commercial

banks followed by companies specialising in mortgage financing.

With the 1960s coming to an end, commercial banks, trust companies,

building societies, life insurance companies, credit unions were the dominant

financial intermediaries in the sector. A Government Savings Bank set up

initially to offer a savings option and later to invest in Local Registered Stocks

issued by the Government of Jamaica also played an important role during

this period.

The Financial System in the 1970s to 1991By 1991, the sector had undergone further expansion and now included

merchant banks. It was also during this period that a unit trust, a mortgage

bank and development banks were first introduced in Jamaica. (see

Appendix 5 for a description of these entities).


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Financial Systems

NB. Commercial Banks were established in 1836

Exhibit 4Time LineThe Establishment of Financial Intermediaries in Jamaica

(8) The Banking Sector

The Jamaican banking sector essentially comprises commercial and merchant

banks. In the early days of the banking sector, foreign-owned banks were the

norm. Initially, commercial banks dominated with merchant banks making their

appearance in 1969. It was soon after this period that the ownership landscape

slowly began to evolve from predominantly foreign-based to local-based

ownership.

Commercial BanksCommercial banks were the first financial intermediaries to operate in the

Jamaican financial sector and by 1961 the operations were well established.

They offered current account facilities, time and savings deposits, and loansand were particularly active in financing agriculture, imports, and hotel

development. Commercial banks operated under the Banking Act (revised

1961 and 1992) and were (and still are) supervised by the Bank of Jamaica

(BOJ).

1950 1960 1970 19801940

Early 196os The CentralBank, Life InsuranceCompanies, Trust

Companies, and BuildingSocieties.

1970Unit Trusts

1941Credit

Unions

1969Merchant

Banks andDevelopment

Banks


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Financial Systems

Merchant BanksMerchant banks provided medium and long-term financing for the business

sector in particular and also played an important role in the development of

the money market. The activities of merchant banks were supervised by the

BOJ, initially through the Protection of Depositors Act and then later, the

Financial Institutions Act (1992). Merchant banks remain under the jurisdiction

of the BOJ.

The Central BankThe BOJ, ultimately answerable to the Ministry of Finance, was established by

the Bank of Jamaica Law (1960) and begun its operations in 1961.

Simultaneous with the establishment of the BOJ was the introduction of

legislation to regulate banking in Jamaica. The new legislation made it

mandatory for any entity carrying on the business of banking to secure a

licence from the Minister of Finance.

Additionally, the law stipulated minimum capital requirements and liquid

assets to deposit obligations, disclosure of certain information to the public

and to the Inspector of Banks (the BOJ) and maintenance of cash reserves at

the Central Bank.

(9) Summary

A clear picture of financial systems and the liberalisation process in general has

been provided, along with an insight to the historical background of the

Jamaican financial sector. The next chapter will investigate this period further

and details its structural characteristics revealing the existence of distortions and

inefficiencies that retarded the development of the financial sector.


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CHAPTER 3

Distortions and Inefficiencies in the Financial Sector

(1) Introduction

This chapter discusses distortions and inefficiencies in the financial sector up to

1991. The chapter then outlines the structural characteristics of the Japanese

financial system and makes comparisons with those that existed in the Jamaican

context. This provides an important insight as Japan is one of the worlds most

advanced industrialised nations. Finally, the objectives of the liberalisation

process that were introduced to eliminate the distortions and inefficiencies in the

Jamaican financial sector are examined.

(2) Structural Characteristics of the Jamaican Financial Sector

The preceding chapter is evidence of the varied financial intermediaries active

in the Jamaican financial system up to 1991. Despite this, however, it was seen

that activity in financial markets were virtually non-existent and as the following

sections will show, the Jamaican financial sector lacked the necessary

ingredients to facilitate sustained levels of economic growth. In general,competition levels were low, resources were allocated inefficiently, and

productivity below desired levels. These were as a result of distortions and

inefficiencies in the market.

(2.1) Over-reliance on Non-market Instruments

There was an over reliance on non-market instruments such as credit ceilings with

funds being directed to certain sectors under pre-established ceilings; asset

ratios that involved a non-remunerated cash reserve ratio (reserve with the BOJ

at zero rate of interest); and a non-cash liquid asset requirement (mandatory

investment in specified government instruments) to carry out monetary policy.

(Appendix 4 shows the predominance of these tools). This predominance

effectively prevented the development of the financial money market, as a


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result of the non-existence of tradable financial instruments. Without these, there

were minimum investment opportunities for investors.

In the case of the former (credit ceilings), commercial banks began

circumventing credit ceilings by shifting loans and deposits to non-bank affiliates

in the interest of maintaining their profitability. These institutions were less

constrained by reserve and capital requirements.

(2.2) The Interest Rate Structure

The financial sector of the early to mid-1980s was characterised as financially

repressive whereby real interest rates were low and sometimes negative. The

inflation rates 1980 to 1991 are shown in Exhibit 5. This is against the background

that the savings rate up 1984 was just below 10%, climbed to a high of 20% in

1985 and thereafter, was reduced to 18%. The savings rate was deregulated in

1990. Negative real rates of interest had an adverse effect on mobilisation of

savings and investments into the system.

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

IR(%) 29 5 7 17 31 23 10 8 9 17 30 80

IRInflation Rate

EXHIBIT 5Deposit and Inflation Rates 1988-1991SOURCE: Trevor Evans, Carlos Castro and Jennifer Jones,, The Impact of Structural Adjustment Programmes onthe public sector in Jamaica, Chapter 3, Structural Adjustment and the Public Sector in Central America and

the Caribbean , 1995 (Cries, Managua,, 1995), Portion extracted from p. 113.

The regime involved a statutory savings deposit floor rate that meant

commercial banks offered rates that were not truly market-determined. This was

compounded by the fact that two (2) commercial banks (Bank of Nova Scotia

and National Commercial Bank) controlled 70% of the market share and under


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such a regime, they could maintain their status quo as a result of the security

their sheer size projected.

(2.3) Subsidised Credit

Also characteristic of the period up to 1991, was the existence of subsidised

credit to the prioritised sectors of the Jamaican economy. The targeted sectors

were agriculture, manufacturing and tourism. Additionally, preferential

rediscounting facilities were operated by the BOJ to facilitate growth in

prioritised sectors. With rediscounting, commercial banks extended loans to

particular sectors that were in turn funded by the BOJ. Inherent in these policies

was the inefficient allocation of resources, as other sectors had to contend with

limited and relatively expensive loan financing. Additionally, with the prioritised

sectors guaranteed lower rates, there was little motivation to improve efficiency.

(2.4) Crowding Out the Private Sector

A further financial constraint witnessed during the period under consideration

was a robust public sector deficit (figures in Exhibit 6) which resulted in rising

inflation. One source of funding to the public sector was a relatively high liquid

assets ratio, which ensured the availability of financing through treasury bills;

while starving the private sector of much needed funding.

Year %

1981/82 15.91982/83 15.71983/84 19.61984/85 15.1

1985/86 13.2

1986/87 5.61987/88 5.41989/90 13.31990/91 8.0

Exhibit 6Public Sector Deficit as a % of GDP (1981 to 1991)SOURCE: Trevor Evans, Carlos Castro and Jennifer Jones,, The Impact of Structural Adjustment Programmes onthe public sector in Jamaica, Chapter 3, Structural Adjustment and the Public Sector in Central America andthe Caribbean , 1995 (Cries, Managua,, 1995), Portion extracted from p. 113.


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(2.5) The Propensity to Borrow

A further element of the market distortions was manifested in the private sectors

preference for borrowed funds as against equity financing. In fact, equity

financing was virtually non-existent, as family owned and closely held enterprises

preferred to operate closed shops. This not only meant a higher cost and

more volatile funding to businesses, but greatly restricted development in the

capital markets.

(2.6) Instability in the Foreign Exchange (FX) Market

Since the late 1970s, the FX regime had been the focus of reforms that sought to

increase the extent of FX inflows into the formal system and stabilise the

exchange rate. (see Appendix 3B for Developments in FX Market).

The Growing Black MarketThe reforms were against the background of a black market in FX trading

that slowly rose to prominence at end of in 1979, in spite of a period of

relative stability in the exchange rate.

The growing ability of the black market to divert FX from the formal network

attested to the non-market-clearing rate offered in the official system. In an

attempt to ease the demand for US dollars in the official system and to

reduce the dependency on the informal market, Special Retained Accounts

were introduced during 1981. Special Retained Accounts allowed approved

importers to hold foreign currency accounts in commercial banks.

During the same period, no funds licences were issued by The Trade Board

to allow payments for imports from balances (typically from export proceeds)

sourced by the importer. With these licences, importers did not have to wait

on the official system to fulfil their FX requirements. These proved unequal to


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the task of easing pressure for US dollars in the official system and lay the basis

for a formalized parallel market.

The Parallel MarketThe parallel market was introduced in January 1983. This succeeded a

system of a fixed parity rate managed by the BOJ. The parallel market

entailed the co-existence of two rates - an official rate and a parallel rate.

The official rate was set by the BOJ and used for all official debt transactions,

essential imports and converting export proceeds. All remaining

transactions such as business travel attracted a parallel rate of exchange

determined by each commercial bank on a daily basis. In May of 1983, a

CARICOM rate of exchange (fixed at US$1 to J$2.25) was introduced into the

mix to be used in CARICOM transactions.

The effectiveness of the parallel system was impeded by the fact that over

time the parallel market placed increasing pressure on inflows still subject to

an official rate. There also continued to be a wide disparity between the

official and parallel rates (see Exhibit 7).

Date Official Rate($J) Parallel Rate ($J)

10/1/83 $1.78 $2.45

31/1/83 $1.78 $2.76

26/2/83 $1.78 $2.80

41/3/83 $1.78 $2.75

29/4/83 $1.78 $2.76

18/5/83 $1.78 $2.76

08/6/83 $1.78 $2.71

30/6/83 $1.78 $2.71

29/7/83 $1.78 $2.7130/8/83 $1.78 $2.96

Exhibit 7The Parallel Market SystemOfficial & Parallel Rates (Jan to Aug 1983)SOURCE: The Bank of JamaicaThe Statistical Digest


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In November of 1983 all three rates (official, parallel and CARICOM) were unified

at US$1 to J$3.00 and in March 1984, an auction regime was implemented.

The auction system for establishing daily FX rates that was introduced in

December 1983 remained in effect until October 1989. The system was

successful at first, as there was a period of relative stability between November

1985 and April 1989 when the rate was approximately US$1.00 to J$5.50.

However, all this time, pressure was building on external payment arrears that

ultimately led to devaluation pressures. Instead of responding, the Governmentwas insistent on its existing auction system. This facilitated the persistence of an

unrealistic exchange rate and fed the growth of a FX black market. The growth

in the black market was blamed on the publics loss of faith in governments

ability to operate a FX market.

The government eventually yielded and suspended the Auction system and

adjusted the rate to US$1.00 to J$6.50 in November 1989. However, devaluation

pressures continued and by 1 February 1990, the rate had depreciated to

US$1.00 to J$7.00.

(3) The Exchange Control Act

The instability in the FX market was against the background of the Exchange

Control Act introduced in 1954. The Act was a very restrictive piece of legislation

(with rigid restrictions on both current and capital accounts) greatly impacting

on the free play of market forces, the movement of FX in Jamaica andinvestment options of potential investors (see Appendices 3A and 3B).

The Exchange Control Act was extensive in its reach and had far reaching

implications. The Act impeded the development of financial markets in

significant ways:


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(3.1) Restriction on Investment Flows

The Act prohibited investment inflows from abroad without prior ministerial

approval. Further, the Act prohibited the transfer of securities (shares, stock,

bonds, etc.) and coupons (represents dividends or interest on a security) to non-

residents without the permission of the Minister.

The bureaucratic nature of this process discouraged many potential interests

and the constraint, in itself, promoted inefficiency in the finance sector as there

was no motivation for financial intermediaries to lower loan rates.

(3.2) Restrictions on Importers and Exporters

Up to the early 1990s, it provided only for exporters and importers buying and

selling foreign currency through the official system (the BOJ and commercial

banks). Exporters sold all their FX to the system, while importers were required to

make applications to fill their requirements. As was shown, transactions were

effected at rates managed by the BOJ and commercial banks acting as agents.

As such, the rate obtained in the FX market was not truly determined by demand

and supply.

(3.3) Restrictions on Dealing in FX

On 25 October 1991, an amendment to the Exchange Control Act provided for

the following:

The requirement that only authorised dealers buy, sell, borrow, or lend in FXunless approved by the Minister; and

Persons buying, selling, borrowing, or lending FX may only do so through anauthorised dealer.

This was against the background that only commercial banks (a total of 11) were

allowed to deal in FX up to 1 July 1991; as at July 1, 1991, two (2)


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building societies and two (2) merchant banks were added to the list of

authorised dealers.

This meant that up to 1991, local businesses had little opportunity to borrow in a

foreign currency to benefit from a lower rate of interest and this was as a result of

restriction on foreign inflows. Additionally, the system maintained the status quo

and prevented the freedom of market forces to prevail in both internal and

external markets. This impeded the development of the FX market.

(4) Arguments for and Against FX ControlsFor all the restrictions imposed by the Exchange Control Act, there was still strong

support for its existence. After all, most countries in the developing world at

some point operated exchange controls.

Proponents of the Act argued that controls prioritised how FX was allocated

prevented capital flight and that a devalued currency was not necessarily

beneficial. They insisted:

1. The importation of capital equipment, energy and food deserved priorityover the acquisition of real estate and equities overseas;

2. Capital flight would lead to a destabilised currency and by fuellinginflation, add to the Governments foreign debt burden; and

3. Depreciation that was likely to accompany the abolition of controls wouldnot lead to an improved visible account as exports and imports were not

responsive to the exchange rate; the effects of depreciation on costswould be nullified by higher wages, and such could have contractionary

effects.

On the other hand, antagonists made a strong case against exchange controls

in that they:


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1. Sustained an overvalued exchange rate as the restrictive nature of theAct meant the existence of a exchange rate that was not truly market-

determined and which, in essence, prevented the orderly operation and

development of the FX market;

2. Discouraged much needed foreign investment, partly because investorsfeared that they would not have been able to repatriate capital, and

partly because rates of return in the trade sectors were depressed by an

overvalued exchange rate; and

3. Distorted the economy, favouring industries that were not exposed toforeign competition (for example financial services).

(5) Structural WeaknessesJapan and Jamaica Compared

Similar to the situation of distortions and inefficiencies that existed in Jamaica

pre-liberalisation, the Japanese financial system (during 1950 to 1973) also had

structural deficiencies. These included regulated interest rates, indirect

financing, window guidance and administrative guidance, and segmentation

and strict demarcation of businesses.

Interest Rate RegulationIn 1947, the Temporary Interest Rate Adjustment law was introduced to

control all interest rates to facilitate the provision of low cost funds to select

industrial sectors. This was similar to the system of subsidised credit and

interest subsidies in Jamaica and resulted in collusion throughout the financial

system, as interest rates were slow to react to supply and demand and their

low-level resulted in excess demand for loan funds. The situation wascontrolled through non-price measures such as informal contacts and

legislation.


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The policy of interest rate regulation had four (4) major effects on Japans

system:

High profit margins that were predictable and resulted in a fairly stablehierarchy within the system;

Little pressure to reduce expenses and increase efficiency; Large banks being in constant negotiation with regulatory authorities who

aimed to influence the flow of loan funds for industrial policy purposes; and

Regulators allowing the banking system to define their own disclosurerequirements through their trade associations.

With the latter, disclosure requirements remained rather flexible as credit

assessment was based on criteria rather than credit worthiness. Further,

depositors did not approach banks on questionable business practices; while

major shareholders were usually the borrowers of funds not interested in rigid

disclosure requirements.

Indirect Financing and the Dominance of Bank LoansThe Japanese capital market in the period under review was small and

regulated and corporations had no direct access to international finance.

This was not unlike the Jamaican situation.

The bond market was suppressed as government bonds were not issued on a

large scale until 1973 and corporate bonds attracted somewhat-expensive

funding because of regulation.

Capital increases through stock issues were costly and trading in both stock

and bond markets remained low until the 1980s. This was a plus for banking

institutions, as there was no competition from loan customers wanting to

access the capital markets. This situation effectively insured the

maintenance of high interest spreads.


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Window GuidanceThe excess demand for funds in the Japanese financial system because of

artificially low rates resulted in a situation known as overloan where the total

capital and deposit liabilities of banking entities fell short of loan demand.

Consequently, banks had to borrow money from the Central Bank to make

loans to the corporate sector making it easy to influence credit by a system

of rationing.

This took place in the process of window guidance, a subset of

administrative guidance specifically geared towards the lending behaviourof commercial banks. (Administrative guidance being a quid-pro-quo

approach that involves a system based on deals, favours, and reciprocal

obligations).

One effect of window guidance approach was that the hierarchy of the

large banks remained unchanged because the Central Bank allocated

credit based on existing market share. This affected the need for strategic

management decisions, cost-cutting efforts, and competitive positioning.

With window guidance, it was not obvious as to who would be responsible

for failure in an environment where financial authorities had such a significant

role in directing the lending behaviour of banks.

Segmentation of the Financial IndustryThe Japanese banking structure up until 1993 was multi-layered. These

included lines to separate commercial from investment banking, lines to

separate institutions by functions such as size, location and/or profession of

the customer) and lines to separate short-term vs. long-term lending among

large banks.


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The existence of these clear lines meant that each bank category had their

own laws special laws, detailed restrictions, and administrative guidance. In

the supervision of these institutions however, the convoy approach was

used. Under this system, the impact on small or weaker institutions was very

important in deciding whether or not to implement planned changes. If it

would negatively impact the institution, then the change would not be

effected.

With the well-regulated structure of the Japanese financial system, some

banks, similar to the practice in Jamaica, moved business to non-bankentities. For example, when the financial authorities asked banks to reduce

real estate loans in 1992, the banks obeyed on paper.

In order to get around this situation, Japanese banks simply utilised their non-

bank affiliates to continue booking loans. The result was a high concentration

of very questionable loans in these entities.

(6) Summary

The structural deficiencies of the Jamaican financial sector were outlined in the

foregoing sections and the characteristics of the Japanese system illustrated.

Financial sector liberalisation measures, timing, etc are not only impacted by

these distortions and inefficiencies, but also by the macro-economic

environment. The following chapter examines Jamaicas economic background

up to the early 1990s.


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CHAPTER 4

An Overview of the State of the Jamaican Economy

(1) Introduction

Chapter 3 provided important insights into the financial sector up to the early

1990s. This chapter examines the macro-economic environment of Jamaica

from the 1960s up to the same point. The International Monetary Funds (IMFs)

structural adjustment policies that commenced in 1977 are also discussed.

Jamaicas relationship with the IMF actually commenced in 1973, but focus will

be placed on the period of significant impact from 1977 to 1992.

The distortions and inefficiencies of the financial sector were against

mushrooming economic difficulties. These difficulties commenced with a

balance of payments crisis in the 1960s when, despite the buoyancy of the

economy (high export earnings from tourism and bauxite), the country

experienced a deficit on its current account that was covered from foreign

inflows. There were other key developments.

In 1972, the Peoples National Party (PNP) led by Michael Manley came to power

and introduced a number of moderate social reforms. In 1974, however, it

moved in the direction of democratic socialism. With this new ideology, the

government tightened controls over the private sector and acquired a number

of enterprises. In time, the programmes of the PNP proved costly and the

government had to resort to massive internal and external borrowing to keep

them going.

Further, in the 1960s, Jamaica was one of the worlds top producers of bauxite.

However, a decline in demand for Jamaican bauxite and alumina and a

government-imposed levy compounded difficulties being faced by the PNP


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government. As a result of the levy, taxes increased sixfold. Alumina production

costs rose by US$30 per ton and made Jamaica, which was one of the worlds

lowest-cost producers, into one of the highest.

(2) Economic Growth Declines

The period 1972-80 averaged negative growth in G.D.P. compared to an

average in excess of 6% in the 1960s. This coincided with Governments

increased share of G.D.P. Other key economic developments were:

Unemployment climbing to 27.9% of the labour force; and Inflation in the period 1978-80 rising to 49%.

According to Lalta and Freckleton (Caribbean Economic Development- The first

Generation), it was during the period (1972-76) that Jamaicas economic crisis

became entrenched.

(2.1) Factors Behind Economic Downturn

A number of factors were cited as being responsible for the economic

difficulties. Some of these were external and included:

Rising oil prices as a result of two oil shocks in 1973 and 1979; Declining terms of trade, for example, while Jamaica experienced higher

rates of inflation than its trading partners, the exchange rate remained fixed

making exports more expensive;

Increasing debt service payments as a result of the growing public sectordebt obligations; and

Declining net capital inflows as a result of political violence and repatriationfears.

The internal factors identified were:


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Structural imbalances manifested in the dependence on imports, aconcentration of exports (bauxite and alumina) and production issues such

as obsolete technology which limit the growth of exports;

Domestic policies e.g. large money wage increases between 1973-76 andexpansionary monetary and fiscal policy fuelled by the bauxite levy that

resulted in inflationary pressures.

(3) Enter the International Monetary Fund (IMF)

(3.1) The First Phase of IMF Policy Measures

With the deepening of Jamaicas balance of payments woes and a worsening

of its FX reserve position, Jamaica had no choice but to enter into a Stand-by

Agreement with the I.M.F. in July 1977. The arrangement was, however,

terminated when the fiscal performance test was failed in December of that

year despite the fairly lenient terms set out by the IMF.

In 1978, new policy measures were implemented. The months following this new

arrangement defined a new era in Jamaica. There was continued economic

downturn with most of the performance standards not met. The country

experienced unprecedented levels of political violence, and social instability

that resulted in massive human and capital flight. The program was terminated

in 1980.

(3.2) A Change in Government

The Edward Seaga Administration came to power in October 1980 and

managed to arrange (under very favourable terms and conditions) a 3-year

Extended Fund Facility in 1981. This facility and a World Bank structural

adjustment loan in 1982 made up the new structural adjustment program. The

program was aimed at the liberalisation of the economy and the diversification

and expansion of exports.


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However, despite what has been described as favourable arrangements,

Jamaica failed the September 1983 I.M.F. performance test and as a result had

to implement much more rigid adjustment measures.

Another stand-by agreement came into effect in 1984 followed by another in

July 1985. On the heels of three subsequent failed tests, it came as no surprise

when the program was suspended in September 1985. The relationship with the

IMF did not resume until 1987 and continued up to 1995. The PJ Patterson

government has since vowed not to enter into any other arrangements with the

IMF.

(4) Structural Adjustment in Context

Structural adjustment in Jamaica can be broken down into three (3) important

periods. These periods, 1977 to 1980, 1984 to 1986, and 1989 to 1992, were

characterised by severe deflationary policies (i.e. policies aimed at reducing

general price levels) in the system.

First Deflationary Period: 1977-80In this first period, the IMF agreements included steep devaluation, wage

guidelines, deregulating prices and large tax increases. However, despite

massive price increases, a sharp fall in real wages, a decline in real

consumption and a shift in distribution of income from wages to operating

surpluses, the economic growth remained flat.

Specifically, real GDP continued to stagnate, the overall current account

deficit widened and fiscal expenditure and fiscal deficit continued to grow.

The latter has been blamed for IMFs suspension of the second Standby

Agreement at the end of 1979.


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Second Deflationary Period: 1984-86In 1981, the new JLP government secured funding under very favourable

conditions from the IMF. The loan was equal to 430% of Jamaicas IMF quota.

The optimistic and unrealistic projections of the IMF led the World Bank to

conclude that political considerations were more important. Between 1981

to 1984, the IMF loan was accompanied by other official loans and grants

totalling US$2.1b.

The growth projections for the 1981 IMF Agreement were not met. The

production of bauxite (Jamaicas principal export), sugar, and bananas were

disappointing compared to projections. Government expenditure that was

projected to decline from over 40% to 30% of GDP by 1983/84 did not budge.

The overall public sector deficit, programmed to decline from over 15% to

10% of GDP, instead increased to over 19%. According to one study, The

easy availability of finance delayed the pressure for structural adjustment.

In March 1983, it was finally accepted that the targets would not be met and

the programme was terminated in September.

Following on this failure, the IMF Agreement in 1984 had extremely harsh

measures. These included:

The lay-off of approximately 20,000 public sector workers in one year A large devaluation, huge tax increases, high interest rates A reduction of bank liquidity Targeted reduction of the fiscal deficit from 19% to 7.5% in one year. These

targets were not met and by 1986, Jamaica broke off ties with the IMF.

Third Deflationary Period: 1989-92The year 1987 saw an upturn in the Jamaican economy. This was attributed

to:

An improvement in the terms of trade;


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A sharp fall in oil prices; The stabilisation of the exchange rate; and The closing of the fiscal gap

Real GDP grew by 5.7% and the trend was expected to continue in the

following year. Major economic dislocation caused by Hurricane Gilbert in

September 1988 killed these expectations. The overall public sector deficit

grew from 5.4% to 13.3% of GDP. This was blamed on low utility revenues as a

result of the hurricane damage. Other consequences included a surge of

demand for FX and insurance reflows were less than anticipated. As a result

in 1989, the country faced a fiscal bind. The IMF Agreement was cancelled in

September.

Sector Estimated Damage (J$)

Electricity Services $580 million

Education $388 million damage to schools

Health $75M to repair health & hospitals

Agriculture $1.3 billion

Tourism $20 and $236 million to airports and hotelsrespectively

Water $60 million

Exhibit 8Damage by Hurricane Gilbert, September, 1988 (Jampress News Release, Sept 26, 1998)SOURCE: Carl Stone, The Run-Up to Elections, Chapter 5, Politics versus Economics, 1989 (Stephensons LithoPress Limited, 1989), Figures extracted from ps. 98 - 101

After the cancelled agreement, another period of severe stabilisation began.

This included a target to reduce the fiscal deficit by 6.5% in one year, high

interest rates, a continuation of wage guidelines, new taxes including a payroll

education tax, and a removal of subsidies causing basic food prices to increase

up to 50%.


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Again, the performance test conducted in March 1990 revealed that some

targets had not been met. In particular, the net international reserves fell short by

US$7m. In March 1991, with the economy growing by an average of 2.5% over

the latter part of 1990 and early 1991, Jamaicas fortunes turned and the

performance tests were passed fairly comfortably.

In June 1991 a Standby agreement was entered into followed by a 3-Year

Extended Fund Facility in December 1992. There was some dispute as to whether

or not Jamaica had passed the IMF test of 1992. For the year, inflation was over

40% and the growth rate, a mere 1.5%. Further, during the year, there was steep

devaluation with the Jamaican dollar trading as high as US$1 to J$30. Through

the intervention of private sector interests by selling additional FX into the system,

the rate at year-end was US$1 to J$22.96.

(5) Summary

As outlined then, it was structural adjustment in 1981 that called for the

liberalisation of the Jamaican economy. The actual process of financial sector

liberalisation commenced in 1985 and is thoroughly examined in the next

chapter.


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CHAPTER 5

Liberalizing the Jamaican Financial Sector

During the past decade, there has been a distinct world-wide trend towards

financial liberalisation. Both developed and developing countries have seriously

considered and extensively adopted various measures to this end.

Dr. Samuel Shieh, Delicate Art of Monetary Policy, 1 September 1996.

(1) IntroductionThis chapter reexamines the actual process of financial sector liberalisation in

Jamaica. The two (2) phases taking place up to 1992 and new banking

regulation and other legislation introduced by year end are discussed. Further,

liberalisation measures introduced in 1992 to 1995, and deregulation in Japan,

and the background to its the ensuing banking crisis complete this chapter.

(2) Structural Adjustment Defined

According to Lalta and Freckleton, Caribbean Economic Development The

First Generation, a structural adjustment package refers to a set of programmes

and policies designed to diversify a countrys economic base so that it is able to

respond effectively to changes in internal and external market conditions.

Structural adjustment programmes introduced in Jamaica were as a result of

domestic policymakers and the IMF realizing that reversal of economic decline

and achievement of viability of balance of payments required structural

changes in the economy. One of the ways in which this could be achieved wasthrough the process of economic liberalisation.

(3) The Objectives of Liberalising the Jamaican Finance SectorFinance sector reform was aimed at eliminating distortions and inefficiencies that

impacted negatively on the efficient allocation of resources in the sector.By


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Liberalising the Jamaican Financial Sector

effectively dealing with these elements and making the financial intermediation

more efficient, economic growth could take place at a much faster pace.

(3.1) Liberalisation ObjectivesThe First Phase

The first phase of financial reform in the Jamaican context (commencing in 1985)

was primarily focused on:

The separation of monetary and fiscal policies; The elimination of market distortions in the financial market in allowing for the

free interplay of market forces in determining interest rates and allocating

financial resources; and

Promoting the development of more efficient financial intermediation.

The Separation of Monetary and Fiscal PolicyThe entanglement of monetary and fiscal policy affected the BOJs ability to

manage money and credit in line with the structural adjustment programmes

of the IMF. This was as a result of the existence of asset ratios credit ceilings,

sectoral credit allocations, and interest subsidies previously alluded to. These

management tools distorted credit allocation and the interest rate structure

by pushing up rates on loans to the private sector in order to compensate low

rates to the public sector.

The situation was compounded by the fact that the means to these funds

the liquid assets ratiopresented a captive market to the public sector and

in doing so retarded the development of the capital markets and imposed a

quantitative credit restraint to the private sector.

By separating the two, government could have greater clarity in its

management of the economy. In particular, with greater emphasis on

monetary policy, open market operations by the Central Bank would

become the mainstay in the management of liquidity in the system. Under


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open market operations, credit allocation would not biased by giving priority

to certain sectors and the interest rate.

Freeing-up the Interest Rate StructureLiberalisation of the interest rate structure was an important aspect of the

reform program. This would pull in more savings from abroad and significantly

boost foreign investment and ultimately contribute to economic growth. The

main emphasis was on removing the floor rate on savings deposits and

allowing commercial banks to set their own rates.

Making Financial Intermediation More EfficientThe predominance of non-financial instruments in the Jamaican financial

sector, namely credit ceilings and asset ratios was discussed. It was noted

that with credit ceilings, some banks were circumventing the restrictions by

shifting a part of their portfolios to non-bank affiliates. This made for inefficient

financial intermediation as the practice ran counter to governments policy

and intentions. While government would have been seeking to limit credit

expansion, commercial banks were surreptitiously doing the opposite.

Financial reform to ensure the proper evaluation, monitoring, and supervision

of financial intermediaries would, in essence, eliminate these distortions.

(3.2) Objectives of the Second Phase

The FX MarketThe main objectives of the second phase of liberalisation were to facilitate a

more orderly FX market and promote its development. A more orderly

operation would lead to magnified flows of FX into the formal system and

greater stability in the exchange rate.


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(4) The First Phase of the Liberalisation Process

Focus on Monetary PolicyThe gradual reduction of the liquid assets ratio of the commercial and

merchant banks commencing 1986 was a part of the first phase of the

liberalisation process. This reduction continued until 1990.

COMMERCIALBANKS

LIQUID ASSETSRATIO (%)

MERCHANTBANKS:

LIQUID ASSETSRATIO (%)

1985

01/05/86

26/03/87

27/01/88

24/02/88

24/03/88

01/07/89

01/04/90

01/05/90

01/11/90

01/07/92

15/06/95

48

44

35

30

25

20

20

25

27.5

32.5

50

47

1985

01/05/86

26/03/87

27/01/88

24/02/88

23/03/88

01/07/89

01/04/90

01/05/90

01/11/90

01/12/90

01/01/91

01/10/91

01/05/92

01/07/92

01/10/9201/01/93

01/04/93

01/07/93

01/09/93

01/08/95

01/11/95

25

20

18

13

9

5

4.5

7.5

7.5

8

8.5

9

9.5

11

12

1314

15

16

17

20

25

Exhibit 9Liquid Assets Ratios for Commercial and Merchant Banks 91985 to 1995)SOURCE: Bank of JamaicaThe Statistical Digest

As is evident in Exhibit 9, however, reduction of the liquid assets reserve ratio was

not sustained and was, over time, brought back to pre-reform levels. In addition

to a reduction in liquid assets ratio, the non-cash portion was phased out over

time. In 1984, the cash reserve ratio stood at 5% and by 1985 it had increased to

20%.


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The Use of Treasury Bills and other InstrumentsBetween 1985 and 1991, treasury bills became increasingly significant as a

financing instrument with the elimination of the non-cash portion of the

reserve requirements. Treasury bills were used to finance the public sector

deficit.

Also, in 1991, Reverse Repurchase agreements were introduced to provide

the BOJ with more control over the money supply. Simultaneous with the

introduction of these instruments was an initiative by the BOJ to create a

secondary market in Government of Jamaica/BOJ Securities.

Liberalising the Interest Rate StructureThe introduction of a more market-determined interest rate took the form of:

The BOJs introduction of a market-determined interest rate on Certificates ofDeposit in November 1985;

The linking of the savings deposit rate to the average weighted term-depositrate of the commercial banks (the floor on the savings deposit rate was

removed in October 1990).

Improving Efficiency of Financial IntermediariesIn order to promote more efficient financial intermediation, the BOJ

embarked on a comprehensive review of the Bank of Jamaica Act, the

Banking Act and the Protection of Depositors Act. This was aimed at initiating

reforms where necessary. In 1992, the revised versions of these Acts were

passed into law.


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(5) Banking Reform

Legislation introduced to ensure the sector was able to cope and continue to

foster and support the development of the Jamaican economy. (see Appendix

2)

Overdraft FacilitiesUp to the early 1990s, many companies borrowed by way of overdraft. This

was a very expensive form of funding. Here it was contemplated that heavily

indebted, under-capitalised companies be encouraged to service debt

more regularly by converting overdrafts to fixed term loans. This form of cash

flow lending placed serious pressures on the cash flow of companies.

Interest on Non-Performing LoansWhere interest on non-performing loans was concerned, the amendments

required reversal of interest accruals from income where payments were

three months in arrears. This significantly impacted the profitability of banks.

Limitation on Lending to Connected PartiesLimitation on lending to Connected Parties also hit bank profits hard. Whereas

before the banking sector made loans without regard to connectivity, this

legislation that took a very broad view of the definition of connected party,

added a new dimension and significantly curtailed lending activity.

In addition, the power of the Minister of Finance was further enhanced allowing

the Minister to take action where there was evidence of a threat of unsafe or

unsound banking practices. This included cease and desist orders, temporary

management of a licensee, suspension of licence, as well as, the revocation of a

licence or the liquidation of a licensee in instances of unsound practices.


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To further enhance the capacity of the BOJ to effectively monitor and supervise

the financial system, the Department of Supervision of Banks and Financial

Institutions was upgraded and strengthened with the primary objective of

promoting the stability of the financial system.

(6) Regulation of the Securities Industry

In 1992 also, the Securities Act was introduced. Through the Securities

Commission, this was designed to regulate the stock exchange, trading in

Government debt instruments, the developing mutual fund market and

formalising a system to monitor the growing stock of IOUs.

Changing securities legislation in liberalised markets was not unique to Jamaica.

For example, in Thailand, where the process of liberalisation began in the early

1990s, the Central Bank (the Bank of Thailand) introduced the Securities and

Exchange Act to facilitate the development of the capital market.

(7) The Second Phase - FX Liberalisation

The Introduction of A and B AccountsFX Liberalisation in July 1990 saw the removal of relevant sections of the

Exchange Control Act that restricted the operations of foreign currency

accounts by residents and non-residents. This meant commercial banks

could, from then onwards, accept foreign deposits accounts designated A

and B in keeping with certain guidelines. (see Appendix 2). This was an

aspect of the process of external liberalisation where foreigners had freer

access to Jamaicas financial markets (in particular the money markets).

A accounts were denominated in foreign currency, while B accounts

were converted to a domestic currency equivalent, but attracted a local

currency interest rateapparently with exchange rate risk in mind.


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The Inter-Bank FX Trading SystemThe Inter-Bank Trading System was introduced in September 1990 and

involved the merger of the official and forward markets. This new system

which was operated by commercial banks on behalf of the BOJ, was

designed to stimulate the FX competitive market free of government

influence. In essence, each commercial bank was authorized to set its own

rate and act as clearing house forFX transactions.

Two exchange rates prevailed. The spot market related to all transactions

completed in two working days, while the forward market related to

transactions taking in excess of five working days. Commercial banks were

free to dispose of all their purchases except a specified amount (25%) that

went to the Central Bank.

With the Inter-Bank Trading System, exporters sold their FX to commercial

banks at negotiated rates. This was particularly beneficial to traditional

exporting industries (bauxite, agriculture and tourism). Despite all these

changes, however, restrictions still existed, as bidders on FX required proof of

purchase or order and approval from the BOJ or a commercial bank.

With FX liberalisation in train, the slide in the value of the Jamaican dollar

continued. In fact, the Jamaica Bankers Association (JBA) introduced new

operating rules on 1 June 1991, which were designed to slow the

depreciation in the exchange rate and encourage a more efficient FX

market. Within these new rules, commercial banks set their own rates within apredetermined range on a daily basis.

Final Removal of the Exchange Control ActPrior to 25 September 1991, some of the remaining aspects of exchange

controls were:


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The requirement that non-residents gain exchange control approval beforepurchasing real estate;

Limits on current account transactions such as vacation travel and businesstravel;

BOJs claim to FX proceeds from identified exports; The need to gain ministerial approval for investment inflows. Restriction of FX trading to Authorised Dealers - chiefly commercial banks1.

After 25 September 1991, the decision was taken to remove the remaining

aspects of exchange controls. This essentially meant foreign and domesticcurrencies became interchangeable as the accepted medium of exchange.

The removal also had significant implications for Jamaicas current account

(trade in currently produced goods and services) and capital account

(difference between domestic outflows and foreign inflows on asset

purchases).

The Process of External LiberalisationThe introduction of A and B accounts described earlier allowed non -

residents to access the Jamaican financial markets with greater freedom;

while the removal of the restrictions of foreign inflows opened up foreign

markets to Jamaicans. For the first time, Jamaican entities could borrow on

the international market with relative ease as long as certain criteria (specific

to the lending institution) were met.

(8) Further Liberalisation Measures (1992 to 1995)

Repealing the Exchange Control ActIn April 1992, it was announced that the Exchange Control Act was to be

abolished once and for all. This was important, as even though the provisions

1See Appendix 3A


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of the Act were removed, Government still had right to impose restrictions at

any time as the law was still on the books. The removal of the Act meant that

once and for all there was no restriction on movement of FX in Jamaica. In

August 1992, the Exchange Control Act was repealed (see Appendices 3B).

Continued Development of the Financial MarketsIn 1993, the BOJ continued with its initiative to develop the financial markets.

Special emphasis was being placed on the secondary market for GOJ/BOJ

instruments. This included increasing the range of instruments that could be

used in Repurchase agreements (REPOS) and the removal of the limit (2 per

month) to the number of REPOS that could be granted to each financial

institution per month. In a REPO arrangement, the BOJ contracts to inject

liquidity into the system via holders of securities.

Reverse REPOS where holders of securities contract to purchase instruments

from the BOJ and resell them to the BOJ at some point in the future also

became popular.

The BOJ was committed to the strengthening of a secondary market for

securities for the following reasons:

Better transmission of monetary policy measures through the economy andthus improvement in the effectiveness of monetary policy;

Easier portfolio adjustment by financial institutions thus reducing reliance onthe central bank to adjust their liquidity position;

An opportunity for further institution building in the financial sector; The development of a genuine market-based pricing.


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Foreign Currency InstrumentsAnother major development in the financial markets was the diversification to

include transactions in foreign currency instruments. In September 1993, the

Government of Jamaica placed on the market a US$20M bearer bond issue.

This bond issue was a means of obtaining foreign currency financing, while

simultaneously introducing a new financial instrument to the local money

market.

The Introduction of Primary DealersFollowing on the introduction of reverse repurchase agreements by BOJ

(mentioned in Chapter 4), it sought to further develop the financial markets

by establishing a group of primary dealers in April 1994 to provide

underwriting support for all new Government of Jamaica securities and to

provide secondary market liquidity.

This move was an important step as the BOJ sought to lengthen the maturity

of securities issued in the market. Candidates for primary dealer status had

to demonstrate strong characteristics of being market makers. Seven (7)

dealers were initially chosen.

New Authorised FX Dealers and The Introduction of CambiosFurther liberalisation of the FX market was designed to improve the volume of

FX flowing through the official system. This involved the introduction of new

authorised FX dealers and Cambios/Bureau de Change system in 1994.

The introduction of a network of Cambios/Bureau de Change in the rural and

tourist areas was particularly important. This expansion would unify the

exchange rate, increase the volume of FX flowing into the official system,

provide the basis for dealing with tourist harassment and illegal FX trading,

and increase efficiency in the market.


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Cambios

No. of Cambio applications 153

No. of applications approved 139

Cambios in operation 63

Cambios not in operation 76

No. of application pending 13

Application rejected 1

Bureaux de ChangeNo. of Bureaux applications 95

No. of applications approved 92

No. of applications pending 3

Exhibit 10The Status of Applications and Approvals of Cambios and Bureaux de ChangeSOURCE: Bank of JamaicaAnnual Report 1994

PURCHASES FROM CAMBIOS/BUREAUX de CHANGE

BY BANK OF JAMAICA (US$M)1994

Apr

1.05

May

1.75

June

5.21

July

26.84

Aug.

35.20

Sept.

34.40

Oct.

19.35

Nov.

2.96

Dec.

28.03

Total

179.79

Exhibit 11Purchases from Cambios/Bureaux de ChangeSOURCE: Bank of JamaicaAnnual Report 1994

The introduction of Cambios/Bureau de Change was significant in that by the

end of the first year, they already controlled 14.6% of the official flows into the FX

market. The other 85.4 %, of course, being controlled by authorised dealers. The

increased competition, in time, negatively affected the profitability of these

dealers.


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(9) Deregulation of the Japanese Financial System

After the first oil shock, some of the basic structural features of the Japanese

financial system began to unravel. First, the recession of the 1970s led to the

government to a large-scale issue of deficit-financing bonds. This resulted in the

development of the bond market, as the government had to lower the

restrictions on dealings in bonds to make them more marketable. The recession

also led to corporations investing their funds in securities firms repurchase

agreements. These agreements had not been included in the interest rate

regulation law.

With the option offered by these securities firms, banks began losing their

corporate customers and as such started to lobby for a interest-free instrument

themselves. This developed into a confrontation between banks and securities

firms. This was similar to the situation in Jamaica, where unregulated financial

institutions were able to offer repurchase agreements at much higher yields to

investors and the funding was not subject to reserve requirements.

The deregulation of the Japanese financial system brought about changes to

the features of indirect finance and bank dominance was also affected. The

revision of the Foreign Trade Law in 1980 and a relaxation of restrictions on

financial transactions in international financial markets led to an increase in bond

issues by Japanese firms in Europe. This was a part of Japans process of external

liberalisation.

The process resulted in a movement of corporations away from financingthrough banks and towards direct means of financing. Again, unregulated

institutions in Jamaica through IOUs offered a similaroption to corporations.


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Japans economic backgroundThe period from 1963 to 1973 when deregulation started was a high growth

period for Japan with growth rates average about 10%. During this period, its

trade balance averaged out at zero. Japans growth in this period was not

fuelled by external borrowing but from an internal drive supported by the

diligence and a collective sense of direction toward prosperity for her

people.

In the years following, 1974 to 1982, the world was bothered by the oil crises

and Japans growth rate was reduced to 5% with its trade balance still

averaging out at zero. Over the period 1983 to 1990, a huge trade surplus

was built up by Japan but growth rates remained between 3 and 5%. Over

this third period, Japans strength was such that even with the erosion of its

wealth as a result of ballooning surpluses, a relatively strong growth rate was

maintained. This erosion, however, in due time took its toll.

Economic Instability in the Early 1980s to 1995While the process of deregulation was in progress from the early 1970s,

developments a decade later asked serious questions of the process.

In the early eighties, the United States was emerging from a period of very

high inflation and was positioned to grow economically. Two important

factors appeared on the world economic scene that ushered in the global

economy as experienced today:

The borrow and spend policy of the Reagan administration which expandedthe American trade deficit enormously and thus introduced the era of

worldwide capital flow; and

The emergence of Japan as the major lender of the world who supplied thecapital desired by the United States of America.


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As a consequence of the introduction of these factors America imported,

borrowed, and spent into prosperity; while the dollar was kept strong by very

high real interest rates due to the relentless appetite of the American

Government to access the financial market to borrow funds. This strong US

dollar stifled the manufacturing sector and resulted in a complete turnaround

by the Reagan administration.

The Plaza AccordAt a meeting between America and other industrialized nations, now known

as the Plaza Accord, an enormous devaluation of the dollar against the yenwas engineered. This resulted in a sharp fall in the value of the dollar from

around 250 yen per dollar, to around 125 yen per dollar by the beginning of

1988.

Japans ReactionAfter the Plaza accord, Japan was urged to stimulate domestic consumption.

As the Japanese economy grew domestically, Japan moved to have

savings spent internally, which resulted in less capital outflow and less trade

surplus for Japan. The consumption boom was not able to keep pace with

the monetary expansion due to the everlasting meddling of Japanese

authority over the markets and also due to the existence of various trade

barriers to retard the free flow of imports.

The Economic BubbleThe excess cash resources flowed into equities and real estate causing prices

to climb to dizzying heights; thus, the infamous Japanese economic bubble

was formed.

Concerned about the consequences this enormous bubble and the reckless

lending of Japanese banks induced by the bubble mentality, the


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Japanese authorities took corrective measures in 1990 that resulted

Japanese economy falling abruptly. With this fall, capital flowed out of

Japan like it did previously and the trade surplus expanded in line with this

development. The authorities were to find that they were late in acting as in

1995, the bubble economy came home to roost.

(10) Summary

The foregoing sections outlined the liberalisation process in Jamaica and also

looked at the experience in Japan. Jamaica as was seen, embarked on a

radical process designed to free both internal and external markets. The resultwas radical change in the Jamaican financial sector, which culminated in its

eventual ruin. The following chapter details the persistence of macro-economic

instability and the changed financial system.


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CHAPTER 6

The Economic Environment and the Financial Sector

(1992 to 1995)

(1) Introduction

Chapter 6 examines the economic environment and developments in the

financial sector from 1992 to 1995. The bad debt crisis experienced in Korea and

Japan are discussed with particular emphasis placed on the Japanese

experience. The chapter provides important insights into the looming crisis in the

Jamaican finance sector.

(2) Post-Liberalisation Trends (1992 -1995)(2.1) The Persistence of Macro-economic Instability

By 1995, the formal liberalisation process had essentially run its course. However,

the programmes that were designed to improve the allocation of resources and

to spur economic growth were being blamed for the economic ills being faced

by the country.

In particular, interest rate policy was erratic with the overall level of rates in the

system remaining at very high levels; treasury bill rates climbed to as high as just

under 40% and to compound the situation, inflationary pressures remained high,

thus ensuring the persistence of financially repressive conditions. For example,

inflation rates, while declining from just over 40% in 1992, averaged in the high

twenties over the period, resulting at times in a negative real rate of interest to

investors.

FX inflows were redirected from the official to the informal market and the

liberalisation of the FX market did little to stabilise the rate of exchange. This was

manifested in the drastic movement in the exchange rate from US$1 to J$23.01

at the end of 1992 to US$1 to J$35.54 at the end of 1995. The high interest rate


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The Economic Environment and the Financial Sector 1992 to 1995

Year Growth (%) Contribution (%)

1987 9.3 6.8

1988 16.9 7.8

1989 20.6 8.8

1990 10.5 9.3

1991 19.4 11.0

1992 8.0 11.7

1993 -6.6 10.7

1994 49.9 15.9

1995 -2.2 15.5

Exhibit 12Rate of Growth and Percentage Contribution of Financial Sector to GDP atconstant 1986 PricesSOURCE: Bank of JamaicaThe Statistical Digest

The Commercial and Merchant Banking SectorsCommercial and merchant banks experienced the greatest expansion within

the sector. From a total number of 18 with total assets of JA$8.9b at thebeginning of the mid-1980s, the sectors expanded to a total of 41 with assets

in excess of J$64b by the early 1990s. The percentages below paint the

picture.

COMMERCIAL BANKS MERCHANT BANKS

1994 1993 1992 1991 1990 1989 1994 1993 1992 1991 1990 1989

RAG (%)* 54 32 70 60 13 22 36 2 73 30 22 33

RDG (%)* 50 38 88 47 19 10 4 11 98 9 12 23

RAGRate of Asset GrowthRDGRate of Deposit Growth

Exhibit 13Rate of Asset & Deposit Growth for Banking SectorSOURCE: Bank of JamaicaAnnual Report 1994


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Commencing in 1992/92, merchant banks grew because of the low capital

base requirements2, the lack of supervision from the regulatory bodies, and

the rapid expansion of unsecured credit (IOUs) to commercial entities and to

a lesser extent, individuals, commencing in 1991/1992. In addition to the

advantages cited, the liquid reserve requirement was lower for merchant

banks than it was for commercial banks.

Financial Institutions DiversifyFrom even before the early 1990s, Jamaican financial institutions embarked

on a path well known to their counterparts in other countries. They began tomove away from their core businesses. Popular areas of departure were

agriculture and real estate development (hotels and residential homes). The

National Commercial Bank, for example, invested heavily in agriculture such

as the growing and exporting of papayas to the North American market. This

was in part based on government initiative to have companies, especially

those over which it had some control, become involved in projects that could

contribute to national development.

Additionally, the concept of financial supermarkets became

commonplace as entities such as the Eagle Group expanded rapidly into

insurance and commercial banking. Eagle, which commenced operations as

a merchant bank, also owned a unit trust, a stock brokerage and a building

society. This form of structure, while helping with efficiency and allowing

rapid expansion, was to prove deadly in time to come.

Diversification in a competitive environment brought about by liberalisation is

sometimes necessary for survival. In the South Korean example, diversification

2Merchant Banks JA$5M, Commercial Banks JA$40M up to 1992: JA$25M and JA$80M

respectively, after 1992


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was permitted by Revised Banking Acts but along more stringent lines than

those seen in Jamaica. For example, banks, inter alia, were allowed to:

Underwrite corporate bonds for private placement; To lead manage underwriting of public and government bonds; Handle some long-term financial business such as housing loans; and to Issue debentures that were only previously issued by long-tern financial

institutions.

Profitability DeclinesThe years 1993 and 1994 saw banks making supernormal profits, to the extentthat in 1994, a surtax (discussed below) was levied by the Minister of Finance,

Dr. Omar Davies. To give a better appreciation of the level of profitability,

profits made in the first half of 1994 were almost equal to that made in all of

1993 which was a record year.

In essence, banks were operating very high interest spreads that were not

being passed on to savers. While this was true, the gains made by

commercial banks from FX trading in the newly liberalized market were also

enormous. Additionally, as the secondary market for trading in government

securities grew, merchant banks began trading heavily in derivatives.

Countries such as Thailand and South Korea like Jamaica, both experienced

increased trading in derivativesalbeit in more sophisticated forms.

In the Jamaican context, this essentially entailed issuing repurchase

agreements against underlying government securities. This form of newactivity added to the bottom line, but, in time, became a dangerous

practice as some players sometimes issued multiple agreements against the

same set of securities with the market not being rigid in having u

Financial Sector Liberalisation in Jamaica

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