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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: .Accessed: 10/06/2014 19:52

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




    James W. Dean


    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


    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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    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


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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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    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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    or in local-currency denominated bonds. Thus the central bank of Brazil, for

    example, would take over the foreign debt of a Brazilian firm in return for

    payment in cruzeiros or cruzeiro-dominated securities. The rationale was that

    the country's foreign debt became solely a public sector or "sovereign" obliga

    tion, therefore permitting the government to negotiate from strength with its

    creditors. A related consideration was that private sector generators of foreign

    exchange might find it in their interest to pay foreign creditors more fully than

    the government deemed to be in the national interest. The assumption of debt

    obligations by the central bank was therefore made much easier if it was accom

    panied by foreign exchange controls.

    In the context of considerable domestic inflation and currency-deprecia

    tion, the long-run consequence of governments' assuming of foreign currency

    liabilities has been that they have been left holding greatly depreciated claims in local currency as assets. (The BOJ practice of borrowing foreign exchange on behalf of importers was a short-term example of this.) Except to the extent

    that the consequent gap between assets and liabilities is met by taxation, it has to be met by issuing domestic government debt. Moreover, governments or

    their central banks typically finance repayment and retirement of their foreign debt by further increasing their domestic debt. As a result, the excessive exter

    nal debt that burdened so many developing countries in the 1980s has typi

    cally been replaced by excessive internal debt in the 1990s. Jamaica, with mas

    sive outstanding government debt, debt service payments and fiscal deficits, is a prime example.

    Monetary policy in Jamaica has long been captive to fiscal policy, an

    inevitable by-product of the country's British legacy of a weak central bank

    subordinate to the financing requirements of the Department of Finance. Al

    though the reasons for excessive monetary creation were varied, a core cause

    was the BOJ's penchant for purchasing government debt and issuing deposits to the government in return: these latter then became part of the monetary

    base. Thus as the fiscal deficit expanded, so too did the money supply. A

    secondary cause was the inflow of capital from abroad, first as generous bilat

    eral and multilateral lending to the Seaga government, and then as insurance

    and other resource transfers from abroad after the hurricane of 1988. These

    capital inflows typically were not sterilized; rather they added to the monetary base. The inflation rate jumped from 8.5% in 1988 to 17.2% in 1989, and the

    Jamaican dollar began to depreciate sharply. Partly also as a result of capital

    inflows, the exchange rate had appreciated from 1987 to 1989. By 1990, de

    spite nominal depreciation, it was still overvalued in real terms.

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  • Can Financial Liberalization Come Too Soon? 53

    Finally, Jamaica's banks, credit unions, and insurance companies were

    under-capitalized, under-supervised, and under-regulated. In fact the oversights were legion, far too extensive to be documented here. For example, regulations

    governing entry and capitalization by merchant banks and by credit unions were casual in the extreme. In the case of credit unions, they dated back to the 19th century. Regulations governing cross-lending between banks and mer

    chant banks were also excessively lax or not enforced, partly because directors

    could not be held liable for bad debts. Moreover government had extremely limited powers to assume control of a financial institution whose management

    was clearly incompetent or corrupt. Deposit insurance did not exist. In the

    context of macroeconomic instability and an overvalued exchange rate, Jamaica's

    financial institutions were ripe for a roller-coaster ride from quick profits to


    When deregulation of interest rates and capital controls came in 1990, the initial consequence was sharp depreciation of the Jamaican dollar. This

    then fuelled inflation and led to further depreciation. The Bank of Jamaica was forced to respond with sharp increases in interest rates in order to attract

    short-term capital from abroad and in order to arrest spiralling inflation, which

    by 1991 had reached 80.2%. In order to fund its rapidly expanding deficit, the

    Bank of Jamaica issued ever-increasing quantities of treasury bills, which drove rates up further, as high as 50% by mid-1992.

    Commercial banks were (and still are) burdened with a 25% primary (cash) reserve requirement as well as a secondary requirement to hold 22-28%

    of their assets as treasury bills. The latter became an extremely lucrative source

    of income as t-bill rates climbed above 40% per annum. One consequence was

    that, "comforted" by this income, some of the banks became overly casual about

    the rest of their portfolio, extending uncollateralized loans and failing to pur sue arrears. As these arrears became public knowledge, a later consequence

    was a "flight to quality" by depositors, who moved their money to the larger

    indigenous banks as well as the three foreign banks. Two of the latter enjoy well established rural branch networks and stable, low-cost deposit bases, and

    became "money-machines" at the same time as many of the indigenous banks

    suffered from disintermediation. The woes of the indigenous banks were some

    times shielded from scrutiny by the BOJ and Ministry of Finance because of

    their ability to shift non-performing assets to merchant banks or building soci

    eties with which they were allied. Finally, when monetary contraction had

    became the order of the day, classic "moral hazard" and "adverse selection" set

    in: banks dependent on interest-sensitive deposits, handicapped by the 25%

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    cash reserve requirement, under-capitalized and over-assured by the BOJ's fre

    quent "loans-of-last-resort," began to extend loans at extraordinary interest

    rates to borrowers of dubious quality.

    By early 1997, after the failures in 1994 and 1996 of a small merchant

    bank and a medium-sized commercial bank, and with the country's insurance

    companies in liquidity crisis, the government had established a sort of resolu

    tion trust called the Financial Sector Adjustment Company (F1NSAC), and

    had committed itself to a J$6.3 billion aid package for the financial industry. In

    addition, the Minister of Finance drew up a comprehensive "fast-track" bill for

    re-regulating financial institutions.


    Fiscal restraint

    The government's most immediate challenge is to reduce its fiscal deficit. Unless it can do this, pressures to print money will prove irresistible, and the painful sequence of double-digit inflation followed by double-digit interest rates will recur. The Ministry of Finance finds itself in the unenviable position of antici

    pating that upwards of 80% of its anticipated revenues for 1997-98 will be

    absorbed by debt service. Meanwhile, certain public expenditure programmes,

    notably education, have been squeezed to a point that severely undermines the

    country's future.

    Fiscal restraint can be achieved by increasing revenue, by reducing debt

    service payments, or by reducing current and capital expenditure. There would seem to be considerable scope in Jamaica for broadening the tax base without

    increasing tax rates. Part of this could involve better collection and enforce

    ment, and closing loopholes. Part of it should also involve an overhaul of the

    external tariff and duty system. Duties on price-inelastic and income-elastic

    imports ? luxuries like high-priced automobiles

    ? should be raised or at least

    enforced, whereas those on price-elastic and income-inelastic imports ? neces

    sities like cooking oil ? should be lowered or eliminated. Such reforms would

    also improve the distribution of after-tax incomes.

    Debt service payments can only be reduced in the long run by using fiscal surpluses to retire outstanding debt. This ought to be one of government/s

    top priorities, though it is difficult to implement in an election year since the

    costs are immediate and the payoff is long-run. In addition the debt might be

    restructured toward the long end; long-term zero coupon bonds would be ideal

    but it is not clear that they would be saleable.

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  • Can Financial Liberalization Come Too Soon? 55

    The potential for reducing current and capital expenditure is beyond this essay's scope, except to remark once again that whereas expenditure on

    physical capital has been badly neglected, top priority ought to be given to human capital For example low-cost and highly effective motivational and educational programmes such as the Special Training and Empowerment Programme (STEP), which is targeted at high school dropouts, surely must

    yield real returns in terms of productivity and crime reduction that exceed those of most private sector projects, not to mention most government expen

    diture. Finally, there is potential for one-shot injections of revenue from

    privatization. Alternatively, government corporations such as the Jamaica Pub

    lic Service Company might be restructured with an eye to increasing efficiency.

    Exchange rate options and coping with capital flows

    In principle the ideal options for a country like Jamaica, which has lost credibil

    ity in the eyes of external investors, is to commit itself to an exchange rate

    regime that is purely market-driven and permits no role for government inter vention. Two polar regimes unambiguously tie government's hands: a currency

    board, and a purely flexible rate. The arguments in favour of each are well known. They have in common the advantage of what might be termed "auto

    maticity": that is, independence from the interfering hand of government or the central bank. A further advantage of a currency board is that, in contrast to a flexible-rate regime, it ties the country's inflation rate to an external an

    chor: in Jamaica's case the obvious candidate would be the US dollar. A step beyond a currency board would be explicit replacement of the Jamaican dollar with the US dollar, as in Panama. Such a visible regime would undoubtedly be

    perceived (wrongly) by the public at large as a disgraceful surrender of national

    sovereignty. Nevertheless dollarization is apparently being advocated by an

    important lobby group, the Private Sector Organization of Jamaica. The current Ministry of Finance is opposed to a currency board, per

    haps because the short-run consequences of surrendering control over shocks

    to money demand or money supply are formidable to contemplate. For ex

    ample, a currency board regime would force contraction of the money supply in the face of a capital outflow or withdrawal of capital inflows, with a conse

    quent hike in interest rates. Facing a massive bailout of the financial sector as

    a result of recent interest rate spikes and having just now got interest rates

    barely under control, the Ministry is understandably loath to risk another

    episode. Although it was commonly alleged after the Mexican crisis of 1994 95 that the Bank of Mexico could have forestalled devaluation by refraining

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    from sterilizing capital outflows and allowing interest rates to rise, the Gover nor of the BOM retorted forcefully in the Wall Street Journal that this was not

    an option because it would have triggered a banking crisis. Indeed Argentina,

    which has a currency board, was hard put to avert bank failures in the after

    math of the "tequila effect" that followed Mexico's troubles.

    This leaves a fully flexible rate. Although flexibility runs the danger of

    fuelling inflation, by the same token it provides a highly visible and potentially

    embarrassing signal to the outside world of the extent to which a country is in

    fact controlling inflation. In addition it provides a shield from the interest rate

    or money supply shocks that volatile capital flows can impose on an open,

    developing economy (Dean, 1996). For example the Mexico episode reinforced

    calls in some quarters for a "Tobin tax" to deter speculative capital inflows and

    outflows. A counter-argument is that speculative flows are deterred by volatile

    exchange rates. Thus if central banks would cease and desist from all interven

    tion in the foreign exchange market, including their customary short-run pur chases and sales to smooth fluctuations around the perceived "fundamental"

    rate, they would find that their dilemmas about sterilizing speculative flows

    would disappear because the speculators would stay at home.

    Hedging against shocks to the external accounts

    Whether Jamaica retains her present managed exchange rate regime or moves

    toward less intervention, she could benefit from greater employment of mod

    ern risk management techniques. These involve financial arrangements to pro

    duce gains (or losses) that offset, at least in part, losses or gains resulting from

    price, exchange rate, or interest rate volatility. Such arrangements take three

    generic forms: futures, options and swaps. For example a futures or options

    contract on the price of bauxite/alumina could be engineered to produce prof its if the price of bauxite/alumina fell, offsetting losses in export revenues.

    Another arrangement, used for example by Mexico in the early 1990s, when

    oil prices were volatile, is to issue bonds to external lenders with coupon or

    even principal payments contingent on export (oil) prices, or even on export


    Although the exchange rate, interest rate, or commodity price risk on

    any accounts payable or receivable can be hedged in principle via futures or

    options, developing countries are replete with missing markets (for example there are no traded futures and options on the Jamaican dollar). Nevertheless

    innovative techniques have been devised in recent years to bridge such missing


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  • Can Financial Liberalization Come Too Soon? 57

    External (or internal) government debt contracted at a floating rate of interest could in principle be swapped with a counter-party for payments at a

    fixed rate. Similarly, external debt denominated in pounds sterling might be

    swapped for external debt denominated in dollars; this might be desirable if most of the country's export revenue is dollar-denominated (Mehran, 1986).

    Techniques for debt management have now evolved to the point that computer

    programmes design optimally-hedged portfolios of external debt (Claessens,


    Optimal government intervention

    We conclude with brief remarks on the extent to which a government in a

    developing economy such as Jamaica's should intervene to do such things as

    create missing financial markets, allocate credit, or promote saving and invest

    ment. It is commonly argued that the Southeast Asian "miracle" economies

    achieved their rapid growth in no small part from such intervention, much of

    which runs counter to the conventional "Washington consensus" that empha

    sizes laissez faire.

    Firstly, it should be emphasized that the Asian economies, almost with

    out exception, achieved their miracles in the context of low inflation and low

    budget deficits, if not surpluses. That is, macroeconomic stability, a centrepiece of the Washington consensus, was also their sine qua non. Secondly, the Asian

    economies typically liberalized financially only in the context of realistic ex

    change rates and (fairly) well supervised financial sectors.

    Nevertheless profound differences in philosophy prevailed and continue

    to prevail between Asian economics and the Washington consensus. Several of

    these are explored in Stiglitz (1996) and Stiglitz and Uy (1996). For example, because East Asian governments have typically not run deficits, they have

    lacked markets for government securities and without that benchmark have

    been slow to develop corporate bond markets. Recently, governments in Hong

    Kong, Malaysia, Singapore, Korea and Taiwan have intervened to foster their

    bond markets.

    A question for Jamaica is whether and how the government should at

    tempt to foster direct financial markets alongside her financial intermediaries.

    Jamaica like most developing countries is disproportionately dependent on

    banks for mobilizing credit, relative to more developed economies. A related

    question is whether Jamaica should foster long-term credit allocation via devel

    opment banks. In many Caribbean and Latin American countries these be

    came sinkholes for government subsidies. Yet as Stiglitz and Uy (1996) point

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    out, in East Asia they succeeded. One lesson may be that development banks should be capitalized, owned and operated independently of government, with the latter's role limited to providing the legislative preconditions for their emer



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    Article Contentsp. [47]p. 48p. 49p. 50p. 51p. 52p. 53p. 54p. 55p. 56p. 57p. 58p. 59


    BOOK REVIEWSReview: untitled [pp. 107-108]Review: untitled [pp. 109-111]

    [Abstracts]Back Matter


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