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

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

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

    CAN FINANCIAL LIBERALIZATION COME

    TDD SOON?

    JAMAICA IN THE 199?S*

    James W. Dean

    ABSTRACT

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

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

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

    crises.

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

    wards a more competitive domestic financial sector and a more open

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

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

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

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

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

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

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

    Pp 47-59

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  • 48 SOCIAL AND ECONOMIC STUDIES

    LIBERALIZATION AND ITS CONSEQUENCES

    The political economy of financial liberalization in developing countries

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

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

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

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

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

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

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

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

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

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

    ties and real estate, and foreign direct investment.

    The spread of liberalization to developing countries was sporadic and

    often serendipitous. Small island economies were frequently induced to open

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

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

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

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

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

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

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

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

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

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

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

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

    realpolitik.

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  • Can Financial Liberalization Come Too Soon? 49

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

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

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

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

    good reasons or bad, care to favour.

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

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

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

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

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

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

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

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

    Although these trends might ultimately lead to liberalization in and of

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

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

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

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

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

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

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  • 50 SOCIAL AND ECONOMIC STUDIES

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

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

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

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

    such as a sharp incr

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