INTRODUCTION

Developed countries take macroeconomic stabilization policies for granted, developing countries cannot. Macroeconomic stabilization policies break down in developing countries because the institutions and mechanisms that make macroeconomic policy effective in the developed countries are either absent or immature. The financial systems of the developing countries are generally ill equipped to handle contemporary economic technology, especially monetary policy.

Based on its financial system structure, Jamaica is still a developing country. Although major changes in the last several years have been positive, Jamaica's financial system still lacks the breadth and depth or degree of sophistication and competition required for successful execution of monetary policies. For monetary policies to be effective they must permeate the entire financial system. In Jamaica, they do not.

The purpose of this paper is to identify remaining weaknesses in the Jamaican financial system and to propose additional reforms, which would facilitate execution of monetary policies. The first section of this paper looks at Jamaica's early post-independence history and the failure of past macroeconomic policies to prime the real economy. This second section outlines the methodology and measurement techniques for evaluating the development of a country's financial system. The third section focuses on the evolution of the structure of the Jamaican financial system to 1980. The fourth section analyzes the financial system reforms of the 1980s/early 1990s and their successes and failures. The last section advances proposals for further reform to make monetary policies more effective.

I. EARLY POST-INDEPENDENCE HISTORY: THE 1960S AND 1970S

On August 6, 1962, Jamaica shook off the last remnants of colonial dependence and became a politically independent state within the British Commonwealth of Nations. It faced its independence with high hopes for a better life. Unfortunately, the euphoria was short-lived. Less than 20 years later, at the start of the 1980's decade, the Jamaican economy was mired in stagflation. Real per capita income was less than half that recorded in 1970, inflation was almost 20% per annum, and the unemployment rate was over 25%. Capital, entrepreneurial ability and the technically skilled workers were leaving the country in droves. The public sector had taken on many new responsibilities in pursuit of fulfilling economic and political objectives. However, as government spending increased, private investment declined. The Jamaican economy was virtually bankrupt. Its balance of payments was in deficit, foreign exchange was in short supply and its external debt was rising. It had enough foreign exchange for approximately two days' imports and only a rudimentary domestic financial network.

Prior to 1980, the Jamaican government engaged every conceivable macroeconomic policy, but with little success. In the late 1960s/early 1970s, the government embarked on an import-substitution program to protect local entrepreneurs who produced commodities that sought to replace imported ones. In 1973, the government implemented planning, especially in the international sector with a system of quantitative restrictions and licensing schemes for imports and special marketing promotions for exports.

To meet a deteriorating balance of payments situation, the government resorted to depletion of its international reserves, increased borrowing, and an increasing array of direct controls. All imports were subject to import licensing and quotas were set to prevent the value of imports from growing by more than 7% per year. The Trade Administration Department (TAD) was established to oversee and determine the types of imports arriving in Jamaica. These decisions were of critical importance because of the potentially adverse impact imports have on net foreign exchange holdings and balance of payments positions. Since 1981, the role of this agency has been curtailed with a general relaxation of rules regarding imports.

To restrain a rising rate of inflation, the government resorted to incomes policies. It set wage-price guidelines and established a Prices Commission to monitor the prices of goods on a national basis. These price inspectors were given increased responsibilities as well as a mandate to determine final selling prices for over 100 commodities (mainly food) and to monitor wholesale and retail mark-up limits for a variety of other items. Wage and price policies were extended to foreign exchange, in an attempt to suppress inflation, but this action was counterproductive because it led to the development of black markets for goods, services and foreign exchange.

To resolve the unemployment and capital formation problems, the government nationalized much of Jamaican industry — sewer and water, electricity, telephone service, transportation, airlines, hotels, the sugar and banana industries, bauxite and alumina. Government spending increased dramatically. The public sector borrowing requirement (PSBR) increased from 4.1% in 1972 to 21.4% in 1976. The bulk of this spending was on non-investment activities, with large increases in wages to the public sector work force, transfer payments, and other social welfare support program payments. To fund these expenditures, the government raised corporate tax rates, imposed a levy on bauxite production, and introduced a wide range of price and foreign trade controls.

From 1972 to 1976, public investment rose from 2.7% to 4.3% of GDP; but over the same four-year period, private investment dropped from 25.5% to 16.7% of GDP. Although government investment grew as a percentage of total investment, the decline in aggregate output suggests a lack of efficiency, in investment. Throughout this period real interest rates were negative, suggesting a failure on the part of the central bank to neutralize the excessive volume of government expenditures (by reducing the rate of growth of the money supply to offset an increase in velocity).

In 1976, further measures were taken to tighten import restriction and reduce aggregate demand. The marginal personal income tax rate was raised to 80% on earnings of J$30,000 and a variety of sales taxes were imposed. During this period, the government entered into two loan arrangements with the IMF, but these facilities were suspended in 1979 due to the lackluster performance of Jamaica's economy. As government borrowing increased to finance its deficits, interest rates rose, credit restrictions were imposed, and private spending was crowded out. The government resorted to printing money to finance expenditure, the money supply rose very rapidly, prices rose, the Jamaican dollar depreciated, and employment and real output declined.

II. METHODOLOGY AND MEASUREMENT TECHNIQUES FOR EVALUATING THE STRUCTURE OF A COUNTRY'S FINANCIAL SYSTEM

The appropriate stabilization policy depends upon the level of development of both the real and financial sectors. At low levels of real economic development, sectoral imbalances are best addressed with income/output management policies that affect the real sector directly. Capital can be more easily accumulated through the direct efforts of government than through the indirect efforts of private economic participants, who must obtain hurdle rates of profit to induce private money balances out of hoarding and into production.

As the real economy develops and becomes more complex, direct income/output management polices by the government become unwieldy and some form of indirect demand management becomes more efficient. Because buyers must always enter markets with money balances, the government can attempt to influence aggregate demand indirectly by controlling the amount of money balances in circulation (monetary policy) and/or the velocity of money balances with either its taxing and spending activities (fiscal policy) or interest rate management (monetary policy).

If the problem is erratic money supply growth, especially in a trade-dependent country, then neutralization of the money supply is key to obtaining non-inflationary growth. However, successful money supply management requires that the monetary authority have the ability to react and respond quickly to adverse movements in the money supply. Reserve requirements, capital requirements, and liquidity ratios are blunt instruments of control. Discount rates and lender of last resort facilities are necessary, but not sufficient, since borrowing is at the discretion of the financial institutions. Open market operations (OMO) are the most efficient means, but require a mature financial sector for successful control of interest rates or the money supply. Foreign exchange intervention may be required when the disturbances are external.

If the problem is erratic velocity, then neutralization of velocity is required. Neutralization can be achieved either through fiscal policy or interest rate policy. However, the former requires a visible tax base and flexibility in government expenditure, while the latter requires a mature financial system to effect the continuous flow of saving into productive investment.

At this stage of development, the government's efforts must be redirected, away from developing the real sector and toward development of a financial sector to keep money balances flowing into production at a fairly stable rate. This shift can be accomplished, first of all, with the creation of financial intermediaries, which provide reduced-risk interest-bearing liquid depositories for money balances and loans to small businesses. Second as backup support to these financial intermediaries, the government must establish a responsible, independent central bank. Third, the government must plan for the introduction of financial markets which provide liquidity for equity and debt financing by individuals, large scale financing for firms as they grow larger, and secondary liquidity for the banks and other financial intermediaries.

In his seminal work on quantifying the development of a financial system, Robert Goldsmith (1969) used several financial asset ratios to obtain estimates of the level of development of a country's financial system relative to its economic development. He measured the sectoral development of the financial system with a series of Financial Intermediation Ratios and the aggregate development of the financial system with a series of Financial Interrelations Ratios. Goldsmith reasoned that in the early stages of development, when businesses are family-sized, internal financing predominates over external financing and debt financing predominates over equity financing. Debt claims tend to be short term because of the predominance of commercial banks in the financial structure. When economies approach maturity, the debt/equity ratio tends to fall, although debt still maintains a majority share of total financial assets. The ratio of financial institution assets to total financial assets rises and increasing diversification among financial institutions leads to a declining share of commercial banks and an increasing share of non-banks. Additionally, the ratio of external finance to internal finance rises, as does the ratio of total financial assets to real assets.

Although the Goldsmith test does not provide conclusive correlations between financial asset structures and economic development, two important generalizations can be made. In general, a financial system is considered to be still in the process of development as long as (1) the share of non-bank financial assets is increasing while that of commercial banks is decreasing and (2) the total volume of financial assets is still below the country's annual GDP. With only a few exceptions, all countries with a total financial assets/GDP ratio (TFA/GDP) well above 100 are deemed to be developed countries with mature financial systems. Countries with ratios approaching 100 are on the verge of economic development and financial system maturity.

The composition and volume of a country's financial assets, however, tell only a partial story. Development of a mature financial system also involves appropriate regulation of existing intermediaries as well as development of such additional intermediaries and market institutions as are necessary to provide for the efficient transmission of loanable funds from surplus income units to deficit spending units. Other relevant factors include the number of financial institutions, the variety of financial institutions, the degree of competition among these institutions, the average spread between borrowing and lending rates at these institutions, and the breadth and depth of both the capital and money markets. The establishment of adequate capital and money markets is especially necessary for successful execution of monetary policies. By increasing the liquidity of domestic securities, these secondary markets encourage the voluntary holding of more domestic government securities (in preference to foreign securities) by financial intermediaries. This shift in financial asset portfolios facilitates the execution of domestic monetary policies. See Exhibit 1: Policy Framework for Non-Inflationary Economic Growth and Development.

III. THE EVOLUTION OF THE STRUCTURE OF THE JAMAICAN FINANCIAL SYSTEM TO 1980

Jamaica emerged from its independence in 1962 with a very immature financial system. FN1 In 1966, four years after its independence, it had a non-functional central bank, only a few foreign owned commercial banks. a Government Savings Bank, two trust companies, seven building societies, 110 credit unions, a network of Peoples Cooperative Banks, 16 life insurance companies, and no financial markets. (See Exhibit 2: Evolution of the Jamaican Banking and Financial System.) The Goldsmith ratios also indicate a very low level development. Commercial banks dominated the financial system with 62.9%, of total financial assets; and life insurance companies and other non-bank financial intermediaries held only 21.3% and 15.7% of total financial assets, respectively. The ratio of Total Financial Assets/GDP was only 47.3. (See Exhibit 3: Measures of Development for the Jamaican Financial System, 1961-1992.)

In 1981, almost twenty years later, the Jamaican financial system was little changed. The country still had only a quasi-functional central bank, eight commercial banks (of which five were domestically owned), the Workers Savings and Loan Bank (formerly the Government Savings Bank.), 26 Protection of Depositors Act (PDA) companies (including ten finance houses, ten trust companies, and six merchant barks), seven building societies, 96 credit unions, a network of Peoples Cooperative Banks, 13 life insurance companies, two government owned development banks, and a rudimentary stock market. The only real change was the government's organization of the Jamaica Mortgage Bank, the National Housing Trust, the Student Loan Bureau, the National Export-Import Bank of Jamaica Ltd, and the Export Credit Insurance Corporation, Ltd. (ECIC) to help finance housing, education, and international trade, respectively. For a short period in the mid-1970s, the government owned and operated the now-defunct Jamaica Development Bank. (See Exhibit 2.)

The Goldsmith ratios, likewise, fared little better. Commercial banks continued to dominate the financial system with 63.3% of total financial assets and the TFA/GDP ratio had risen but only to 79.1. The biggest change occurred in the composition of the limited assets held by the non-bank financial intermediaries. The PDA institutions, building societies, and credit unions gained asset shares at the expense of life insurance companies. (See Exhibit 3.)

On paper, the Central Bank of Jamaica (BOJ), organized in 1960, looked like any other central bank. According to its handbook, the BOJ was responsible for formulating and executing money supply management policies; issuing currency, handling the government's banking and advising the national government; regulating, supervising, and monitoring commercial banks through inspections; and managing foreign exchange. BOJ's oversight of the financial community included statutory liquid assets and cash reserve ratios for commercial banks and non-bank financial institutions, a statutory deposit/capital ceiling on commercial banks, direct controls over interest rates (the bank rate, the discount rate, and the savings deposit rate), credit, and foreign exchange, and moral suasion.

Due to the open nature of the Jamaican economy however, the BOJ must continually (and very delicately) balance control of domestic credit with protection of the balance of payments position. During its first decade of operation, the BOJ lost much of its power for two reasons: (1) the automatic convertibility between the J$ and sterling made traditional monetary instruments legally available to the BOJ potentially unviable, and (2) the already acute unemployment problem was not to be further aggravated. The BOJ was forced to rely on "moral suasion," the weakest of all monetary policy tools. Execution of moral suasion was accomplished through the formation of committees, one consisting of the Governor of the BOJ and managers of commercial banks and the others consisting of the Governor of the BOJ and representatives of finance houses. The purpose of these committees was to discuss the economy and the banking and finance industries and to obtain consensus opinions on the best course of action. Unfortunately, the BOJ lacked any forcible means for ensuring full cooperation on the best course of action.

During the 1970s, with the demise of the Bretton Woods agreement and fixed exchange rates, the BOJ was concerned primarily with minimizing the depreciation in its currency, the Jamaican dollar (J$). In 1973, Jamaica entered its first 1-year Stand-by Agreement with the IMF for SDR 26.5 million. The BOJ also realigned the J$ with the US$ instead of the pound sterling and adopted a dual exchange rate system. When this realignment failed to stem the outflow of international reserves, the BOJ terminated the system, devalued the J$, and returned to the International Monetary Fund (IMF) for support. Jamaica's membership in the IMF (since 1963) has further limited the BOJ's domestic monetary policy powers. The country's initial fund quota of SDR $20 million has been increased over the years to support its balance of payments problems. Because of its international liquidity crises, Jamaica has developed an unhealthy dependence on the IMF and its sister, organization, the World Bank (IBRD), borrowing heavily through its various facilities: (1) Gold Tranche, (2) export compensatory financing, (3) oil facility provisions and (4) SDR allocations. As a result, the IMF plays an active role in the determination of Jamaican monetary policies.

To coordinate domestic monetary policy with exchange rate determination, the BOJ relied heavily on its ability to set interest rates (IRs), adjust the required liquid assets ratio (LAR) and control credit (CCs) directly, both in the aggregate and categorically. In fact, IRs and the required LAR were adjusted almost every year and more than once in several years. (See Exhibit 4: Changes in Required Liquid Asset Ratio for Commercial Banks.) These tools, however, are bulky and unwieldy instruments for fine-tuning real economic activity. They are arbitrary, may be inconsistent with real economic conditions, and may distort the allocation of economic and financial resources. The bank engaged in no OMO and could not for lack of the requisite financial markets and a dearth of appropriate securities.

In 1969, the Jamaica Stock Exchange (JSE) was organized as a subsidiary of the BOJ. The JSE however was small and played no active role in circulating money balances to productive uses. It lacked the breadth and depth necessary for providing relatively risk-free investment for savers. Prior to 1980, this investment void was filled, first, by foreigners and, second, by the government. Neither proved satisfactory. Foreign ownership, on the one hand, resulted in a negative net transfer of international payments and economic decisions made in foreign boardrooms were aimed at narrow objectives for particular industries. If the overall economy benefited from these foreign decisions, it was merely coincidental. Government ownership, on the other hand, resulted in increasing deficits, which needed to be financed, much to the financial distress of smaller privately owned companies on the island.

IV. FINANCIAL SYSTEM REFORMS OF THE 1980S: THE SUCCESSES AND FAILURES

The Jamaican financial system has developed more rapidly in the list few years (see Exhibit 5: Flow of Money and Credit Through the Jamaican Financial System, 1991), but as of 1981, it remained relatively immature. Some of its more recent development has come from small changes in the institutional structure. However, much can be attributed to other financial system reforms which have improved the flow of money and credit throughout the Jamaican financial system. The first major financial system reform occurred in 1981 with the establishment of two development banks — the National Development Bank (NDB) and the Agricultural Credit Bank. (ACB). The purpose of these development banks, which were born out of the now-defunct Jamaica Development Bank, was to replace a highly inefficient and ineffective direct public sector lending program with more effective channels for the delivery of medium- and long-term credit to the private sector. These banks acted and continue to act as wholesale lending institutions by rediscounting loans made by commercial banks, the Peoples Cooperative Banks, and the PDA institutions. Funding for these institutions comes from foreign and local sources with Jamaican government guarantees. The NDB borrows funds from the Caribbean Development Bank and the European investment Bank to support loans for tourism and manufacturing, while the ACB borrows abroad to support loans to small Jamaican farmers and entrepreneurs. Preferential borrowing rates and exemptions from banking system credit controls have allowed these banks to aid development by providing low-cost funds, especially to the manufacturing sector, at below-market rates.

In 1985, the two government-owned development banks were supplemented by the creation of a third privately owned development bank, the Trafalgar Development Bank (TDB). The TDB functions as a venture capital company, offering medium- and long-term loans, leases, and equity financing, along with project development and technical services, to emerging companies, especially in the agricultural, tourism, and manufacturing sectors. It finances new investment with funds from the United States Agency for International Development (USAID) and the Commonwealth Development Corp.(CDC). In 1991, TDB contracted with the government to act as a wholesale bank for selected intermediaries, including the credit unions, the Enterprise Development Trust (EDT), the Self-Start Fund (SSF), the National Development Foundation of Jamaica (NDFJ), and the Agency for Selection and Support of Individuals Starting Trade (ASSIST). In the absence of a mature capital market, these three development banks have filled and continue to fill a highly visible investment void by funneling idle money balances to productive uses in Jamaica.

The second major financial reform occurred in 1984 with the introduction of the Foreign Exchange Auction System. During the 1960s and 1970s, Jamaica suffered from a severe shortage of foreign exchange. Prior to 1984, this shortage was addressed through a multiple exchange rate system: the official BOJ rate, the parallel market rate, the CARICOM rate, and the (unofficial) "street" market rate. Under this system, an importer could sell his foreign exchange (bought on the street or elsewhere) to the commercial bank at the parallel rate and obtain a commitment from the bank to sell these funds back, to the user at some future date. However, proceeds from traditional exports and receipts from tourism and bauxite could not be sold on the parallel market and foreign exchange for medicine and school were obtained only at the official rate of J$1.788125 = US$ 1.00. The multiplicity of rates resulted in a need for some unification of the various rates. This unification system, however, had to reflect the forces of supply and demand and, at the same time, build in flexibility to adjust to the competition of the "street" market.

The Foreign Exchange Auction System (FEAS) incorporated wider participation in the available pool of funds and ensured the proper, reflection of market forces. The auction rate replaced all other rates as the proper exchange rate. Auctions were held twice weekly by the BOJ. Eligible participants included commercial banks, bona fide exporters, and others in the private and public sectors with due and/or outstanding foreign payments in excess of US$50,000. Those with obligations of less than US$50,000 were required to bid through commercial banks. In addition to bidding for their customers, commercial banks also bid for foreign exchange as required for their normal operations.

In its early stage, FEAS maintained a band with an upper and lower limit. The maximum bid price could not exceed the rate at the upper end of the band less four cents per US$. The minimum bid price could not fall below the lower limit of the band. The band was subsequently removed to allow for free floating of the J$. Payments for foreign exchange sold at the auction to successful bidders were at the clearing price plus a commission of two cents J$ per US$ for banks and four cents J$ per US$ for non-bank participants. The amount available in the pool of funds to be auctioned was published on the morning of the auction. Applicants were required to submit their bids on prescribed forms in sealed envelops clearly marked "Bid for Foreign Exchange Auction" to the BOJ, no later than 12:00 p.m. (noon) on the day of the auction.

The FEAS was relatively successful in both stabilizing the exchange rate of the J$ and increasing inflows into the banking system. FEAS had promises of being a more efficient means for allocating foreign exchange resources than the prior multi-rate system. However, it also had weaknesses. First, the only priority afforded bidders was their ability to pay rather than the desirability of the end toward which the foreign exchange was put. Second, not all foreign exchange payments were channeled through the system. Government debt and oil payments were settled outside of the auction mechanism. If these had been included, the exchange rate for the J$ would rot have remained so stable at J$5.50/US$1.00 for the rest of the 1980s decade. Third, FEAS increased pressure on the BOJ to monitor domestic credit expansion more carefully in order to ensure that the demand for foreign exchange at the auction was not based on such credit expansion.

In 1990, after several modifications in the auction, the short-lived establishment of a fixed exchange rate in 1989, and the auction's failure to stop the depreciation in the J$, the BOJ abandoned the FEAS. It privatized the process for exchange rate determination by authorizing the commercial banks, who became "authorized dealers" in the "inter bank system," to buy and sell for their own accounts. The following year, the BOJ expanded the interbank system to include four more institutions — two building societies and two merchant banks — to operate as dealers. This increased competition led to a narrowing of the spread between the buying and selling rates. In addition, the government abolished all foreign exchange controls, liberalized the rules for holding and lending non-J$ balances at Jamaican financial institutions, and let the J$ float freely.

While some critics argued that this decontrol merely shifted the administrative function of exchange rate determination from the BOJ to the authorized dealers, others applauded them as the most successful foreign exchange reforms to date. They discouraged the emigration of non-J$ balances and provided liquidity with which to finance investment. While the net result was not sufficient to prevent a further depreciation in the J$, the excess liquidity was sufficient for priming the explosive growth in share prices on the JSE from 1990 to 1992. Rising share prices encourage additional equity financing for development by both old and new businesses and attract new participants by increasing the expected rate of return on share holdings. Perhaps, for the first, time, a BOJ monetary policy measure managed to permeate and generate real spill over effects in other markets.

The third major financial reform also occurred in 1984, when the government revised banking and non-bank financial intermediation legislation to make the holding of reserves more attractive to commercial banks by advancing interest payments on a portion of reserve balances. The legislation provided for two separate accounts to be held by commercial banks with the BOJ: (1) a non-interest-bearing Statutory Reserve Account for meeting the daily cash reserve requirement and (2) a Clearing House Account, which could be counted as part of the banks' liquid assets for meeting the required LAR and would also earn interest on credit balances at a rate corresponding to the average discount rate for T-bills. In 1985, the volume of Clearing House Account balances eligible to receive interest was restricted to 3% of its liabilities used in calculating the banks' LARs. This restriction reduced the attractiveness of holding Clearing Account balances and credit, once again, expanded.

The fourth major financial reform occurred in 1985 with the introduction of BOJ certificates of deposit (BOJ CDs) as the main instrument of an active open market policy to fine-tune domestic liquidity. OMO, per se, had not been viable for lack of a well-organized money market, a government-controlled ceiling on the volume of T-bills issued, and a dearth of other financial securities. By 1985, less than one-quarter of Jamaican government debt had been financed with short-term bills, Jamaica had no government securities dealers to speak of, and the commercial banks held almost 64% of the total bills outstanding. In addition, the BOJ imposed a penalty rate for commercial bank discounting of T-bills at the BOJ prior to maturity. Although the BOJ adjusts this penalty rate periodically to act as an incentive/disincentive to discounting, its imposition tends to conflict with the use of OMO as an effective tool of monetary policy by encouraging banks to buy and hold, but not to sell T-bills. The BOJ uses its CDs to absorb excess liquidity from the financial system. Initially, the rate paid on BOJ CDs was determined by an auction designed to bring bank rates into line with actual credit conditions. However, this auction mechanism failed in 1986. It was temporarily suspended and replaced by fixed rate offerings. In 1988, the BOJ suspended the fixed rate offerings and resumed the auction. The introduction of BOJ CDs has been a boon for absorbing excess liquidity from the banking system when necessary. However, the BOJ also maintains a penalty rate for early encashment of BOJ CDs. Although the BOJ adjusts this penalty rate like it does the one for T-bill discounting, its imposition has the effect of limiting the BOJ's ability to add liquidity when necessary. In effect, the BOJ CDs act as a one-way liquidity drive for absorbing 'liquidity but not for increasing it.

Fortunately for the BOJ, the volume of T-bills has expanded rapidly since 1985. The government has successively raised the T-bill ceiling from J$750 million. in 1984, the year prior to inauguration of the BOJ CDs, to J$6.5bn. in 1992. As of the end of 1992, the total volume of T-bills had reached J$6.461bn., an amount twice as large as the government's medium and long-term debt. Participation by other financial institutions has increased and the share of T-bills held by commercial banks has dropped steadily to less than 24%. The BOJ still relies more heavily on its CDs for liquidity management; however, the expansion in T-bill issues has added to the BOJ's flexibility by allowing it to combine open market sales and purchases of T-bills with its CD offerings.

Unfortunately for, the BOJ, the market for both T-bills and BOJ CDs remains narrow. The principal participants are the commercial banks and the PDA institutions. Together with the BOJ, which holds T-bills, and the government, which holds BOJ CDs, they account for over 75% of both markets. As a result, the BOJ's OMO have only limited effect in influencing interest rates and credit conditions throughout the financial system. There is a visible lack of permeation of BOJ OMO to other parts of the financial system and, in the absence of spill-over effects, the BOJ continues to supplement its OMO with periodic adjustments in IRs, the LAR, and the CCs.

The fifth major financial reform occurred throughout the latter part of the 1980s with the government's privatization program. In 1986 and 1987, the government sold some of its majority share holdings in the National Commercial Bank of Jamaica Ltd. and the Caribbean Cement Co. and, then, in 1992 sold its remaining 39% to two private sector mutual organizations. From 1986 to 1990, the government sold its shares in Telecommunications of Jamaica Ltd. to Cable and Wireless of the U.K. and to the public at large. In 1991, the government sold its shares in the Workers Savings and Loan Bank to a group of private investors.

The government currently owns approximately 55 companies whose local registered stock is held by the BOJ and is used by the BOJ, on occasion, in its OMO with the commercial, banks. It could continue to add breadth to the supply side of the JSE by divesting its control of other major holdings and turning their ownership and operation over to the private sector. These concessions could come from privatization of hotels, national airlines, and commercial banking.

The sixth major reform occurred in 1991 with the unification of the three stock markets in Jamaica, Barbados (SEB) and Trinidad (TTSE). The purpose of cross-listing and cross trading among the exchanges was twofold: (1) to make it easier for investors to buy stock on any of the three exchanges and (2) to facilitate equity financing by allowing any company incorporated within CARICOM to be listed once it met the listing requirements for the specific exchange. The enlarged listing was expected not only to increase stock trading within CARICOM but also to attract investors from outside. Jamaica, however, has benefited little from the unification. The JSE has received no applications for cross-listing, the country continues to experience speculative capital outflows and, on net, Jamaicans have bought more shares on the SEB and TTSE than investors from Barbados and Trinidad have bought on the JSE.

Seventh, several minor, but nonetheless important financial reforms occurred in the early 1990s. First in 1990, the BOJ decontrolled the savings rate. Commercial banks and PDA institutions are now authorized to set their own rates. Second, in 1991, the BOJ removed all credit controls from loans and advances extended by commercial banks and PDA institutions. Also, in 1991, two Jamaican banks were licensed to operate outside the country in Miami, Florida, and a legislative amendment to Section 29 of the Bank of Jamaica Act temporarily provided the BOJ with greater flexibility in administering the liquid assets requirement by allowing the BOJ to fix different percentages for individuals banks during the period January, 1992 through July 1992, when the new ratio will be set at 50%.

Last, in 1992, the BOJ equalized the cash reserve ratios (CCRs), between commercial banks and PDA institutions. Prior to this date, the BOJ maintained separate required ratios for the different institutions. While the CRR for commercial banks was held steady at 20%, the BOJ was continually adjusting the CRR, along with the LAR, for the PDA institutions. This constant readjustment activity made monitoring the financial soundness of and credit expansion by these institutions more difficult. The revised legislation is expected not only to provide stricter operational controls, but also to enhance the supervisory powers of the BOJ.

The post-1980 financial reforms get mixed reviews. On the one hand, some of the benefits of reform are already evident. Real GDP growth has improved steadily, rising to an annual average of 6.3% in the 1986-1991 period. This more rapid real growth has reduced the unemployment rate from over 27% in 1980 to less than 20%. However, this real economic improvement was accompanied by a higher than desired average annual inflation rate of 20.5% throughout the decade. (See Exhibit 2.) Much of the recent inflation can be attributed to the rapid depreciation in, the foreign exchange value of the J$. Such depreciation has the immediate short-ruin effect of inflating domestic prices and compressing real wages. In the long run, however, as depreciation in the J$ slows and its value stabilizes, producers can switch resources to satisfy any increase in demand for exports resulting from the price effects of devaluation and this increase in production will be good for the real sector.

On the other hand, major financial reform often requires several years to work its way through the financial sector to the real sector. With all of the post-1980 financial reforms, Jamaica's financial system continues to remain underdeveloped. Its Financial Intermediation Ratios have barely budged, the commercial banks' share of total financial intermediary assets has fallen little since Jamaica's independence and its key Financial Interrelations Ratio (TFA/GDP) has hovered for the last half-dozen years at only 100. Therefore, it may be too early to judge the appropriateness or effectiveness of these reforms.

VI. PROPOSALS FOR THE 1990S AND BEYOND

Over the last 10-12 years, the Jamaican government has relaxed its conservative financial posture. In doing so, it has made a positive contribution to the development of the country by allowing the Jamaican financial system some measure of growth. This growth, in turn, has facilitated the use of monetary policies to stabilize the domestic economy. These reforms, however, are incomplete. The following is a partial list of the remaining problems with proposals for change.

The first problem is the absence of a money market. In a developed economy, money market instruments including T bills, commercial paper, bankers' acceptances, and negotiable CDs, are the Kingpins of liquidity for the financial system and the primary instruments through which monetary policy is effectuated. Yet, in all of the literature on the Jamaican financial system, not one mention was made of commercial paper or bankers' acceptances and neither the Jamaican T-bills nor the BOJ CDs are perfectly negotiable. This omission must be a failure to communicate. In a country so dependent on exports for its income, bankers' acceptances must exist and they must exist in a volume sufficient to create a secondary market for them. Likewise, in a country that boasts companies large enough to be listed on a stock exchange, commercial paper must be a viable means of financing current expenditures and this volume of financing must be sufficiently, large enough to create a secondary market for this paper. The problem of negotiability of T-bills and BOJ CDs and the creation of markets for these instruments is even easier to resolve.

Therefore, Proposal #1 is creation of a money market. Like the JSE, it can be organized through the BOJ which would charter, license, or otherwise authorize certain financial institutions, JSE dealers, brokerage houses or independent persons to act as dealers for these money market instruments. Alternatively, companies could issue their own commercial paper, which would trade along with the common shares on the JSE. In addition, the BOJ must eliminate the penalty rate for premature discounting of T-bills and early redemption of BOJ CDs. This would allow for the development of efficient secondary markets for T-bills and BOJ CDs with the BOJ acting as a tertiary market maker.

The second problem is the lack of flexibility by BOJ in its conduct of monetary policy. The BOJ is still restricted by the immaturity of the Jamaican financial system and by its own obsolete monetary tools. Only within the last five or so years has the BOJ expanded its tool kit to include the more subtle form of financial persuasion, namely, OMO. Otherwise, its own "stop-and-go" policies is one of the biggest negatives overhanging the BOJ's effectiveness. The periodic and abrupt about-face adjustments in IRs, the LAR, and CCs create much environmental uncertainty for the financial intermediaries. Without secondary securities markets to provide back-up liquidity for these institutions or absent derivatives markets and products with which to hedge their interest-rate risk, financial institutions remain overly cautious in lending activities. In such an uncertain environment, the marginal borrower, usually the budding entrepreneur who remains the biggest credit risk, is squeezed out of the market.

Therefore, Proposal #2 is establishment of a fixed set of statutory requirements, elimination of all interest-rate and credit controls and the penalty rates for discounting T-bills and redeeming BOJ CDs prior, to maturity, and increased use of OMO to offset adverse changes in credit availability. This realignment in the use of policy tools would minimize erratic fluctuations in interest rates and credit conditions, reduce uncertainty, and improve the flow of funds through financial intermediaries to worthy borrowers. On occasion, the BOJ has used the securities of the local Registered stock companies to conduct OMO. The BOJ could supplement these operations with the purchase and sale of JSE securities; or the BOJ could make loans against these securities to broaden the scope of its OMO; or, the BOJ could conduct OMO with its newly developed money market instruments — commercial paper and bankers' acceptances. By using a variety of instruments to conduct OMO, the BOJ would also help to broaden the capital and money markets.

The third problem is a lack of competition among financial intermediaries. This failure is evidenced by the continuous, abnormally high percentage of total financial assets held by the commercial banks. As of 1990, the last year for which complete financial asset data was available, commercial banks held 55.5% of total financial intermediary assets, not much less than the 62.9% share held by the banks in 1966. This lack of competition is also evident from the limited number of financial intermediaries and the high concentration ratios for banks and non-banks within their respective markets. As of 1991, Jamaica had only 10 commercial banks. The three largest commercial banks held 70% total commercial bank assets, 73% of total commercial bank deposits, and 75% of total commercial bank loans. Within the non-bank group of 29 PDA institutions, the 22 merchant banks held 94% of total FDA assets and the four largest merchant banks held over 50% of total PDA assets. This concentration of financial power in the hands of a few large financial institutions short-circuits the BOJ's efforts to conduct effective monetary policies, because large oligopolistic organizations need not pass along BOJ policy measures in the form of competitive rates. Rather, they can administer, their own interest rates and maintain wider spreads on their borrowing and lending rates.

Therefore, Proposal #3 is elimination of a parochial licensing scheme for financial institutions and extension of an overt invitation to foreign banks to establish local subsidiaries in Jamaica. Now that foreign exchange controls have been eliminated and both residents and non-residents can hold either J$ balances or non-J$ balances, Jamaicans have far less to fear and everything to gain from additional foreign banks. Moreover, foreign banks can bring with them the technology for delivery of international ATM and credit card services, derivative products, other international banking facilities, and access to outside financial markets. Likewise, Jamaican banks should move more aggressively to establish branches outside of the country. Foreign branches of Jamaican banks can reciprocally appropriate any new banking technologies as well strengthen their capital positions from such foreign exposure.

The fourth problem is the latent development and underutilization of Jamaica's stock market. The government's privatization program and the linking of the JSE with the SEE and TTSE have added some breadth to the supply side of the JSE. The demand side of the market, however, remains weak. Subsequent to the 1990 decontrol of the foreign exchange markets and the 1991 elimination of foreign exchange controls, foreign participation increased to some extent; but, overall, it remains sparse. Primary participation is still by local residents whose income is insufficient to support the investment needs of listed companies. Currently, Jamaica has no capital gains tax on shares traded on the JSE, but dividends are subject to a 33 1/3% withholding tax.

Therefore, Proposal #4 is continued privatization of government-owned companies, promotion of the JSE beyond the Caribbean region (perhaps through the sale of a managed fund or basket of stocks or depository receipts of Jamaican companies or, foreign exchanges), elimination of or a reduction in the withholding tax, and solicitation of foreign companies to list on the JSE. The current supply of offerings could be supplemented with CMOs derived from securitization of financial institutions' assets. In addition, the government should consider eliminating or reducing the cumbersome licensing and registration procedures for a listing on the JSE as well as participation by foreign investment brokerage houses, and the BOJ should consider OMO in listed stocks.

A fifth problem is the country's heavy reliance on the IMF and the IBRD for external financing. Even as the Jamaican economy develops, the country borrows more from these organizations. This borrowing could be reduced if outmoded Jamaican fears of colonial exploitation by foreigners were excised. Such paranoia and parochialism in an era of globalization of financial markets is unwarranted and unnecessarily burdensome. Jamaica is too trade dependent to be without a network of financial allies around the world. It can neither develop its financial institutions nor allow them to operate in a domestic vacuum. The linking of the JSE with the SEB and TTSE is one positive overt, gesture. There are more. Therefore, Proposal #5 is broadening the financial system to include foreign financial institutions, listing Jamaican companies on other non-Caribbean exchanges, and networking by Jamaican financial institutions to develop reciprocal banking facilities and agreements with financial institutions in other countries.

Finally, Jamaica has a dearth of financial instruments and services. Economic studies have shown that increasing the spectrum of financial alternatives reduces the interest elasticity of money demand and that monetary policy is always more effective when money demand is interest inelastic. Therefore, Proposal #6 is to implement all of the above changes along with increasing integration of the Jamaican financial system.

Once Jamaican policy makers establish the requisite financial infrastructure, economic participants will have the means to circulate money balances more efficiently within these countries. The government will have less need to depend on printing money and foreign borrowing. Velocity should be more stable and the central bank will gain more flexibility in its conduct of monetary policies.

ENDNOTES

FN1. Unfortunately, a dearth of statistical data for some categories of institutions creates measurement errors. However, certain trends are clearly visible.

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