The great collapse

Edward Seaga, Contributor

Below is more analysis of the financial meltdown in Edward Seaga's autobiography. The first excerpt was published last week.

In my presentation on the Budget of 1996-7, made to the House of Representatives on May 2, 1996, I spelt out the consequences for people of this crucial 1991-95 period:

No one can forget the suffering and damage of this period: businesses fell apart; household budgets were abandoned; school careers had to be replanned; pensions became meaningless; tenants fought with landlords; thousands became newly poor and the life of the poor deteriorated to the ultimate level, the poorest of the poor.

The result was that the very conditions which Michael Manley had expected to correct were intensified: further shortage of foreign exchange, increased inflation and interest rates. These and other economic variables, notably economic growth and employment, moved negatively, or insignificantly, for years after. A prolonged period of economic stagnation became entrenched for the entire decade and beyond.

It was not that the Jamaica Labour Party (JLP) was against the removal of exchange-control restrictions. It was simply a matter of timing. The Medium-Term Economic Programme, 'Going for Growth', prepared in 1988 by the JLP Government, projected that at the rate of improvement of some US$100 million annually in foreign-exchange balances of the Bank of Jamaica (BOJ) occurring in the last half of the 1980s, the international reserves would be positive by 1993. This would set the stage to remove exchange-control restrictions and meet demands that might occur from capital flight without serious depreciation of the Jamaican dollar.

None of this disaster would have occurred if there had been a proper understanding by the political leadership of the dynamics of the market system. This gross error of premature deregulation was compounded by another potent factor, apparent ignorance of the role of money supply, which was also a fundamental market force.

Excessive money supply would increase purchasing power, creating hyperinflation.

This, in turn, would result in the classic conundrum of too much money chasing too few goods, driving up price inflation and, eventually, interest rates, while economic growth and job creation would be depressed.

Despite this clear danger, money supply was allowed to grow excessively, over the five-year period 1991-96, with the result that inflation surged, the commercial bank lending rates zoomed, and the exchange rate was left to cascade on a path of rapid depreciation, propelled by insufficient foreign exchange.

annual exchange rate

Over the crucial 1991-5 period following the deregulation of exchange control, the annual average exchange rate for the succeeding five years was J$25.8:US$1.0. The consequences of this failure to take positive action are set out in Table 12.

The BOJ preferred to ignore the immediate damage to the economy. On October 25, 1991, it published the result of a BOJ study, one month after the deregulation, focusing on the ultimate benefits in the medium to long term (The Gleaner). The BOJ study stated: "The success of liberalisation more often than not comes in the medium term after 'early-day' reactions of defensive interest rates, domestic currency devaluation and heightened inflation." A more accurate version would have included a caveat: 'providing the economy could tolerate prohibitive interest rates, currency devaluation and heightened inflation'.

Dr Headley Brown, the immediate previous governor of the BOJ, in an article, also published on October 25 in The Gleaner, chided Prime Minister Michael Manley for claiming that the inflows in the 19 working days after the announcement of deregulation attracted 100 per cent more foreign-exchange inflows than the comparable 19 days before.

Citing double-counting, Dr Brown asked how the prime minister could have been so misled, as "the improvement was, at best, US$10 million" instead of the US$87.8 million indicated. The answer as to whether the economy was receiving the boost in foreign exchange, which Manley was told and believed it would, was easy to determine. If the foreign-exchange flows were improving, there would be more foreign currency to satisfy demand and the dollar would become stronger, that is, the rate would appreciate rather than depreciate. But this was not the case in the short term, nor in the medium, nor, indeed, as it turned out, in the longer term. The expectations projected were wrong.

At the outset, the deregulation was a popular political action as business interests and the public enjoyed the convenience of being able to obtain and move foreign exchange abroad without resorting to nefarious methods.

On the other hand, as the days passed, more knowledgeable persons began to express doubts over the wisdom of the action. I had predicted doom because the move was premature and injurious. But soon I was no longer the only voice. This step should not have been taken at that time.

Public opinion by then was turning from support to rejection. The weaker dollar bought less and less as the depreciation continued. Public attention was now closely following the daily foreign-exchange saga and its untold misery as the exchange rate continued to slide on a slippery slope.

With excessive money supply (Table 12) still driving the system, business carried on, borrowing at impossible interest rates and defaulting because of the impossible rates. With money supply creating a glut of deposits which had to be loaned to cover costs, banks contracted loans with less than prudent concerns. This practice soon turned to folly, as bad loans mounted.

This was particularly the outcome for the indigenous banks which, unlike the foreign-owned banks, were heavily involved in borrowing at higher interest rates and high-risk lending.

Banks found it necessary to access BOJ overdrafts to replace some of the liquidity dried up by bad loans. The BOJ charged punitive rates in an attempt to force a restoration of best practices to the system. This further weakened the financial position of the indigenous banks. But they immersed themselves even deeper.

With few of the traditional entrepreneurial big investors still around after the fearful mass migration of the 1970s, the banks became heavy investors in projects they launched themselves, departing from their core banking business as lenders. In concert with their insurance counterparts and financial intermediaries that they established or acquired, they invested in building hotels, shopping centres, office complexes - including some 'palaces' for their own headquarters - resort villas and residential housing developments as well as in big farms.

The foreign banks avoided this route, sticking to core business. Whether this was a result of prudent business decisions or directives from overseas headquarters forbidding non-core investment matters little. As it turned out for those banks, the safer course was the wiser one.

split in lending

The different approach of the indigenous and foreign banks was indicative of the split in lending policies. Overseas banks relied on oversecuritisation of loans, 'providing short-term working capital financing, staying clear of any long-term position' (Paul Chen-Young, 'With All Good Intentions'). This is in keeping with the UK, Canadian and US model. The alternative model, supported by German, Japanese and French banking policy, was based on the position that 'more-direct involvement in the productive sector by the banking sector was vital for investment and growth' (ibid.).

This was the model which influenced banking policies of the indigenous sector in the expansionary period of the 1980s and, more so, in the 1990s. The dilemma was settled at a meeting under the chairmanship of G. Arthur Brown, governor of the BOJ, by limiting direct investments by banks to 20 per cent of capital in any one entity other than financial institutions and 40 per cent of capital for all investments.

Life insurance companies were central to the investment strategy. They were not bound by unfavourable features of the banking system, which had to sterilise up to 50 per cent of its funds from lending by depositing them with the BOJ as prudential reserves, nor did they have to withhold taxes on interest earned from deposits. They exploited these advantages to generate increased business in an effort to compensate for the reduced purchase of life policies, which was decreasing because of public fears for the future. Sale of life policies also presented a serious problem. They required payment upfront of most of the commission earned by life underwriters.

negative cash flow

This created a negative cash flow for many years until the inflow from premium incomes could catch up with the reducing level of commissions paid. It was the financial weight of these accumulated negative cash flows that led to massive problems affecting the insurance companies and banks associated with them.

The stock exchange provided another outlet for investing the excess liquidity, pushing up the market index to an annual average growth of 70 per cent between 1990 and 1995, then slowing substantially in the remaining years of the decade to 11.5 per cent per annum. With excess liquidity in the system to be invested, the exchange offered ready access. Investors overindulged, driving up stock prices until the system tumbled precipitously in 1993. Real estate prices moved in tandem, first on a high, then falling to a sustained low for several years.

See more next week.

Edward Seaga is a former prime minister. He is now chancellor of the University of Technology and a distinguished fellow at the University of the West Indies. Email feedback to columns@gleanerjm.com and odf@uwimona.com.