How the financial crash of the 1990s happened and why

Edward Seaga

Sunday, July 29, 2018

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The financial shock which began in 1991 ballooned unchecked over the next five years until it exploded with a catastrophic bang in 1996. The explosion left shrapnel scattered over the financial landscape which still impacted on the economy a dozen years later.

This was not unexpected, given the developments which were occurring during the first half of the decade of the '90s when the financial system was pulled apart by the inappropriate policies of Government and bad management by the financial institutions.

To establish a baseline for these unfolding disastrous events, it must be recognised that the cause was not natural disasters nor international crises. There were no monster hurricanes, earthquakes or epidemics; no external crises, financial or political. In fact, the global economy was experiencing an exceptional period of stability and growth. These external factors apart, the explosion was purely the failure of the players to measure up to the need to manage the shock of an imploding system caused by their own inadequacies.

The circumstances which seeded the implosion should never have occurred. The recovery in the last five years of the 1980s had stabilised the economy and restored reasonable economic growth. Even though the condition was still fragile, prudent handling and maintenance of the same course would have sustained the recovery.

This should have been no problem. Michael Manley had promised the business community and had publicly proclaimed “continuity” of the policies of the then governing Jamaica Labour Party (JLP) to be the objective of his Government, if his party won the election. The People's National Party (PNP) was successful in the 1989 General Election.

As a new Government, it made all the politically correct statements about the “private sector being the engine of growth” and the Government the “facilitator”. However, as events would quickly prove, making the right statements and doing the right things could be substantially different. At the heart of the difference was a lack of knowledge of the inner workings of a market economy.

The problem which led to the undoing of the financial system was the extraordinary depreciation of the rate of exchange. This was now possible after the auction system was abandoned, having worked effectively in stabilising the rate of exchange. But the Manley Government was now being tutored by the IMF, which, notwithstanding the success of the auction, wanted a system with free determination of the rate of exchange by market forces only.

The Manley Government had developed a poor reputation in the 1970s for its inability to mobilise the foreign exchange required to run the economy. The Government of the 1970s was tormented by the shortage of foreign currency. It ended its term of office with a mere US$11 million in international reserves which became available from the Government of Iraq only on the day before the general election of October 30, 1980.

This vulnerability sent shivers through the business community, even in later years, whenever the rate of exchange showed any adverse movement. The rate had been stable for nearly five years at $5.50 to US$1.00, from January 18, 1985, to October 31, 1989, using the auction system. But thereafter, even comparatively slight movements were signals to many of returning to the “bad old days” of stressful foreign currency shortages.

Immediately after the auction was disbanded on October 31, 1989, the exchange rate jumped from $5.50 to $6.50. Instead of the auction system, each bank was allowed to set its own exchange rate — another mistake which resulted in a return to the unstable dollar, this reinforcing the perception of worse to come.

Without effective corrective measures this perception grew, and by September 25, 1991 the exchange rate had depreciated to $13.97. This was a huge fall from the settled $5.50 value in February 1989 when the PNP took control of the Government. Put another way, the exchange rate fell from $1 equal US$0.18 cents to $1 equal to US$0.07 cents in that period of two and half years. It was at this point that panic took charge and a cataclysmic error occurred.

With the sharp adverse movement of the rate of exchange, it was clear that the economy was heading for serious trouble. Manley was under severe pressure from the business community and general public to act. Depreciation of the rate of exchange resulted in higher prices for goods, prohibitively higher interest rates, and a politically crippling consequence which would hold much danger for the economy. All were bad for business.

Manley was persuaded that the time was ripe to take the decision to repeal the remaining powers of the Exchange Control Act, which controlled the movement of foreign exchange. This would allow foreign exchange to move freely in and out of the country. He was told that with the removal of the psychological barrier restraining the movement of foreign exchange, scarce foreign currency would, in fact, flow into the country, since it would be free to leave anytime at the discretion of the holder.

In short, there would be no shortage of foreign exchange, according to top businessmen who urged him to take this critical step. While some genuinely believed that the move would be beneficial, others were acting in their own self-interest, irrespective of the impact on the economy.

The scenario mapped out to Manley could be possible, generally speaking, but it would not hold during a start-up period, particularly when there was a severe shortage of foreign exchange reserves in the Bank of Jamaica (BOJ). The more realistic expectation was that as soon as foreign exchange movement in and out of the country was allowed, there would be immediate capital flight.

In such circumstances, the Bank of Jamaica would require adequate reserves to overcome the flight of capital. This expected reaction was ignored by the authorities, both Government policymakers and the BOJ officials.

The BOJ at the time had no net international reserves. The reserve balance was minus US$372 million. There would be no foreign exchange to satisfy demand in the event of any capital flight. The Bank of Jamaica, most of all, did not exert sufficient persuasive pressure to overcome its own vulnerability.

In September 1991 I received information that a high-level delegation of business leaders from the leadership of the Private Sector Organisation of Jamaica (PSOJ) was going to Jamaica House to present their case to Prime Minister Manley. At that time the House of Representatives was in session. I timed my intervention in the debate which was in progress to speak when the presentation was to be made.

I looked directly into the television camera filming the proceedings of Parliament for live broadcast. I spoke “directly” to Manley, who I understood was watching. I strongly urged him not to be misled by the appeal of the PSOJ and spelled out what would be the consequences of removal of the regulations prematurely without backup by the BOJ.

But, as expected, Manley bowed to the private sector appeal and the ensuing period created an awesome shock. Between 1991 and 1995 inflation was crippling, averaging over 40 per cent annually; interest rates averaged even more, 42.58 per cent — a prohibitive level. Economic growth plunged from a robust 5.5 per cent in 1990 to marginal levels, averaging less than one per cent up to 1995. Job creation almost fizzled out. Without doubt, this was one of the most negative periods in the Jamaican economy, historically.

In my presentation on the budget of 1996-97, made to the House of Representatives on May 2, 1996, I spelled out the consequences for the 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 Manley expected to correct — further shortage of foreign exchange, increased inflation and interest rates — were intensified. 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 JLP was against the removal of exchange-control restrictions. It was simply a matter of timing. The medium term economic plan, '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 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, thereby creating hyper—inflation. This, in turn, would result in the classic conundrum of too much money chasing too little 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 of 1991-96, with the result that inflation surged, commercial bank lending rates zoomed, and the exchange rate was left to cascade on a path of rapid depreciation, propelled by insufficient foreign exchange.

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 these banks immersed themselves even deeper.

With few of the traditional, entrepreneurial big investors still around after a 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, which they established or acquired, they invested in building hotels, shopping centres, office complexes, including some “palaces” for their own headquarters, resort villas, residential housing developments, as well as investment 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 which forbade non-core investment, matters little. As it turned out, those banks with the safer course were the wiser ones.

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 powers of life policies which were decreasing because of public fears of the future. Sale of life polices also presented a serious problem. They required payment up front of most of the commission earned by life underwriters. 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.

This episode made clear the need for recognising the fragility of the financial system, the danger of over-expansion, and the importance of careful and confidential handling of its affairs.

Prophetically, I had asked Dennis Lalor, Paul Chen Young and Oliver Jones — leaders of three powerful financial groups — to come to see me. My message to them was, “They are coming for you next.” This warning was born out of my background experience of how the PNP thought and acted in regard to the issue of wealth. The party had historically resented established big business during its anti-wealth socialist days, particularly if the wealth was not bonded with its leadership in terms of its racial and political preferences. Lalor, Chen Young, and Jones did not fit this bonding profile.

In the 1960s I had introduced merchant banks and other financial institutions, such as a unit trust (mutual fund) and mortgage bank, to diversify the financial system. A stock exchange was established and I proceeded to convince both the banks and insurance companies, which were virtually all foreign-owned, to 'Jamaicanise' by establishing subsidiaries that could list some of their equity on the stock exchange for Jamaican investors.

The banks and insurance companies were profiting from but not investing in Jamaica. The banks cooperated readily and some banks went further to establish merchant banks. I established the Jamaica Unit Trust to introduce this type of financial intuition to the financial system, since the private sector was not willing to finance it.

At that time, the life insurance industry was struggling to stay afloat. It had come to the realisation that it was facing a huge financial problem. The public was losing interest in buying life or long-term insurance. This type of policy was the “bread and butter” of the industry. It created a predictable cash flow over a long term because of the longer-term nature of life policies. The alternative was term policies, which provided coverage over short periods.

The root of the problem was that the industry, by practice, paid heavy commissions to underwriters in the early start-up period of the policies sold, creating a negative cash flow before the accumulated payment of premiums began to show profitable returns. The net effect was a severe drain on capital which had to be covered by short-term high interest borrowings at 35 per cent and more.

Over time, this drying up of the capital base of insurers left them no other recourse but to close the gap by heavy borrowings and accumulated debt. The borrowings were generally from affiliated commercial banks which had to seek funding through high cost overdrafts from the BOJ, deepening the financial crises. This precarious condition had now become a mushrooming threat to the industry.

The rapid expansion of the web of lending institutions in the 1990s, spearheaded by excessive growth in money supply which drove inflation and interest rates, made both lending and borrowing high risk ventures. This was even more precarious because short-term money was being used to finance long-term lending, since long-term savings were, out of fear, drying up. This was a prescription for staggering loan defaults which would ricochet throughout the system, causing turmoil. That is precisely what happened.

Paul Chen Young reports in his, With All Good Intentions: “In May 1996, Dennis Lalor from Life of Jamaica, Marshall Hall from Mutual Life and myself from Crown Eagle were asked to represent the industry by meeting with Finance Minister Omar Davies and to bring to his attention the imminent collapse of the industry unless help was forthcoming. Davies seemed receptive in providing assistance and each company was later invited to provide financial information and submit forecast on its future viability to the Ministry of Finance.”

In anticipation of more problems to come, in January 1997 Government established the Financial Sector Adjustment Company Ltd (FINSAC) to handle all take-overs and arrange the management and disposal of assets. A fund of $6.3 billion was provided for interventions initially. This would prove to be a pittance. Crown Eagle alone required $5 billion.

FINSAC intervened in 200 companies, making it, in a sense, the largest conglomerate in Jamaican history.

In terms of rating the crisis, the Jamaican meltdown ranked third behind Argentina's crisis in 1980, which cost 55 per cent of GDP, and Indonesia's crisis in 1997 that cost 50 per cent of GDP. In Jamaica's case, the meltdown of the financial sector was at a cost of some 44 per cent of GDP.

This crash of the financial sector left the equivalent of a cosmic “black hole” in the economy, which sucked away nearly one-half of the production and associated wealth of the country. The damage was some $140 billion by the time the notes issued by FINSAC were brought on the books of Government for payment. These comprised mitigation of the losses of bank deposits and those of pension funds, as well as life insurance investments.

The strategy employed by FINSAC was to take over the failed financial institutions, wholly, or with majority control, and refinance them to meet their obligations to depositors, pension contributors, and holders of life insurance policies. This made sense as a vehicle to clean up what would have been over two million accounts, once the Government decided to absorb these losses in full.

The breakout of the FINSAC intervention was:

* $68.7 billion for 1,500,000 depositors with bank accounts;

* $174.8 billion for 569,000 life insurance policy holders;

* $19 billion for 55,000 pensioners:

25,000 non-performing loan accounts comprised of:

* $34 billion in principal;

* $18 billion in interest;

* $52 billion in total.

These non-performing loan accounts were not compensated. They had to deal directly with FINSAC.

The total number of accounts compensated was 2,124,000 or virtually all holders of saving, pensions and life insurance policies hit by the financial meltdown, leaving 25,000 holders of non-performing loans to find solutions with FINSAC or elsewhere.

The $140-billion cost to Government was an immense surcharge on the national debt and sinking the country further, with the infamous designation of being one of the three most-indebted countries in the world.

Let us make sure that this never happens again.

— Edward Seaga is a former prime minister of Jamaica and currently a distinguished fellow at The University of the West Indies, and chancellor, University of Technology, Jamaica.

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