Public Information Notice No. 00/3

Public Information Notice: IMF Concludes Article IV Consultation with Jamaica

January 27, 2000

On January 10, 2000, the Executive Board concluded the Article IV consultation with Jamaica.¹

Background

During the 1996/97-1998/99 period, Jamaica achieved significant progress in reducing inflation, restructuring the financial system after the crisis in 1995-96, and further liberalizing the economy through external tariff reduction and privatization. However, the policy mix of tight monetary policy and large fiscal imbalances continued to result in very high interest rates and appreciation of the Jamaica dollar in real effective terms that have contributed to weak economic growth. In addition, public sector debt rose sharply on account of a large bailout of the financial sector and the large public sector deficit.

Inflation was reduced from 31 percent in 1995/96 to about 5½ percent in October 1999, and real wage increases slowed significantly in 1998, after several years of large increases, as the authorities' success in reducing inflation fed into new wage contracts. The average nominal lending rate fell by 400 basis points but real interest rates remained high. Output contracted by a cumulative 4½ percent during the two-year period 1996/97-1998/99 mainly because of high interest rates that slowed investment, and a deterioration in competitiveness for manufacturing and nontraditional exports. Unemployment remained at about 15½ percent in 1997-98.

Real effective exchange rate appreciation had cumulated to about 35 percent during the 1996/97-1998/98 period, but slowed significantly since August 1998 as inflation in Jamaica approached that in trading partner countries and the Jamaica dollar depreciated moderately in nominal effective terms.

The external current account deficit widened from 1½ percent of GDP in 1996/97 to 4½ percent of GDP a year during 1997/98-1998/99 as export volume and prices declined, despite a sharp fall in import prices. The current account deficit was financed mostly from foreign investment as large external commercial borrowing was offset by large official debt amortization. As the overall balance of payments recorded a deficit of US$70 million in the 1997/98-1998/99 period, gross international reserves fell to about US$700 million by end-March 1999, equivalent to nine weeks of prospective imports of goods and services and 105 percent of prospective debt service payments.

After a significant widening of the fiscal deficit in 1997/98, efforts were made to consolidate the public finances in 1998/99 but they were insufficient to offset fully the high interest bill. The overall public sector deficit increased by 4 percentage points of GDP to 9½ percent in 1997/98 as central government revenues relative to GDP fell for the second consecutive year and most expenditure categories—especially wages—rose sharply. Significant efforts at fiscal adjustment in 1998/99 included strengthening tax administration, cutting nonwage primary expenditures and capital outlays, and some tax increases. However, the growing interest bill on domestic debt resulted in the overall deficit rising further to 12 percent of GDP. Even though the external debt declined for the sixth consecutive year, total public debt (net of central government holdings of government-backed liabilities issued by the Financial Sector Adjustment Company (FINSAC) rose from 126 percent of GDP at end-1997/98 to 139 percent at end-1998/99.

In the area of structural reforms, considerable progress has been made in the financial sector and in privatization, while trade liberalization continued. The financial sector crisis that emerged in 1995/96 was contained by replacing nonperforming loans with government-backed securities, restructuring the intervened institutions, and strengthening the prudential and supervisory frameworks. Four state-owned banks and a number of smaller entities were merged into the Union Bank, and restructuring of the National Commercial Bank continued with both banks being prepared for privatization. Three of the five intervened insurance companies have been sold, with negotiations for the sale of the remaining two in progress. Following some setbacks—when some privatized entities reverted to public ownership or continued to need government subsidies—privatization gained momentum in 1999 with the sale of some high-profile entities. Also, Jamaica reduced, as envisaged under the aegis of CARICOM, the maximum external tariff on nonagricultural products to 20 percent in January 1999.

The authorities' policy strategy for 1999/2000 continues to be centered around moderate further improvements in the primary fiscal balance, and tight monetary policy to contain inflation. To that end, their aim is for a central government budget deficit of 4½ percent of GDP and inflation of 4-6 percent. Based on developments during the first half of the fiscal year, the staff projects that the central government deficit is likely to be around 5½ percent of GDP, due to lower than anticipated revenues associated with weak growth, and higher wage and interest payments; the total public sector deficit would decline to 8 percent of GDP and the public debt would broadly stabilize at about 140 percent of GDP. Real output growth, constrained by still high interest rates, is likely to be modest—about ½ percent—mainly on account of a recovery in agriculture and some growth in tourism. The external current account deficit would widen to 4½ percent of GDP, financed largely by direct investment and private capital inflows, with gross official reserves remaining at about US$700 million.

Executive Board Assessment

Executive Directors noted that the authorities have been dealing with a very difficult situation and have achieved some successes. Inflation has been significantly reduced in the last three to four years; fiscal efforts in the last two years have been substantial, although more than offset by the large interest bill; the restructuring of the financial system after the crisis in 1995/96 has progressed in a broadly satisfactory way; and the economy has been further liberalized via privatization and tariff reduction. However, Directors observed that the fiscal deficit has remained large, primarily because of the heavy public debt burden, and has required substantial domestic borrowing. High real interest rates, resulting from tight monetary policy and large fiscal deficits, have contributed to a significant appreciation of the Jamaican dollar in real effective terms. Moreover, the cost of the financial system bailout in recent years has combined with these developments to raise public debt and generate adverse debt dynamics.

Directors noted the convergence of views between the staff and the authorities over the macroeconomic challenges facing Jamaica, but observed that there were differences about the perceived risks to, and vulnerability of, the economy, and hence about the appropriate pace of adjustment. Directors welcomed the authorities' strong actions to raise the primary surplus in order to reverse the adverse debt dynamics while maintaining low inflation, which had been working better than earlier expected. However, they noted that, because of the rising interest bill, this strategy had put the public debt on only a moderately declining trajectory. Most Directors considered that there were risks associated with the more gradual path preferred by the authorities, as it might yield only weak economic recovery and could leave the economy vulnerable for a prolonged period to further external or domestic shocks. Furthermore, the erosion of competitiveness poses a major obstacle to a more vigorous economic recovery. Accordingly, these Directors urged the authorities to strengthen their efforts to put the economy on a less vulnerable path by a more ambitious, up-front fiscal adjustment, wage restraint, flexible exchange rate policy, and accelerated structural reforms. Some Directors, however, supported the authorities' concern that there might also be some risks associated with an accelerated adjustment path.

Directors considered that the emphasis of fiscal adjustment should be on expenditure reduction—particularly primary current expenditures—while strengthening social safety net programs. At the same time, while noting that tax rates in Jamaica are already high, they felt that some revenue measures may be needed, including steps to eliminate exemptions and improve tax administration. Directors noted that the pace of wage increases has been lowered, reflecting the authorities' success in reducing inflationary expectations. However, wage gains have outstripped productivity growth by a substantial margin during the preceding several years. Therefore, sustained moderation in wage increases remains necessary to enhance the chances of success for the authorities' adjustment strategy.

Directors agreed that it would be desirable to have greater flexibility in the exchange rate by abstaining from sustained intervention in the foreign exchange market. They considered that, in the context of a tighter fiscal policy, such greater flexibility would allow for a gradual reduction in domestic interest rates. In this regard, a number of Directors, although acknowledging the authorities' concern about the danger of renewing a wage-price spiral in the event of a significant depreciation, were of the view that the present low inflation environment provided room for such greater exchange rate flexibility. Many others, however, supported the authorities' cautious approach.

Directors welcomed the recent progress with structural reforms. Of particular note were the marked acceleration in privatization during 1999 and the strengthened financial sector framework that has been established with the recent rationalization of publicly-owned financial institutions and improvements in the supervision of the financial system. Directors encouraged the authorities to accelerate these and other reforms. They recommended strengthening the supervision of financial institutions that are not under the supervisory authority of the central bank. Directors were of the view that the authorities should undertake a comprehensive reform of the public service to reduce its size and improve efficiency in the delivery of public services.

Jamaica's economic statistics are generally adequate for surveillance and Directors commended the efforts to strengthen the provision of general statistics. At the same time, they urged the authorities to strengthen these efforts by matching the tasks of statistics agencies with adequate resources to implement the recommendations of recent technical assistance.