The Dutch Disease in a Small Economy: the Case of Jamaica

2003:024 SHU

BACHELOR’S THESIS

The Dutch Disease in a Small Economy The Case of Jamaica

DANIEL WIKSTRÖM HENRIK ÖSTERBERG

Social Science and Business Administration Programmes ECONOMICS PROGRAMME

Department of Business Administration and Social Sciences Division of Economics Supervisor: Bo Jonsson

2003:024 SHU • ISSN: 1404 – 5508 • ISRN: LTU - SHU - EX - - 03/24 - - SE SAMMANFATTNING

Syftet med denna uppsats är att undersöka om Jamaica lider av, eller har lidit av Dutch Disease samt vilken policy den jamaicanska regeringen använt sig av för att diversifiera strukturen på den inhemska ekonomin. Uppsatsen undersöker också vilka effekter fokuseringen på bauxit- och aluminaproduktion har haft på andra, icke-mineralbaserade, sektorers relativa konkurrenskraft jämfört med konkurrerande länder. Uppsatsens begränsning utgörs av att det är den jamaicanska bauxitmarknaden under åren 1970 till 1999 som undersöks. Tillämpade teorier är traditionella och moderna handelsteorier, växelkursteorier samt teorin om Dutch Disease. Under tiden som studien omfattar är det möjligt att dra slutsatsen att Jamaica inte har lidit av Dutch Disease. Den jamaicanska regeringens försök att diversifiera ekonomin, med hjälp av inkomster från bauxitskatten, har inte lyckats. För att Jamaica skall bli mer konkurrenskraftiga inom bauxit- och aluminaindustrin, krävs en ökad produktivitet av arbetskraften samt en förnyelse av de fabriker som förädlar bauxit till alumina.

ABSTRACT

The purpose of this thesis is to determine weather Jamaica has, or has had a Dutch Disease problem and examine what economic policies have been used by the Jamaican Government in order to diversify the structure of the economy. The thesis also examines what effects the high focus on bauxite and alumina production has had on other sectors´ relative competitiveness towards competing countries. The scope for the thesis is based on the Jamaican bauxite market during the time period 1970 to 1999. Applied theories are traditional and modern trade theories, exchange rate theories, and finally the theory of the Dutch Disease. During the time period of this study, it is possible to conclude that Jamaica has not suffered from the Dutch Disease. The Jamaican Governments’ attempt to diversify the economy, with help of the bauxite levy revenues, has not been very successful. For Jamaica, in order to become more competitive within the bauxite and alumina industry, productivity must be improved and the plants where the bauxite is refined to alumina must be equipped with more advanced technology.

ACKNOWLEDGEMENTS

The authors would like to thank all people who helped them in the preparation of this study. Without their assistance and contributions the thesis would never have been realized. Special thanks to:

Chris; who bigheartedly introduced the authors to the streets of Kingston and to the Jamaican way of living.

Mr. Wilberne Persaud; at the University of West Indies, Mona Campus, who provided housing and an introduction to the Jamaican economy. Mr. Dennis Morrison, for explaining the structure of the Jamaican bauxite industry, and Ms. Olive Johnson, for providing information in great manner, both employees of the Jamaica Bauxite Institute. Further, the authors would like to thank Mr. Franklin Brown, at the Office of Utilities Regulation, for taking time to explain and giving them essential information.

Stefan Hellmer and Bo Jonsson at Luleå University of technology, division of economics, for discussions, critical comments and guiding throughout the preparation, and finally, the Swedish International Development Agency (SIDA) for granting the authors the scholarship needed in order to conduct this thesis.

III

TABLE OF CONTENTS

SAMMANFATTNING...... I ABSTRACT ...... II ACKNOWLEDGEMENTS ...... III LIST OF FIGURES AND TABLES ...... IV INTRODUCTION ...... 1 1.1 Background...... 1 1.2 Purpose ...... 1 1.3 Method...... 2 1.4 Scope and Limitations ...... 2 1.5 Reliability and Validity ...... 2 1.6 Outline ...... 2 JAMAICA AT A GLANCE...... 3 2.1 Brief History of Jamaica...... 3 2.2 Some Demographic Data...... 5 2.3 The Jamaican Economy...... 6 2.4 An Overview of the Mineral Industry of Jamaica ...... 9 2.5 Jamaica’s Bauxite and Alumina Industry...... 12 2.5.1 Total Production of Bauxite ...... 15 2.5.2 Total Production of Alumina...... 16 2.5.3 Total Exports of Bauxite and Alumina...... 17 2.6 The World Bauxite and Alumina Industry ...... 18 THEORY...... 20 3.1 Theory of the Dutch Disease ...... 20 3.2 International Trade ...... 21 3.2.1 Absolute Advantage ...... 22 3.2.2 Comparative Advantage ...... 22

3.2.3 Production, Demand, and Trade in a Sector under Perfect Competition ...... 23 3.2.4 Relaxation of the Assumptions in the Heckscher-Ohlin Model ...... 25 3.3 Exchange Rate Theory...... 29 3.3.1 Demand Side...... 29 3.3.2 Supply Side...... 29 3.3.3 The Foreign Exchange Market ...... 30 3.3.4 Flexible Exchange Rates ...... 30 3.3.5 The Effects of Fiscal Policy under Different Capital Mobility Assumptions 33 3.3.6 Effects of Monetary Policy under Different Capital Mobility Assumptions. 35 EMPIRICAL DATA AND ANALYSIS...... 38 4.1 Data...... 38 4.2 Gross Domestic Product ...... 39 4.3 Unemployment ...... 40 4.4 Consumer Price Index ...... 41 4.5 Average Annual Exchange Rate...... 42 4.6 Alumina and Bauxite’s Contribution to Total Exports...... 43 4.7 Total Exports of Banana and Sugar...... 44 CONCLUSIONS...... 46 CONCLUDING REMARKS...... 48 REFERENCES ...... 50

LIST OF FIGURES AND TABLES

Figure 2.1, Total exports and imports for different time periods ...... 9 Figure 2.2, Total production of bauxite in million tonnes, 1973 to 1999...... 16 Figure 2.3, Total production of alumina in million tonnes, 1970 to 1999...... 17 Figure 2.4, Value of total exports of bauxite and alumina, 1970 to 1999 ...... 18 Figure 3.1, The physically capital-rich country is biased towards producing the capital-intensive good...... 23 Figure 3.2, Model for trade in a market under perfect competition ...... 24 Figure 3.3, Equilibrium in trade under transport costs...... 25 Figure 3.4, Effects of a tariff ...... 27 Figure 3.5, Trade with differentiated products...... 28 Figure 3.6, A simple model for the foreign exchange market...... 30 Figure 3.7, Income and the interest rate: the IS curve...... 31 Figure 3.8, Income and the interest rate: the LM curve ...... 32 Figure 3.9, The effects of changes in the exchange rate on the BP curve...... 32 Figure 3.10, Fiscal policy in the open economy with flexible exchange rates under alternative capital mobility assumptions ...... 34 Figure 3.11, Monetary policy in the open economy with flexible exchange rates under alternative capital mobility assumptions ...... 36 Figure 4.1, GDP in million JA$, 1970 to 1999...... 39 Figure 4.2, Level of unemployment, 1970 to 1999 ...... 40 Figure 4.3, Consumer Price Index, 1970 to 1999...... 41 Figure 4.4, Average annual exchange rate, 1970 to 1999 ...... 42 Figure 4.5, Alumina and bauxite’s contribution to total exports, 1970-1999 ...... 43 Figure 4.6, Total exports of banana and sugar, 1970 to 1999 ...... 44

Table 2.1, Production of mineral commodities, 1995 to 1999 ...... 11

IV Chapter 1 INTRODUCTION

1.1 Background Large parts of the Jamaican land mass are used for bauxite mining and alumina production. In 1990, bauxite and alumina were Jamaica’s second leading hard currency earners, accounting for 17.3% of GDP and 62.9% of total exports. Jamaica is the third largest producer of bauxite ore, after Australia and Guinea, and fourth in the production of alumina (Rabchevsky, 1995).

Following natural resource discoveries and increases in price, a number of small developing economies, which has been relatively poor found them to be relatively wealthy. However, the existence of significant quantities of minerals with strong export potential has generally been seen as a mixed blessing for national development. All of these small economies have thus adopted conscious policies of diversification aimed at increasing the economic contribution of other sectors (Heeks, 1998).

Initial diversification strategies focused mainly on the development of large enterprises. More recently, though, these economies have begun to take a greater interest in small enterprises. This has chimed with growing recognition of the potential impact these enterprises can have on factors such as employment and income generation, income distribution, and technical innovation (ibid). Has the diversification strategies in the case of Jamaica have had any success in reducing the above mentioned problems?

1.2 Purpose The purpose of this thesis is to determine whether Jamaica has, or has had a Dutch Disease-problem and examine what economic policies have been used by the Jamaican Government in order to diversify the structure of the economy. The thesis also examines

1 what effects the high focus on bauxite and alumina production has had on other sectors´ relative competitiveness towards competing countries.

1.3 Method This thesis is based on a nine weeks long field study in Jamaica. It contains primary data in form of interviews as well as secondary data in form of literature on the topic. Empirical data is collected through a field study launched in Kingston, Jamaica.

1.4 Scope and limitations The paper is limited to the years 1970 to 1999. A further limitation is that the comparison of other sectors’ relative competitiveness will be focused on the sugar and banana industry.

1.5 Reliability and Validity Most data was collected from official sources in Jamaica. It is not impossible that these data can be manipulated in a development country, but since the same data was found with different statistical sources the reliability of this study should be acceptable.

Problems concerning validity might occur in this thesis since some data has been calculated by the authors. These data include figure 4.3 where the Consumer Price Index had different index years, and had to be modified in order to obtain a new base year for the index values. Additionally, in figure 4.7, some small errors occurred when the numbers where narrowed down.

1.6 Outline The first chapter gives an introduction to the thesis. The second chapter presents Jamaica, the mineral industry of Jamaica, and the bauxite and alumina market of Jamaica and the world. The third chapter provides the theoretical framework of the thesis, and the fourth chapter contains the empirical data and analysis of the data. Finally, conclusions are presented in the fifth chapter.

2 Chapter 2 JAMAICA AT A GLANCE

Jamaica is the third largest island in the West Indies, only smaller than Cuba and the island of Hispaniola. Almost at the center of the Caribbean Sea, Jamaica lies about 150 kilometers south of Cuba. The closest point to Jamaica in South America is Cartagena in Colombia, a distance of 710 kilometers. Jamaica’s central and eastern parts are highly characterized by peaks from the chain of Blue Mountains. When going westwards, the mountainous district transfigures into a plateau of limestone with partly almost impassable terrain. The so-called Cockpit Country is a landscape with cavities, caves and subterranean watercourses. The scenery of the coastal regions in the south and the west is relatively flat. For a map over Jamaica, contact the authors.

The flora of Jamaica is rich. There are about 3000 species of flowering plants on the island from which 800 doesn’t grow anywhere else. Jamaica’s climate is tropical with only negligible variations in the temperature, both between the seasons and between night and day. However, it is significantly cooler in the mountainous districts. The precipitation is quite unevenly distributed; the trade wind brings five times more rain to the northeast side of the island than to the coast in the south. Most rain falls between May and October (Johannesson, 2001).

2.1 Brief History of Jamaica Prior to the arrival of Columbus in 1494, Arawaks, living in simple communities based on fishing and hunting, inhabited Jamaica. The Arawaks originated from what nowadays is called Venezuela and settled on the island approximately in the 700th century. They called the island Xaymaca, “The Land of Forest and Water”. The impact of the contact with the Spanish was traumatic, and the Arawak communities disappeared in 70-80 years. Plunder, disruption of economic activities, new diseases, and migration decimated

3 the indigenous population. Except for some artifacts that remain from this period there are no traces or influence of the Arawak era on the island. When the Spanish realized that the island wasn’t as full of gold as they had been expecting, they instead used Jamaica as a base for their conquer of the Americas. The population of the Spanish and their slaves was at no period large. The administration was carried out from Spanish Town. Economic activity existed but the production was primarily for domestic consumption (Casserborg 2000).

In 1655 the island was discovered by a British expedition (Höök-Skärham et al., 2000). By this time, the island was of little significance to the Spanish crown, hence, very little was done to protect it from the British. Apart from leftovers of buildings with the distinct Spanish colonial architectural styles, and names of places, there is very little visible evidence of the Spanish occupation. The British saw no other use for the island except for growing sugar, and started a large scale import of slaves from Western Africa. The slaves were used as workers on the plantations. Jamaica brought fabulous prosperity to the British plantation owners. The plantation dominated the economy in every sense, it occupied the best landmasses, the laws supported the slave system and other economic activity depended on the activity of the plantations. Some slaves inevitably ran away from the estates to live in small bands in the mountains (Johannesson, 2001).

By the end of the 18th century, sugar was losing its economic preeminence due to competition from beet sugar as well as rising production costs. In 1834, the slaves were emancipated and the plantations had to begin paying wages to their workers. One of Jamaica’s national heroes, the Reverend Sam Sharpe, is celebrated for his leadership role in the famous Christmas rebellion of slaves in 1831, a few years before emancipation. After the freeing of the slaves, many of the former slaves settled down as small farmers in the mountains cultivating steep hill slopes far away from the plantations. Others settled on marginal lands in the plains nearby the plantations on land leased or bought in various settlement schemes organized by Christian groups. Struggles over land were a central theme in the history of this period when many had to pay with their lives. Sugar continued its decline during this period, whilst exports of log wood, coffee and

4 eventually bananas grew steadily. In this way, the economy started to diversify away from its traditional dependence on sugar (ibid).

The roots of the national movement for independence reach back into the struggles for land in the 19th century. More immediately, it was inspired by the political ideas and agitation of Marcus Garvey, and also evoked by the reaction of the sugar and dockworkers to the economic crisis, brought forward by the Great Depression in the 1930s (ibid). The movement for independence emerged as a political force in the context of the rebellion in 1938. The period after the 1938 rebellion did not only see major political changes, but also major transformations of the structure of the economy. From a monocrop export economy, the economy became diversified around the export of sugar, bananas and other agricultural commodities, the export of bauxite and alumina, and the tourist industry. These in turn, stimulated a vital construction industry, and an import substituting manufacturing sector. The USA displaced the UK as Jamaica's principal trading partner. There was also a tremendous migration of labor to the UK and the USA, who needed labor for the post-war reconstruction, and expansion of their economies. Political independence was granted in 1962, following Jamaica's rejection, by referendum, of membership in the Federation of the West Indies, (Höök-Skärham et al., 2000). Jamaica was given a Westminster style constitution, with a Governor-general as the representative of the British Crown, and a bicameral Parliament. There is a House of Representatives consisting of elected representatives and a Senate appointed by the Prime Minister and the Leader of the Opposition. A Prime Minister heads the Government (Casserborg, 2000).

2.2 Some Demographic Data Almost 2.6 million people inhabit the island. Jamaica has a total area of 10 990 km2 (CIA, 2002 08 07). 56% of the population lives in the cities, of which Kingston is the largest with 700,000 habitants. In 1999 the birth rate was 2.2% while the mortality rate was 0.7%; however the number of emigrants, especially to the US, has increased rapidly during the last two decades primarily due to the better living conditions offered. Average length of life is 75 years for men and 77 years for women (Johannesson, 2001). Roughly

5 95% of the population is black descendants to the African slaves. There are also small minorities of Lebanese, Chinese and Indians (Casserborg, 2000). Even though the official language is English, the rich and innovating Jamaican Creole (patois) is heard more often and the Jamaican Government is seriously considering acknowledging the Creole as a second official language. Religion has a big part of the life on Jamaica; the biggest religious group is Protestants, to which 70-75% devotes themselves (Johannesson, 2001). Most distinguishing are the Rastafaris, a movement that came forward in the beginning of the 20th century. Marcus Garvey gave the foundation to this faith, which has its name after ras (prince) Tafari Makonen who 1930 was crowned as the emperor of Ethiopia under the name of Haile Selassie. The religious discourse on Haile Selassie is that of him being Messiahs who will free the blacks from the oppression of the whites and eventually bring the Rastafaris back to Africa (Barker, 1989).

Politics has since the independence been dominated by two parties: the almost social democratic PNP (People’s National Party) and the conservative JLP (Jamaica Labor Party) (Ministry of Finance and Planning, 1999). While PNP has alienated from its earlier socialistically ideals, the ideological differences between the parties has decreased. The big unions support Percival Patterson or Edward Seaga, the respective leaders of PNP and JLP; accordingly they have an extensive influence over the Jamaican politics. There are also numerous lobby groups exerting power. Amongst the public at large, the apathy for politics is widespread, especially amid the youth. Violence and social alarm is the biggest problem relating to domestic politics. Jamaica is one of the countries where most murders are committed. Most of the murders are settlings between criminal gangs. Generally, the violence increases during times of election since gang leaders have connections to the big parties. Today the parties try to separate from the gangs; nonetheless there still exist contacts between politicians and local gang leaders (Johannesson, 2001).

2.3 The Jamaican Economy Among the English speaking countries in the West Indies, Jamaica occupies an economical front position, and the cooperation among these countries is substantial.

6 Jamaica is a member of the Caribbean Common Market (CARICOM), which is an organization that strives for an improved regional integration, mainly in the economic field. In the long run, CARICOM will try to achieve free trade within the organization. Jamaica’s most important trade partner is the US, though the relationship between the countries has in recent years been strained due to Washington’s demands on Jamaica to destroy marijuana plantations, marijuana that in large scale is smuggled to the North American market (Johannesson, 2001).

Despite long periods, and partly successful efforts to diversify the Jamaican economy it is still based upon three large sectors – the mining industry, tourism and agriculture. All three sectors are dependent on the global demand, which consequently means that the Jamaican economy is vulnerable for declines in the international business cycles. Tourism is the present largest source of income. Up to 25% of the population is in an occupation related to tourism (ibid). Exports are dominated by the mining industry. Jamaica is the third largest producer of bauxite, and some of the bauxite is refined to alumina inside the country (Rabchevsky, 1995). Bauxite and alumina represent more than half of the total exports (Höök-Skärham et al., 2000).

Sugar and bananas are other important trade products. The banana sector is struggling nowadays since the European Union had to abolish the advantages former colonies had on the European Union-market in the late 1990s. Banana production costs, while on the same level as the rest of the Caribbean countries, are high relative to Latin America. The banana sector is making efforts to increase competitiveness in the external market by diversifying and improving productivity. New products developed include banana-based drinks, banana flour, and cereal products. In 1998, as a part of the restructuring, the sector eliminated redundant labor, and reduced labor costs through lay-offs and lower wage settlements (Ministry of Finance and Planning, 1999).

To support the sugar industry in order to improve its efficiency and long-term viability, the Government launched a program, which was in response to problems being experienced by the sector, caused by prolonged drought conditions and fluctuations in the

7 ECU/British Pound Sterling exchange rates. The financial support to the sugar industry has been focused on replanting, factory improvement, and financial restructuring of some entities. Loans given to companies are expected to be repaid from the assignment of the proceeds of export sales of sugar (ibid). One reason for the Government to give subsidies to the sugar industry is that sugar exports are an important source of foreign exchange (Griffith, 2002).

After a long period of modest economic growth, the trend turned downwards in the 1990s. This was due to a crisis in the middle of the decade when the state was forced to take over several neglected banks and insurance companies, which in turn led to an increase in the already substantial budget deficit. There were also further problems: the mining industry suffered by falling world market prices, the agricultural sector had harvests ruined due to droughts and the recession in the US markets led to less tourism (Johannesson, 2001). Before 1984 the Jamaican Dollar was only allowed to float against the US Dollar in a prescribed band. After a modification of the foreign exchange auction system in November 1984, the Jamaican dollar has depreciated. From being JM$/US$ 3.94 in 1984, the exchange rate depreciated to JM$/US$ 39.33 in 1999 (Bank of Jamaica, 2000).

Throughout the years between of 1970 to 1999 the point-to-point inflation rate has been fluctuating with a high of 80.2% and a low of 4.6% (Statistical Institute of Jamaica, 2001). During the 1990s the Government pursued an aggressive fiscal and monetary policy in order to bring inflation under control (Personal communication, Mr. Franklin Brown). These actions helped to reduce the inflation rates from 40.2% in 1992 to 6.8% in 1999. The Government also achieved a reduction in the unemployment rates (Statistical Institute of Jamaica, 2001).

The imports/exports ratio has revealed a big deficit since the 1970s. This in turn creates a persistent shortage of foreign currency. In 2000, the trade deficit totaled of 83 billion Jamaican Dollars (Statistical Institute of Jamaica, 2002). Figure 2.1 below, illustrates the imports and exports of Jamaica for various time periods.

8 30000

25000

20000 M 15000

US$ X 10000

5000

Total imports/exports in thousand inTotal imports/exports thousand 0 1970s 1980s 1990s Time period

Figure 2.1, “Total exports and imports for different time periods” Source: Statistical Institute of Jamaica (2002)

The United States is the greatest importer of Jamaican goods. In 2000 the US represented 39% of all Jamaica’s exports. Other important trade partners are United Kingdom, Canada and Norway. Jamaica is an import dependent country and imports most goods from the United States, from where nearly 45% of all imported goods come. Trinidad and Tobago, Japan and Venezuela are also big exporters to Jamaica. Raw materiel and intermediate goods represent over 50% of all imports while consumer goods stand for roughly 30% (Boote et al., 2001). In cooperation with the International Monetary Fund, Jamaica’s Government began a program to reduce the external debt in 2000. This program covers raised taxes, deregulation, and selling of licenses for the mobile phone market (Johannesson, 2001).

2.4 An Overview of the Mineral Industry of Jamaica Bauxite is significantly the most economically important mineral. The bauxite industry of Jamaica will be introduced more thoroughly in chapter 2.5. When it comes to non- bauxite metallic minerals, the extraction is not as well developed as it is in the bauxite industry. As mentioned earlier, the main purpose of the Spanish occupation of Jamaica was to acquire the precious metal of gold. However, the Spanish never found any gold

9 and there is no evidence of gold having been mined in Jamaica. But in March of 2001, a small high grade gold mine was developed as a result of co-operation between the Mines and Geology Division of Jamaica and the Canadian International Development Agency (Mines and Geology Division, 2002 05 18).

Copper occurs extensively in the eastern parts of the island, mainly as sulphide minerals and is the second most widespread metalliferous mineral in Jamaica after bauxite. Several attempts to mine copper were made in the 19th century, but for various reasons these mines were closed down before the end of the century. Lead and zinc has also been mined, this was done 8 kilometers northwest of Kingston. This mining activity continued until 1860 when large amounts of galenia and sphalerite had been removed. Lead is still produced on the island, but as a by-product (Fenton, 1981).

Approximately 2/3 of the island is covered by tertiary carbonates of varying properties. The exploitation of carbonates as industrial minerals are slowly growing with the hope of finding external markets for the carbonates, and Jamaica has great potential for future development in this area. Limestone is Jamaica’s largest source of non-metallic minerals. There are approximately 50 billion tonnes available for mining (Industrial Minerals of Jamaica, 1980). 85% of annual production of limestone goes into the domestic building and construction industry and small parts of the production are calcined to produce lime which is used in the bauxite industry. Only small fragments of the total production are exported, the exports are small shipments made periodically to the USA. (Mines and Geology Division, 2002 05 18).

Another carbonate which occurs throughout Jamaica is marble. Marble was first quarried in 1962, but due to a lack of knowledge of the deposit and due to a lack of quarrying and processing technology the mining ended a couple of years later (Fenton, 1973). Despite various attempts by the Government and also private entrepreneurial interests, this resource remained untapped until 1992 when a joint program between the Jamaican Government and the United Nation Development Programme found and identified 21 potential marble deposits with 350 million tonnes of recoverable material. From this

10 program, an enterprise was established with a plant in Hellshire 1992 (Mines and Geology Division, 2002 05 18).

Gypsum is, next to bauxite, the most important mineral being mined at present, with an approximated reserve of 85 million tonnes. The main internal use of gypsum in Jamaica is in the cement industry and in the manufacture of plaster boards. When it comes to aggregate, Jamaica produces about 10 million tonnes annually, from which the most widely used are mark fill, crushed stone and sand and gravel. More than 85% of the aggregate are derived from crushed limestone. The last non-metallic mineral with a substantial production that is quarried in Jamaica is silica sand, which occurs on the south-western margin of the island. There are approximately 1.3 million tonnes of recoverable silica sand, which is used in the local manufacturing of glass-bottles (Fenton, 1981). Jamaica’s production of different mineral commodities can be seen below in Table 2.1.

Table 2.1, “Production of mineral commodities, 1995 to 1999” Commodity 1995 1996 1997 1998 1999 Bauxite, dry equivalent t.t 10,858 11,863 11,987 12,646 11,688 Alumina t.t 3,03 3,199 3,414 3,44 3,57 Gypsum m.t 208,02 338,875 263,662 154,451 235,9 Lead, refined (estimated) m.t 800 800 800 800 800 Silica Sand m.t 16,3 15,79 12,089 6,128 9,4 Limestone t.t 3,385 3,351 3,35 3,201 3,3 Marble m.t 2,8 2 1,5 750 400 Sand and Gravel t.t. 1,8 1,836 1,928 1,839 2,06 (m.t: metric tonnes, t.t: thousand tonnes) Source: U.S Geological Survey Minerals Yearbook (1999)

11 2.5 Jamaica’s Bauxite and Alumina Industry Bauxite occurs as irregularly shaped deposits on karstified tertiary white limestone. It occurs in the form of infilling of circular or oval dolines, large elongated glades, or blanketing uneven depressions of limestone plateaux. Bauxite mining in Jamaica was established in the early 1950s and is, after tourism, the second largest industry of Jamaica, with a reserve of over 1.8 billion tonnes (Mines and Geology Division, 2002 05 18). Jamaica’s bauxite is of the terra rossa type and is finely divided earthy material, soft to moderately hard, porous and can vary from dark red, reddish brown to yellow in color. It contains 45-50% alumina and is highly ferruginous with iron oxides of up to 20%. Its content of titania is around 2% and its silica level is generally less than 3%. The size of individual deposits varies from small pockets to basins of over 125 hectares and it varies in thickness from a couple of meters to over 30 meters. The main deposits occur in the parishes of Manchester, St Elizabeth, St Ann and Trelawny (Fenton, 1981).

With the Bayer process, alumina is extracted from bauxite. Water, calcined limestone and caustic soda are added to the bauxite. This mixture is then cooked in huge pressure vessels. By the help of this process, called the Bayer Process, alumina is precipitated and the residue of red mud is discharged into large dams. The alumina is then passed through a kiln and it emerges as a super-dry, white powder, somewhat finer than table salt (Personal Communication, Mr. Leslie James). For a flow chart over the Bayer Process, contact the authors. About 2.5 tonnes of Jamaican bauxite yield one ton of alumina. Alumina is a chemical bonding of aluminium and oxygen. 1.95 tonnes of alumina produce one ton of aluminium (Jamaica Bauxite Institute, 1992).

Until the World War II little attention was paid to the rich deposits of bauxite outside Europe and the United States. Between 1938 and 1942 a business man in Jamaica wanted to improve the fertility of his farm. The business man, Sir Alfred D’Costa, had soil tests done and on analysis the soil proved to be highly aluminous. Through the exertions of Sir Alfred and the colonial authorities this fact was brought to attention of aluminium producers in the allied countries. The mineral was vested in the Crown, with the expectation that it might be needed for the war effort. Jamaican bauxite was never to be

12 used in the war, but three North American companies: Alcan, Reynold’s and Kaiser, came to Jamaica to survey and to organize operations over the next few years. In June 1952, Reynold’s began exporting bauxite from Ocho Rios. Thus, the industry began in Jamaica (ibid).

Production increased rapidly and by 1957 Jamaica became the largest producer in the world, representing almost a quarter of all bauxite mined in the world that year. In 1963, a fourth company, Alcoa, began mining operations in Jamaica. The production of alumina also increased, especially after the mid-1960s. By 1974 Jamaica had become the world’s fourth largest producer and second largest exporter of alumina. However, no smelters for extraction of aluminium are built in Jamaica. The biggest reason for this is that aluminium smelting, or reduction, requires massive amounts of electrical energy. Hence, smelters are usually located in places with access to hydropower, coal or natural gas, whereas Jamaica gets its energy from imported petroleum. In 1971 Australia overtook Jamaica’s position as the leading producer of bauxite and in the beginning of the 1980s, the West African country, Guinea, which has the world’s highest grade bauxite, also drew ahead of Jamaica (ibid).

From the start of the bauxite production in 1952 there has been a lot of disputes over the taxation of the industry. In the beginning there didn’t exist a clear market for the bauxite, so the present companies were able to use transfer prices. Hence, the companies could show profits or losses, whatever suited them the best with regards on taxation (Personal communication, Mr. Dennis Morrison). Important changes in the ownership of the industry were made during the 1970s. Although minerals had been owned by the state since colonial times, the companies in this industry were wholly-owned subsidiaries of North American based aluminium companies. Then, in the 1970s, the Government of Jamaica purchased 51% of Kaiser and Reynold’s and smaller parts of Alcoa and Alcan. They also repurchased most of the ore reserves formerly owned by the companies. In return, the companies were granted 40-year mining leases. In 1974, following dramatic increases in the oil price, the Government increased their bauxite revenues from less than US$ 25 million to over US$ 170 million by imposing a bauxite production levy

13 (American University, 2002 06 08). The levy indexes the price of bauxite to the price at which aluminium companies sell aluminium ingot (Jamaica Bauxite Institute, 1992). This fiscal regime was taken as bad news from the actors on the market since they felt it made Jamaican bauxite less competitive on the world market, and it has continually been reviewed over the years (Personal communication, Mr. Dennis Morrison).

To manage its enlarged interest in the industry, the Jamaican Government established agencies such as the Jamaican Bauxite Institute (JBI). The JBI began operating 1976 to regulate, oversee allocation of reserves, determine quantity of reserves, to be a coordinating function in terms of the levy, and to advise the Government on all aspects of the industry (ibid). With the introduction of the production levy there was also established a fund called the Capital Development Fund. All sums received as payment of the production levy is to be paid into the fund. Any moneys and investments forming part of the fund may from time to time be invested or realized in accordance with the directions of the Minister (The Bauxite (Production Levy) Act, 1974). In a Ministry Paper, laid by the then present Prime Minister, Michael Manley, it is said that the additional revenues from the levy would be used to rationalizing and building up the production capacity of the economy. Since bauxite is a non-recoverable asset, it was said to be wise that the major part of the income earned from this asset should be invested in a way as to create future income to replace bauxite income. Withdrawals could be made from the fund for budgetary purposes, and for specific projects of high national priority, such as projects with the means of increasing the production in the major sections of the economy. The latter could be within the agricultural sector, the industry or the supply of adequate infrastructure facilities to support efficient production (Jamaica Bauxite Institute, 1992).

In an attempt to make the bauxite industry more competitive, to increase export earnings and to attract more investors, the Jamaican Government decided to improve the fiscal regime under which the industry functions. After consulting all companies involved, a framework with all revisions made on the regime, has been agreed. These revisions

14 involve a withdrawal of the bauxite production levy on certain specified conditions, including:

(i) a minimum expansion of capacity; (ii) a guaranteed minimum tax payment over a 5-year transitional period; (iii) increased royalty per ton of bauxite; (iv) provision for additional royalty in certain circumstances; (v) and certain financing structures. Alcoa was the first company with which negotiations were carried out. Those negotiations led to an agreement signed on April 27, 2002, and provides for a 25% expansion of the JAMALCO plant. Tax payments based on the average annual payments over the previous 5-year period that is to be applied to the 5-year period following the completion of the expansion, was also guaranteed (Jamaica Bauxite Institute, 2002).

Today, the production of bauxite and alumina is led by the private sector, but the Government of Jamaica is a partner or has minority equity in several mineral producing companies (Torres, 1999). The bauxite and alumina industry of Jamaica currently employs about 4,000 workers (Ministry of Finance and Planning, 1999). Large international companies such as Alcoa Inc., Alcan, Kaiser, and Norsk Hydro A/S through their Jamaican subsidiaries, sometimes in partnership with the Government or with each other, produce all bauxite and alumina in the country (Torres, 1999). For an overview of the companies, the structure of ownership and the capacity of the industry, contact the authors. For a geographical overview of the bauxite and alumina operations in Jamaica, contact the authors.

2.5.1 Total Production of Bauxite Figure 2.2 displays the total production of bauxite for the years 1973 to 1999. Production of bauxite has declined from a maximum of 15,071,000 tonnes in 1974 to a production of about 11,127,000 tonnes in 1999. In 1975, the year after imposing the Bauxite Production Levy Act, the production of bauxite declined with almost 4,000,000 tonnes. Declines in

15 the production can also be explained by the fact that bauxite companies, which engage in much intra-firm trade, were able to increase bauxite production in other countries such as Guinea, whose taxes on bauxite exports were about 50% lower than the levy imposed in Jamaica (Griffith, 2002).

16 14 12 10 8 6 4 2 Production in millionProduction tonnes 0

3 7 81 85 89 93 97 975 197 1 197 1979 19 1983 19 1987 19 1991 19 1995 19 1999 Year

Figure 2.2, “Total production of bauxite in million tonnes, 1973 to 1999” Source: Jamaica Bauxite Institute (2000)

Another reason for declines in the Jamaican bauxite production is due to countries such as Australia, Guinea, and Brazil experience economies of scale. Capacity for many of the mines in those countries is exceeding the capacity of the mines in Jamaica. Actually, the six biggest mining operations in the world account for 59% of the worlds total bauxite production (Roskill Information Services, 2002 08 25). Notable is that Australia and Brazil produce bauxite at about two-thirds of what it cost Jamaica to produce a metric ton of bauxite (The Mineral Industry of Jamaica, 1999). Furthermore, it can not be denied that a lack of technology and entrepreneurship also played a part (Griffith, 2002).

2.5.2 Total Production of Alumina In figure 2.3 it is shown that the total production of alumina has been in a positive trend the last decade. In 1970 the production was 1,719,000 tonnes, while the number had increased to 3,570,000 tonnes in 1999. Alumina production declined in 1975, as a

16 consequence of the Bauxite Production Levy Act. As well as the bauxite production, the alumina production suffers from a lack of technology and entrepreneurship, and that competing plants in other countries experience economies of scale.

4 3.5 3 2.5 2 1.5 1 0.5 Production in millionProduction tonnes 0

2 74 76 82 84 88 90 9 96 98 9 9 1970 1972 19 19 1978 1980 19 19 1986 1 19 19 1994 1 19 Year

Figure 2.3, “Total production of alumina in million tonnes, 1970 to 1999” Source: Jamaica Bauxite Institute (2000)

The Alpart plant in Nain, St Elizabeth which has a capacity of 1,500,000 tonnes, was closed on August 15, 1985. This effected the total alumina production negatively. When the plant was reopened in December, 1988, the level of production increased, from 1,514,000 tonnes in 1988 to 2,221,000 tonnes in 1989, a 47% growth in production (Torres, 1999).

2.5.3 Total Exports of Bauxite and Alumina Figure 2.4 displays the value of the total exports of bauxite and alumina 1970 to 1999. The value of alumina exports has varied to a large extent, with great fluctuations within the specific decades. Fluctuations in the export value can be explained by the fact that production varied between years and that the market price of alumina has also fluctuated. The price on alumina in 1993 was 149.2 US$/ton, while it was as high as 210.1 US$/ton in 1995 (Ministry of Finance and Planning, 1999).

17 700000

600000

500000

400000 Alumina 300000 Bauxite

200000

100000

Total exports in thousand US$ inthousand exports Total 0

1 73 79 85 94 970 9 976 9 982 9 988 99 9 997 1 1 1 1 1 1 1 1 1 1 Year

Figure 2.4, “Value of total exports of bauxite and alumina, 1970 to 1999” Source: Jamaica Statistical Institute (2001)

Total value of bauxite exports 1970 to 1999 had a high in 1978 of 233,987,000 US$. Since 1978, the value of bauxite exports has been declining steadily. The value in 1999 was 55,905,000 US$, which was a decline from 81,042,000 US$ in 1998. The main reason for this was an explosion at the Kaiser-plant, in Louisiana, which before the accident received 60% of Jamaica’s crude bauxite exports from Kaiser Jamaica Bauxite Co. Ltd. This accident represented a loss of 27,000,000 US$ in sales to Jamaica (Torres, 1999).

2.6 The World Bauxite and Alumina Industry After a weakening trend during the first half of the 1990s, the bauxite and alumina industries have expanded rapidly in the last few years. World production of bauxite and alumina grew at an unprecedented rate between 1994 and 2000 to leave bauxite production in 2000 at 135.7 million tonnes, some 26% higher than in 1994, and alumina production at 51.6 million tonnes, 28% higher. Average annual growth rates over this period were 3.9% and 4.1% respectively. Growth in both commodities was relatively broadly based, and although Australian production accounted for the largest share of the increase in volume terms, Chinese and Brazilian output of both bauxite and alumina

18 showed the most rapid expansion in average annual percentage terms. In 2000, the Darling Range Mines in Western Australia, operated by Alcoa World Alumina Australia (AWAA), accounted for about 21% of world bauxite production. The Boké mine in Guinea and the Weipa mine in Australia accounted for a further 9% each. AWAA’s three alumina refineries produced about 15% of world alumina output in 2000. Eleven operations accounted for over 50% of total production (Roskill Information Services, 2002 04 17). For tables over the production of bauxite and alumina in different countries of the world, contact the authors.

19 Chapter 3 THEORY

This chapter starts with a presentation of theory of the Dutch Disease, and continues with traditional and modern trade theories. Finally the exchange rate theories are presented.

3.1 Theory of the Dutch Disease The name of the theory is distilled from the experience that followed a sharp rise in Holland’s natural gas exports in the 1970´s (Davis, 1995). The Dutch manufacturing sector experienced a loss of competitiveness, particularly export competitiveness, because of an overvalued currency due to the strength of Dutch hydrocarbon exports (Heeks, 1998).

The distortion created by export booms in the economies of primary-commodity- exporting countries is important to the explanation of the Dutch disease. These distortions are not simply transitory and disappear when the boom subsides; they affect the structure of production and investment required for future growth in a manner that may impair sustainability. If revenues from mineral exports were stable or expanding slowly, there would be no special economic impacts generating distortions that inhibit sustainable growth. Mineral exporting countries are subject to temporary surges in export income, mainly from increase in world mineral prices, but in some cases from new discoveries, such as a large petroleum-reservoir. Whatever the cause of the rise in export income, it levels off or declines so that it is no longer a source of increased income. Export booms are not only increasing the domestic income, but affect savings and investment, Government expenditures, and relative prices in different sectors of the economy. These economic impacts are significantly different between countries, and depend on the structure of the economy and the policies adopted by the Government. In

20 most cases occur distortions that tend to depress output and investment in key sectors (Mikesell, 1998).

A typical set of responses to an export boom by a developing country heavily depend on primary-commodity-exports, will be outlined in the following paragraphs.

1. A surge in foreign exchange sold in the foreign exchange market by both Government and private firms causes the exchange rate to appreciate and domestic income to rise. The combination of a rise in the nominal exchange rate and domestic price inflation results in a rise in the real exchange rate.

2. The real exchange rate appreciation tends to reduce relative prices for tradable products, e.g. manufactured goods and agricultural products, relative to prices of non- tradable products, e.g. construction and services, so that a flow of capital and labor from the tradable sector into the non-tradable sector is created.

3. Exports of non-resource tradables decline and imports rise. The increase in imports and fall in exports is often reproduced by the Government with impose of import restrictions and subsidizing exports. This brings on further distortions by attracting investment to high-cost importing-substituting-manufacturing. Higher prices for manufactured goods depress agriculture and further reduce competitiveness of all tradables in the export markets, including mineral exports (Mikesell, 1998).

3.2 International trade Factors of production are distributed differently on countries. The countries differ in population density, labor skills, climate, raw materials, capital equipment, etc. Because factors are relatively immobile, these differences tend to persist. Land and climate are obviously totally immobile, but even with capital and labor there are more restrictions on their international movement than on their movement within countries. The theory of international trade has two different definitions of advantage in terms of trade, absolute advantage and comparative advantage (Sloman, 2000).

21 3.2.1 Absolute Advantage When one country can produce a good with fewer resources than another country, it is said to have an absolute advantage (Lundberg, 1995).

3.2.2 Comparative Advantage Trade between two countries can still be beneficial even though one country has an absolute advantage; this is the case as long as the relative efficiency with witch the goods can be produced differs between the two countries. The Heckscher-Ohlin theorem states that, within the assumptions of the Heckscher-Ohlin model, the capital-rich country will have the comparative advantage in the capital-intensive production, and the labor-rich country will have the comparative advantage in the labor-intensive good. The assumptions of the model are that:

(1) there are no transport costs or other impediments to trade; (2) there is perfect competition in both commodity and factor markets; (3) all production functions are constant returns to scale; (4) the production functions are such that the two commodities show different factor intensities at any common factor price ratio; (5) the production functions differ between commodities, but are the same in both countries; (6) labor and capital are perfectly mobile between industries within the same country, but perfectly immobile between countries.

These assumptions give the relative shape of the two production-possibility curves, and the relative positions of the points corresponding to E, F, and G, must be approximately as shown in Figure 3.1. The physically capital-rich country (B) is biased towards the production of the capital-intensive good (Y). This means that at any two points where the two production-possibility curves have the same slope, the same opportunity cost, the ratio of Y production to X production is higher in the physically capital-rich country (Södersten et al., 1994).

22 Y

B E A

X 0 B A

Figure 3.1, “The physically capital-rich country is biased towards producing the capital- intensive good” Source: Södersten et al. (1994)

3.2.3 Production, Demand, and Trade in a Sector under Perfect Competition International trade and production specialization within one sector under perfect competition can be studied with the following model of analysis. The market for a certain commodity in two countries, A and B, is assumed to be described by the supply- and demand curves SA and SB, respectively DA and DB in figure 3.2. A further assumption is that trade for some reason is not possible. Price, production and consumption of the commodity will then be determined by demand and supply in each country. The equilibrium price will then be pA and pB, and the production, which in an isolated country must equal the consumption, will be qA respectively qB.

23 Country A Country B Export supply Import demand p DA SA pp

pA ESB SB

pW ID pB A

DB q qq QA qA CA CB qB QB E

Figure: 3.2, “Model for trade in a market under perfect competition” Source: Lundberg (1995)

If instead trade is assumed to be possible, the transaction costs are low enough to be disregarded, the commodity is homogenous, and the exchange rate between the currencies of the two countries equals one, a “world market” will be created. This market will have a unitary price, since all consumers and producers in each country will trade to the most favorable price, without consideration to nationality. As long as the import price of the commodity is less than the price of the domestic manufactured commodity, more and more consumers in country A will change to the imported commodity. A greater part of the production in country B will at the same time redistribute from the domestic market to the export market as long as the export market price is higher than the domestic market price. An increasing import of the commodity will decrease the price of the domestic manufactured commodity in country A. The price on the domestic market of country B’s producers tends at the same time to increase since a greater and greater part of the production is being exported. The new “world market” price and quantity will stabilize in equilibrium where the prices in country A and B are equal, the market price in country A is equal for the imported as well as for the domestic manufactured commodity, and the import in one of the countries equals the export in the other country (Lundberg, 1995).

24 3.2.4 Relaxation of the Assumptions in the Heckscher-Ohlin Model If transport costs, tariffs, and imperfect competition within commodity and factor markets are introduced to the Heckscher-Ohlin model, assumption (1) and (2) will no longer be fulfilled.

First of all, if transport costs are introduced to the model, they will decrease the international trade and production specialization. This is shown in the figure 3.3. The curve ESB, which is derived in the same way as in figure 3.2, shows how the export supply varies with the price that the producers in country B receive, pB. The transport costs will be $X/Unit, thus the price of the imported and domestic manufactured commodity that the consumers in country A pay, pA, will exceed pB with $X/Unit. The export supply for country B, ESB, has to be shifted upwards with the amount of $X/Unit in order to derive the supply curve for the imported commodity in country A, ISA. The equilibrium price will then be pA in market A for the imported as well as for the domestic manufactured commodity. The equilibrium price in market B, pB, will be $X/Unit below pA (Lundberg, 1995).

Country A Counrty B Export supply Import demand

pppDA SA

ISA D S B B ESB

IDA

qqq QA QB E

Figure: 3.3, “Equilibrium in trade under transport costs” Source: Lundberg (1995)

Secondly, when tariffs are introduced to the model, will the trade be less than without tariffs. It is easy to see that this is the case in figure 3.4, where the market for a good, which is produced and consumed in two countries, country A and country B, is shown.

25 DA and DB are demand curves and SA and SB are supply curves. It is assumed that the measures taken are valid for one or a few groups of goods, no other sectors of the economy are affected, and it is perfect competition in the market. The import demand in country A, IDA, and the export supply in country B, ESB; are derived in the same way as in figure 3.2. The equilibrium price, p0, is determined on the “world market”, when export supply equals import demand. At the same time are production, Q0, consumption,

C0, and the size of trade, E0, settled in both countries. It is assumed that country A introduces a tariff on the imported good by $X/Unit and that the good, which is produced in both countries, is homogenous. The introduction of the tariff will shift the export supply of country B, ESB, upward with the size of the amount of the tariff, e.g. $X/Unit

(t), and a new “world market” equilibrium will be established at the price level pA, and the new “world market” quantity will be E1. The tariff has effects on the market price and production, and the consumption and trade in both countries. The increase in price will lead to a higher market price in country A, which will cause a higher level of domestic production, Q1, and employment, but a smaller consumption, C1. As a result of this decreases the import to E1, e.g. C1-Q1. The revenue of the producers, the rectangle pAQ1, will increase and the import price before addition of the tariff will decrease to pB. The last effect, which will be caused by the introduction of the tariff, is an increase in public income in country A by the size of the tariff, E1t. The effect for country B, caused by the tariff introduction, is a decrease in export price to pB, which leads to a lower level of export, production and producer revenues but a higher level of consumption (Lundberg, 1995).

26 Country A World market Country B

D S p A A p p

ESB(t) DB

t ESB pA p0 p0

IDA

q q q Q0Q1 C1C0 E1 E0 C0C1 Q1Q0

Figure: 3.4, “Effects of a tariff” Source: Lundberg (1995)

The third and last relaxation of the Heckser-Ohlin model, which will be made in this chapter, is the assumption of imperfect competition within commodity and factor markets. The models, which have been shown earlier, have all built on the assumption of perfect competition within commodity and factor markets. This, however, is not always the case since most of the industrial markets can be described as markets under monopolistic competition or oligopoly. That the markets can be described as markets under monopolistic competition or oligopoly is the case since the products that the companies produce on these markets are not homogenous and the demand of a company’s product is not solely determined by the price of the product but also by the price and characteristics of competitive products. The curve D in figure 3.5 shows the demand of a product on the domestic market. The marginal cost of the company is assumed to be constant. The company has to choose the production volume where the marginal cost, MC, equals the marginal revenue, MR, in order to maximize the profit. The price, p, will hence exceed the marginal cost; the less price sensitive demand of the product, the bigger becomes this difference. For a monopolist are the company’s demand curve and the market’s demand curve identical. For a company, which is active on a market where the company meets competition, is the demand of the company’s product, normally, more sensitive for a change of the own price, when the prices of the competitors are held constant, than what is given by the price elasticity of the market e.g.

27 the change in total sales at a contemporaneous price change made by all companies on the market. The demand of the company’s product becomes more and more elastic for every company, which enters the market. The effect of the introduction of trade between two countries with markets for a differentiated product will now be further examined (Lundberg, 1995).

Domestic market Export market pp

p D

p' p' D' DE

MC MC

MR' MRE qq q´ q q´

Figure: 3.5, “Trade with differentiated products” Source: Lundberg (1995)

In figure 3.5, p and q show the price and production of a typical company, which is isolated from trade with other countries, on its domestic market. The opening of trade with an unchanged number of companies on each market will result in a greater number of sellers on the both markets. The demand for the product of a typical company will decrease and the demand curve will become more elastic, D shifts to D’, on the company’s domestic market. On the other side will a demand occur from the export market, DE. A result of the introduction of trade will be that the prices will decrease, from p to p’, since the difference between price and marginal cost becomes less. The sales on the domestic market will decrease but the sales on the export market will increase. The model shows that trade is possible even though there is no difference in marginal cost between the participating countries; the marginal cost for the typical company is identical

28 for both countries. The incentive for trade, instead of just price, is the fact that the demand of the consumers is differentiated, either through that the consumer appreciates a multitude of products on the market or that every consumer has an “ideal product” which, he or she, prefers above all other products on the market (Lundberg, 1995).

3.3 Exchange Rate Theory The foreign exchange rate is the price of the one currency in terms of another e.g. US$/ JA$ or, alternatively, JA$/US$. The price mentioned above can be viewed as the result of the interaction between the market forces of demand and supply for the foreign currency in any particular period of time (Krugman et al., 2000).

3.3.1 Demand Side One can participate in the foreign exchange market for a number of reasons. On the demand side, one of the principal reasons an individual desires foreign currency is for purchase of goods or services from another country or to send a gift or investment income payments abroad. A second reason to acquire foreign currency is to purchase financial assets in a particular country. A third reason for individuals to demand foreign currency may be to speculate in foreign currencies. The total demand for a foreign currency at any one point in time thus reflects these three underlying demands (Appleyard et al., 1998).

3.3.2 Supply Side Foreign currency supply to the home country results firstly from foreigners purchasing home exports of goods and services or making unilateral transfers or investment income payments to the home country. A second source of supply arises from foreign investment in the home country. The third and final reason of supply is foreign speculation and hedging activities. The total supply of foreign exchange in any time period consists of these three sources (Appleyard et al., 1998).

29 3.3.3 The Foreign Exchange Market The foreign exchange market presented in figure 3.6 is shown from the Jamaican perspective and contains a downward-sloped demand curve and an upward-sloped supply curve. (Appleyard et al., 1998).

JA$/ US$ SUS$

eeq

D'US$

DUS$

q q' eq q US$ Figure: 3.6, “A simple model for the foreign exchange market” Source: Appleyard et al. (1998)

The price on the vertical axis is started in terms of the domestic currency in price of foreign currency, e.g. JA$/US$, and the horizontal axis measures the units of US$ supplied and demanded at various prices (exchange rates). In the intersection of the supply and demand curves of US$, are the equilibrium exchange rate (eeq) and the equilibrium quantity (qeq) simultaneously determined. An increase in demand for US$ on the part of Jamaica will cause the demand curve to shift, up to D'U.S.$ and the exchange rate to increase to e'. The JA$ is now said to be depreciated against the US$ since it takes more Jamaican currency to buy each US$. Exactly the opposite will happen in a case of appreciation of the JA$/US$ exchange rate (Appleyard et al., 1998).

3.3.4 Flexible Exchange Rates With an exchange rate that continuously adjusts to maintain equilibrium in the foreign exchange market, there exists no longer an incentive for the central banks to intervene in order to remove any excess supplies or demands for the foreign exchange.

In order to examine the effects of economic policy under flexible exchange rates an IS/ LM/ BP model will be employed.

S+M+T I+X+G i

i2 S+M+T i0 i I'(i )+X+G 1 1 IS I(i0)+X+G

I''(i2)+X+G 0 Y Y Y2 Y0 Y1 Y2 Y0 Y1

Figure: 3.7, “Income and the interest rate: the IS curve” Source: Appleyard et al. (1998)

The IS curve of the model in figure 3.7 shows the various combinations of income and the interest rate that produce equilibrium in the real sector of the economy. The LM curve in figure 3.8 shows the various combinations of income and the interest rate that produce equilibrium in the money market1.

1 All variables influencing the demand for money other than interest rate and income are held constant along any given LM-curve

31 Interest Interest M S rate(i) rate(i) LM

i1 i1

i0 i0

L'(Y1) i2 i2 L(Y0)

L''(Y2)

Money Y2 Y0 Y1 Income (Y)

Figure: 3.8, “Income and the interest rate: the LM curve” Source: Appleyard et al. (1998)

Finally the BP curve, which is presented in figure 3.9, is the curve that shows the various combinations of income and interest rate that produce equilibrium in the balance of payments, e.g. a country’s economic transactions with all other countries during a particularly time period, usually a year (Appleyard et al., 1998).

BP2 BP0

BP1 Appreciation Depreciation

Figure: 3.9, “The effects of changes in the exchange rate on the BP curve” Source: Appleyard et al. (1998)

The domestic responses to combinations of income and interest rates that lie off the BP curve will produce disequilibria situations in the foreign exchange market; this will lead

32 to an adjustment in the exchange rate that brings the foreign exchange market back into equilibrium. When this happens, the BP curve will shift reflecting the new equilibrium exchange rate (Appleyard et al., 1998).

If the initial Balance-of-payments equilibrium at the exchange rate e0 is depicted by the

BP0 curve, depreciation will lead to an expansion of exports and a contraction of imports2. Thus, for any given level of income, a larger amount of net capital outflows, and thus a lower rate of interest, is required to balance the Balance-of-payments. The BP curve will thus shift down (to the right) with currency depreciation to BP1. In analogous fashion, an appreciation of the currency leads to greater imports and fewer exports, thus requiring net capital outflow, to obtain external balance. Therefore, a higher interest rate is required at all levels of income, causing the BP curve to shift up (or leftward) to BP2 (Appleyard et al., 1998).

3.3.5 The Effects of Fiscal Policy under Different Capital Mobility Assumptions The effects of fiscal policy under various international capital mobility assumptions will now be investigated. Expansionary fiscal policy is represented by a rightward shift in the IS curve. Each of the four diagrams in figure 3.10 reflects a different assumption about capital mobility. In each case, the economy begins with equilibrium at Y0 and i0. An expansionary fiscal policy, increased Government spending or decreased taxes, shifts the IS curve to the right (IS'). This will cause income and imports to rise, which leads to an incipient deficit when the capital is perfectly immobile, as in panel a, or relatively immobile, as in panel b, and a depreciation of the currency. Currency deprecation shifts the BP curve right (BP1), and increases exports and decreases imports, which generates an additional shift in the IS curve (IS''). A new, higher equilibrium, Y2 and i2, will be the result. However, when capital is relatively mobile, as in panel c, the effectiveness of fiscal policy is reduced. This is shown when an expansionary fiscal policy (IS'), produces an incipient surplus and currency appreciation. The BP curve thus shifts up and the IS curve shifts left as imports increase and exports decrease. The trade adjustment offsets some of the expansionary effect of the fiscal policy, and the expansionary effect on

33 income is reduced, not enhanced as when capital was immobile or relatively immobile. Finally, with perfectly mobile capital, as in panel d, a fiscal expansion sets in motion a currency appreciation that continues until the current account effect, e.g. decrease in exports and increase in imports completely offsets the initial fiscal policy, leaving income at Y0 (Appleyard, 1998).

i i BP BP 0 1 BP0 BP 1 LM LM

i2 i i2 1 i0 i1 i0

IS'' IS'' IS' IS' IS IS Y Y Y0 Y1Y2 Y0Y1Y2 (a) (b) i i

LM LM

BP1

BP0 i1 i2 i i 1 0 i0 BP

IS' IS' IS'' IS IS Y Y Y0Y2Y1 Y0 Y1 (c) (d)

Figure: 3.10, “Fiscal policy in the open economy with flexible exchange rates under alternative capital mobility assumptions” Source: Appleyard et al. (1998)

2 All other factors are held constant

The effectiveness of fiscal policy under a regime of flexible exchange rates depends strongly on the degree of international mobility of capital. When capital is completely or relatively immobile, fiscal policy is effective in moving the economy to income and employment targets. On the other hand, when capital becomes more and more mobile, fiscal policy becomes less and less effective (Appleyard, 1998).

3.3.6 Effects of Monetary Policy under Different Capital Mobility Assumptions In figure 3.11, the effects of monetary policy under different capital mobility functions are shown. Increases in the money supply shift the LM curve to the right and in all four cases expand domestic income from the initial Y0, put downward pressure on the domestic interest rate from the initial i0, and produce an incipient deficit in the balance of payments. Under a system of flexible exchange rates, expansionary monetary policy, e.g. an increase in money supply, or a decrease in interest rate, leads to a depreciation of the domestic currency, accompanied by an increase in exports and a decrease in imports. With the depreciation, both the BP and IS curve will shift to the right. The end result is an increase in equilibrium income and a strengthening of the trade balance (Appleyard, 1998).

35 i i BP0 BP0 BP1 BP1

LM LM LM' LM'

i0 i2 i1

i2,i0 i 1 IS' IS IS' IS Y Y Y0 Y1Y2 Y0 Y1 Y2 (a) (b) i i LM LM' LM BP0 LM' BP1

i0 i2 i0 BP i1

IS' IS' IS IS

Y Y Y0 Y1Y2 Y0 Y1 Y2 (c) (d)

Figure: 3.11, “Monetary policy in the open economy with flexible exchange rates under alternative capital mobility assumptions” Source: Appleyard et al. (1998)

Starting at equilibrium at Y0 and i0, expansionary monetary policy shifts the LM curve to the right (LM'), lowering the interest rate and increasing income (Y1,i1). The lower interest rate causes a reduction of the net capital flow or worsens the net capital outflow, except in case a where the capital is assumed to be totally immobile, and the higher income level increases imports. Consequently, there is an incipient deficit in the Balance-

36 of-payments, resulting in a depreciation of the home currency and a rightward shift of the IS curve (IS'). Depreciation, a rightward shift of the BP curve, and improvements in the trade balance, the rightward shift of the IS curve, continue until all three curves again intersect at a common point and equilibrium is obtained (Y2,i2). In panel d, where it is assumed that the capital is perfectly mobile, all the adjustments take place along the BP curve, since it remains horizontal at the world rate of interest with flexible exchange rates, expansionary monetary policy is effective in influencing income regardless of the degrees of capital mobility, and the current account effects complement the monetary policy in all cases (Appleyard, 1998).

37 Chapter 4 EMPIRICAL DATA AND ANALYSIS

This chapter starts with a presentation on how the data was collected. Further, the data for some main economic indicators is presented and analyzed. Finally are specific data on the mineral industry shown and discussed.

4.1 Data Data was primarily collected from different web pages administrated by various economical institutes, e.g. International Monetary Fund, the Statistical Institute of Jamaica, and the Bank of Jamaica.

During the field study in Kingston, Jamaica, information was gathered at several official institutes’ libraries, e.g. the Jamaica Bauxite Institute, the Statistical Institute of Jamaica, the Mines and Geology Division, and the University of West Indies, Mona Campus.

Some problems occurred when searching data within the relevant time period. For example, when finding the data for total exports, the data for the first part of the time period was presented in JA$, whilst the rest of the data was presented in US$. In order to deal with this, the average annual exchange rate was used to convert JA$ into US$. More problems arose when calculating alumina and bauxite’s contribution to total exports, and consumer price index. The first problem was that the decimals were narrowed down for the calculation of alumina and bauxite’s contribution to total exports. A second problem was that the consumer price index had to be calculated from a number of statistical yearbooks, all with different index years.

38 4.2 Gross Domestic Product As can be seen in the figure below, the gross domestic product has been increasing over the time period. The growth in GDP does not seem to have increased during the years 1970 to 1980, but the case is that Jamaica had a growth of 399.1%, from million JA$ 1196 to million JA$ 4773.1, in GDP over this time span. The largest contributors to GDP are manufacturing, tourism, financial services, and mining.

350000

300000

250000

200000

150000

100000 GDP in million JA$ million in GDP 50000

0 1970 1973 1976 1979 1982 1985 1988 1991 1994 1997 Year

Figure 4.1, “GDP in million JA$, 1970 to 1999” Source: Jamaica Statistical Institute (2001)

Figure 4.1 is only showing GDP in nominal terms, consequently, no inflation rates have been accounted for. In fact, the real growth in GDP had an annual average increase of 4.9% from 1985 to 1990; the number for next 5-year period was 1.1%. This reduction was due to the Governmental program which was introduced in 1991. The program accelerated structural reforms of the domestic economy by deregulating trade, prices, and foreign exchange market. Short-term effects from this program were sharp currency devaluation, high inflation, and the above mentioned slow-down in the growth of real GDP. Both 1996 and 1997 displayed negative growth in real terms of GDP, by 1.8% respectively 2.4%. Main reasons for this were difficulties in the financial and insurance

39 services sector during 1996 and 1997, and a severe drought in 1997. (Ministry of Finance and Planning, 1999)

4.3 Unemployment Jamaica’s labor force consisted of approximately 1,133,750 persons in 1997. In figure 4.2 it is shown that during the 1990s, the unemployment rate has been fairly stable. This is due to the program mentioned in chapter 4.2.

10 Unemployment (%) Unemployment 5

0 4 74 78 8 84 88 92 9 96 98 9 1972 19 1976 19 19 1982 19 1986 19 1990 19 19 1 19 Year

Figure 4.2, “Level of unemployment, 1970 to 1999” Source: Jamaica Statistical Institute (2001)

Still the figures of unemployment are high, 16% of the population were unemployed in 1999. (Statistical Institute of Jamaica, 2001) Many of those without a job support themselves within the informal sector, as street vendors or by interacting in illegal activities such as drug smuggling. Estimations have been made, and it is thought that the informal sector is as large as 1/5 of Jamaica’s GDP. (Johannesson, 2001)

According to the theory of the Dutch Disease, the level of unemployment will rise in a country due to a decrease in the relative competitiveness in other sectors than the sector of the primary commodity. From this it is possible to conclude that Jamaica has not

40 suffered from the Dutch Disease since the unemployment trend over the years has been falling.

4.4 Consumer Price Index Figure 4.3 presents the Consumer price index for 1970 to 1999. Between the years 1971 to 1989, the annual average inflation rate was 17%, and the number for the following decade was 27.2%, with peaks of up to 80% in the beginning of the 1990s. The aggressive fiscal and monetary policy which the Government pursued in the early 1990s brought down the inflation rates, from 80.2% in 1991 to 6.8% in 1999.

20000 18000 16000 14000 12000 10000 CPI 8000 1970=100

Index value, 6000 4000 2000 0

0 3 6 9 2 5 8 1 4 7 8 8 8 9 97 197 197 197 1 19 19 19 19 199 199 Year

Figure 4.3, “Consumer Price Index, 1970 to 1999” Source: Jamaica Statistical Institute (2001)

For the period of this Governmental program, which was aimed at protecting the exchange rate in order to bring down inflation, rates of interest went up significantly, which in turn may have contributed to the difficulties experienced by the financial sector in the middle of the 1990s (Personal communication, Mr. Franklin Brown).

In a country suffering from the Dutch Disease, the CPI is supposed to rise. This has been the case in Jamaica, where the inflation rate at an average has been between 17% and

41 27.2%, but recently, though, it has decreased to levels around 7%. Hence, the CPI fulfills the conditions stated in the theory of the Dutch Disease.

4.5 Average Annual Exchange Rate With the beginning of a dismantling process of the foreign exchange controls in 1990 and a total abolishment of all remaining exchange controls with the repeal of the Exchange Control Act in 1992, the JA$ was allowed to float freely without an announced trading band or target set by the Government. In figure 4.4 an immediate effect of the abolishment is shown, with the rate going from JA$ 12.85 in 1991 to JA$ 23.01 in 1992.

45 40 35 30 25 20 JA$/US$ 15 10 5

Average annualAverage Exchange Rate, 0

0 2 4 8 0 2 4 6 8 0 2 6 8 7 8 8 9 9 97 98 99 1 197 197 1976 19 1 198 198 19 19 1 199 1994 19 19 Year

Figure 4.4, “Average annual exchange rate, 1970 to 1999” Source: Bank of Jamaica (2000)

The abolishment of the exchange controls removed a serious barrier to trade. Prior to this reform, importers were unable to obtain foreign exchange without substantial delays leading to arrears in import payments. The resulting depreciation of the JA$ is however affecting the ability to finance imports and other types of financial transactions for the private sector. Macroeconomic policies in order to maintain relative stability in the foreign exchange market is carried out by the Jamaican Government. Since 1994 the exchange rate has been somewhat stable, depreciating from JA$/US$ 33.35 to JA$/US$ 39.33 in 1999.

42 Since the annual exchange rate has been depreciating throughout the time period after being allowed to float freely, Jamaica does not satisfy the conditions, which states an appreciation of the nominal exchange rate, of the Dutch Disease.

4.6 Alumina and Bauxite’s Contribution to Total Exports Figure 4.5 presents alumina and bauxites’ contribution to total exports. During the 1970s, the industry contributed to roughly 70% of the total exports, while the same number for the 1990s is about 55%. These figures reveal the vulnerability of the Jamaican economy, being strongly dependent on the bauxite and alumina sectors.

90 80 70 60 50 40 30

Contribution (%) 20 10 0

0 8 2 72 80 86 88 94 96 97 9 976 97 9 982 984 9 9 990 99 9 9 998 1 1 1974 1 1 1 1 1 1 1 1 1 1 1 1 Year

Figure 4.5, “Alumina and bauxite’s contribution to total exports, 1970-1999” Source: Jamaica Statistical Institute (2001)

A condition of the Dutch Disease is that the primary commodities’ contribution to total exports is to surge in a so called export boom. Since the first shipment of bauxite in 1952 the exports has boomed and contributed during the 1970s and beginning of the 1980s to about 71% of total exports value. The decrease in the value of total exports during the latter part of the time period for the study might indicate that Jamaica experienced the Dutch Disease during the 1970s and the beginning of the 1980s but successfully managed

43 to diversify the economy and, hence, managed to decrease its dependence on bauxite and alumina.

4.7 Total Exports of Banana and Sugar Figure 4.6 shows the total exports of banana and sugar 1970 to 1999. Exports of sugar were unstable throughout the 1970s and increased during the following 20 years. In 1997, the Government undertook a program, which in 1998 was worth 100US$ million. Jamaican sugar producers have the benefit of a guaranteed export market to the European Union under preferential agreements. In addition, a preference quota is in place for exports to the United States.

Exports of banana were during the 1970s and 1980s around, or below 20,000,000 US$. However, in the 1990s the trend turned upwards with a high of 46,148,000 US$ in 1994. After the EU-US Banana Dispute which started in 1993, the previous export quotas for the former colonies were abandoned with preferences maintained over a transitional time period, thus insuring stable medium-term demand for Jamaican bananas.

180000 160000 140000 120000 100000 Banana 80000 Sugar 60000 40000 20000

Total exports in thousnad US$ in thousnad exports Total 0

70 76 82 88 94 19 1973 19 1979 19 1985 19 1991 19 1997 Year

Figure 4.6, “Total exports of banana and sugar, 1970 to 1999” Source: Jamaica Statistical Institute (2001)

44 As stated by the concept of the Dutch Disease, the non-primary goods sectors will suffer from the appreciated exchange rate and, consequently, decrease their relative competitiveness towards other countries. This will lead to a decline in the non-primary goods sectors exports. This has not been the case in Jamaica, where the exports of banana and sugar have steadily grown during the years for this study. From these results it is not possible to draw any conclusion whether Jamaica has suffered from the Dutch Disease.

45 Chapter 5 CONCLUSIONS

The purpose of this study was to determine whether Jamaica suffers, or has suffered from the Dutch Disease and investigate what economic policies have been used by the Jamaican Government in order to diversify the structure of the economy. Theory states that if a country suffers from the Dutch Disease, the foreign exchange rate will appreciate. In our case, empirical data shows the opposite situation, with depreciation in the JA$/US$. Bauxite and alumina’s contribution to the value of total exports has decreased, from about 70% in the 1970s to about 55% in the 1990s. Hence, during the period of this study, it is possible to conclude that Jamaica has not suffered from the Dutch Disease.

Further, it is said in the theory of the Dutch Disease that all other tradable products will suffer from the, expected, high exchange rate. Firstly, as said earlier, the exchange rate did not appreciate. Secondly, when looking at data for the chosen tradable goods sectors, e.g. banana and sugar, it can be seen that the production has not declined. Here it should be regarded that those two sectors have had advantages, through quotas, on their main export markets. Moreover, the capital intensive character of the extractive industries does not lead to much employment creation, in fact, the whole alumina and bauxite industry employs only about 4.000 workers. It is therefore highly unlikely that the mining sector attracted labor and capital away from the tradable goods sectors, or from other export sectors, thus causing production costs in those sectors to rise and their exports to become less competitive. Besides, Jamaica experienced a high level of unemployment.

After the introduction of the levy, Jamaica grew gradually more and more dependent of the levy as a stable income. In the fiscal year of 1978/1979, the levy’s part of the Jamaica’s budget financing was as high as 15.2%. Earnings from the levy have been used

46 as a financier of social programs and it could be said to have been a budgetary safety net for successive Governments. This dependence on the bauxite levy is dangerous because of the risk that the companies may leave the country to establish new bauxite mines and new alumina plants in countries where the production cost is lower, e.g. Australia, where no levy exist, or Guinea, where the export tax is significantly lower.

The problem with high production costs has been reduced by the revision of the fiscal regime of the bauxite and alumina industry. The withdrawal of the levy will act as an incentive for the companies to expand their production and modernize throughout the organization, which will improve the competitiveness towards other bauxite and alumina producing countries.

47 Chapter 6 CONCLUDING REMARKS

The Jamaican Governments’ attempt to diversify the economy, with help of the bauxite levy revenues, has not been very successful. US$ 113 million has on an annual average, been paid by the companies as production levy. The levy was used in the establishment of a number of state enterprises, such as the Jamaica Public Service Company and Caribbean Cement Company. Some of the enterprises created value for the country, however, they have made sizeable financial losses, and hence, the establishment of those enterprises has not been successful in order to create financial value for the country.

Other projects financed by the levy were the Black River Upper Morass Development Company and the Forest Industries Development Company. The first mentioned involved the development of an 11,000 acre piece of land for mixed agricultural development. The second entailed a pine plantation, the establishment of a new saw mill and construction of the required infrastructure. Nothing of value was created from these projects, inter alia, due to droughts. Parts of the projects that do not depend on weather conditions were also set backs, this include both land acquisition and road construction.

Some of the failures might be explained by the fact that it was the first time the Jamaican Government had an express source of money to be used for development and diversification of the economy. The Jamaican Government was eager to establish an own production of domestic goods, since a country using domestic resources to produce goods for domestic consumption will enjoy a higher level of growth and development than if it imports substitutes for consumption. Nevertheless, the projects should have been more thoroughly thought through and specialists that had been involved in similar projects earlier should have been employed in the process.

48 For Jamaica, in order to become more competitive within the bauxite and alumina industry, productivity must be improved. In fact, it is estimated that Jamaica has 1.8 billion tonnes, which is about 40 years of economically recoverable reserves. However, the plants where the bauxite is to be refined to alumina in the future are up to 50 years old, and hence, not the most efficient compared to newer and technologically more developed plants. Since the reserves are estimated to last only 40 years, and with regard to high production costs and the low productivity it is not likely for companies to invest in new plants. Because of these reasons it is not seen to be economically defendable.

What further needs to be done in Jamaica is to advance the level of education and somehow change the psychological perception saying that downturns in natural-resource exports resulting from external elements are temporary and that conditions soon will return to their former equilibrium.

49 REFERENCES

ARTICLES

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52 Södersten, B, & Reed, G, (1994), International Economics – Third Edition, The Macmillian Press Ltd., London. LAWS

The Bauxite (Production Levy) Act, 1st January, 1974.

PERSONAL COMMUNICATION

Mr. Dennis Morrison, Senior Officer, Jamaica Bauxite Institute, (2002 05 14).

Mr. Franklin Brown, Economist at the Office of Utilities Regulation, (2002 05 18).

Mr. Leslie James, Corporate Environmental Officer, WINDALCO, Ewarton Works, (2002 05 06).

FACSISMILE

“The New Fiscal Regime”, from the Jamaica Bauxite Institute, Kingston (2002 08 07).

WEBPAGES

American University, Washington DC, Jamaica Bauxite Case, http://www.american.edu/TED/BAUXITE.HTM (2002 06 08).

CIA World Factbook 2001, http://www.cia.gov/cia/publications/factbook/index.html (2002 08 07).

Information on Jamaica’s bauxite and alumina industry, http://www.minesandgeologyjamaica.com (2002 05 18).

Information on the world bauxite and alumina industry, Roskill Information Services http://www.roskill.co.uk (2002 05 16).

Map of Jamaica from Lonely Planet, http://www.lonelyplanet.com/mapshells/caribbean/jamaica/jamaica.htm (2002 08 07).