World Bank Document

ReportNo. 4457-SL SierraLeone i FinancialSector Study

Public Disclosure Authorized February8, 1984 West Africa Region ProgramsI, Division B

FOR OFFICIALUSE ONLY Public Disclosure Authorized Public Disclosure Authorized

Documentof the WorldBank Public Disclosure Authorized

This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosedwithout World Bank authorization. Currency equivalents

Year US$ per Leone

1977 .95310

1978 .9531

1979 .9637

1980 .944:1

1981 .8516

1982 .8113

1983 (October) .3984

Fiscal year

July 1 - June 30 FOR OFFICIALUSE ONLY

Table of Contents

Page No.

SUMMARY AND RECOMMENDATIONS ...... i

I. THE ECONOMY ...... 1 A. Aggregate savings and investment ...... 2 B. Domestic and international value of the Leone ...... 2 C. Balance of payments ...... 5 D. Government finances ...... oo...... 8 E. Industry ...... 9 F. Agricultural production problems .o ...... 9

II. MAJOR ISSUES OF THE FINANCIAL SYSTEM ..... o...... 12 A. The Government's demand for credit ...... 13 B. Excess liquidity in the financial system ...... o 14 C. The foreign exchange pipeline .. o...... 18 D Interest rate policy ...... o...... 0 .... 20

III. THE RURAL FINANCIAL SYSTEM ...... o...... 24 A. The functions of a rural financial system ...... o. 24 B. The shortcomings of the present rural financial systemo ...... o...... 25 C. The proposed rural-banking scheme ...... 28 D. Issues and dilemmas of rural banking ...... o.o...*.. 28 E. Conclusion ...... 30

IV. FINANCING OF INDUSTRIES ...... 32 A. Current status ...... *...... 32 B. Future developnent ...... o...... 35 C. Reorganization of the National Develolnent Bank ...... 36

REFERENCES ...... o...... o...... o 38

ANNEX A INSTITUTIONS AND FINANCIAL INSTRUMENTS OF THE FINANCIAL SYSTEM 40 A. Institutions of the financial system 40 B. The assets of the financial system . .56 References.. 64

ANNEX B THE RURAL FINANCIAL INSTITUTIONS .65

This report is based on the findings of a mission comprising Messrs. Rashid Faruqee (principal author), I. Husain (leader), Iqbaluddin Ahmed, and Paul Beckerman (consultant), who visited Sierra Leone in June 1982. The mission's findings were updated by a staff mission in October-November 1982, and the draft of the report was reviewed in July 1983 by a technical committee set up by the Government of Sierra Leone.

This documenthas a restricteddistribution and may be used by recipientsonly in the performanceof their official duties. Its contents may not otherwise be disclosedwithout World Bank authorization.

Taibleof Contents (cont'd)

ANNEX C THE NATIONAL DEVELOPMENTBANK ...... 71 A. The recent performanceand current situation of the NDB ...... 71 B. "What is to be done?" ...... 79 C. Some particularissues for the NDB. 81

Tables in Main Text

I.1 Resources and uses. 3 I.2 Index numbers of consumer p rices...... S 4 I.3 Balance of payments .. 6 I.4 The financing of imports...... 7 I.5 Current revenue, recurrent expenditure,and developmentexpenditure .... 10 II.1 Selected interest rates.. . 22

Tables in Annexes

A.1 Commercial banks' deposit liabilities . . 43 A.2 Commercialbanks' loans and advances by major economic groups.44 A.3 Commercialbanks operatingin Sierra Lene .45 A.4 Profits on operations of commercial banks . .47 A.5 Assets and liabilitiesof the Bank of Sierra Leone. 48 A.6 Post Office savings.50 A.7 Cooperatives'aggregate balance sheet, 1978.52 A.8 Summary balance sheets: The Diamond Mining Company (Sierra Leone) Ltd...... 54 A.9 Summary consolidatedbalance sheets: Sierra Leone Produce Marketing Board...... 55 A.10 Monetary savings stocks ...... 57 A.11 Determinantsof the money supply.. . .59 A.12 Liquidity positionsof commercial b anks.60 A.13 Government obligations outstanding ...... 61 A.14 Principal financialassets as a proportionof gross domestic expenditure...... 63 B.1 Agriculturalloans by commercialb ans. 67 C.1 Loans to the National DevelopmentBank . .72 C.2 National DevelopnentBank: Summary profit-and-loss accountsc c o ..... u nts.. . . 74 C.3 National DevelopmentBank: Summary balance sheets.. . 76 C.4 Cumulativeannual loan approvals between 1971 and 31 December 1981...... 1.... 84

SUMMARY AND RECOMMENDATIONS

1. At the request of the Government of Sierra Leone, the World Bank undertook a review of that country's financial sector to gain a better under- standing of (a) the structure, functions,and operations of its financial institutions, (b) Government policies affecting the operationsof these institutions, and (c) the various instrumentsused in the financial system. This review was considered necessary in formulatinga plan to restructurethe National Development Bank (NDB), for which the Government had already set up a commiittee(Technical Committee on the Reorganizationof the NDB) and for which the Government sought World Bank help.

2. The immediate purpose of this review is to provide an overall context within which policies to restructurethe NDB can be formulated. In this connection,the Bank's mission conferredwith the reorganizationcommittee and contributedto the committee's final report. The present study includes a general survey of the financial sector and highlights the policy issues relating to that sector.

3. The problems of Sierra Leone's financialsystem are bound inseparably to the general problems plaguing Sierra Leone's economy. The difficulty the financial system has experiencedin acquiring assets, for example, is related to the poor and uncertain prospects for productive activity. Any considera- tion of the problems of the financial system must thereforeinclude a considerationof Sierra Leone's broader economic problems.

4. Till July 1983 Sierra Leone maintained an overvaluedexchange rate. This can be demonstratedby various means, including the usual balance-of- payments equilibriumand purchasing-power-paritycriteria. The low price of foreign exchange was a serious disincentiveto exporting and to financing export activity. Furthermore,since Government revenues depend in substantial measure on foreign trade, their growth was adversely affected by the low price of foreign exchange and the consequent low volume of exports and imports. The Leone was devalued 100 percent in July 1983, and domestic agriculturalprices were accordinglyraised. Since devaluation,however, the scarcity value of forsign exchange, partly reflected by its black market rate, has gone up substantially,making the new official rate fall again out of line with its scarcity value.

5. The stagnation of exports has severely diminished the capacity to import. The depletion of the nation's internationalreserves made it necessary to use non-price schemes for rationing foreign exchange. Even after the July devaluation,a system of foreign exchange allocation by the Bank of Sierra Leone was retained to ensure rational allocation in line with national priorities,effective coordinationwith the import licencing system, exchange control approvals and expected foreign exchange receipts. A substantial volume of Sierra Leone's foreign exchange transactions,however, still take place outside the banking system in parallel markets. - ii -

6. Sierra Leone's Government expenditures have grown rapidly, without a corresponding growth in revenues. The resulting deficit has been financed principally by the central bank. In a sense, the expansion of public-sector borrowing has crowded out private-sector credit. It may be argued, however, that Sierra Leone avoided runaway inflation only because of the limited growth of private-sector credit and the loss of international reserves.

7. The price of foreign exchange and the price of international commodities have been disincentives to export activity. Government policy consti- tutes a further significant disincentive, since where the Government can set producer prices, particularly in the agricultural sector, it has tended to set them at unremunerative levels.

8. The structure of Sierra Leone's formal f'inancial system is simple and not well developed. For the formal sector, it iEI just barely an exaggeration to say that the commercial banking system is the nation's financial system. There is, however, a fairly extensive informal markets of traders' credit and rural credit from money lenders.

9. The commercial banking system appears tc, have excess liquidity, although interest rates offered to depositors are!significantly below the rate of inflation. The commercial banks' holdings of liquid assets are substantially above the required liquidity ratio (40 percent) now in effect. The principal reason for this excess liquidity appears to be the commercial banks' inability to acquire satisfactory assets because of the nation's distorted price structure and depressed economic situation. Some of the excess liquidity results from the idle balances in the blocked accounts, which accumulated because of the delay in foreign exchange allocation (see below).

10. The bulk of commercial bank assets are loans for commercial purposes, principally for imports. Commercial banks do relatively little lending to industry and to agriculture; although they have tried to increase lending activities in these sectors, they face limitations of staff and a lack of potentially viable projects.

11. The Government's increasing deficit has been financed largely by the banking system. Government debt is funded at low interest; rates through overdraft credit on its checking account at the central bank and by issuing short-term bills. The debt has tended to be short term even where it has gone to finance long-term development infrastructure.

12. Before January 1983 foreign exchange was allocated by means of a simple queue, known in Sierra Leone as the foreign exchange pipeline. Pur- chasers placed orders with the central bank, usually through their commercial banks, and the orders were met as foreign exchange became available. At the time of the Bank's mission (June 1982), orders that had been placed fifteen months earlier were being filled. The pipeline required firms to maintain significant idle balances in the blocked accounts until their orders were filled. Further additions to the pipeline ended lith the Government announcement, "The Modification of Exchange Arrangements," dated December 1982. The announcement set up an officially sanctioned commercial market for foreign exchange in addition to the official market. The two markets were merged into - iii -- one in July 1, 1983, with an across-the-board100 percent devaluation. Henceforth there will be no further additions to the pipeline, and it is hoped that pipeline obligationswill be met gradually out of expected foreign exchange earnings after devaluation.

13. The provision of financial services in Sierra Leone's rural areas is deficient. Sierra Leone's commercialbanks have limited rural operationsand can provide no service to the nation's subsistencefarmers, who together with their families comprise roughly 65 percent of the nation's population. Farmers' seasonal credit requirementsare met largely by traders and moneylenders, who often charge high interest rates. Many cooperativeshave been set up over the past three decades under several large-scaleschemes, but these schemes have all had disappointingresults. They all suffered severe decapitalizationcaused by extreme problems of loan recovery, and they provided virtuallyno investment opportunityto rural savers.

14. The problems impeding the developmentof Sierra Leone's rural financial institutionsderive partly from price controls,the overvaluedexchange rate, and the volatile (and currently depressed)international prices generally afflicting the nation's rural economy. Sociologicaland legal factors have apparently also been obstacles. These factors include the tribal structure of the rural population,social relationshipsof farmers with tradersand moneylenders,and traditionallandownership patterns (which, among other disadvantages,make it impossible to use land as collateral).

15. The Bank of Sierra Leone and the Ministry of Agricultureand Forestrieshave been working on a new rural-bankingscheme, modeled after rural-bankingschemes in Ghana and the Philippines. The first of the rural banks is to be establishedduring 1983, and its experiencewill serve as a guide for subsequent rural banks.

16. The National DevelopmentBank (NDB) was founded in 1968 for the expriesspurpose of providing loans and equity finance for small- and medium- size business enterprises. The performanceof the NDB has been disappointing, in part because of several large-scalefinancings that turned out poorly and in part because of severe loan recovery problems. The NDB now appears to have lost its capitalizationand by any reasonablemeasure is insolvent and incapable of carrying on lending activities.

17. By the end of the 1970s the NDB was virtuallywithout resources to lend1to small-scaleindustry. As a consequence,small-scale industry has had no source of capital finance. The commercialbanks have generallybeen unwilling to provide such finance because of its risky nature.

Recommendations

18. The recent devaluationis a step in the right direction. However, further adjustment of the exchange rate seems necessary because the official rate is already significantlylower than the scarcity value of foreign exchange. As an alternativeto further adjustment of exchange rate, import and export duties should be adjusted to give a higher effective price for foreign exchange. - iv -

19. Import policy should favor inputs for the prcductive sectors, with substantial taxation (by excise taxes or tariffs) of luxury inputs.

20. Government efforts to contain public expenditure should be further intensified.

21. Monetary policy can probably not be effective during periods of excess liquidity. However, monetary policy may become critically important as inflationary pressure develops from devaluation or other reasons.

22. Agricultural producer prices should be set at levels sufficient to cover production costs and to provide an additional margin as an incentive to produce and invest. The recently announced price increases seem adequate, but further review of prices will be necessary to allow the prices to fully reflect the scarcity value of the foreign exchange.

23. In the financial system proper, the aim of Government policy must be to encourage financial institutions to increase financial savings and make viable and socially useful loans/investments. If more appropriate scarcity prices were allowed to take effect in the economy, investment would increase, as would the efficiency of the use of capital.

24. It is essential that interest rates (both for depositors and borrowers) in Sierra Leone's financial system ultimately be raised above the rate of inflation, even if this is not feasible now under present circumstance of excess liquidity. As Sierra Leone's economy improves, the policy should be to ensure a positive interest rate in real terms.

25. Managers of the commercial banks informed the mission that they see few "viable proposals" for industry and small business; the Ministry of Trade and Industry and the UNDP, on the other hand, informed the mission that they receive large numbers of viable proposals. The Ministry should on a selective basis assist would-be business investors in preparing proposals that satisfy the requirements of commercial banks. It would be beneficial for both the commercial banks and the nation's would-be "small" investors if the Ministry could show its best projects to the commercial banks and explcre ways that the commercial banks could help finance them. For the longer term, it is to be hoped that the NDB will recover sufficiently to serve as a major source of industrial investment finance.

26. The Government should finance its credit needs more appropriately. That is, it ought to restrict "ways-and-means" financing by the central bank to its short-term needs, and it should repay such borrowing. At the same time, it should be encouraged to finance its longer-term needs by longer-term instruments. It is to be hoped that as Sierra Leone's economy improves, it will become possible to sell Government obligations to private and semi- private institutions at competitive rates of return.

27. The foreign exchange pipeline should be cleared as soon as possible after the devaluation. No further addition to the pipeline should take place. No license should be granted unless there is a sufficient amount of foreign exchange to match the licensed amount. - v -

28. The proposed rural-bankingscheme should be implementedas an experiment. At the outset a pilot rural bank should be set up; on the basis of its evaluation,other rural banks should be planned. The distinguishingfeature of the rural banks is that they will be local institutions,with local ownershipand control.

29. Commercial banks must be encouraged to maintain and increase their agriculturallending where they believe they can operate effectively. In particular,the commercial banks should be encouraged to provide commercial credit to traders and transportersof agriculturalproduce, as well as to provide complementaryworking capital for agriculturalprojects.

30. Considerationshould be given to the feasibilityof establishinga high-level committee to coordinate policy for Sierra Leone's rural financial system. Such a committeemight include representativesof the Ministry of Agricultureand Forestries, the Bank of Sierra Leone, the projected rural banks, the Sierra Leone Produce Marketing Board, and other institutions. Sierra Leone's rural financial system should be thought of and managed as a system.

31. The Government has rightly decided that independentauditors should examine the NDB's loan portfolio and establish the institution'scurrent capital position. After the auditors' examination,decision must be taken regardingits recapitalizationand possibly its reorganization. Following this, the staff or NDB or its successor institutionshould concentrateits energies on constructionof a core portfolio of prime investments. The income from this portfolio should then be applied to providinga stable operating budget. After a suitable recuperationperiod, there could be expansion into somewhat riskier areas.

32. Once the NDB has recovered, it will presumably continue to provide financing for small- and medium-scaleenterprises. It seems inappropriatefor the NI)Bto engage in financing small-scaleagriculture because of its specialized character and needs; commercial agriculturemay, however, be an appropriate activitg. The charter of the NDB could be altered to permit it to provide "permicnent"working capital along with its long-term financing. To reduce the e:change risk of the NDB, it may be possible to implemonta selective policy under which some borrowers bear the risk and some do not. The Government might be requested to bear the risk for those who cannot do so themselves.

CHAPTER I: THE ECONOMY

1. Sierra Leone is a small, poor, and relatively open economy. Agri- culture and mining are the principal sectors, accounting for 30 percent and 13 percent of the GDP. Nearly 65 percent of the population depend on subsistence agriculture for their livelihood. In contrast, mining provides a livelihood for fewer than 5 percent of the population. Agriculture, primarily coffee and cocoa, and mining, primarily diamonds, account for all exports. Although some import-substituting industries exist, employing about 10 percent of the labor force, the manufacturing sector is small. Most manufactured goods are imported.

2. Between 1962 and 1972, the first decade of independence, production and income rose impressively. GDP grew nearly 5 percent a year, foreign exchange earnings were adequate, and public revenue grew satisfactorily. The Government enjoyed adequate financial resources. After 1972, however, diamond output declined, mainly as a result of the depletion of alluvial deposits, oil prices increased sharply, and the price of manufacturedimports rose. The situationdeteriorated further in 1975 when the country lost its second largest source of export earnings. The only iron-ore mine, at Marampa, closed because of rising production costs and decliningquantity of iron ore.

3. Diamond prices fell sharply in the early 1980s, deepening the crisis. The prices of coffee and cocoa also fell. As the country's terms of trade deterioratedand the value of its exports diminishedsubstantially, serious balance-of-paymentsdifficulties arose. An increasinglyovervalued exchange rate was maintained. The volume of imports declined because of the growing shortage of foreign exchange. Furthermore,since the Government'srevenuas were--and still are--heavilydependent on internationaltrade, the Government budget went deep into deficit, a deficit financed increasinglyby the monetary authority. In 1979 and 1980 the Government deficit widened considerably because of a rapid investment in infrastructureto host the summit meeting of the Organizationof African Unity.

4. The Government'seconomic policies have tended to meet short-term problems rather than to address medium- to long-term structuralproblems such as stagnationin the productive sectors, a low saving rate, and poor use of human resources. Structuraleconomic problems have continuedand in fact worsened.

5. Unfortunately,Sierra Leone's economy is subject to several severe constraints. It is highly dependent on agricultureand mining, although there is unexploited scope for small-scaleindustrial activity. Most agricultural production is for subsistence,but rice has to be imported despite the fer- tility of the land. Exports are confined to diamonds, coffee, and cocoa. The economy depends on imports for almost every kind of consumer good, for capital equipment,and for essentialinputs, principallycil. The industrialbase of the economy is small and has generated little backward linkage to agriculture thrcugh agro-industrialenterprises. The country suffers from poor maintenance of its physical infrastructure,especially the transportationand com- municationsnetworks. Finally, the country'sdomestic market is both small - 2 -

and poor. Even if the markets of neighboring Guinea and Liberia are regarded as available, the market in which Sierra Leone's producers find themselves operatingis too limited to permit economies of scale in production.

6. The remaining sections of this chapterwill briefly describe

o saving and investmentrates; o domestic and internationalvalue cf the Leone; o balance of payments and foreign debt; c government budget; o developmentof industriesand agriculture.

A. Aggregate savings and investment

7. Table I.1 gives Sierra Leone's macroeconomicaggregates from 1976/1977 to 1981/1982, at both current prices and constant 1972/1973 prices.

8. The table shows that the flow of domestic savings has been disappointing. As a proportion of GDP, the highest saving rate since 1976 was 8.1 percent, in 1977/1978. Thereafter the rate plunged and was apparently negative in 1980/1981. One important reason for the low saving rate must be the low rate of real per capita GDP growth. Sierra Leone's population has been growing faster than real GDP, implying that per capita GDP has been steadily falling over the past five years. The problems of the financial system--analysedin this report--undoubtedlycontribute to the problem of low savings.

9. Sierra Leone's investment rates, while not high for a developing nation, have been far higher than the saving rates. The growth rate of real investment,however, declined significantlyin 1978/1979. Private investment fell in real terms during that year, while public investment grew substantially. Public investment took on increased importance over the following two years, largely on account of preparationsfor the summit meeting of the Organizationof African Unity.

B. Domestic and internationalvalue of the Leone

10. Domestically,the value of the monetary unit, the Leone, has been falling for nearly a decade. Sierra Leone has had a persistent inflation problem since 1974, the time cf the first oil-pricerise. After 1979 there was another acceleratedrise in the price level. The imported component of Sierra Leone's inflation is undoubtedly significant,since imported input prices constitutea substantialproportion of prime cost, and imported goods contributea large part of final consumption,particularly in Freetown. A later sectoin of this report provides a monetary analysis of the causes of inflation. From that analysis it becomes clear that Government borrowing from the monetary authority is the major cause of the nation's money supply increase and consequent inflation.

11. Table I.2 gives various measures of Sierra Leone's internal rates of inflationsince 1970. TABLE I-1: RESOURCES AND USES, 1976-81

At Current Prices At Constant 1972/73 Prices

1976/ 1977/ 1978/ 1979/ 1980/ Projected 1976/ 1977/ 1978/ 1979/ 1980/ 1981/ 1977 1978 1979 1980 1981 1981/82 1977 1978 1979 1980 1981 1982

GDP at Market Prices 744.2 850.1 1008.8 1145.5 1338.0 1565.0 416.8 415.8 439.4 454.9 460.1 463.1 Imports of Goods 212.0 241.5 317.6 441.6 414.5 410.0 118.7 118.1 138.3 175.4 142.5 121.3 Total Resources 956.2 1091.6 1326.4 1587.1 1752.5 1975.0 535.5 533.9 577.7 630.3 602.6 584.4

Consumption 715.7 796.1 954.9 1135.9 1354.0 1533.0 400.8 389.4 415.9 451.1 465.6 453.6

(a) Public 111.7 76.8 95.5 109.8 143.0 152.0 62.6 37.6 41.6 43.6 49.2 45.0

(b) Private 604.0 719.3 859.4 1026.1 1211.0 1381.0 338.3 351.8 374.3 407.5 416.4 408.7

Gross fixed capital formation 86.9 99.7 128.0 171.6 160.6 188.0 48.7 48.8 55.8 68.1 55.2 55.6 (a) Public 29.3 32.0 59.7 126.3 110.0 125.0 16.4 15.7 20.6 50.2 37.8 37.0 (b) Private 57.6 67.7 68.3 45.3 50.6 63.0 32.3 33.1 29.7 18.0 15.6 18.6

Change in stocks -2.8 -3.6 10.1 15.4 10.0 19.0 -1.6 -1.8 4.4 6.1 5.3 5.6 Exports of goods 148.4 199.4 233.4 264.2 227.9 235.0 83.1 97.53 101.7 104.9 90.9 69.5

Domestic savings 28.5 54.0 53.9 9.6 -6.4 32.0 16.0 26.4 23.5 4.8 -5.5 9.5

Source: IBRD -4-

TABLE I-2

A: INDEX NUMBERS OF CONSUMER PRIC]ES - FREETOWN

(1961 = 100)

Financial All Food and Period Items(100.0) Drinks(58.8) Housing(22.8) Clothing(7.4) Misc. (110)

1970/71 127.3 126.0 136.6 122.4 118.8 1971/72 129.5 129.5 138.4 122.5 119.0 1972/73 136.5 141.1 138.3 122.5 119.4 1973/74 150.0 159.4 147.4 124.5 126.6 1974/75 171.1 187.3 158.6 130.1 141.4 1975/76 210.6 233.9 192.2 155.1 167.1 1976/77 238.7 267.6 209.7 189,3 182.1 1977/78 259.8 285.3 225.1 235.7 204.5 1978/79 295.8 318.1 250.6 335.2 232.4 1979/80 352.8 388.5 259.6 443.9 265.0 1980/81 401.0 431.2 305.0 537.1 311.9 1981/82 506.7 561.9 353.6 690.5 358.9

B: INDEX NUMBERS OF CONSUMER PRICES FOR MINING AREAS (1960 = 100)

Financial All Food and Period Items Drinks Housing Clothing Miscellaneous

1971/72 127.2 130.7 121.0 101.8 126.1 1972/73 130.5 145.5 123.1 101.5 125.4 1973/74 142.8 165.7 129.1 114.9 129.5 1974/75 170.1 203.4 147.7 142.9 142.7 1975/76 189.0 223.8 182.7 151.4 149.1 1976/77 194.5 238.6 199.1 168.0 152.8 1977/78 216.1 260.7 220.6 194.8 162.3 1978/79 243.3 285.7 231.0 255.2 186.5 1979/80 285.3 338.5 269.9 300.6 214.0 1980/81 350.1 425.1 326.1 358.3 258.3

C: WHOLESALE PRICE INDEX (1970 = 100)

Fuel, Power All Food Liquor & Light & Period Commodities Articles Tobacco Lubricants Manufactures

1977/78 321.6 291.8 220.9 289,9 262.8 1978/79 374.7 320.5 287.2 289.9 434.2 1979/80 482.9 372.5 300.0 442.2 610.1

(1975 =100)

1979/80 221.6 115.4 213.7 201.1 255.7 1980/81 278.2 178.9 289.6 282.1 316.2 1981/82 335.1 222.1 301.3 306.,7 397.1 -5-

12. Externally,the Leone was originally linked to the pound sterling at the rate of Le 2 per pound. Beginning in November 1978 this link was replaced by a link to the IMF Special Drawing Right, with a 5 percent devaluationof the Leone against sterling at the time. Since then, the Leone has been devalued further against sterling and against the US dollar. In November 1982 the rate was approximatelyLe 1.25 per US dollar. On December 17, 1982 the Governmaentintroduced a system of dual exchange rates--officialand commercial. On July 1, 1983 the two markets were merged and the new exchange was fixed at Le 2.5 per US dollar, implying a 100 percent devaluationof the official exchange rate.

13. The overvaluationof the Leone has been large. Before merging of the two exchange rates, the commercial rate, which was supposed to be determined by free auctioning of foreign exchange,was al Le 2.40 per US dollar, w'hich the Government obtained by manipulatingthe auctions. If the auctions wtere free, the commercial rate would have been higher (the black market rate of the dollar at that time was close to Le. 3.20). This gives an idea of the overvaluation of the Leone in the official exchange market at that time. The current exchange rate after devaluationalso gives an overvalued Leone as reflected in the black market rate, which has meanwhile increased sharply.

C. Balance of payments

14. Sierra Leone's balance of payments has consistentlyrun a deficit, and the deficit has become increasinglysevere. Table 13 gives the most recent balance-of-paymentsfigures, and Table I.4 provides a useful inter- pretation of these figures. Let the balance-of-paymentsidentity be written:

,mports = exports + long-term capital inflows + short-term inflows + net other items.

In this form, the nation's imports are taken to be "financed"by the right- hand--sidevariables.

15. For each of the right-hand-sidevariables, Table I.4 provides the figures for the period 1968-1979. The followingpoints may be observed from this table. First, throughout the 1970s Sierra Leone's imports grew at a high rate, well in excess of the growth rate of the nation's GDP. The growth rate of imports was negative only in 1975, following a rise in imports of almost 48 percent in 1974. During the 1970s the ratio of exports to imports fell and has persistentlybeen well under unity. Long-term capital inflows have financed between 15 and 20 percent of total imports w-1tochis on the high side compared to most developing countries. Some of the large trade deficit represents success in attracting aid at concessionalterms. However, much of it also represents borrowing on harder terms the country cannot afford (and which cannot in any event be repeated year after year).

16. A number of circumstanceshave combined to cause a persistent balance-of-paymentsproblem, particularlysince 1979. In 1973-1974 the country's terms of trade deterioratedas a consequenceof the oil-pricerise, Table 1-3: BALANCE OF PAYMENTS (Thousands of Leones)

Classification 1976 1977 1978 1979 1980 1980

1. Goods and services -74,807 -67,044 -132,954 -229,903 -247,000 -227,000 2. Freight insurance -15,827 -17,561 -26,742 -36,977 -42,000 -35,200 3. Other transport 6,215 6,576 6,278 20,991 16,600 14,600 4. Travel -887 -970 -1,115 -1,293 -4,300 600 5. Investment income -11,171 -17,021 -40,772 -44,518 -22,900 -34,200 6. Other services -16,473 -14,404 -8,218 -16,861 -13,600 -12,500 7. Other government -276 -2,123 -2,955 -4,035 -8,400 -6,300 8. Private transfers 5,680 5,384 8,067 6,661 8,700 7,800 9. Public transfers 6,213 17,904 12,587 27,660 46,800 29,000 10. Long-term capital (net) 27,379 27,823 74,704 77,881 43,100 44,000 Official capital (net) 18,081 19,809 51,164 54,267 49,700 19,400 Of which, drawings 12,907 18,394 22,306 26,699 64,800 47,700 Of which, payments -6,353 -3,260 -18,784 -18,655 Private capital (net) 9,298 8,014 23,540 23,614 -6,600 24,600 Of which, direct investment 9,397 5,529 19,834 16,945 -19,600 20,600 11. Short-term capital (net) 4,755 19,533 38,226 78,704 85,600 85,200

12. Trust, Fund Loans ------10,100 --

13. SDR allocations ------4,404 4,400 4,300 14. Errors and omissions 3,775 1,032 11,438 28,865 10,900 33,500 15. Overall balance 18,959 -7726 16,529 2,040 -62,700 -61,600 Table 1-4: THE FINANCING OF IMPORTS, 1968-1979

1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)

286.9 319.4 1. Import of goods 67.2 89.7 87.5 85.9 94.2 125.7 185.7 163.9 179.8 203.7 0.408 0.113 la. Change over previous periods -- 0.335 -0.025 0.018 0.097 0.334 0.477 -0.117 0.097 0.133 241.5 2. Exports of goods 77.2 87.6 84.3 79.4 97.8 111.8 131.2 123.3 132.9 170.2 200.1 0.207 2a. Change over previous period -- 0.135 -0.038 -0.058 0.232 0.143 0.174 -0.060 0.078 0.281 0.176 0.739 0.836 0.697 0.756 2b. Ratio, (2)/(1) 1.149 0.977 0.963 0.924 1.038 0.889 0.707 0.752 52.2 53.9 3. Net long--term capital 12.7 15.5 16.3 11.1 17.3 16.8 40.1 33.3 27.4 26.5 3a. Change over previous period 0.033 of Var. No.2 -- 0.220 0.052 -0.319 0.559 -0.029 1.387 -0.170 0.177 -0.033 0.970 0.182 0.169 3b. Ratio, (3)/(1) 0.189 0.173 0.186 0.129 0.184 0.134 0.216 0.203 0.152 0.130 4. Change in reserves and 2.1 related items -11.3 9.1 -2.3 1.8 -10.2 -7.3 6.7 20.7 18.9 -10.6 5.6 -1.528 -0.625 4a. Change over previous period -- -1.805 0.101 -1.253 -1.783 -0.284 -1.918 2.090 -0.087 -1.561 -0.052 0.020 0.007 4b. Ratio, (4)/(1) -0.168 0.101 -0.026 0.021 -0.108 -0.058 0.036 0.126 0.105 21.9 5. Residual -11.4 -22.5 -10.8 -6.4 -10.7 4.4 7.7 -13.4 0.6 17.6 29.0 5a. Change over previous period 0.974 -0.520 -0.407 0.672 -1.411 0.750 -2.740 -1.045 28.333 0.648 -0.245 0.101 0.069 5b. Ratio, (5)/(1) -0.170 -0.251 -0.123 -0.075 -0.114 0.035 0.041 -0.082 0.003 0.086

Source: World Bank, Sierra Leone: Prospects for Growth and Equity (1981) and 3ank of Sierra Leone - 8 - but after 1975 they actually improved significantly,mainly on account of high world prices for diamonds, coffee, and cocoa. In 1979, however, the second round of oil-price increases reversed the nation's terms of trade again, and since then world prices of the country'sprincipal exports have all fallen. The internationaldiamond price has been falling since 1980. Prices of coffee and cocoa have been sluggish in recent years, and there are indicationsthat they will remain sluggish for several years to come in view of large plantings throughout the world.

17. The effect of increased oil prices has been severe because the country depends entirely on imported oil. Between 1978 and 1979 the nation's oil bill roughly doubled. The industrialand mining sectors are the principal users of this energy, together accounting for 60 percent of oil-derivatives consumption. Road transportand household uses account for another 20 percent each. The country's dependence on oil imports will almost certainlypersist.

18. Yet another source of pressure on the balance of payments has been the need to import rice. Despite its pursuit of food self-sufficiency,the country has had to import about 10 percent of its consumption requirements during the 1970s, and this percentagehas actually increased to about 18 percent since the end of the decade because of increasing problems in domestic production. A rice deficit is expected throughout the 1980s, so that pressure on the balance of payments from this source is likely to continue.

19. For the immediate future Sierra Leone's balance-of-payments problem will undoubtedlypersist. From a macroeconomicpoint of view, the country's marginal propensity to import is high, averaging about one-third. In the coming decade, it will be necessary to pursue export expansion vigorously as well as to contain import growth.

D. Government finances

20. A substantialportion of the difficultiesof Sierra Leone's economy in general and of its financial system in particular is closely linked to fundamentalproblems in the budget of the national Government. The Government plays a fundamentalrole in the economy, partly by design and partly by circumstance. It is the nation's principal employer of white-collarurban workers, and is also responsiblefor all infrastructuraldevelopment. The Government'soperations have been inefficient. Expenditureshave risen far more rapidly than revenues, and there have been difficultieswith control of expendituresas well as with collection of revenues.

21. Table I.5 provides recent data on current revenue, recurrent expenditure,and development expenditurein Sierra Leone. Figures are given in current Leones and in Leones adjusted for purchasing power, along with the annual rates of change for adjusted Leones. Government revenue and recurrent expenditurehave run at about one-seventhto one-sixth of the nation's GDP for the years covered. About two-thirdsof Government revenue comes from indirect taxes, of which roughly three-fifthsis import levies and one-fifth is export levies. Of recurrent expenditure,roughly one-third to two-fifths goes to salaries and wages. In real terms, the growth rates of the categories have varied. 22. Developmentexpenditure increased sharply in 1977/1978and again in 1978/1979. In those two years heavy infrastructureexpenditures were made to prepare for the summit conferenceof the Organizationof African Unity held in Freetown in October 1980. Investmentsin hotels and conference facilities were undertakenhastily, and the facilities are now largely underutilized.

E. Industry

23. Sierra Leone is a small economy by any standard,and its domestic market is too small to sustain large-scaleindustries. There is, however, considerablescope for expansionof Sierra Leone's industry. To date, however, the growth of the nation's industrial output has been disappointing.

24. Some relatively capital-intensiveenterprises provide goods for the local market (includinga brewery and a soap factory), but there is virtually no nanufacturingfor export. A detailed study of Sierra Leone's existing manufacturingsector was recently completedby UNIDO. A list of domestic resources on which to base manufacturingindustries in Sierra Leone includes agricultural,mineral, and other natural resources. Agro-based manufacturing prospects include parboiling and milling of rice; production of cereals, canned fruits, and fruit juices; and spinning and weaving of cotton. Other possibilitiesare mats from husk fibers, ropes from coconut, cattle feed and starch from cassava, oil extraction from palm kernels, peanut butter from groundnuts,cocoa butter, coffee roasting, and alcohol and candies from sugar cane. Importantmineral resources for manufacturinginclude diamonds for cutting, polishing, and setting, and rutile for paint manufacturing. Still other available resources with manufacturingprospects are wood, plywood, and bamboo for furniture and handicrafts,and elephant grass for thatch mats, fences, and partitioning.

25. Serious problems, however, have hampered the growth of the manufac- turiLngsector. The distorted price structure of the economy, the foreign exchange shortage, the inabilityand unwillingnessof the financial sector to support manufacturingenterprises (see the followingchapter), as well as var:ioussector-specific problems have so far caused industrial developmentto lag far behind its apparent potential.

F. Agriculturalproduction problems

26. Sierra Leone enjoys a comparativeadvantage in agriculture in view of its relatively fertile soil and abundant rainfall. Nearly 80 percent of the nation's population is rural, and 65 percent depends on subsistenceagricul- tureafor its livelihood. Agricultureaccounts for about one-third of the GDP and of export earnings. In recent years, however, agriculturalproduction, particularlyin rice, has stagnated. The recent devaluationshould improve the situation. The Government has decided to put the rice import in the private sector. The price of imported rice as well as domestic rice will therefore rise. Effective July 1983, the Governmenthas also announcedhigher prices for export commodities,which it is hoped will boost production. -10 -

Table 1-5

CURRENT REVENUE, RECURRENT EXPENDITURE, AND DEVELOPMENT EXPENDITURE 1975/1976-1980/1981 (Millions of Leones)

1975/76 1976/77 1977/78 1978/79 1979/80

1. Total Government revenue 96.95 117.12 161.36 169.38 171.24 Deflated 63.74 65.62 82.79 77.31 68.00

Percentage change over _ preceding period +2.95 +26.17 -6.62 -12.1 la. Of which: indirect taxes 53.07 77.61 106.40 108.88 113.31 Deflated 34.89 43.45 54.60 49.69 49.87 Percentage change over preceding period +24.53 +25.66 -8.99 -9.4 lb. Of which: import duties 29.41 36.58 49.87 49.87 42.73 Deflated 19.34 20.48 25.59 18.03 19.60 Percentage change over preceding period +5.89 +24.95 -11.06 -25.4

Ic. Of which: export duties 9.26 20.46 25.59 18.03 19.6 Deflated 6.09 11.46 13.12 8.23 7.78 Percentage change over preceding period +88.18 +14.49 -37.27 +8.7 ld. Of which: direct taxes 25.40 25.36 36.94 43.44 39.15 Deflated 16.70 14.20 18.95 19.83 15.54 Percentage change over preceding period -14.97 +31.05 +4.64 -21.6

2. Recurrent expenditure 101.19 112.28 150.99 184.71 184.12 Deflated 66.53 62.87 77.47 84.30 73.12 Percentage change over preceding period -5.50 +23.22 +8.82 -13.3

2a. Of which: salaries and wag:s 11.51 38.36 44.54 46.94 59.30 Deflated 22.03 21.48 22.85 21.42 23.55 Percentage change over preceding period -2.50 +6.38 -6.26 +9.9

2b. Of which: pensions, gratuities 2.73 2.55 4.15 4.01 3.96 Deflated 1.79 1.43 2.13 1.83 1.57 Percentage change over preceding period -20.11 +48.95 -14.08 -1.2

3. Development expenditure 38.88 34.44 20.72 35.44 100.44 Deflated 25.66 19.28 10.63 16.18 39.89 Percentage change over preceding period -24.57 -44.87 -16.08 +146.5

3a. Of which: economic services 25.85 26.14 8.63 19.06 26.76 Deflated 16.70 14.64 4.43 8.70 10.63 Percentage change over preceding period -12.34 -69.74 +96.38 +22.1

3b. Of which: social services 4.32 3.08 3.56 4.89 6.96 Deflated 2.34 1.72 1.83 2.23 2.76 Percentage change over preceding period -39.44 +6.40 +21.06 +23.8

3c. Of which: general services 8.71 5.22 8.53 11.49 66.72 Deflated 5.73 2.92 4.38 5.24 26.50

Percentage change over preceding period -49.04 +50.0 +19.63 +405.7

4. GDP implicit deflator 152.1 178.6 194.9 219.1 251.8

5. GDP 603.7 733.0 833.1 938.1 1145.5

Source: Ministry of Development and Economic Planning, Sierra Leone - 11 -

27. Taxation of the rural sector is substantial;tax revenues collected appear to exceed Government expenditureson agriculture. A chronic and growing labor shortage in the rural areas hampers production. Technical shortcomingsexist, and shortages of critical inputs, including credit, create further barriers to increasedproduction.

28. The ability of Sierra Leone to expand its productive capacity depends upon its success in securing investable funds. In its present depressed state, the national economy is evidently incapable of providing these funds; the saving rate is currentlyat or below zero. The flow of private foreign capital has been negligible in recent years. Sierra Leone thereforerelies heavily on official foreign sources of capital. - 12 -

CHAPTER II: MAJOR ISSUES OF THE FINANCIAL SYSTEM

29. The banking system of Sierra Leone consists of a central bank and five commercial banks, of which two expatriate cormmercialbanks are the dominant financial intermediaries,acquiring their currency and deposits principally from the househcld and business sectors. A single Gcvernment- owned finance company is engaged mainly in vehicle finance. There is a moribund postal savings system; four relatively large and four or five smaller insurance companies; more than one thousand ccoperativesocieties and a National CooperativeDevelopment Bank, which, however, are alsc moribund. One Farmers' Finance Ccmpany and two project credit units associated with the three Integrated AgriculturalDevelopment Projects cperate in different parts of the country. Finally, there is a severely troubled official National DevelopmentBank. No private finance companies,ncr bill brokers, nor private investment banks exist, ncr is there an equities market. There are nc housing finance enterprises. There appears tc be no cpen market in financial instruments.

30. The range of Sierra Leone's financial instrumentsis limited. They consist almost entirely cf money, quasi-moneybank liabilities,and Gcvernment cbligaticns. The array of assets available tc savers is limited to time and savings depcsits cnly. The financial institutionsare mainly based in Freetown, with a few branches scattered in provincial capitals and district headquarters. Although the financing needs cf the mining sector are adequately met, cther productive sectors of the economy such as agricultureand manufacturingby and large remain outside the financial system. Treasury bills and Government stccks constitute the largest single asset held by non- banking financial institutions. The rest of the world is an importantlender to Sierra Leone, providing funds both to the Government and, to a limited extent, tc business.

31. At this writing, Sierra Leone's economy is generally depressedand particularlyconstrained by lack of foreign exchange. This makes it more difficult fcr the financial system to functicn effectively,since financial instituticnsperceive relatively few opportunitiestc acquire earning assets. The chronic shortage of foreign exchange makes many potentiallyprofitable projects that depend cn imported inputs or capital appear too risky. Further- more, general uncertaintyabout the future cf the economy contributestc pessimism among entrepeneursand financiers.

32. It is not always pcssible to differentiatesharply between "financial system" problems and problems that have their origin outside the financial system. Because the financial system is an integral part of the economy, in formulating pclicy it is essential tc take into account not only those problems specific tc the financial sector, but also the structural problems cf the economy as a whole. Some of the apparent problems cf the financialsystem are actually the manifestationscf brcader economic problems. As a brcad generalization,we shall argue here that the short-termproblems of the financial system are largely the consequenceof the nation's economic situation rather than of financial system policies. In the chapters fcllowing this one, where we discuss long-term issues, including agriculturaland industrial - 13 -

development,we shall argue that institutionaldevelopment of the nation's financial system can contribute to the resolutionof these long-termissues.

33. There are currently four major problems in the financial system: (A) the Government'sheavy use of credit; (B) the financial system's current excess liquidity; (C) the foreign exchange pipeline;and (D) the inadequacy of the financialsystem for agriculturaland industrial development. This chapter will deal with the first three issues. The next chapter will deal with developing Sierra Leone's rural financialsystem. Chapter IV will deal with the question of industrial finance. Annex A contains a quantitative descriptionof Sierra Leone's financial system.

A. The Government'sdemand for credit

34. The Government'soutstanding ways-and-means overdrafts from the Bank of Sierra Leone (BSL) alone are approximatelyequal to the broadly defined money supply (M-2). If other Government obligationsare added, total Govern- ment;obligations to the banking system amount to considerablymore than M-2.

35. Government budget deficits have been severe, and the Government is now making a strenuous effort to bring its expendituresunder control. The budget of Sierra Leone, however, is subject to significantvariation and uncertaintybecause the bulk of the nation's revenue comes from levies on exports and imports, as well as on mining and agriculturalproduction, and these values fluctuate considerably.

36. Such variation inevitablyposes a challenge to a small country's central bank. At times of reduced revenues, and hence increased deficit, the Government will naturally increase its borrowing from the central bank. When revenues increase, however, the Government will find itself under political pressure to increase spending rather than to reduce its debt to the central bank. For both these reasons, Government debt to the banking system has grown.

37. Nevertheless,even after taking due account of the problems inherent in Sierra Leone's budget, the growth in the banking system's (that is, the BSL's) credit to the Government has been excessive during the past few years. Much of the growth came in the form of ways-and-meansadvances, which appear to violate the Bank of Sierra Leone (Amendment)Act of 1970 (Article34, Section). The growth rate of the banking system's credit to the Government has been above 30 percent a year since 1975; after June 1979 outstanding creiit exceeded 100 percent of M-2. During some years the money supply (M-2) grew at a slower rate than the "contribution"of Government credit to money supply growth. This was possible, as we have seen, because the banking system's foreign reserves and other net assets have fallen, and because the growth of the banking system's credit has been relatively restrained,even falling in real terms during some years.

38. At least two principles may be recommendedto guide the Government of Sierra Leone in financing its deficit. The Government has three means of obtaining domestic finance: (a) ways-and-meansadvances from the BSL, (b) sale of three-monthTreasury bills, and (c) issue of long-termGovernment - 14 -

stock. In financing its deficit, the Government should use a mix of these three forms of finance, as appropriate to the nature of its deficit. In addition, the Government should pay the opportunityinterest cost on its borrowed funds, as closely as this can be estimated.

39. The import of the first principle can be described as follows. The purpose of an overdraft facility is to allow the Government to meet its recurrent expendituresduring those months when exports, imports, and production are seasonally lower than average, and the Government'sdeposit account is accordingly low. During those months when revenue flows are above average, the BSL must insist that the Government repay its overdraftborrowings. It is appropriatefor the BSL to charge a low, discount;rate of interest on these overdraft credits because the Government is a prime borrower. It is inappro- priate, however, for the Government to use this overdraft facility to borrow money for developmentprojects because this overdraftcredit is short-termand should be secured against Government revenues soon to be received,not against uncertain project revenues. It is more appropriateto finance development expendituresthrough the issue of Government stocks yielding a high rate of interest.

40. The second principle follows from the view that the Government (and untimately the taxpayers), like any economic agent, should pay the price of its borrowed resources to ensure proper allocation of these resourcesand fair payment to primary savers. The promotion of savings should be an objective of the BSL, and it is desirable that an increasing proportion of the Government's debt be held voluntarily by private citizens and enterprises.

B. Excess liquidity in the financial system

41. Sierra Leone's banking system is excessivelyliquid. This excess liquidityis curious because resources for investmentand for working capital are urgently needed in the economy; indeed, one might suppose that excess liquidityin an underdevelopedeconomy like Sierra Leone is not possible. Nevertheless,as Annex Table A-12 shows, commercialbanks' liquidity ratios are well above the 40 percent required by the BSL. ("Liquid assets" are defined to include cash, deposits at the BSL, Government bills, and domestic private bills.) The banks are all well within their assigned credit ceilings. That the banking system has an excess liquidityproblem is evident from the fact that the BSL has seen fit to set a minimum rate for commercial bank savings and time deposits, and that the commercialbanks have clearly endeavored to pay the lowest possible interest rate on these accounts and still comply with the letter of the regulation.

42. There are at least three circumstancesthat make this excess liquidity situation enigmatic. First, a significantdemand for investable funds clearly exists. Although there are not very many local enterpreneurs, businesses and individualswould carry out investment projects if financing was available. The Ministry of Trade and Industry with the help of a UNIDO expert has listed approximatelyUS$300 million worth of feasible small- business projects that could be financed over the next five years. Economic appraisals of the possible projects are necessary. But some of these projects must be "bankable",and there must be some enterpreneursto undertake them. - 15 -

In June 1981 the excess liquidity position of the commercial banks (liquid assets in excess of the 40 percent liquidity requirement)amounted to about Le 13 million. Some of these funds could be made available to finance the best among the available projects listed by the Ministry of Trade and Industry if economic appraisals indicate they would yield high rates of return.

43. Second, the commercial banks have satisfactoryprofit margins. One may ask how these banks earn satisfactoryprofits when so large a proportion of their deposits is held in liquid form. The spreads between lendingand deposit rates are substantial,but not unusuallyhigh: loans earn between 15 and 22 percent, and although demand deposits offer no return, time and savings deposits yield 10 percent. Furthermore,commercial banks have relativelyhigh overhead costs because they do a relativelysmall volume of business and because they maintain branches in the interior.

44. Third, excess liquiditypersists despite the fact that interest rates on loans and interest rates on deposits are lower than the rate of inflation.

45. No formal financial market in Sierra Leone sets interest rates com- petitively. The Government and the monetary authority determine the fundamental rates on Government obligations,on deposits by commercialbanks at the BSL, and on time and savings deposits at commercial banks. There is no open market in securities. The interest rates have been increased on several occasions over the past few years with the principal objective of encouraging savings and controlling the growth of credit. Interest rates have been changed more frequently in Sierra Leone than in other West African nations (See Leite, p. 57).

46. Several hypotheses can be advanced to explain the excess liquidity in the Sierra Leone banking system:

(a) Lack of viable projects

Commercial bank managers, while agreeing that they have funds to lend, told the Bank mission that viable project proposalswere limited. Bankers seem to imply several things by this. First, key prices (includingthe price of foreign exchange) in Sierra Leone are controlled somewhat arbitrarily,and the controlled prices make otherwise profitable projects unprofitable. Second, either the availabilityof required inputs (includingforeign exchange) or the reliabilityof the output market is frequently too uncertain for a bank to risk backing a particular project. Third, Sierra Leone's internal market is small and poor, and this remains true even when neighboringGuinea and Liberia are considered to be availablemarkets. Thus for many manufacturing projects economies of scale cannot be achieved. Fourth, banks require substantialdocumentation before they can approve a production loan, includingproper production and market evaluations. Would-be entrepreneursare often incapable of providing these themselves,and are often unable to secure the services of the requisite engineers or market analysts. Fifth, the commercial banks require entrepreneurs to provide equity of their own as well as security for the loan. This is orthodox - 16 -

and universal banking practice. Unfortunately,Sierra Leone's entrepreneursapparently have unusual difficulty fulfillingthe equity and security requirements. Given Sierra Leone's present circumstances,it is understandablethat few projects can meet all of the commercialbankers' conventionalrequirements for viability.

(b) Lack of foreign exchange

Commercial bankers often cite the lack of foreign exchange or the uncertaintyabout its availabilityas a reason why many loan projects are unbankable. A large range of possible projects, they argue, require foreign capital equipmen-tor a reliable flow of imported inputs.

A reluctance to bear risk is the other side of the coin of the commercial bankers' claim that they rarely receive viable projects. Many people outside the commercial banks feel that the problem is not that project proposals are not viable but that the bankers are too demanding. These people arguaethat commercial banks must be prepared to take more risks in their portfolios and must expect to write off a larger quantity of assets than they ordinarily would in a developed economy. In return they should expect to receive a higher interest rate spread than they would in a developed economy.

The BSL's Credit-GuaranteeScheme, instituted in 1974, was an attempt to ameliorate this problem. Under this program the BSL provided a &uarantee of 66 (recentlyincreased to 80) percent of the outstandingbalance of selected commercial bank loans. This program has generally been regarded as a failure because only a small number of loans have been guaranteedunder it and because a large proportion of the guaranteeswere applied to trade, not production,credit. BSL officials informed US that the commercial banks found even one-thirdof many loans too much risk for them to bear. (See National Workshop, p.78 for a tabulation of loans given under BSL guarantee between July 1974 and June 1978),

(d) Positive yield on liquid assets available to commercial banks

Commercialbanks' deposits at the BSL earn an annual rate of 6 percent. (A bank must hold at least 5 percent of its deposits in vault cash or BSL deposits; only BSL deposits in excess of this amount earn 6 percent.) Treasury bills earn 10 percent. Commercial banks' deposits at the BSL are fully liquid and are virtually costless to the commercial banks; holdings of Treasury bills are very nearly fully liquid and are also virtually costless. Loans offer higher rates of return, but entail considerablecost and risk. If the commercialbanks are risk 17 -

averters, they will find liquid assets more attractive at the presentmargin (althoughyielding a negative return in real terms) than the riskier kinds of loans. The BSL offers interest on its commercial bank deposits in order to encourage the banks both to pay the minimum high rates on deposits and to stay liquid, as an anti-inflationarypolicy.

(e) The state of the economy

That Sierra-Leone'seconomy is depressedand uncertain has at least two consequencesaffecting liquidity: first, relatively few people are likely to have the confidence to go into debt in order to invest or to expand existing productivecapacity; second, wealth holders particularlythe smaller ones, are likely to seek to keep their wealth liquid, even at some real cost, rather than place it in risky assets. In other words, in a depressed economy like Sierra Leone's, in which people clearly feel considerableuncertainty about the future, would-be borrowersare apt to be risk-aversewhile wealth holders are apt to have a strong liquidity preference. These factors tend to bring down interest rates.

47. We have offered five possible reasons why there is excess liquidity in Sierra Leone's financial system: lack of viable projects,lack of foreign exchange, reluctance of commercial banks to bear risk, preferenceof commercial banks to earn returns (though negative in real terms) on safe liquid assets, and the depressedstate of the economy generally. We now offer some suggestionsfor policies that might serve to alleviate the excess liquidity.

48. First, The Ministry of Trade and Industry should carefullyreview the best of the projects it has identified and bring the projects the Ministry considers sound to the attention of the commercialbanks and seek the assistance of these banks in determiningwhich projects are bankable. The Ministry can also identify prospectiveenterpreneurs and help them, if needed, in drawing up-the required engineeringand marketing evaluationsfor these prcjects. This will at a minimum test whether these are good projects potentiallyavailable and, if so, will help increase industrialinvestment.

49. Second, since shortage of foreign exchange is unlikely to ease in the near future, loans must be directed preferentiallyto projects that are sparing in their use of foreign exchange. Agro-industrialenterprises that use the output of domestic agricultureappear to be the most suitable projects (See Chapter IV).

50. Some people argue that the commercialbanks must be encouraged to change their attitude toward risky assets. This is not an appropriate approach to the problem. It is a mistake to question a professionalbank marager's judgementwhere the riskiness of his portfoliois concerned. The proper approach is not to thwart a professionalsense of risk aversion, but to create better conditionsfor investment through appropriate pricing and exchange rate policiesand through provisionof supportive services. - 18 -

C. The Foreign Exchange Pipeline

51. Over the past few years Sierra Leone's foreign exchange crisis has deepened, primarily because the country's terms of trade shifted sharply against it and because it persistentlymaintained an overvalued exchange rate. The shortage became so acute that a lengthy backlog of commercial arrears--theso-called "pipeline"--developedfor foreign exchange. In June 1982 the BSL was filling orders for foreign exchange that had been placed fifteen months earlier. The pipeline has had a corrosive effect on both the financial system and the national economy; moreover, the question of how to liquidate the existing pipeline still remains although further additions stopped with the exchange rate reform in December 1982. We begin, therefore, by describing the pipeline, and then consider what the Government can do to liquidate the existing pipeline and to ensure that there is no pipeline in the future.

52. The basic operation of the pipeline was straightforward. A purchaser of foreign exchange worked through an authorized foreign exchange dealer, usually one of the commercial banks. 1/ The purchaser deposited the Leone equivalent of the foreign exchange with the commerc-ialbank, stated the intended use for the foreign exchange, and submitted whatever documents were required to show that this use was legitimate and atuthorized.An importer, for example, had to present an import license. The commercial bank then opened an equivalent account with the BSL, and thereby took the next place in the pipeline queue. When the purchaser'sturn came and foreign exchange became available, the BSL turned it over to the bank, which supplied it to the purchaser. During this whole process the accounts of the purchaser at the bank and of the bank at the BSL were blocked, so that if either one was withdrawn, the purchaser lost his place in the pipeline. The purchaser bore the foreign exchange risk; that is, when his turn came, he received foreign exchange at the rate then prevailing.

53. A small amount of foreign exchange was retained and legally trans- acted outside the pipeline. The commercialbanks were authorized to maintain "working balances" in foreign exchange, to purchase exchange for these balances and to sell from them. The two large paraLstatalfirms, the Sierra Leone Produce Marketing Board and the Diamond Mining Company, as well as the private diamond-buyingconcern, Diamond Corporation,and the bauxite mining enterprise,SIEROMCO, maintained some foreign exchange balances outside the country. The SLPMB, DIMINCO, and SIEROMCO were subject to surrender requirements, and accounted for more than half of the foreign exchange flow to the BSL. Oil purchasers were exempt from the pipeline and received foreign exchange without waiting.

54. The quantities of exchange involved in the pipeline were and remain quite large. The two largest banks separate their pipeline accounts in their balance sheets. On December 31, 1980 Barclays' "special deposit with the BSL

1/ The Finance Ministry authorizes all foreign exchange dealers, under the 1954 and 1965 Foreign Exchange Control Acts. Commercial banks are authorized dealers. - 19 - relating to arrears of external payments" stood at nearly Le 52 million; on December 31, 1981 it was just over Le 68 million. Standard's epecial deposit werLtfrom nearly Le 20 million on December 31, 1980 to more than Le 40 million one year later. At this writing the magnitude of the pipeline is on the order of Le 150 million to 200 million, roughly three-fourthsof the broad money supply (M-2).

55. The commercial banks supplied two kinds of letter of credit: "soft" and "hard". Under the soft letter of credit, the commercial bank promised to effect the remittance only when the foreign exchange became available through the pipeline. Overseas creditorshad to wait indefinitely,and naturally many suc:hcreditors either raised the prices of their goods substantiallyor simply refxusedto do business with Sierra Leone. Hard letters of credit are the conventionalkind. They became increasinglyrare in Freetown because of the growing foreign exchange shortage. The BSL provided confirmedand unconfirmed letters of credit for its payments on the Government'saccount, corresponding to the private banks' hard and soft letters of credit.

56. Strictly speaking, neither the pipeline nor the foreign exchange shortage were in themselves financial problems. The Leone price of foreign exchange was apparently too low, foreign exchange was therefore in short supply, and the queue was simply devised to ration the available exchange. Nevertheless,the pipeline clearly had importantrepercussions for Sierra Leone's financial system as a whole. A large quantity of business funds remained tied up for a period of time that could not be closely, let alone precisely, predicted. Some enterpriseshad to borrow the funds to place on deposit. Even when they used their own funds, they had to borrow funds for other purposes. The interest that they had to pay--or the interest foregone on funds tied up--must be regarded as a de facto increase in the price of foreign exchange over and above the official price, caused by its scarcity. But the specific way in which the effective price was raised was by tying up investablefunds.

57. As we have stated, the scarcity of foreign exchange also rendered a broad range of investment projects unattractiveas loan propositions. It made foreign borrowing almost unthinkable,because a local borrower who had to remit amortizationand interest payments found it impossible to ensure his supply of foreign exchange.

58. By all accounts, the functioningof the pipeline as an allocative mechanism for foreign exchange left much to be desired. As a basis for allocating a scarce resource, "first come, first served" is strikingly arbitrary, and the pipeline was subject to considerableabuse and even fraud. A consequence of the overvaluedLeone was a growth in diamond smuggling. The foreign exchange fetched by the sale of smuggled diamonds could be sold within the country--illegally--ata considerablepremium over the official rate. The typical final purchasershave been merchants who then used the foreign exchange to import goods.

59. When a merchant obtained an import license, he joined the pipeline, and the presumptionwas that he would wait his turn before effectinghis import since the banking system was the only legal source of foreign - 20 -

exchange. In fact, however, few merchants waited for the pipeline. They obtained their foreign exchange from illegal sources, typically from intermediaries who purchased it from diamond smugglers. In order to permit merchants to import with illegal funds, the Government used to issue them unnumbered import licenses that fell outside the usual licensing system. The unnumbered licenses ensured a flcw cf consumer goods to the economy, while at the same time effectively laundering earnings from diamond smuggling. The Government announced the discontinuation of unnumbered licenses in December 1981, but then reversed its decision. The unnumbered licenses were discontinued again with the introduction of the dual exchange rate in December 1982, which was intended, among other things, to permit the pipeline to be phased cut. After the Government announcement of December 17, 1982, nc further transactions were placed in the pipeline, and previous pipeline commitments were tc be "ocnsolidated and liquidated on the basis of a schedule tc be announced." On July 1, 1983 the dual exchange rate was discontinued with a 100 percent devaluation of the official exchange rate.

60. The new exchange rate measures also reform procedures for import licenses. The specific import licenses previously required are replaced by open general licenses, and the paperwork is simplified. Import priorities are generally liberalized, as are exchange control provisions governing imports and related services, such as travel, education, medical treatment, advertis- ing, emigrants' and expatriates' allowances, profit remittances, and so on. All restrictions on overseas borrowing not officia:Lly guaranteed are removed. Hcwever, a system of foreign exchange allccation by the Bank of Sierra Lecne was retained to ensure rational allocation in line with national priorities, effective coordination with the import licencing system, exchange control approvals and expected foreign exchange receipts.

61. The new system is a considerable improvement cver the pipeline system. Nevertheless, barring a sharp improvement in international prices for Sierra Lecne's exports, the back log in of the pipeline will inevitably persist for some time. The Gcvernment will have to review the claims in the pipeline and allocate foreign exchange to meet the claims on a priority basis.

62. The policy of not issuing any unnumbered licenses and of issuing licenses only with available foreign exchange should be strictly adhered to. The new exchange rate will allccate foreign exchange resources mcre efficiently; if, however, the severe shortage of foreign exchange persists, the new exchange rate will have to be supplemented with further devaluation, or at least higher tariffs (accross the board) that will increase the effective price of foreign exchange.

D. Interest Rate Policy

63. What is the appropriate interest rate policy for Sierra Leone? How should the interest rate structure be determined? We address these questions here in the light of the characteristics and issues of the financial sectcr cutlined above.

64. In Sierra Lecne today the interest rates (Table II-I) are generally lower than the inflaticn rate, giving to depositors a negative real rate of return. As in most countries, the structure of interest rates is heavily influenced by the central bank. -21 -

65. There are strong analytical grounds for making interest rates positive in real terms. A financial system with interest rates below the inflation rate produces undesirableeconomic effects: poor mobilizationof savings, capital flight, poor allocation of resources,and so on. A low interest rate discouragesdepositors, reduces demand for money (which increases demand for goods and services) and, with a given nominal money supply, drives up prices. A continued negative interest rate in real terms also aggravates problems of income distributionbecause subsidized credits go to wealthy indivlduals,whereas a large fraction of time and savings deposits are held by people with moderate incomes.

66. If the financial and capital markets operate competitivelyand if there are no distortionsand rigidities in the market, then the market- clearing interest rate in real terms should over the long run be positive (and would reflect the opportunitycost of capital). If price distortionsexist, however, and if the financialmarkets are too thin or oligopolistic,a market- determined rate may not be positive in real terms. Some people argue that if market conditions are such that the market-clearinginterest rate has to be low (and negative in real terms), then holding interest rates at positive levels would unnecessarilydepress investment. But this situation is not tenable in the long run because, as has been mentioned, a negative real interest rate has many adverse effects. Moreover, in a segmented credit market, a low interest rate benefits only those who have access to the credit market; some would-be borrowers from the productive sectors do not have such access. Those few who do benefit may, in a recession,borrow for consumption and for speculativepurposes. Furthermore,in Sierra Leone low interest on deposits has accentuated the inflationarypressure caused by heavy Government borrowing.

67. Generally speaking interest rates should be determined by market forces, but in Sierra Leone today, as in most developing countries, the financial sector is underdeveloped. As noted earlier, a few expatriate commercialbanks dominate financial activity. The lack of competitionis partly reflected in the high profitabilityof these commercial banks despite the present depressed condition of the economy (see Table A.4). (Although conmercial banks' lending rates are lower than the inflation rate, the spread between the deposit and lending rates is quite substantial), If the financial institutionsare few and oligopolistic,as they are in Sierra Leone, a market- determined interest rate will not reflect the opportunitycost of loanable funds. Hence the need for the central bank of Sierra Leone to influence the interest rate structure when distortionsemerge (particularlythrough setting minimum deposit rates). Interest rates are currentlylower than the inflation ra'te,yet the commercial banks have excess liquidity because of the lack of viable investment opportunities,which in turn is due to the severe recession and to mistaken policies of the Government in the past (for example, an overvalued domestic currency). The solution for insufficientcredit demand lies in a macroeconomic reform program that includes adjustment of the exchange rate, reduction of the budget deficit, control of the moneysupply,and so on. The interest rate itself will in the start have little effect on the demand for credit. As the economy recovers and demand for credit strengthens, however, there will be a need to set interest rates at a positive level in real terms, a goal which can also be fostered through competitionamong commercial banks. At the some time, the formal sector covers only a part of the economy; the informal sector is perhaps the major source of credit for many TA.E 11-1: 9LFECJM IERESr RATES

(Percent per anmim)

QtMECIAL BANKS'DEP0SIT RAIES

Tme Deposits

Central Over Over Post Conmercial Treasury Bank 3 months 6 months Office Bank's lending Blll DiscDunt but not but not Over Savings Savings & Overdraft Period Rate Rate 6 months 12 months 12 mnmths Deposits Deposits Rates

From To

4 Nbv. 1965 29 Nov. 1967 5 5-1/2 2-1/2 2-1/4 - 3 3-1/2 - 4 3 3 8 - 10 "3 30 Nbv. 1967 29 Jan. 1969 6 6-1/2 3-1/2 3-3/4 -4 4-1/2 - 5 4 4 8 - 10 30 Nbv. 1967 30 Jun. 1973 5-1/2 6 3 3-1/4 - 3-1/2 4 - 5 4 4 8 - 10 I Jul. 1973 30 Jun. 1975 5-1/2 6 3 3-1/4 - 3-1/2 4 - 5 4 4 8 - 12 1 Jul. 1975 31 Dec. 1976 5-1/2 6 6 7 8 5-1/2 4 8 - 13

Over Over Over Over Over Over 1 month 3 months 6 mnaths 9 mnths 12 mnxths 18 months & up to & up to & up to & up to & up to & up to i wnth 3 months 6 months 9 months 12 months 18 moths 24 months

1 Jan. 1977 30 Sept. 1979 5-1/2 8 6-1/2 7 7-1/2 8 8-1/2 9 9-1/2 7 7 11 - 16 1 Oct. 1979 31 May 1980 8-1/2 10 7 8 8-1/2 9 9-1/2 10-1/2 10-1/2 8 8 14 - 16 1 Jun. 1980 - 10 12 9 10 10-1/2 11 11-1/2 12 12-1/2 10 10 15 - 18 - 23 - productive activities such as small-scaleagriculture and small-scale industry. Unfortunately,very little is known about the informal seCtor in Sierra Leone.

68. Consideringthe above factors, we recommend the following:

(a) Follow-up work on the financial sector should review the composition cf the present financial institutions,including the informal market for credit and the linkages between the formal and the informal markets. This study would help in designingpolicies to forge links between formal and informal markets of credit and to promote competitionin the credit market. The study could be carried out by the Bank of Sierra Leone.

(b) The Government should encourage competitionamong commercial banks by encouragingmore banks to cperate in Sierra Leone.

(c) Interest rates (for both depositorsand borrowers) in Sierra Leone's financial system should ultimately be raised above the rate of inflation. But in the present situation of excess liquidity,raising the interest rates would discourage commercialbanks from accepting deposits and probably lead to further increases in lending rates. This would discourage the commercialbanks from acquiring assets because the prcfitabilityof enterpriseswould become more uncertain. It is desirable, therefore, that policy be directed first toward relieving price distortionsso that a basis for a viable demand for credit can be established. As Sierra Leone's economy improves, the policy should be to ensure a positive interest rate in real terms.

69. Three issues discussed in this chapter--thehuge public-sectorborrowing, the excess liquidity of the commercialbanks, and the foreign exchange pipeline--mayall be said to derive from problems exogenous to the financial system. For the most part, their resolutionwill require policy actions outside that system. Public-sectorborrowing requirementsmust be brought under control; appropriate pricing policies must be set to enable and to encourage productive enterprisesto borrow from commercial banks; and exports must be stimulated in order to supply the banking system with foreign exchange. Over time, as the compositionof assets of the banking system shifts away from public-sectorobligaticns toward private-sectorand foreign obligations,these issues will be resolved. On the whole, they require no significantinstitutional reforms of the financialsystem. The fourth issue, interest rate policy, does require some institutionaldevelopment; competition among commercialbanks must be promoted and links between formal and informal financialmarkets must be forged. The issues to be considered in the following two chapters of this report entail substantialinstitutional development. The deficiency in agriculuturalfinance calls for developmentof the nation's rural financial system, while the deficiencyin industrial credit calls for a thorough reorganizationand revitalizationof the National DevelopmentBank. - 24 -

CHAPTER III: THE RURAL FINANCIAL SYSTEM

70. The economy of Sierra Leone is criticallydependent on its agricultural sector. Many problems plaguing this sector are a consequenceof problems in the nation's rural financial system, although it is also true that the rural financial system's problems derive from the agriculturalsector's circumstances. The purpose of this chapter is to identify the major shortcomings of the existing financial system and to consider possible policies for its improvement. (See Annex B for a descriptionof the institutionsin the existing rural financial system.) We do not intend to provide a detailed analysis of the rural financial system since extensive analysis has already been undertaken by others whose works are cited here.

71. This chapter has five sections. Section A outlines the functionsof a rural financial system in an economy like Sierra Leone's. Section B summarizes the shortcomingsof the existing rural financia'linstitutions. Section C presents a brief descriptionof the proposal made by the Bank of Sierra Leone (BSL) which is at present the principal rural finance project. Section D summarizes the difficultiesand dilemmas that the proposed rural- banking scheme may face and offers further suggestionsfor rural finance policy. Section E contains some concluding remarks.

72. The rural economy of Sierra Leone embraces about 75 percent of the nation's population of approximately3.5 million. There are between 450,000 and 500,000 families in the rural sector. About 80 percent of all farmers grow rice, although cassava, corn, millet, sweet potatoes, peanuts (grcund- nuts), citrus fruits, and oil palm are also important crops, and many farmers maintain livestock. The average farm size appears to be between one and two- and-a-half hectares. Less than 13 percent of the nation's arable land is presentlyunder cultivation. Estimated average per capita rural income is Le 115 per year. This appears too low to allow a significant surplus for saving.

A. The functions of a rural financial s,ystem

73. On its asset side, a rural financialsystem must provide

(a) working capital for production;

(b) commercial credit to suppliers of agriculturalin-uts and to commercial purchasers of agriculturaloutput;

74. The characteristicsof these three broad classes of credit are quite distinct, and each one poses different technicalproblems in its management. Because working capital finance has been regarded as the most difficultkind of agriculturalcredit operation, policymakershave tended to direct their energies to the solution of its problems. Nevertheless,a rural financial system must somehow provide all three classes of credit, which are complementary. - 25 -

75. A rural financial system must also capture savings. One reason is that the possibilityof accumulatingwealth induces farmers to produce beyond their subsistenceneeds. Second, farmers' accumulatedsavings constitute an investment fund they can use to expand their productive capacity.

76. There is no question that Sierra Leone's agriculturaldevelopment objectiveswill require an effective rural financial system capable of carrying out the operationswe have summarized. Nevertheless,an improved rural financial system cannot by itself ensure agriculturaldevelopment. If the level of agriculturalprices is insufficientto cover costs, if technical support for farmers is unavailable,or if agriculturalinfrastructure remains underdeveloped,then agriculturaloperations will not be creditworthyand even the best conceived and best managed rural financial system will not be effective in boosting agriculturaldevelopment.

B. The shortcomingsof the_presentrural financialsystem

77. (a) Credit is quantitativelyand qualitativelyinadequate. It is difficult to estimate the total quantity of institutionalcredit outstanding in Sierra Leone's rural sector at any moment, partly because some institutions(particularly the cooperatives)provide poor data, and partly because credit categories are somewhat arbitrary. For example, commercial bank credit going to commerce in agriculturalproducts would not be included in agriculturalcredit. A further problem is that a substantialproportion of outstanding rural credit is in arrears; ideally, we would prefer to estimate total performing rural credit. Bearing these caveats in mind, an estimate of the total value of institutionalcredit outstandingin the rural sector can be made. Outstandingloans of cooperativesare assumed to be unchanged from 1978. The NDB's outstandingagricul- tural loans are assumed to be the same percentage of its total 1962 loans (16.2 percent) as cumulative agriculturalloan approvals were of total cumulative loan approvals.

ESTIMATE OF FINANCIAL LOANS TO THE RURAL SECTOR, SIERRA LEONE, 1982 (thousandsof Leones)

Commmercialbanks 5,043.0 Bank of Sierra Leone 0.0 Cooperatives 1 ,100.0 Farmers' Finance Company 1,805.0 National DevelopmentBank 727.0

Total 8,675.0

All the financial institutionsoperating in Sierra Leone's countryside provide services to their clients that are deficient in one way or another. Moneylenders,providing rapid, informal service, usually offer no technical support and charge exorbitant rates of interest. - 26 -

Commercial banks, the Farmers' Finance Company (FFC), and the NDB require much paperworkand place restrictionson the farmers' use of the borrowed funds, even if they try to provide technical support and a lower interest rate. Cooperativeshave inadequate resources to be even minimally effective in most areas, and they provide poor technical support.

(b) Rural savings are inadequatelymobilized. A review of the list of institutionsengaged in rural finance in Sierra Leone shows that very few were conceived with any intention of mobilizing rural savings (see Annex B). The commercial banks, the FFC, and the NDB were all intended to serve as conduits for outside resources. (A partial exception is the commercialbanks, whose branch offices in the interior of the country receive some rural savings.) The cooperatives were, of course, designed to aggregate their members' savings, but in fact they too serve mainly as conduits for outside grants and loans. The BSL's Premium Savings Bond Scheme is more in the nature of a lottery than an effective wealth-accumulationprogram. Although some rural moneylendersperform services of'money custodianship(see Bessell and Raswant, p. 18), it is clear that this activity falls well short of being a serious rural savingEsmechanism.

(c) Staff is inadequate to carry on rural financial activities The larger commercial banks in Sierra Leone have almost no st: Ff with adequate expertise in agricultureand in agriculturallencding. The cooperativesand the National CooperativeDevelopment Bank also suffer from staff deficiencies. The NDB never had sufficient agriculturalexpertise to manage a rural portfolio and, in any case, was unable to supervise rural loans adequately. The FFC's poor loan recovery record can be attributed to two main factors, "managerial inefficiencies"and "wilful default by borrowers."

(d) Loan recovery is insufficient. It is clear that since the 1960s every financial institutionthat has operated in Sierra Leone's countryside,with the apparent exception of'the moneylenders,has had disastrous loan recovery problems. The Registry of Cooperative Societies (RCS) Loan Scheme, the FFC, and the NDB have all undergone significant decapitalization. The commercialbanks have had some loan losses, although on the whole the bad experiences of other lenders appear to have made them wary.

Probable reasons for the loan recovery problems include the following:

(1) There exists among rural borrowers a view that there is nothing wrong with failing to repay Government funds. There is an implied threat that a borrower in arrears will be ineligible for further credit, but the force of this threat is mitigated by the fact that since each individualexpects his neighbors not to pay, it is rational for him to assume that, whether he pays or not, the system will fail and no funds will be available to him in the future; by the willingness of moneylendersto provide him - 27 -

finance as before; and by the apparent willingness of some financial institutions(particularly the cooperatives)to provide loans to borrowers already in arrears.

(2) Agriculturalprices have often been so low that farmers could not afford to repay their loans. Rice prices for domestic producers have until recently been insufficientto cover costs, and the depressed world markets for coffee and cocoa, combined with Sierra Leone's overvaluedcurrency, have drastically reduced cash crop margins. Where little profit is expected, loans should not be provided. If loans have been provided in such cases, then, the appraisal of credit requests has been inadequate. But low agriculturalprices cannot bear the entire blame for poor loan recovery;both the RCS Loan Scheme and the FFC experiencedrecovery problems even when prices were relatively high.

(3) Low technology and lack of productive opportunitiesin agriculture can be a cause of poor loan recovery. If rural credit cannot be used in agriculturalactivities with a high return, then farmers will have trouble repaying their loans. Credit, therefore, has to be provided as part of a package that includes improved seed, fertilizer,water, and other necessary inputs of productive agriculture.

(4) The staff and the procedures of the financial institutionshave not proved effective in the task of recovery. Farmers, understandably,prefer to pay off local traders, moneylenders, informal organizations,relatives, friends, and tribal authorities before paying off commercial banks, not to mention the Government.

(e) Loan security is inadequate. Loan security is a severe problem because apart from the Western Area (the territory around Freetown) there is in Sierra Leone practicallyno outright freehold with title deed to a piece of land. While individual farmers have firm customary rights which, in effect, often amount to ownership, there is no legal basis on which they can pledge land as collateral.

783. The virtual ineligibilityof land as collateralin most of Sierra Le,onemust be accepted as a fact of life. Unless the country experiences agrarian reform, land is unlikely to be owned under transferabletitle deeds in the near future.

79. What security can a small farmer offer for a loan? The BSL Report suggests, first, that the approach should be "productivity-based"rather than "asset-based." The real credit backing should be the productive potential of the person rather than his wealth. Second, rural credit should tie individual liability with group responsibility. If guarantors are selected from within the group, they are likely to ensure that the borrower fulfills his obligation to the institutionso that the group is not excluded and its members thereby prevented from getting further loans. - 28 -

80. In some parts of the country, a farmer can acquire a legally valid "right of usufruct" for a limited time. If this sort of document could be made legally transferable,or otherwise legally regulatedunder special legislation,it might be possible for farmers to provide land security at least in this limited way.

C. The proposed rural-bankingscheme of the BSL

81. The Bank of Sierra Lecne has been carefullypreparing a new rural- banking scheme. The 1978 National Workshop cn AgriculturalCredit and Banking laid the conceptualgroundwork fcr preparationof the propcsal. Bessel and Raswant (1981) evaluated the scheme and made precise suggestionsfor its implementation. The distinguishingfeature of the new proposal is that rural banks are to be local institutions,receiving deposits and making loans within a limited geographicalarea. Ownershipand control are to be local. Speci- fically, the BSL will provide half the capitalization(at least Le 50,000) of each rural bank to be established. The Board of Directors cf each bank is to consist of between five and seven persons (accordingto the wishes cf the shareholders),of whom two are to be appointees of the BSL and the others residents of the area served by the bank. Bank directors must be shareholders (at least Le 500).

82. The BSL will play a fundamentalrole in promoting the rural banks. It will offer technical assistance,provide term loans to the banks, underwrite or guarantee financing from other sources, train staff in bank practice, loan appraisal, bookkeeping,and secretarialwork. In the early stages of cperation, the BSL will alsc perform auditing services at no charge.

83. It is proposed that the rural banks be legally empowered to carry out a broad range of financialservices. However, at least initially, they will limit their acceptance of deposits to the simplest kind of passbook operaticn, avoiding the costly complexitiesof demand deposits. The BSL intends to move cautiously in setting up the scheme.

D. Issues and dilemmas of rural banking

84. Given the miserable loan recovery rates already noted, there can be no question about the riskiness of rural finance in Sierra Leone. In the rural-bankingscheme, therefore,every effort must be made to ensure reason- able rates of loan recovery through careful loan appraisaland vigorous collection methods. Even were loan recovery perfect, rural banking is still a difficult business, involving a number of dilemmas. (a) Staff incentives. The success cf a rural bank will obviously depend cn the skill and vigor of its staff members, whc should be motivated by appropriateincentives. The dilemma, cf course, is that if they are paid well the costs cf the institutionwill be high; if they are paid inadequately,they will perform their jobs poorly. The rural bank could hire retired bank personnel fcr management positions. Since the retiree will have his pension, he can be paid a lower salary, while the bank gets the benefit cf his experience. This appears to be common practice in Ghana's rural-bankingscheme. - 29 -

(b) The involvementof the Government and the BSL. The involvementof the Government in the rural banks must appear to be minimal. Loan recovery will be adversely affected if it is generally thought that the bank's resources are Government funds Moreover, it is important that the institutionbe controlled locally, to the extent possible. On the other hand, it is obvious that the rural banks will require extraordinaryGovernment and BSL support to succeed. The BSL will provide half the capitalization,as well as training,auditing, and other technical support services. The dilemma is that the Government must promote local control while retaining sufficient control itself to inspire trust and confidence.

(c) Loan supervision. There are two apparently competing principlesof loan supervision. The first is that credit must be closely supervised at all stages because credit resourcesare scarce goods with high social value. The second is that individual farmers should have some flexibility in the use of credit for which they are paying interest. These two principlesneed not, however, be contradictory in practice. Farmers should state the specific purpose for which they want credit. Once this has been approved, supervision,should entail helping them to carry out their plans.

(d) Security. Security is another difficult issue for rural banking. Because of the nature of their clientele, it is out of the question for rural banks to insist on the stringent loan criteria common to commercial bank lending. Nevertheless,the rural bank cannot lend without some security considerations. A proportionalcollaterali- zation of loans at, say, 50 percent of value and some guarantee scheme through social pressure or by enlisting the cooperationof local leaders might provide a partial solution to this dilemma.

85. We offer several further observationson rural finance policy.

(a) Rural trade credit. The rural financialsystem in Sierra Leone could be more effective if more attention were given to the provision of trade credit in the rural sector. In many instances,agricultural inputs could be provided efficientlyby private suppliers who need to have trade credit only to finance the time gap between their purchases (of seeds, of fertilizer,of tools) and their sales. Probably more important,agricultural produce could be purchased ef-ficiently by intermediaries(probably lorry owners) who, again, need trade credit only to finance the time gap between their purchases from farmers and their sales either to urban markets or to the Produce Marketing Board.

(b) Role of commercial banks. Even if commercial banks cannot be expected to provide credit for small-scaleagricultural production, they should be able to finance related commerce in agricultural inputs and outputs. A useful service that commercialbanks could perform is discountingProduce Marketing Board receipts; the SLPMB sometimes delays payment for produce up to a month. (See the paper by Tommy and Roberts in National Workshop, pp. 161-70.) - 30 -

(c) A separate AgriculturalDevelopent Bank? It has been suggested that Sierra Leone establish an agriculturaldevelopment bank to serve as an apex institution (Funna, pp. 19-20). A detailed proposal for such an institutionwas presentedin the National Workshop-in 1978 (NationalWorkshop, pp. 155-60). The Report of the Sierra Leone CommercialBank's Symposium on "Strategiesfor the Improvementof AgriculturalCredit in Sierra Leone" (1980) also urges the establish- ment of such an institution (p, 3). This proposal has considerable merit for several reasons. The bank could serve as the apex institution for the rural-bankingscheme, which would allow the BSL to concentrateon central banking. It could also serve as the apex institutionfor the cooperatives,either revitalizingthem or turning them into rural banks (according to local wishes and possibili- ties). It could become an effective conduit for foreign and Govern- ment funds to the agriculturalsector. It could sell its own shares and bonds to raise funds. It could carry out the agricultural lending that the NDB was expected to carry out. It could also provide specific services for its member rural finance institutions, including training, auditing, legal services, and bill collection (factoring). It might be advisable to proceed gradually in this direction,however. A useful starting point could be the establish- ment of an official policy coordinationcommittee for the rural financial system, with the participationof such institutionsas the Ministry of Agricultureand Forestries, the BSL, the rural banks, and the commercial banks. As mentioned before, the rural financial system should be regarded as a system, with rural banks, commercial banks, and cooperativesas agencies of the system. Private enterprises, such as moneylenders,are also a part of the system in an analytic sense and could be brought in more formally, since this informal credit system is willing to take more risks than the formal system and has a much lower default rate. Each institutionbelonging to the rural financial system should fulfill the functions that it is best able to fulfill. An apex institutioncould then coordinate all these functions.

E. Conclusion

86. Consideringall the relevant issues in developing a rural finance system in Sierra Leone, we fully endorse the recormendationby Stoneham (1982) that the BSL should begin by setting up7a pilot rural bank as an experiment. On the basis of an evaluation of the experimentwith the pilot bank at Mile 91 in the Magbosi area (in the Northern Province), more rural banks might be set up. The projectedinitial capitalizationof the ;pilotbank at Mile 91 will be Le 250,000, of which the BSL will supply one-half. According to the estimates made by Stoneham (1982), the Mile 91 rural bank will become profitable after four years of operation. The BSL will have to give interest-freeloans to the pilot bank to compensate the loss in the first four years. The following policies should govern the operations of the pilot bank.

87. Loans could be made to individual farmers or groups of farmers, to small businessmenin trade or commerce or local industry,and to individuals or groups transportinglocal farm produce, but only if the rural bank was - 31 -

satiLsfiedthat the loan applicants were known locally as trustworthyand had the capacity to repay promptly. Agriculturalloans could be made to meet farm expenses, to purchase goods, fertilizer,pesticides, farm machinery, and equlpment, and to rear livestock. Commercial loans could be made for supply of farm inputs, purchase or processingof farm produce, or any activity supporting the growth of the rural economy in the area.

88. Security for agriculturalloans would include pledging land, buildings, standing crops, or a savings account. Group lending would be particularly encouraged,security being the joint and several guarantees of the group.

89. Most agriculturalloans would be for seasonal purposes, but some will be f'orterm loans for improvementof land including drainage and irrigation. Larger farm loans for tree crops could be made on the merits of each case, subject to availabilityof funds. Commercialloans would generally be repayable in a year or less, while loans for vehicles would be repayablein three years or less. To prevent diversion or misapplicationof funds, release in cash and in lump sums would be discouraged.

90. Repayment terms and conditionscould be altered in case of emergen- cies including drought, flood, fire, pestilence,or serious illness of the borrower, either by extending the repaymentperiod, by increasing future repayments over the same period, or in any other equitableway. All such changes would require Board approval. No changes in loan conditions would be made for wilful defaulters.

91. A question arises about the prospects of success of rural banks in Sierra Leone, when other formal institutionsfor rural credit have had a poor performance record, as noted earlier. Although formal institutionshave not done well, one informal institution,that of the village moneylenders,seems to have operated successfully. If the rural banks can assume some of the characteristicsof informal institution-- closeness to the villagers, inti- mate knowledge about them, and unwillingnessto accept defaults -- the rural banks will stand a better chance of success. It is also important for the rural banks to become truly local, with ownership and control on the hands of the local people, who can then view the bank as their own institution.There is, of course, a chance that the local politicianswould gain control of these local banks and use them to their own benefit in the same way as they have done with other rural institutions(e.g. cooperatives). To guard against such exploitationby local politicians,the Bank of Sierra Leone will have to retain some control of the rural banks, as we have suggested. In any case, the pilot bank at Mile 91 should be regarded as an experiment,and only if it is successful,should a large part of the country be covered by a network of such banks. If successful,the pilot bank scheme could be a useful component of an agriculturaldevelopment program supported by internationalaid agencies. - 32 -

CHAPTER IV: FINANCING OF INDUSTRIES

92. As in other developing countries, lack of financing is a serious constraint to industrial developmentin Sierra Leone. This chapter contains a review of existing sources of industrial financing and recommendations about future sources. Of all the industrial enterprisesin Sierra Leone employing 20 or more workers, some 25 percent are publicly owned, 40 percent are limited liability companies, and the remaining 35 percent are partnershipsor are privately owned. Government participationin industrial enterpriseshas taken the form of public corporations1/; extension of Ministries,such as Govern- ment printing shops; extension of other Government;or semi-Governmentbodies, such as provincial printino shops; and Government shares in limited liability companies.

A. Current status

93. A substantialpart of industrial investment in the public sector has been financed by foreign aid. The private limited liability companies are almost entirely foreign owned and are mainly subsidiariesof overseas firms. The other private industrial enterprisesare predominantlyfinanced and run by members of the Lebanese and Indian communitiesin Sierra Leone. Indigenous participationin enterpriseshaving 20 or more workers is negligible. This makes some people argue that the real constraint to industrial growth in Sierra Leone is not the lack of industrial capital, but the lack ol local enterpreneursand the Government's reluctance to encourage Lebanese, Indians and other outsiders in taking the lead in industrial enterprises. In Sierra Leone there is no evidence that the Government pursues a deliberate policy of discouragingoutsiders from setting up industries. The dearth of local enterpreneurs remains a serious problem, but some local enterpreneursespecially from the Western Province, are coming up. The National DevelopmentBank (NDB) has recently helped some locals to set up small-scaleenterprises.

94. According to the Liedholm and Chuta study (1976), the overwhelmingly predominantsource of financing for small-scaleenterprises is personal and family savings, which account for approximately80 percent of the funds used for initial investment. Almost 90 percent of the funds used for expansion comefrom profits. The initial capital requirementsare relatively modest in small-scaleenterprises, generally less than Le 100. The study found that farms with access to small amounts of initial capital were as successful in generating economic profit as those with larger amounts of initial capital. Farms that expanded with only reinvested profits were sometimesmore successful in generating high economic profits than those with access to outside funds. This does not mean, however, that a lack of capital is not a serious constraint for small-scaleindustries.

1/ There are four public corporationsthat run one or more industrial enterprises: the SLP4B runs palm oil mills, palm kernel oil mills, and rice mills; the Forest Industries Corporationruns timber processing and furniture factories; the Road Transport Corporationruns vehicle repair shops; and Freetown Ports Authority also runs repair shops. - 33 -

95. A shortcomingof the Liedholm and Chuta study is its failure to differentiateenterprises by the number of workers. More than 50 percent of the small industrial establishmentssurveyed consisted of one-man enterprises, the proprietorsof which often have other sources of support. The pre- dcminance of one-man enterprisesin the study biased its findings, since it is doubtful whether such enterprises can be judged by the same indicators as enterpriseswith five or more workers. In particular the findings about the contributionof access to capital to the success of an enterprise would have been different if one-man enterpriseshad been treated separately. This is consistent with another finding of the same study: that the shortage of capital or credit was considered the most serious problem encounteredby small business enterprises. Thus, it is reasonableto assume that the overall supply of capital for financingindustrial enterprisesis as much a constraint for small enterprises as it is for large enterprises.

96. The existing institutionalframework for supplying capital to industrial enterprises is weak. At present three major institutionsprovide finance for medium to large enterprises - the NDB, the Bank of Sierra Leone (through commercial banks), and the National CooperativeDevelopment Bank. The commercial banks also lend directly in a limited way for industrial enterprises,but mostly for short-term,working-capital needs.

97. By 1980 the NDB provided industries about Le 8 million, which accounted for 60 percent of its total finance. It is clear that the NDB could have done more if only it had more funds available. Several prospective projects could not be executed for lack of funds. There seems to be a vicious c:Lrcleoperating. The country's developmenthas been slow, resulting in low capacity to undertake viable projects. Lack of industrialgrowth, in turn, has contributedto the slow development. Although the commercialbanks generally have funds to lend, the NDB does not. Because it is small, the NDB cannot make available special funds to stimulate industrial d;3velopmenton a large scale.

98. The small size of the NDB also creates a problem of efficiency. Its fixed costs are relatively high compared with its investment portfolio. These costs are barely covered by revenues from investment,and the large number of bad loans further reduces its lending base and its revenues. Its small staff has limited capability to give the industrial counseling that is also essential for industrial growth. The European DevelopmentFund is financing a line of credit to the NDB for small- and medium-scaleenterprises. The credit line, started in 1979, provides up to Le 1.5 million cn favorable terms with low interest rates and a long amortizationperiod. This is the kind of loan that the NDB needs for its operation and expansion. Nevertheless,two years after the credit line started, only 31 percent of the loan was disbursed. The main reason for this is lack of developmentmomentum due to the general economic situation. Lack of industrialcounseling and promotionalactivity further inhibits use of the loan. The NDB claims that the conditions of the EEC credit are so rigid that it can be used only for the purchase of fixed assets by borrowers, and it considers this a handicap because, in many cases, the real need is for working capital and not for fixed capital. This particular restrictionshould be carefully reviewed; still, the kind of credit that the European DevelopmentFund has provided to the NDB is generally needed and should be encouraged. - 34 -

99. The Bank of Sierra Leone has gone beyond ids traditionalfunction of central banking to engage in developmentfinancing through a credit-guarantee scheme for small borrowers. The scheme is intended to overcome the reluctance of commercial banks to extend loans to small enterprisesbecause of the inadequate security that small borrowers can offer; the Bank of Sierra Leone guarantees to pay 80 percent of the value of the loan in the event of a default. The scheme is a laudable attempt to provide small entrepreneurswith access to existing credit facilities,but it has a few drawbacks:

(a) Success depends completely on the cooperation of commercial banks. If commercial banks are reluctant to make small loans because they are too costly to appraise and process compared with expected revenue, this scheme does not help at all.

(b) The guarantee does not cover the entire loan. Therefore, the commercial banks still need collateral,which at the moment must cover the entire loan. So in a sense the guarantee scheme merely provides additional security to the commercialbanks.

(c) Although the Bank of Sierra Leone relies largely on the judgementand good faith of the commercial banks, in principle the system involves a procedure for its appraisal and approval of loans. Complaints about long delays before applicationsfor guarantees are approved or rejected are not uncommon. To avoid bureaucraticdelays, a more specialized agency for extendingcredit to small industrieswould probably function better than the present system.

100. The National CooperativeDevelopment Bank (NCDB), along with its affiliated cooperativesocieties, constitutesanother source of industrial financing. The number of existing cooperativesocieties is about 1,000, of which nearly 85 percent are thrift and credit societies, 10 percent are marketing societies, and the remaining 5 percent are other types of societies. The last category includes what could be called industrial cooperativeswhich finance mainly the handicraft sector. Thus the cooperativeshave played an exiguous role in financing small industries. Cooperativescan be developed, however, to help agro-based industries engaged in, for example, milling, parboiling rice, and extracting palm oil in press mills. Likewise, a number of small artisans can combine their activities within an industrial cooperative in order to purchase jointly certain machinery which would be beyond their individualneeds. Such cooperative societes can then become eligible for credit and other facilities.

101. The NCDB was set up in 1971 by the Government to mobilize savings and issue credit to cooperatives. It was supposed to become the apex financial institutionof all cooperatives. In practice, however, this never happened because it never had either sufficient cash or the required professional banking staff. Even today the NCDB is managed by civil servants from the cooperativedepartment of the Ministry of Trade and Industry, which also provides office facilities and part of its budget allocation to meet the cost of the Bank. - 35 -

B. Future development

102. How can financing for industrialdevelopment be improved? Expansion of small or large industries requires capital. Even when prospects for new ventures are good, small entrepreneursare often prevented from embarking on them because of lack of capital or lack of sufficient collateral to borrow from commercial institutions. A special financingmethod, differentfrom commercial banking practices and geared primarily to development,is therefore needed to overcome the unavailabilityof medium- and long-term loans. To meet this need, most developing countries have establishedone or more institutions under various names such as development financingcorporations or development banks. Financing corporationswork as chanelingagencies for funding industrial projects financed by foreign aid. In this way one loan can serve to develop many projects and render it unnecessary to negotiate separate loans for each industrial project.

103. In Sierra Leone there is need for a central agency to finance industrial development. The task of such an agency would be to promote industrial developmentby granting loans for working capital and for the purchase of fixed assets such as land, buildings, machinery, and equipment, and also to act as a guarantor for loans, especially those to small enterprises. Such an agency should also participate in equity capital, and it should make machinery and equipment available to small enterprisesby means of leasing or hire- purchase arrangements. Finally, it should also establish, manage, and make available to small industries common infrastructuralfacilities such as industrial estates. Wherever such agencies exist, they should have autonomous status in the form of a limited company directed by a Board, the chairman of which is appointed by the Government. The Board normally should have final authority to approve and execute the financing of projects. The agency should obtain its financial resources directly from the Government, from the central bank, and from commercial banks, as well as from external donors, either in the form of equity capital, loans, or grants. The Government often retains control of such agencies by deciding who should hold equity in the corporation.

104. The central agency has to be, in principle, a self-supportingorgani- zation, which means that its revenues should cover its costs. This will not be easy, however, in an economy like Sierra Leone's. The operationalcost will be higher than is usual in commercial banking, as will the risk of loss on investment. This extra cost and extra risk will have to be compensatedby low interest rates on loans given to the agency by the Government and by external donors.

105. The agency will still have to obtain from its customers the usual bankable collateral,if possible. If the value of the collateral is less than the value of the loan, the risk should be minimized by close supervisionor monitoring of the client's operations by the agency.

1,06. An important objective of the operation of a central financing agency must be expedient processing of loan applications. Delay can cause as much a problem as overall shortage of funds. It will be desirable for the agency to open branches in parts of the country that have industrial potential. Close cooperationwith the Ministry of Trade and Industry is essential. - 36 -

107. An important question in this regard is whether the corporation should be establishedas a new institutionor whether the NDB should be transformedinto this new kind of institution. The argument against such a transformationis that the NDB at the moment operate?swith a much wider mandate than just financing industries. The present;shareholders view the NDB as a bank and not as a developmentorganization. A drastic reorganizationof the NDB and revision of its capital base will be req[uiredif it is to take up the function of a central agency for industrial finance.

108. The main argument in favor of transformingthe NDB is that it will save money and that the creation of another bureaucraticbody will thereby be avoided. That the NDB is also involved in financing other sectors of the economy may be an initial advantage, as it can provide a broader operational base with better risk distribution. The expertisewithin the NDB for industrial counseling is now limited, but this can be easily compensatedfor the present by cooperationfrom the Ministry of Trade and Industry. Consider- able industrial expertise can be developed within the NDB in time. Thus, even in the initial phase, the NDB can take on the responsibilitythat would otherwise have been given to a separate central agency set up for industrial financing.

C. Reorganizationof the NDB

109. The NDB in its present form cannot perform any significant role in industrial financing. So the first step towards the developmentof industrial financing is to reorganize the NDB. We have analyzed the problems of the NDB elsewhere and recommendedspecific measures to make it viable and effective (see Annex C). Here we shall summarize the salient points. In this connection, we fully endorse the recommendationsof the Technical Committeeon the Reorganizationof the NDB--the committee with which the Bank mission worked closely.

The problems of the NDB can be summed up as follows:

(a) Financiallythe institutionis nearly bankrupt. It now has a totally inadequate equity base, cumulative losses having already wiped out more than half of the original equity.

(b) Its portfolio is made up mostly of either poorly secured small-scale (includingagricultural) borrowers or excessively large (in relation to its portfolio) Government-guaranteedborrowers, who have frequently failed in paying capital or interest.

(c) The NDB has not been treated as a banking institutionand has no access to banking system resources,nor has it been able to identify and exploit new sources of revenue to improve its profitability.

(d) The NDB's lending volume has grown very slowly. Its portfolio is too small to provide income sufficient to meet the administrative expenses which unfortunatelyhave been rising steeply. - 37 -

(e) The NDB does not have adequate expertise to appraise agricultural loans or small scale industrial loans, nor is it capable of supervisingsmall-scale loans.

(f) The NDB has not worked on the basis of any consistent administrative procedures, and decisionshave tended to be ad hoc.

110, To reform the NDB the first step is to appoint an accountant firm to examine all of the NDB's books. The firm must be asked to determine, as rapidly as possible, the actual financial situation of the NDB, what its investmentsand fixed assets are truly worth. The NDB's capital must be adjusted accordingly. The second step will be for the Board of Directors to decide: whether the NDB should be wound up and liquidated before the capital is eroded any further, or whether it should be continued on the basis of fresh injection of capital. To take the first decision will obviously be very difficult for the NDB Board of Directors, but the appeal of this course of action is that a new institutioncould then be started with a clean slate. If the decision is taken not to wind up NDB, it will require fresh capital. Future lending should then be primarily to medium- to large-scaleindustries, with some limited loans to small-scaleindustries. Only on exceptional grounds should the reformed NDB participatein financing commercial,plantation-typeagriculture. The reformed NDB will have to build up a strong hard- core portfolio (of medium- to large-scaleindustries) which will provide it withla sound income base. The role of the NDB should be complementaryto rather than competitivewith commercial banks. It can act as a refinancing institutionfor the commercial banks and for their network of branches in the provinces, thus sharing risk with them. Another area of cooperationcan be in financingworking capital: the NDB should consider financing permanent working capital while the commercial banks can finance revolving working capital, especially since the commercialbanks have excess liquidity.

111. If the NDB is retained and reformed,it should function as an autonomous institutionand should make its investment decisions on the basis of the economic viability of projects. If the Governmenthas to finance certain projects because of social and equity considerations,the Government should provide the NDB with the required funding for such purposes and absolve it from the credit risks involved. In the past many projects were undertaken at the insistence of the Government. After the thorough audit if the NDB is reorganizedand retained, the Government should assign those projects to a separate fund so that the reformed NDB does not have to charge the bad debts to its profit and loss account. Such a fund could be managed by the new NDB but should not become an integral part of its operation. - 38 -

References

Bank of Sierra Leone. National Workshop on AgriculturalCredit and Banking (held at the Bank of Sierra Leone, Freetown, October-November1978).

Bank of Sierra Leone, Development Finance Department. Report on Rural Banking, 1980.

Barclays Bank of Sierra Leone Ltd. Annual Report, 1980, 1981.

Bessel, J.E. and V C. Raswant. Rural Banking and Credit Study, consultant's report for the Ministry of Agricultureand Forestry, February 1981.

Funna, J.S.A. Speech at the Governor's Banquet, Freetown, January 29, 1982.

Liedholm, C. and E. Chuta. The Economics of Rural and Urban Small-Scale Industries in Sierra Leone. East Lansing, Michigan, 1976.

Leite, Sergio Pereira. "InterestRate Policies in West Africa", IMF Staff Papers, Vol. 29, No. 1, March 1982.

Sierra Leone Commercial Bank, Report on Symposium. "Strategiesfor the Improvement of AgriculturalCredit in Sierra Leone," 1980.

Standard Bank Sierra Leone Ltd. Annual Report, 1980, 1981.

Stoneham, A. M. Bank of Sierra Leone Rural Bank and Credit Studies: Proposals for a pilot rural bank, 1982.

Taylor, A.B. Money and Banking in Sierra Leone. Finafoica - CARILO - Milan, 1980.

UNIDO. TechnicalReport: Industrial Review, 2 vols., Vienna, 1981. 39- ANNEX A Page 1 ANNEX A

INSTITUTIONSAND FINANCIAL INSTRUMENTSOF THE FINANCIAL SYSTEM

1. The purpose of this annex is to describe the institutionsand the assets that make up Sierra Leone's financial system. This annex provides the institutionaland statisticalbackground for the considerationin Chapter II of the principal problems and policy issues of the system.

2. Besides the institutionslisted in Chapter II as comprising the financial system of Sierra Leone, three others may be regarded as financial institutions. They are the state-ownedSierra Leone Produce Marketing Board, the state-ownedDiamond Mining Company, and the various pension funds.

3. As financial instruments,Sierra Leone uses principallymoney, quasi- money, Government obligations,and small quantities of other assets. There are virtually no merchant bills nor exchange acceptances,nor any formal short-termnon-bank financialmarket. Such instrumentsas negotiable certi- ficates of deposits, commercialpaper, and the like are apparentlyunknown. There are no private debenturesnor negotiated corporateequities.

A. Institutionsof the financial system

(a) Commercial banks

4. Five commercial banks now operate in Sierra Leone. Two of these, the Barclays Bank of Sierra Leone Ltd. and the Standard Bank Sierra Leone Ltd., are subsidiariesof large internationalbanking groups with head offices in the United Kingdom. They have been operatingin Sierra Leone since 1917 and 1894 respectively. Barclays has 40 percent local ownership;Standard has 19.4 percent local ownership. A third commercialbank, the Sierra Leone Commercial Bank Ltd., has been operatingsince 1973. It is owned by the Government,but its operations are independentof Governmentpolitical control. A fourth bank, the Bank of Credit and Commerce International,has been operating in Sierra Leone since 1978; Middle Eastern interestshold a controllingshare of its equity. A fifth bank was opened in November 1982. The equity of the new bank is held by a wealthy Freetown businessmanin partnershipwith foreign interests.

5. Commercialbanking is carried on in Sierra Leone under the Banking Act;of 1970. Sierra Leone's commercialbanking law is straightforwardand conventional. Any company that engages in commercialbanking must have a license, which is issued by the Governor of the central bank, the Bank of Sierra Leone, in consultationwith the Finance Minister. The minimum capital required of a bank whose head office is in Freetown is Le 400,000. A foreign bank must maintain a balance of Le 800,000 with the central bank. The Gover- nor has the power to suspend a bank's operations. (Banking Act, 1970, Part II). - 40 _ ANNEX A Page 2

6. Commercialbanks licensed for operaticn in Sierra ]Lecneare subject to simple and conventionalrestrictions. Each is required bo maintain a reserve fund within the country. If the fund stands at less than one-half the capitalizationof the bank, one-half of the bank's annual net pre-tax profits must be contributedto the fund; if the fund stands at more than one-half but less than the total capitalization,one-fourth of the bank's annual net profits mustbbe contributed. The commercialbanks are!required to maintain a proportion of their deposit liabilitiesin the form of local assets. The proportion is set by the central bank (with a maximum of 85 percent set by law). Banks are required to publish their annual balance sheets and to submit periodic reports to the central bank. The specific form of these reports is given in the law. There are conventionalrestrictions on the quantity of loans that may be made to any single economic entity (no more than 10 percent of the loan portfolio may be lent to a single individual),and to bank officials. The central bank has full powers of examination.(Banking Act, 1970).

7. The principal means of monetary regulation is the liquidityratio, which is required to be at least 40 percent. Liquid assets are defined to include: "(a) notes and coin which are legal tender in Sierra Leone; (b) balances at the central bank; (c) net balances with other banks in Sierra Leone and money at call in Sierra Leone; (d) Treasury Bills issued by the Government and maturing within ninety-threedays; (e) domestic bills of exchange and promissory notes which are eligible for re-discountat the Central Bank, subject to such limitationsin amount as the Central Bank may from time to time prescribe". (BankingAct, 1970, Part IV).

8. In addition to the 40 percent liquidityratio, the central bank has required banks to maintain a 5 percent cash ratio; that is, for each bank, legal tender plus deposits at the central bank must be at least 5 percent of total deposits. Finally, credit ceilings are now in force: the central bank establisheslimits for each broad category of credit for each commercial bank. These restrictionswere enacted in 1980 on the advice of the IMF, with the objectivesof controllingthe growth of the money supply and of controlling the growth of imports. Since that time, however, commercial banks have apparently found it difficult to remain under these credit ceilings.

9. Supervisionof commercialbanks is carried out by a department of the Bank of Sierra Leone (BSL). The commercialbanks are required to submit four reports to the BSL: an annual balance, monthly balances, a quarterly statement of loans and advances by sector, and a weekly statement of liquidity position. There are various penaltiesfor failure to report, but according to the supervisiondepartment staff no penalty has ever been imposed for failure to report.

10. The broad characteristicsof the commercial banking business in Sierra Leone are the following. The resourcesof the commercialbanks come from demand deposits, time deposits, and savings accounts in a rough 40-30-3C ratio (see Table A.l). Loans are mainly provided through overdraft facilities. At present 60 to 70 percent of commercial bank credit goes to finance foreign trade or activities associated directly with foreign trade. Loans to small business and to agricultureaccount for roughly 10 percent each. _ 41 _ ANNEX A Page 3 11. Table A.1 shows the commercialbanks' deposit liabilities. For the most recent years, the table shows the extent to which growth in commercial banks' deposit liabilitieshas stagnated. Between June 1977 and June 1981, however, there was a rise, then a fall in the quantities of all classes of deposit in real terms. For 1980/1981deposits declined even in nominal terms.

12. Table A.2 shows commercialbanks' loans and advances in the various categories. BSL officials emphasized to us that the categories were sometimes arbitrary (that is, a loan may be for several purposes); therefore, these figures should be considered only as broadly indicative. The overall credit growth has been generally sluggish,with the exception of 1973/1974and 1977/1978. In terms of purchasing power, commercial bank credit increased only 4.7 percent between June 1977 and June 1981.

13. Table Ao3 presents the summary balance sheets of the three largest commercial banks in December 1980 and December 1981. There are pronounced differencesin the structure of the banks' balance sheets. Nevertheless,some of the balance sheet ratios are striking and require some explanation. First, all the banks have relativelyhigh cash-depositratios. These may be precau- tionary cash balances; however, deposits by each commercial bank at the BSL in excess of 5 percent of total deposits earn interest of 6 percent a year. This is less than the 15 to 22 percent that the banks earn on loans, and it is less than the 8 to 12 percent net yield that banks can earn on Government obligations. Nevertheless,these funds are fully liquid and free of the administrative and recovery costs associated with loans.

14. A second striking feature of the balance sheets is their low loan- deposit ratios. Standard's ratio is somewhat higher than the others. Accord- ing to bank managers, the low loan-depositratios are consequenceof the lack of viable loan proposals, of the difficulty that borrowershave in legally obtaining foreign exchange, and of the generally depressed state of the economy. It may also be in part a consequenceof a positive rate of return (nominal terms) to banks on their cash reserves.

15. Current assets also include the foreign exchange pipeline. Up to December 1982 most private purchasers of foreign exchange entered the pipeline through their commercial bank. They left a Leone deposit with the bank, and the bank made a correspondingdeposit at the BSL. These are blocked accounts. When the foreign exchange becomes available, both accounts are liquidated.

16. The five banks in Sierra Leone vary in the nature of their operations. All of them carry on considerablebusiness with Freetown merchants. Barclays has a close traditionalrelationship with the diamond-producing sector. Standard is said to provide a larger proportion of loans to small businesses and to salaried people. Sierra Leone Commercial Bank, being owned by the Government, carries on a relativelylarge amount of business with Government-ownedenterprises. The two larger banks have branches throughout the country--18 for Barclays, 16 for Standard--althoughsome of these branches are engaged almost exclusivelyin deposit receipt. TABLE A-1: COMMERCIALBANKS' DEPOSIT LIABILITIES (Thousands of Leones)

June June June June June June June June June June June June 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

1. Demand deposits 10305 12757 16232 19384 20867 25511 31126 44529 56071 66928 62041 75421 *Deflated: June 1977 31126 41265.9 42665.3 39009.3 28820.6

2. Time deposits: under 3 months 1838 2904 2415 4973 5286 6752 8042 14014 17381 22589 19631 34702 3 to 6 months 338 628 1215 1782 1422 2379 5014 6924 5143 9721 8041 9794 6 to 12 months 1077 932 1820 2840 3171 4233 7539 5536 9032 8771 14610 19955 more than 12 months 0 0 0 0 0 0 0 5246 13546 9703 5094 20276 Total time deposits 3253 4464 5450 9595 9879 13364 20595 31720 45102 50784 47376 84727 Deflated: June 1977 20595 29395.5 34318.8 28656.9 22574.3

3. Savings deposits 11250 12953 15907 18894 19519 22124 26886 34013 40808 51902 61236 70429 Deflated: June 1977 26886 31520.5 31051.5 30309.7 29178.5

4. Total 25808 30176 37589 57874 50265 59999 78607 110272 141981 169614 170653 230577 Deflated: June 1977 78607 102191.1 108035.6 98975.9 80573.4

* Deflated by the wholesale price index. Source: Bank of Sierra Leone Annual Report 1980, Tables 7 and 11, and updated information provided by the BSL. TABLE A-2: COMMERCIALBANKS'S LOANS & ADVANCESBY MAJOR ECONOMICGROUPS (Thousands of Leones; also as a percentage of total loans)

June June June June June June June June June June June March June 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1982

1. Government 13 17 4261 1 341 701 2052 1959 1280 3 0 291 0.1 0.1 11.4 0.0 0.9 1.7 3.9 1.9 1.8 3 0.0 0.1

2. Local authorities 60 354 314 213 253 211 241 290 290 0.2 1.0 0.8 0.4 0.4 0.3 0.3 0.3 0.3

3. Public utilities 21 223 627 911 2291 1773 192 196 725 3378 3290 1038 0.1 1.0 1.7 2.5 6-3 4.4 0.4 0.3 1.0 3.8 3.3 1.07

4 Financial institutions 568 126 1295 1070 1158 1496 1336 2186 2279 2896 2147 2456 2439

2.7 0.6 6.1 2.9 3.2 4.1 3.3 4.2 3.4 4.1 2.4 2.5 2.5

5. Agriculture 195 81 79 53 709 467 670 839 2501 4437 4013 5403 3891 0.1 0.0 0.0 0.0 2.0 1.3 1.6 1.6 3.8 6.4 4.5 5.0 4.0

6. Mining 1342 430 842 1535 1571 1341 2281 2554 3227 2429 12717 13654 13799 6.4 2.2 4.0 4.1 4.4 3.7 5.6 4.9 4.9 3.5 14.2 13.6 14.2

7. Manufacturing 1342 1114 2615 2103 1739 1784 2392 2866 4175 3445 6843 6057 3808 6.4 5.7 12.3 5.6 4.9 4.9 5.9 5.5 6.3 4.9 7.7 6.0 3.9

8. Building & construction 1179 414 1054 1521 1814 1680 2023 1428 2979 5930 4733 6677 6604 5.7 2.1 4.9 4.1 5.1 4.6 5.0 2.7 4.5 8.5 5.3 6.7 6.8

9. General commerce* 14265 15391 11641 21519 18526 20188 20938 27777 32782 32557 46973 51785 48300 68.4 78.5 54.6 57.3 51.8 55.8 51.5 52.9 49.6 46.6 52.6 51.7 49.8

10. Miscellaneous 1760 2027 3550 4844 9267 6205 8204 12390 15797 15908 8263 10904 16942 8.4 10.3 16.7 12.9 25.9 29.7 30.4 32.4 30.8 22.8 9.3 10.9 17.4

11. TOTAL 20851 19617 21316 37533 37533 36147 40632 52497 66148 69818 89311 100156 97112 Percentage increase over preceding period -5.9 +8.7 +76.1 -4.7 +1.1 +12.4 +29.2 +26.0 +5.5 +27.9 +12.7 -3.0

12. Percentage increase of wholesale price index over preceding period. +7.9 +21.8 +30.3 +22.6

* Including export/import finance Source: Bank of Sierra Leone Annual Report 1980, Table 13, and m m updated information provided by the BSL. TABLE A-3: COMMERCIALBANKS OPERATING IN SIERRA LEONE (Thousands of Leones)

31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 1980 1980 1980 1981 1981 1981 1982 1982 Barclays Standard SLCB Barclays Standard SLCB Barclays Standard (1) (2) (3) (4) (5) (6) (7) (8)

1. Cash and short-term funds 20506.0 10622.7 12446.3 20900.4 10394.5 14896.8 48052.6 52268

2. Investments 27413.4 17168.6 5652.9 28013.5 17086.3 5712.9 28069.1 21094

3. Advances to customers 35809.2 38361.5 10156.6 43086.7 40902.1 11115.1 45148.2 45739

4. Total current assets* 144529.2 88060.1 28255.8 166350.8 110105.0 31724.8 217099.7 166598

5. Total assets 178051.6 105380.6 74250.6 194898.7 123182.7 76680 244693.7 184280

6. Customers' deposits 76542.8 55463.8 34561.0 81919.0 57526.0 33726.3 119360.4 105580

7. Other current liabilities 63115.9 28915.1 3968.0 79023.0 48405.3 5645.8 92340.4 56668

8. Total share capital and res. 7367.6 6200.4 4688.3 8071.7 7364.1 5445.3 10004.1 7285 (1)/(6) 0.268 0.192 0.360 0.255 0.181 0.44 0.403 0.495 (3)/(6) 0.468 0.692 0.294 0.526 0.711 0.330 0.378 0.433

Including special deposit with the Bank of Sierra Leone maintained in connection with the "foreign-exchange pipeline." Source: Annual Reports of the Banks.

oe xD X' 45- ANNEX A Page 7 17. The gap between total assets and total current assets is made up of fixed assets and various "per-contra"accounts, that is, asset accounts for which there exists a directly correspondentliability account (for example, payment orders).

18. In spite of their high liquidity ratios, the banks are solidly profitable (see Table A.4). Barclays paid a dividend of 80 cents per 1 Le share in 1980 and 85 cents in 1981; Standard paid a dividend of 90 cents in both years. This is probably indicative of the relatively low capital base of the banks. A more relevant ratio is the pre-tax profit on operations divided by total deposits. The solid profitabilityof these institutionsis apparently based largely on the substantialspread with which they work, and on the opportunityof earning 6 percent rate of return on deposits at the BSL when no opportunitiesexist to acquire income earning assets.

(b) The Bank of Sierra Leone (centralbank)

19. The Bank of Sierra Leone was establishedin August 1964 under legislation passed in March 1963. It is now regulatedunder the Bank of Sierra Lecne (Amendment)Act, 1970. The BSL is a central bank in the tradition of the Bank of England; it is a bank of issue, it accepts deposits only from the Government,commercial banks, and certain other financial institutions,it acts as the Government'sbanker, and it is responsiblefor international monetary settlementsand foreign exchange dealings.

20. The Bank of Sierra Leone (Amendment)Act of 1970 specifies the legal status of the Bank, its capitalization,its ownership (all outstandingshares are owned by the Government),and its administration. The Governor of the BSL is appointed for a five-yearterm. In addition, the Act provides the legal basis for the nation's currency.

21. The 1970 Act also regulates the BSL's relationswith the Government and.with commercial banks. The Act allows the BSL to grant advances to the Government in respect of internationalobligations and in respect of budget deficit. Advances to cover budget deficit may not, in total amount outstanding, exceed at any time 5 percent of the estimated recurrentbudget revenue, although it appears that this rule has been stretched in practice. The Act also provides the BSL with broad powers to regulate commercialbanks' activities,including the imposition of required reserve ratios and the regulation of interest rates and credit.

22. The Act requires the BSL to establish and to maintain a Development Credit Fund, to be funded by the Government and the BSL itself, which is to be applied "to cooperativebanks and to corporationsor institutionsin which the Baik is entitled to invest". The BSL is authorized to purchase debt obligations through this Fund with maturities up to eight years.

23. Table A.5 provides a summary balance sheet of the Bank of Sierra Leone. The BSL's rediscountsand advances have gone largely to the Govern- ment, although it has provided some funds to the National CooperativeDevel- opment Bank and to the National DevelopmentBank from the Development Credit Fund. Advances to the Government have grown considerablyin recent years, at -46- ANNEX A Page 8

TABLEA. 4: PROFITSCN OPERArIONSOF QIIIERCIALBANKS (Trousands of Leones)

Year Barclays Standard SLCB

1. Profits on operations 1980 4791.3 2618.1 1312.2 before taxes 1981 4225.6 3041.0 1672.7 1982 2000.4 1804.0

2. Total deposits 1980 76542.8 55463.8 34561.0 1981 81919.0 57526.0 33726.3 1982 119360.4 105580.0

3. (1)/(2) 1980 .063 .047 .038 1981 .052 .053 .050 1982 .017 .017

Source: AnnualReports of the Banks. TABLE A.5: ASSETS AND LIABILITIES OF THE BANK OF SIERRA LEONE (Thousands of Leones)

A S S E T S

EXTERNAL RESERVES

Foreign currencies & Foreign TOTAL balances with Government Holdings Government Rediscounts Fixed Other ASSETS/ End of Period banks abroad Securities of SDR Securities & Advances Assets Assets LIABILITIES

1970/71 June 18096 7082 2604 1349 4673 1360 9548 44491 1971/72 16603 9767 4786 3101 4099 1105 14185 53647 1972/73 28201 5298 4759 1502 2969 858 25442 69029 1973/74 26599 6340 3698 3155 3982 716 43087 87577 1974/75 26501 3066 3407 15691 11334 592 76719 137310 1975/76 22462 12009 4549 17634 6247 608 94518 158028 1976/77 22558 8965 2865 20389 10444 688 118937 184846 1977/78 39341 3744 497 64162 14476 771 148421 271412 1978/79 30884 4521 1680 59564 106971 3936 212129 419685 1979/80 35335 3065 3131 43347 198406 4052 221591 508927

1980/81 20503 1998 231 43410 289850 4133 228481 588606 1981/82 14067 - 43 49315 454356 1004 233933 752718

L I A B I L I T I E S

SIERRA DEPOSITS LEONE CURRENCY Comm. TOTAL General Allocations Other End of Period ISSUED Govt. Banks Others DEPOSITS Capital Reserves of SDR Liabilities

1970/71 June 22520 1465 1497 1720 4682 1500 722 4329 10977 1971/72 23957 3477 1684 605 5766 1500 1302 6538 14584 1972/73 32414 4686 1972 230 6888 1500 1801 - 26426 1973/74 37436 2886 1547 2343 6776 1500 1801 - 40064 1974/75 37423 615 3208 11610 15433 1500 2226 - 80728 1975/76 41055 4798 2546 1832 9176 1500 2697 - 103600 1976/77 48705 1540 8789 2438 12767 1500 3031 - 118843 1977/78 59694 14252 13334 26223 53809 1500 3320 - 153089 1978/79 76640 20844 56409 42286 119539 1500 3766 - 18240 1979/80 87210 17302 100625 64517 182444 1500 4280 - 233497 1980/81 93963 8281 114736 139910 262927 1500 4817 - 227230

1981/82 101054 36132 207474 172946 416552 1500 4952 - 228660

Source: Bank of Sierra Leone, Annual Report 1980, Table 5. _48 _ ANNEX A

a rate apparently above what is authorized by the 1970 Act. The BSL carries virtually no rediscountingactivities for the nation's commercialbanks, appa-- rently because it has not been necessary. There is no open market for purchase and sale of Government securitiesin Sierra Leone. Consequentlythe BSL's monetary policy instruments,such as required reserve ratios, interest rates, and credit ceilings are entirely involuntary. Even these policy instrumentshave had limited effectivenessin practice. As noted before, the BSL sets a minimum 40 percent liquidity ratio, bultthe commercialbanks regularly exceed this ratio. The BSL also sets a minimum interest rate on time and savings deposits, and it sets interest rate guidelines for loans, although as in most countries interest rates on bank loans are difficult to control precisely. Banks charge commissionsas well as risk premia where they feel they are appropriate.

(e) Finance companies

24. The Government-ownedBentworth Finance Company is the only finance company operating in Sierra Leone. The company was formed about ten years ago as a partnershipof the Government and various Governmentagencies, local business interests, and Hambro Brothers of London. Since then Hambro has withdrawn and private business interestshave reduced their participation. Of the capitalizationof Le 450,000, roughly Le 180,000 is now held by the Government,Le 90,000 by the National DevelopmentBank, Le 135,000 by the Bank of Sierra Leone, and Le 45,000 by a private insurEnce firm, Guardian Royal Exchange Assurance (Sierra Leone) Ltd. Bentworth is engaged almost exclu- sively in financing the hire-purchaseof vehicles. its sizable business is with civil servants, who repay their loans through payroll deductions. It also does substantialbusiness with private individuals. The usual term is between 9 and 15 months. The vehicle dealer guarantees 50 percent of any outstandingbalance, and is responsiblefor determining the purchaser's creditworthiness. Bentworth'soutstanding loan portfolio is approximately Le 4,500,000, of which about Le 900,000 is owed by civil servants. Bentworth also provides a small quantity of loans to Freetoownmerchants. The company's funds come entirely from local sources, including overdraft facilities at Barclays and Standard, a loan from the American Life Insurance Company, and a loan from the NDB.

25. Until recently Bentworthwas a reasonably profitable enterprise,but Sierra Leone's current economic difficulties,particularly the shortage of foreign exchange,have recently reduced this profitability.

(d) The Post Office Savings Bank

26. Sierra Leone's Post Office Savings Bank has functioned since 1896. When it was founded, and for many years thereafter,no other accessible savings institutionexisted. Once commercialbanks made savings accounts available, however, the Post Office Savings Bank proved uncompetitive. Since 1975, it has experiencednet withdrawalseven in nominal terms (see Table A.6.). The commercialbanks' savings account rate, now 10 percent, is also paid on Post Office accounts. The process of withdrawal from the Post Office is complex, however, and takes several days. Hence most savers prefer the liquidity of commercialbank savings accounts. 49_ _~ANNEX A Page 11

TABLE A.6: POST OFFICE SAVINGS (Thousands of Leones)

Net Fiiiancial Net balance period Deposits Withdrawals deposits outstanding (1) (2) (1) - (2)

1970/71 654 786 -132 3099 1971/72 704 807 -103 3111 19;72/73 781 748 +33 3264 1973/74 913 912 +1 3265 19'74/75 824 984 -160 3105 1975/76 902 1078 -176 2929 1976/77 823 1075 -252 2677 1977/78 855 903 -48 2629 1978/79 908 1048 -140 2489 1979/80 894 939 -45 2444

Source: Bank of Sierra Leone, Annual Report 1980, Table 12 _ 50. ANNEX A Page 12

(e) Cooperatives

27. There are more than 1,000 cooperativesocieties in Sierra Leone. Of these, about 400 are shareholdersin the National CooperativeDevelopment Bank, establishedin 1972 by the Government to serve as an apex institution for the movement. There are a number of types of cooperativesocieties, including agriculturalproduce marketing associations,thrift and credit societies, women's thrift and credit societies, and others. Since their operations are mainly in the countryside,we shall say more about the cooperativesin Annex B, which deals with rural financial institutions.

28. The cooperativemovement is plainly demoralizedand moribund, and its reputationis poor. The commercialbanks have suspended their overdraft facilities to cooperativeson account of "slow repayment". The National CooperativeDevelopment Bank is understaffedand apparently has inadequate data; it does not even have a recent balance sheet. In a paper given at the National Workshop on AgriculturalCredit and Banking in Sierra Leone, F.B. Samura provided an estimate of the cooperative'saggregate balance sheet on 30 June 1978 (Table A.7).

(f) Insurance companies

29. There are nine insurance companies operatingat present in Sierra Leone. Of these four carry about 70 or 80 percent of the business. These are the government-ownedNational Insurance Company, the American Life Insurance Company, the Northern Assurance Company, and the Royal Guardian Exchange.

30. Sierra Leone's gross premium non-life market is estimated to be between Le 11 million and Le 12.5 million. The principal non-life policyholders are commercial,although private home owners are a significantpro- portion of the market. Sierra Leone's insurance law requires that each company leave a technical reserve deposit of Le 60,000 with the BSL for each class of insurance business in which it engages (for example, a company engaged only in fire and in marine insurancewould have a technicalreserve of Le 120,000). Life insurance is provided only by the (government-owned) National Insurance Company and the American Life Insurance Company. The National Insurance Company has some 3,500 outstandinglife insurancepolicies, while the American Life Insurance Company has about 6,000. The other insurance companieshave either ended, or decided not to undertake, life insurancebusiness. The principaldifficulty for life insurance appears to be the shortage of foreign exchange in Sierra Leone; the life insurance must be reinsured,and while a small part of this can be done by the National Insur- ance Company, the better part of it must be done abroad. If it were not for this constraint,more life insurance could be sold.

31. The National Insurance Company (NIC) was establishedin 1972. The NIC has approximatelyLe 4 million of the country's gross premium income on non-life insurance. Since 1975 the NIC has also received the cession of 20 percent of all other companies'non-life business as their reinsurer,under a law passed that year. ANNEX A - 51 - Page 13

TABLE A.7: COOPERATIVES' AGGREGATE BALANCE SHEET, 1978 (Est.) (Leones)

Liabilities & net worth Assets

Shares/Savings 850,000 Liquid funds 500,000

Reserves 180,000 Loans to members 1,000,000

Appropriation 315,000 Other assets 500,000

Loans outstanding and Sundry 150,000 other liabilities 515_00_ 1,860,000 2,150,000

Source: National Workshop, p. 35 -52 - ANREX A Page 14

32. The American Life Insurance Company is a subsidiary of the j.S.-owned American InternationalGroup. It has been operatingin Sierra Leone for about two decades. It concentrates,unlike the other companies,on life insurance. The Northern Assurance Company (±NAC)is a wholly-owned agency of a British firm, and it is the oldest insurance enterprise i.nthe nation. The British firm receives a 28.5 percent commissionon its agency's local premium earnings. The Royal Guardian Exchange (Sierra Leone) Company is a subsidiary of the well-known British firm (25 percent of the equity is locally owned). It is engaged in the same insurance lines as the NAC.

33. The insurance business in Sierra Leone is small and probably con- siderablybelow its potential. The shortage of ioreign exchange now prevailing in Sierra Leone affects the operationsof insurance companies in two main ways: first, since there are fewer imports, the volume of marine and other types of commercial insurancehas fallen; and second, it is difficult to acquire reinsuranceabroad. Foreign reinsuranceis necessary for the companies to support their risks.

34. The life insurance companiesprovide a small quantity of loans to their policyholders. In addition, some insurance companieshave acquired shares in local joint-stockcorporations. There is some scope for increased provision of finance by the insurance companies.

(g) The National DevelopmentBank

35. The National DevelopmentBank was establishedin 1968 to provide term financing for small and medium-sizeenterprises. The NDB has never managed, unfortunately,to expand its operations to a significantlevel. Severe and persistent problems of loan recovery as well as Ea consequent chronic shortage of funds became a vicious circle from which the enterprise has never been able to escape.

36. The problems of the NDB are discussed in Annex C.

(h) Parastatal enterprises

37. There are some twenty-four parastatal enterprisesin Sierra Leone, that is, productive enterprises the majority of whose capital is owned by the the Government. Of these, the most important are the Sierra Leone Ports Authority, Sierra Leone Petroleum Refining Company, Sierra Leone External Communications,Sierra Leone Electricity Corporation,Guma Valley Water Company, and the nation's two largest earners of foreign exchange, the Diamond Mining Company (DIMINCO) and the Sierra Leone Produce Marketing Board (SLPMB). Some of the parastatal enterprisesreceive Government subsidies (in particular,the Electricity Corporationreceives a subsidy essentiallyso that its rates can be kept relativelylow).

38. From the perspective of the financialsystem, the principal interest; of the parastatals is that the two largest, DIMINCO and the SLPMB, are importantholders of financialassets, mainly Government stocks (see Tables A.8 and A.9). Holdings of Government stocks by DIMINCO and the SLPMB amount 53 ANNEX A Page 15

TABLE A.8: THE DIAMONDMINING COMPANY(SIERRA LEONE) LTD. SUMMARYBALANCE SHEETS (Thousands of Leones)

1979 1980 1981

Assets

Calsh 3002.1 3686.7 891.7 Diamond stocks 7430.5 9432.4 11456.8 Accounts receivable 654.01 1852.8 1257.1 Treasury bills 2403.3 882.3 0.0 Government stocks 8406.5 10327.9 5664.6 Tot,a -,overnment assets 21896.4 26182.1 19270.2 Storos 5996.9 8181.0 9906.9 Investments 846.9 528.1 209.4 Fixed assets 4232.3 4387.9 5192.2 Current liabilities 7994.3 12749,9 5243.8 Reserves 14978.1 16529.2 19335.0 Share capital 10000.0 10000.0 10000.0

Source: Annual Reports of the Diamond Mining Company (Sierra Leone) Ltd. A,,,,"IX A _ 54 _ Page 6

TABLE A.9: SIERRA LEONE PRODUCE MARKETING BOARD SUMMARYCONSOLIDATED BALANCE SHEETS

1979 1980 1981

Assets

Current assets 36455.1 42363.6 31910.0 Governmentstocks 6631.4 12111.0 13310.7 Govt. developmentfund 0.0 2866.5 3845.3 Other investments 682.1 1278.7 973.1 Fixed assets 4872.7 8213.6 8959.6 Current liabilities 5084.9 12536.8 14225.8 Price maintenancefund 6000.0 6000.0 0.0 Building fund 141.9 4141.9 4141.9 Capital account 44154.7 37396.5 40631.0

Source: Annual Reports of the Sierra Leone Produce Marketing Board. ANNEX A Page 17 to between 80 and 90 percent of the total holdings by parastatalsof Government stock and more than 20 percent of all Government stock outstanding. This is the principal form in which these enterpriseshold their surplus funds. The working capital needs of these two enterprisesare met entirely from their own internal funds. Both enterprisesmaintain working balances of foreign exchange abroad, DIMINCO to meet its foreign representationcosts, the SLPM'Bto meet its charges for rice imports and representationcosts.

B. 'Theassets of the financial system

39. The savings instrumentsavailable to the public in Sierra Leone are:

o currency outside banks; o demand deposits at commercialbanks; o time deposits at commercialbanks; o savings deposits at commercialbanks; o Post Office savings accounts; v Treasury bills; o Government stocks; o other instrumentsof relatively small quantitativeimportance.

(a) Monetary assets

40. Table A.10 shows the growth of Sierra Leone's monetary assets over the past decade. Demand deposits steadily increasedas a proportion of M-1, although even in 1981 they were still barely more than 40 percent of M-1. In turn, the relative importance of M-1 in M-2 steadily diminished over the decade, although the other components of time and savings deposits together came to barely more than 40 percent of M-2 in 1981. Savings deposits varied between one-fifthand one-fourth of M-2 over the decade with no strong trend over time. The relative growth of time deposits over the decade was substantial;they went from about 7 percent of M-2 to nearly 20 percent.

41. Since 1977 there have been reasonably reliable wholesale-price statisticsfor the Freetown area. Based on these, from 1977 on all elements of the monetary series--M-1,time deposits, savings deposits,and M-2--display similar behavior in real terms: a high rate of growth between June 1977 and June 1979, followed by a sharp decline. Thus, measured in 1977 Leones, liquidity in Sierra Leone was, by either the M-1 or the M-2 definition,considerably lower in June 1981 than in June 1977. This is probably only partly explained by the controls imposed on money supply and credit expansionbegin- ning in 1980. As discussed in Chapter II, the scarcity of foreign exchange Table A-10: MONETARYSAVINGS STOCKS, 1971-1982 (Thousands of Leonies)

June June June June June June June June June June June March June 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1982

1. Currency outside banks 20905 22590 30746 35588 36073 39194 46666 57015 72044 81845 87696 91753 (1)/(3) 0.684 0.642 0.630 0.633 0.622 0.600 0.565 0.575 0.557 0.591 0.542

2. Demand deposits 9645 12610 15713 20890 20959 23773 31062 43848 53207 64978 60732 69064 77422

3. Money supply, M-1 30550 35200 46461 56478 5/032 62967 77728 100863 125251 146823 148428 169175 Deflated (1977) 77728 93471.6 95305.5 85741.8 70724.8

4. Time deposits 3253 4464 5450 9595 9779 13364 20595 31730 48253 50784 47376 62078 84727 Deflated (1977) 20595 29404.8 36716.5 29772.5 22574.3 (4)/(6) 0.072 0.085 0.080 0.113 0.136 0.164 0.164 0.225 0.204 0.184 0.261

5. Savings deposits 11250 12953 15907 18894 19519 22124 26886 34013 40808 51902 61236 64013 70429 Deflated (1977) 26886 31520.5 31051.5 30194.1 29178.5 (5)/(6) 0.250 0.246 0.235 0.222 0.226 0.225 0.225 0.204 0.190 0.207 0.238 0.217

6. Money supply, M-2 45053 52617 67818 84967 86432 98455 125209 166606 214312 249509 257040 324331 Deflated (1977) 125209 154396.9 163073.4 145708.4 1224/1.5

7. Post office savings 3099 3111 3264 3265 3105 2929 2677 2629 2489 2441 Deflated (1977) 2677 2436.3 1893.9

8. Wholesale price index 142.9 154.2 187.8 244.7 295.0 365.2 Source: bank of Sierra Leone Annual Report 1980, Tables I and 7. 2n,l _ 57_ ANNEX A Page 19 and the generally depressed economic circumstances have made it difficult for the banks to acquire assets. Table A.1 suggests that, in addition to growing in quantity over the decade, the term structure of the nation's time deposits has lengthened somewhat.

42. One reason why real money supply growth has been sluggish in recent years may be that foreign exchange is increasingly used for transactions within the economy. The overvaluation of the Leone and the scarcity of foreign exchange have increased the incentive to smuggle diamonds. The foreign exchange that enters the economy in this way may be involved in an increasing number of intermediate transactions within the economy. Unfortunately it is not possible to determine the quantitative significance of this trend.

43. Table A.11 provides an analysis of the determinants of the growth of Sierra Leone's money supply (M-2) over the period June 1971 to June 1982. In this table, the growth of the money supply from July to June is analyzed as a function of the principal underlying banking system assets: net claims on the Government, claims on the private sector, and net foreign assets. The contribution of each of these assets to the growth rate of the money supply over a given year is taken to be the product of (1) the proportion of the money supply represented by the asset at the start of the year (that is, the end of the year previous to the date indicated at the top of the column) and (2) the growth rate of the asset. We have not included all the banking system assets in this exercise, only the three principal ones; moreover, there are "inter- action" effects among the contributions. Hence the sum of the contributions differs from the growth rate of the money supply. The difference between the growth rate of the money supply and the sum of the contributions is therefore given as well.

44. Several general conclusions can be derived from this analysis. Since 1977 the principal driving force of monetary expansion has been claims on the Government, followed by private sector credit. After June 1977 net claims on the Government increased every year in real terms. Claims on the private sector actually diminished in real terms after June 1979.

45. Table A.12 gives the liquidity positions of Sierra Leone's commercial banks over the period 1971-1982. This table shows clearly that the commercial banks have generally exceeded their required liquidity ratio considerably, especially since 1976. Furthermore, the commercial banks' deposits at the BSL have become an incresingly significant proportion of commercial banks' liquid assets, particularly since 1978.

(b) Government obligations

46. The principal government obligations are given in Table A.13. There are three main classes of government obligations: ways-and-means advances (that is, an overdraft facility at the BSL), Treasury bills, and Government stock. TABLE A-li: DETERMINANTS OF THE MONEY SUPPLY, 1970-1979 (Thousands of Leones)

1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

1. Total monetary assets 45053.0 52617.0 67818.0 84967.0 86432.0 98455.0 125209.0 166606.0 214312.0 249509.0 257040 324331 la. Change over previous period -- 0.168 0.289 0.253 0.017 0.139 0.272 0.331 0.286 0.164 0.030 0.262

2. Banking system claims on the Government 4956.0 6834.0 16098.0 17754.0 42709.0 74992.0 107327.0 144757.0 215751.0 267669.0 367316.0 507783.0 2a. Change over previous period -- 0.379 1.356 0.103 1.406 0.756 0.431 0.349 0.490 0.241 0.372 0.382 2b. Ratio, (2)/(1) 0.110 0.130 0.237 0.209 0.494 0.762 0.857 0.869 1.007 1.073 1.429 1.566 2c. [2b(-1)I[ZaJ -- 0.042 0.176 0.024 0.294 0.374 0.328 0.299 0.426 0.243 0.399 0.546 2d. (2c)/(la) -- 0.248 0.609 0.097 17.034 2.685 1.209 0.094 1.488 2.353.

3. Banking system claims on the Private Sector 21354.0 20294.0 21835.0 44422.0 38136.0 39128.0 42529.0 55923.0 74584.0 77384.0 94694.0 102076 3a. Change over previous period -- -0.050 0.076 1.034 -0.142 0.026 0.087 0.315 0.334 0.038 0.224 0.078 3b. Ratio, (3)/(1) 0.474 0.386 0.322 0.523 0.441 0.397 0.340 0.336 0.348 0.310 0.368 0.315 3c. [3b(-1)f13a] -- -0.024 0.029 0.333 -0.074 0.011 0.035 0.107 0.112 0.013 0.069 0.029 3d. (3c)/(la) -- -0.140 0.101 1.317 -4.291 0.083 0.127 0.324 0.391 0.080 2.300 0.111

4. Banking system net foreign assets 27394.0 35724.0 43978.0 43203.0 26877.0 16166.0 14242.0 12920.0 -2635.0 -49614.0 -163337 -236964 4a. Change over previous period -- 0.304 0.231 -0.018 -0.378 -0.399 -0.119 -0.093 -1.204 9.927 4b. Ratio, (4)/(1) 0.608 0.679 0.648 0.508 0.311 0.164 0.114 0.078 -0.012 -0.115 4c. [4b(-1)J [4a] -- 0.185 0.157 -0.011 -0.192 -0.124 -0.020 -0.011 -0.093 -0.122 4d. (4c)/(la) -- 1.101 0.543 -0.045 -11.144 -0.891 -0.072 -0.032 -0.326 -0.743

5. Residual -8651.0 -10235.0 -14093.0 -20412.0 -21290.0 -31831.0 -38889.0 -46994.0 -73388.0 -45930 -41633 -48564 'a. Change over previous period -- 0.183 0.377 0.448 0.043 0.495 0.222 0.208 0.562 0.330 5b. Ratio, (5)/(1) -0.192 -0.195 -0.208 -0.240 -0.246 -0.323 -0.311 -0.282 -0.342 -0.391 5c. [5b(-1)1[5a] -- -0.035 -0.073 -0.093 -0.010 -0.122 -0.072 -0.065 -0.158 -0.113 5d. (5c)/((la) -- -0.209 -0.254 -0.368 -0.599 -0.877 -0.264 -0.196 -0.553 -0.689

Source: Bank of Sierra Leone, Annual Report, 1980, Table 2.

* Banking system claims on Government (net) and Banking system net foreign assets redefined in 1980 TABLE A-12: LIQUIDITY POSITIONS OF COMMERCIALBANKS, SIERRA LEONE, 1971-1981 (Thousands of Leones)

June June June June June June June June June June June June 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12)

1. Cash in hand 1615 1367 1668 1848 1350 1861 2039 2679 4596 5365 6267 9301

2. Deposits at the BSL 1497 1684 1972 1547 3208 2546 8789 13334 56409 48117 28382 84221

3. Treasury bills 6165 7392 13312 12792 13200 19550 35103 49022 49076 50213 48077 50077

4, Other internal bills 654 638 480 1378 1446 1568 506 1256 3833 2416

5. Comm.-bank liquid assets - [(1)+(2)+(3)+(4)] 9931 11081 17433 17565 19204 25525 46437 66291 113914 106171 82726 143599

6. Total com,. bank deposits 25808 30176 37589 57874 50265 59999 78607 110272 141981 169614 170653 230577

7. Liquidity tatio: - (5)/(6) 0.384 0.367 0.464 0.304 0.382 0.425 0.591 0.601 0.802 0.626 0.485 0.623

8. Reg. liquidity ratio 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.30 0.40 0.40 0.40 (7) - (8) 0.084 0.067 0.164 0.004 0.082 0.125 0.291 0.301 0.502 0.226 0.085 0.223 (2)/(5) 0.151 0.152 0.113 0.088 0.167 0.100 0.189 0.201 0.495 0.454 0.343 0.586

Source: Bank of Sierra Leone, Annual Report 1980, Table 7.

01 TABLE A-13: GOVERNMENTOBLIGATIONS OUTSTANDING, 1971-1982 (Thousands of Leones)

June June June June June June June June June June June June 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

1. BSL: Ways and means advance 2420 2510 910 2610 8660 3090 10440 14370 104780 191110 271000 437550

2. BSL: Other advances 2258 1563 8588 9244 9042 15081 24534 10510 13040 22383 36383 36383

3. BSL: Total advances 4678 4073 9498 11854 17702 18171 34974 24880 117820 213493 307383 473933

4. BSL: Government deposits 6611 7356 8602 9497 5021 -15159 -16782 -3197 12904 38356 35383 63287

5. BSL: Total -1933 -3283 896 2357 12681 33330 51756 28077 104916 175137 272000 410646 deflated (1977) 51756.0 26019.5 79832.2 20315.7 17455.3

6. Treasury bills outstanding 10200 12900 17720 19720 26000 32145 41760 57480 59120 59120 59120 59120 - BSL holdings 533 441 14 0 7747 6905 2 2261 9 366 2311 325 - Coemmercial bank holdings 6165 7392 13312 12792 13200 19550 35103 49023 49876 50509 48060 50260 3502 5067 4394 6928 5053 5690 6655 6196 9235 8245 8749 o 6655.0 5741.9 7027.1 4814.9 4168.8 - NDB holdirkgs 249 508 29 155 29 120 100 844 4 4 4 4 - Other financial institutions 439 780 1023 1653 1720 1963 3067 2585 3424 5537 5278 5696 - Semi-Government institutions 2056 2736 1205 2746 1783 353 2692 1605 4625 1162 934 1182 - PIivate holdings 758 1043 2137 2374 1521 3254 796 1922 1182 1542 2533 1653 796.0 1781.2 899.4 900.5 1207.0

7. Govt. stocks outstanding 19500 25500 37500 42500 50700 97200 99500 99500 99500 99500 - BSL holdings 1497 3155 10726 12663 20738 60201 59837 43768 43689 50552 - Sinking Funds 5226 3099 - Commercial bank holdings 950 700 1546 1750 1500 500 2700 1517 3449 4365 17053 21645 25228 28087 28462 36499 36963 54215 28462.0 33824.3 * 28125.7 31660.5 - NDB holdings 534 137 283 209 209 209 209 209 209 209 - Other financial institutions 11199 15378 18067 20970 20974 21161 20447 27960 25899 30004 - Semi-government institutions 4966 5728 6293 6474 5857 11321 13038 25293 20298 10633 - Private holdings 354 40Z 585 434 1422 3808 3269 753 728 637 1422.0 3528.9 2487.4 439.7

8. Deflator* 142.9 154.2 187.8 244.7 299.9

* Wholesale price index 1975 100

Source: Bank of Sierra leone A_nual Report 1980 Tables 17 and 18. s to - 61 -- ANNEX A Page 22

47e The Government'suse of its overdraftfacility at the BSL has grown considerablyin recent years and now accounts for a large proportion of the money supply. We can calculate the ratio of the outstandingoverdraft balance (net of the Government'sdeposit balance) to the broadly defined money supply (M-2):

June:

1975 0.147 1976 0.339 1977 0.413 1978 0.169 1979 0.450 1980 0.826 1981 0.959

This proportion has clearly grown steadily since 1975, except for a sharp drop in 1978. The sharp increase after 1978 was associated with the increased Government expenditurefor infrastructurefor the 1980 Organizationof African Unity summit conference in Freetown. The Government pays a nominal rate of interest on its outstandingoverdraft credit at the BSL, between zero and 3 percent.

48. The Government issues two classes of marketable assets. Treasury bills are three-monthsecurities with an annual yield of 10 percent. Table A.13 shows that the bulk of the Treasury bill issues (roughly80 percent) are held by the commercialbanking system. Most of the remainderare held by other financialinstitutions, including the NDB, insurance companies,and the nation's various company pension funds, and also by parastatal enterprises, principallyDIMINCO and the SLPMB. Unambiguouslyprivate holdings of Treasury bills (principallyby firms) are relatively insignificant.

49. Government developmentstocks (bonds) are the only longer-termsecu- rities available in Sierra Leone. The Government has issued these since 1973 for various developmentpurposes. Their maturities have ranged from two to eight years, and the yields of presently outstandingissues are in the range of 8 to 12 percent a year. Slightly under half the issues are held by the commercialbanking system. The remainder are held mostly by insurance companies, pension funds, and semi-Governmentinstitutions. Government stocks are the only fixed-yieldlong-term earning assets available in Sierra Leone.

50. Finally, Table A.14 shows the principal financial assets of Sierra Leone as a proportion of gross domestic product for those years for which data are available. Between 1975 and 1979 there appears to have been a slow but steady "monetization"of the economy. The money supply M-1 is now just over one-tenth of GDP (that is, the velocity of monetary circulationis about 10 per year), which is a typical figure for an underdevelopedeconomy like that of S:LerraLeone. The money supply M-2 grew as a proportion of GDP from 15 to 22 percent over the same period. The stocks of Treasury bills and of Govern- ment stocks held outside the banking system remained a small proportion of GDP over the period. TABLE A.14 PRINCIPAL FINANCIAL ASSETS AS A PROPORTION OF GROSS DOMESTIC EXPENDITURE (Thousands of Leones)

June June June June June 1975 1976 1977 1978 1979

1. Money supply M-1 57032 62967 77728 100863 125251 (1)/(6) 0.100 0.103 0.104 0.118 0.128

2. Money supply M-2 86432 98455 125209 166606 214312 (2)/(6) 0.151 0.160 0.168 0.196 0.219

3. Ways and means advance 12681 33330 51756 28077 104916 (3)/(6) 0.022 0.054 0.070 0.033 0.107

4. Treasury bills* 5053 5690 6655 6196 9235 (4)/(6) 0.009 0.009 0.009 0.007 0.009

5. Government stocks* 25228 28087 28462 36499 36963 (5)/(6) 0.044 0.046 0.038 0.042 0.038

6. Gross domestic product 572700 613500 744200 850100 978800

* Outside the banking system Source: Bank of Sierra Leone, Annual Report 1980, Tables 1, 12, 17, 18. - 63 - ANNEX A Page 24

Referencesto Annex A

Bank of Sierra Leone. Annual Report and Statement of Accounts, 1980.

_ National Workshop on Agricultural Credit and Banking, 1978.

_ Research Department. "Index of Wholesale Press in Sierra Leone," 1982.

Government of Sierra Leone, Printing Office: The Banking Act, 1970; The Bank of Sierra Leone (Amendment)Act, 1970.

Barclays Bank of Sierra Leone Ltd. Annual Report, 1980, 1981.

Guardian Royal Exchange Assurance (SierraLeone) Ltd. Annual Report, 1981.

National Insurance Company Ltd. Ninth Annual Report and Accounts, 1980.

National DevelopmentBank Ltd. Annual Report and Account, 1981.

The National Diamond Mining Company (Sierra Leone) Ltd. Report and Accounts, 1980, 1981.

Re-crganisationof Post and TelecommunicationsDepartment, 1975.

Sierra Leone Commercial Bank. Annual Report and Accounts, 1981.

Sierra Leone Produce Marketing Board. Annual Report, 1979, 1980, 1981.

World Bank. Sierra Leone Prospects for Growth and Equity, July 1981. - 64 - ANNEX B Page 1

ANNEX B

THE RURAL FINANCIAL INSTITUTIONS

1. A wide range of rural institutions engages in financial activities in the agriculturalsector, from infcrmal moneylendersto official project lenders. Between 1971/1972 and 1980/1981 a total cf Le 115 million (in current prices) was invested through official prsojectsin the rural sector (Funna, p. 16).

(a) Informal Scurces of Credit

2. The informal sources--primarilymonelenders and some input suppliers -- provide most of the working capital credit in rural Sierra Leone. The BSL Report on Rural Banking summarizes the reasons why farmers usually find it relatively convenient to borrow from moneylenders: moneylendersare genrally more approachablethan formal financial institutions;they require no paper work; borrowers and moneylenderstypically know one another well; moneylenders collect no fees nor commissions; moneylenders' dealings are fully confiden- tial; moneylenders can usually make funds available reliably and rapidly; they can make flexible security arrangements;and some borrowers can negotiate their terms.

3. The drawback of moneylendersis, of course, that they usually charge very high interest rates partly to cover the risks of ncnpayments. Bessell and Raswant cite reports of annualized rates between 100 and 500 percent (p. 26). To the extent this is true, moneylendersability to charge high interest rate (cver and above the premium for the risk of nonpayment)repre- sent their monopoly power. The moneylenders'monopoly power may have been indirectlyhelped by the Government policies and programs. The Government policy tc discourage mcneylendersmay have actually limited the entry cf newcomers into the market and thereby increasedthe monopoly power cf the existing moneylenders. The Government programs of rural credit are cften so poorly designed and inefficientlyrun and, partly because cf this, sc limited in amount that they cost resources to the Government but offer no real competitionto the mcneylenders.

4. In some developing countries, input suppliers have become an important source cf rural credit. In Sierra Leone, some input suppliers offer credit and some moneylenderscum shop keepers deal in agriculturalinputs. The Government can promote competitionin the rural credit market by encouraginginput suppliers, and village traders to offer credit to farmers. More generally, since informal sector moneylenders are the most successful intermediaries for rural credit, expansion of this market along with increased competitionwithin it should be encouraged. This implies,,in part, better access tc the formal market. A closer link between the formal and informal credit markets and more competitionamong the infcrmal lenders will help bring down the high interest rate now charged by the moneylenders. - 65 - ANNEX B Page 2

(b) Commercialbanks

5. Sierra Leone's two older banks, Barclays and Standard, began only in the miLd-1970s to provide agricultural loans. The proportion of commercial banks' total loans and advances classified as agricultural is given in Table B.1. (See National Workshop, p.21, for earlier years.) The two smaller banks in existence before 1983, the Sierra Leone Commercial Bank and the Bank of Credit and Commerce Internatlonal, have virtually no agricultural activities. Column 5 shows that in real terms the commercial banks' agricultural lending increased relatively little between June 1977 and June 1981.

6. The commercial banks' managements feel themselves under pressure to expand their agricultural portfolios, but they are moving rather cautiously and slowly. The Standard Bank Chairman's Statement for 1980 explains this as follows: "The Bank recognizes the role it must play in order to contribute to an increase in agricultural productivity, but at the same time it is mindful that its prime duty is the protection of its depositors, by ensuring that lending conforms to normal banking criteria."

7. From the point of view of the commercial banks, agricultural lending presents problems of supervision and risk that go beyond what they have regarded up to now as their business. The Registrar of Cooperative Societies Loan Scheme, which Barclays and Standard supported from 1950 to 1968, failed, and this no doubt hardened the banks ' attitude toward agricultural lending.

8. The BSL Report on Rural Banking cites the following reasons for commercial banks' limited participation in agricultural operations: (1) the high standards that commercial banks require for security, (2) the com- plicated informatlon that commercial banks require from their borrowers to evaluate their applications, (3) the inevitable delay in processing a loan application, (4) the high risk perceived by the commercial banks in rural operations, (5) the inability of most small farmers to contribute substantial equity capital to their projects, as commercial banks typically require, (6) the geographical dispersion of borrowers, which makes it difficult for the commercial banks to supervise and monitor their loans, and (7) the orientation of commercial banks' lending, the result of decades of operating according to traditional and conservative principles in Sierra Leone.

9. The challenge for Sierra Leone polaicymakers is to devise some means by which resources can be channeled from commercial banks to the agricultural sector without obliging the commercial banks to hold assets that fail to meet their standards.

10. (1) Credit-guarantee scheme. The Bank of Sierra Leone has attempted to circumvent the problem posed by the inability of most rural borrowers to presetnt acceptable collateral by establishing a Credit-Guarantee Scheme for Small Borrowers. Under this program, the BSL provides a two-thirds (now raised to 80 percent) guarantee of any loan covered under the scheme. Four lending institutions--Barclays, Standard, the Sierra Leone Commercial Banks, as well as the National Development Bank--were permitted to provide covered loans. - 66 -

ANNEX B Page 3 TABLE B-1: AGRICULTURAL LOANS BY COMMERCIAL BANKS (Thousands of Leones)

(1) (2) (3) (4) (5) Agricultural Total Percentage Wholesale Change of (1) Loans Loans (1)/(2) price index over the June 1975 = 100 preceding year

1975 709 35,756 1.98 1976 467 36,147 1.39 1977 670 40,632 1.65 142.9 1978 839 52,497 1.60 154.8 +19.7 1979 2,501 66,148 3.78 187.8 +3.5 1980 4,437 69,818 6.36 244.7 -19.0 1981 4,013 89,311 4.49 299.9 +4.4 1982 (March) 5,043 100,156 5.04 1982 (June) 3891 97,112 4.01

Source: Bank of Sierra Leone Annual Report 1980, Table 13. - 67 - ANNEX B Page 4

11. Only a small number of loans were approved under the scheme, and of these relatively few went to agriculture. The number of applicationshas actually declined since 1978. The principal problem appears to have been that the proportion of the guarantee was insufficientto satisfy the commercial banks' collateral requirement. In early 1982 the BSL increased the proportion to 80 percent. It is too early to know whether this will prove sufficiently encouraging.

12. The Credit-GuaranteeScheme is clearly not the best solution to the collateral problem. In effect, it solves the commercialbanks' risk problem by backing particular loans with the central bank's capacity to create money.

13. (2) Premium Savings Bonds. The BSL has sought to mobilize rural as well as urban savings by means of its premium savings bonds, first available in 1979. Under this program, the BSL issues non-interest-bearingperpetual bonds, promising to cash the instrumenton demand. Prizes are offered by lottery drawings. The bonds must be held for three months before their numbers may be drawn. The scheme has been regarded by the public as a lottery and persons who do not receive prizes tend to cash in their bonds quickly.

14. (3) Finally, the BSL has actively promoted the rural-bankingscheme discussed in Chapter III.

(d) Cooperativesocieties

15. The oldest rural financial institutionsoperating in Sierra Leone are cooperativesocieties, including produce marketing societies (for cacao, coffee, palm kernels, cassava, and ginger for sale to Sierra Leone's Produce Marketing Board) and credit and thrift societies. Cooperativeassociations were promoted by the colonial government in the post-WorldWar II period. As of June 30, 1977 there were 1,215 cooperativesocieties, with 52,357 members; some 760 of these societies were apparently small credit unions. Estimated total assets for June 1978 were Le 1,860,000,of which Le 515,000 were loans outstanding.

16. The Registry of CooperativeSocieties (RCS) instituted a Loan Scheme beginning in 1950, using funds derived from an initial Government loan and a commercial bank overdraft facility guaranteed by the colonial Government. Loans were provided to individual farmers through their cooperatives. In 1968 the RCS Loan Scheme was terminated,with heavy losses. The commercial banks ended their associationwith the cooperatives,and after paying the commercial banks' guarantees the Government phased out its support. Even today the memory of the RCS Loan Scheme's failure affects bankers' attitudes, not only toward cooperativesbut toward agriculturalfinance generally. In any case, cooperativefinancial activity has continuedat an extremely low level. The principal problem of the cooperativescontinues to be loan recovery. This problem is the result of (1) acceptance by cooperativesof inadequate security for loans, (2) extension of additional credit by cooperativesto individuals who are still in arrears on preceding loans, (3) poor credit supervision,(4) excessive overhead expenditure,(5) poor project appraisal, and (6) poor con- nections between credit and marketing, so that loan recipients could frequently sell their produce without having to pay any of the proceeds to their - 68- ANNEX B Page 5

creditors. There seems to be a widespread perception that cooperativefunds are Government funds, that Government funds are "free funds", and that to fail to repay Government funds is not unethical.

17. In April 1971, following the collapse of the RCS Loan Scheme, a National CooperativeDevelopment Bank (NCDB) was established. The original capitalizationof Le 10,000 (later increased to Le 30,000), contributedby about one-third of the existing cooperatives,was obviously inadequate,and even with a Government grant of Le 190,000 and a British Government loan of Le 250,000 the institutionremains far too small to provide effective service to Sierra Leone's cooperatives. The institutionhas a relativelyhigh overhead, although NCDB staff are civil servants earning (relativelypoor) civil- service salaries. The institutionhas all the problems of being associated with the Government in addition to its problem of undercapitalization. The NCDB was unable to provide financial statements to the Bank mission.

(e) Other agriculturalcredit schemes

18. In 1961 the Government set up an AgriculturalLoans and Credit Scheme, in an attempt to promote both food and export production. The scheme was administeredby the Ministry of Agriculture. Loans were to be granted for supervisedproduction activities. The scheme collapsed in the late 1960s because small farmers could not go through its complicatedapplication procedure, because the loan appraisal staff was inadequatelytrained, and because the appraisal procedure was too heavily political.

19. An earlier scheme, the Developmentof the Industries Board Scheme, also collapsed. This scheme, set up in 1946 by the colonial Government, included some agriculturalloans.

(f) The Eastern Farmers Finance Company (IntegratedAgricultural Project).

20. The Eastern Area Integrated AgriculturalProject was set up in 1971 by the Government of Sierra Leone, with financing mainly from the IDA of the World Bank. The purpose of the program was to provide credit, supplies, and technicalassistance on a coordinatedbasis to subsistencefarmers within a specific area of the Eastern Province of Sierra Leone. Similar Integrated AgriculturalDevelopment Projects (IADPs) were launched in other areas and it is hoped eventually to extend the IADP approach to the whole country (Funna p. 17).

21. In 1976 the credit operations of the Eastern IADP were separated institutionallyinto a Farmers' Finance Company (FFC). The FFC has provided three classes of loans: developmentloans now at a 15 percent annual interest rate to permit farmers to establishup to 10 acres of oil palm, 2 acres of cacao, or 3 acres of swamp rice; seasonal loans now at 15 percent interest rate for swamp rice inputs; and medium-term loans now at a 15 percent interest rate for purchase of farm capital equipment. These loans are supposed to be closely supervised and adequate technical support is supposed to be provided. - 69 - ANNEX B Page 6

22. During the first few years of the IADP, loan recovery was apparently near 100 percent. Beginning in 1974 or so, however, the IADP experienced severe recovery problems, and when the FFC was set up, it inheriteda substantialbad debt problem. Since then the problem has worsened: loan recovery is estimated at between 30 and 60 percent, which implies that the FFC will soon be completely decapitalized.

23. The FFC's general manager argues that in some measure the FFC may have been the victim of its own success; some farmers who became relatively wealthy from their swamp rice projects changed occupationin 1973 and 1974, preferring to work as petty shopkeepersand moneylenders. Others preferred to move out of lowland farming back into upland farming. Some apparently felt that they could leave bad debts behind. In any case, it appears that the FFC entered into a vicious circle. Once its bad debts became ap,preciable,it lost revenue, which made it more difficult to provide new loans and to pay the operatingcosts necessary to supervise its loans. As a result its portfolio deterioratedeven further.

(g) The National Development Bank

24. The National Development Bank is discussed in Annex C of this report. The issue of whether the NDB ought to provide rural credit is explored there. - 70 - ANNEXC Pa-ge ~1

ANNEXC

THE NATIONALDEVELOPMENT BANK

1. Since 1968 Sierra Leone has had a single development investment bank, the Government-owned National Development Bank Limited (NDB). The NDBwas established to carry on the business of financing enterprises engaged in industry, commerce, agriculture, and the exploitation of natural resources in Sierra Leone, with a view to contributing to the economic development of the country. Unfortunately, the NDBhas never been able to play an effective role in the nation's development effort. Its volume of lending has remained small, and its lending never coalesced into a coordinated, well-conceived development program. Since its founding the NDB has been plagued by problems of irre- coverable debt and inadequate staff. In recent years, the financial position of the NDB has deteriorated so badly that it may now be said to be effectively bankrupt. 2. This annex has three sections. Section A briefly describes the recent performance and current condition of the NDB. Section B presents some broad suggestions for what the NDBought to do next to begin to reverse its situation. Section C discusses several issues of development bank policy that will become fundamental once the NDBis past its present crisis.

A. The recent performance and current situation of the NDB

3. The purpose of this section is to highlight the NDB's situation by describing the NDB's essential problem. Tables C.2 and C.3 present the NDB's summary balance sheets and profit-and-loss statements for the years 1976 through 1981. 4. The NDBwas set up in 1968 with an authorized capital of Le 10 million. The total capitalization of the NDBis presently Le 4,545,301. Of this amount, Le 2,001,820 represents the value of the building, Leone House, in which the NDBhas its offices. The ownership of this building was transferred by the Government to the NDB in March 1981 in exchange for a correspondingly increased Government equity position. The Government, the Bank of Sierra Leone, and the Sierra Leone Produce Marketing Board together hold the majority of the remaining shares (roughly 80 percent). (During 1981 the SLPMBwrote down the valuation of its holdings from Le 468,655 to Le 163,135, "as it was considered that the cost no longer represented a fair value.") The remaining shares in the NDBare held by Barclays and Standard Bank, the (foreign-owned) Diamond Corporation of West Africa (DICOR), and the African Development Bank. There are also small holdings by local private and public institutions.

5. The NDB's capitalization is supplemented by a number of unsecured medium- and long-term loans amounting to Le 4,701,836 as of December 1981 (see Table C.1). - 71 - ANNEX C Page 2

TABLE C.1: LOANS TO THE NATIONAL DEVELOPMENT BANK December 1981

Annual interest rate (including Creditor Balance Term ends commissions)

Bank of Sierra Leone Development Fund: Loan I Le 36,250 1982 4 Loan II 250,000 1985 4 Loan III 312,000 1986 5 Loan IV 262,500 1988 6 Loan V 500,000 1992 8

African Development Bank - first line of credit 661,425 1986 7

African Development Bank - second line of credit 2,352,727 1990 8.5

Govt. of Sierra Leone --Netherlands loan 470,000 (no formal agreement)

EEC loan 548,717 2017 l Total 5,394,119 (Due within 12 mos.) -675,700 Provision for gain on foreign currency loans -16,583 Le 4,701,836

Source: Annual Reports of the National Development Bank, 1977-1980. -72 - ANNEX C Page 3

6. An earlier African Development Bank line of credit has ended. The Netherlands provided a loan in 1978 which went specifically to finance the purchase of equity in the Mabole Fruit Company Limited, a food processing and packaging enterprise. This enterprise has proven unsuccessful, and the corresponding investment by the NDB has been fully written off in its asset accounts. An EEC loan was provided under a line of credit which has not been fully used.

7. The NDB's capital accounts include a supplementary reserve, which the NDB's Articles of Association require be formed from 25 percent of each year's profit. This reserve has not grown in recent years on account of the NDB's losses. (See Table C.2 for a summary of profit-loss accounts.)

8. The NDB's current liabilities consist principally of its own loan repayments due within twelve months (see Table C.1).

9. As a development investment bank, the NDB's investments comprise shares in enterprises as well as medium- and long-term loans. On December 31, 1981 its net equity position came to Le 486,350, that is, a total of Le 1,149,990 from which provision of Le 663,640 for valueless shares had been deducted. (Of this amount, Le 470,000 was the investment in the Mabole Fruit Company.) Net outstandingloans were Le 3,520,883.

10. Table C.4 reproduces Schedule IV of the 1981 NDB Annual Report, showing cumulative annual loan approvals since the NDB's inception. The Annual Report provides a complete list of all loan and equity-acquisition approvals. (During 1982 no loans nor equity acquisitions have been approved.)

11. We can now draw together some salient characteristics of the NDB's operations.

(a) The NDB's investments have amounted to Ea small proportion of Sierra Leone's aggregate fixed-capital formation. Gross domestic fixed- capital formation in the accounting years July 1974/June 1975, 1975/1976,1976/1977, 1977/1978, and 1978/1979was, respectively,Le 76.0 million, 76.8 million, 86.9 million, 106.9 million, and 140.0 million. Total NDB approvals for the years 1974, 1975, 1976, 1977, and 1978 were, respectively, Le 1.2 million, 1.5 million, 1.0 million, 1.0 million, and 1.0 million. In rough numbers, then, new NDB approvals have never been so much as 2 percent of Sierra Leone' s gross domestic fixed-capital formation, and by 1978/1979 they were below 1 percent.

(b) Originally, the NDB's operations were intended mainly to serve Sierra Leone's small business ventures. It was assumed that loans on the order of Le 5,000 would be the norm. In fact, the NDB's loans and equity acquisitions have averaged much more than this. The average amount of the 161 loans and equity acquisitions approved by the NDB over its history is Le 81,125. Of these approvals, 27 were in excess of Le 100,000; these had a total value of Le 9.4 million, which was 72 percent of the total quantity approved. In sum, the bulk of the TABLE C.2 NATIONAL DEVELOPMENT BANK: SUMMARY PROFIT-AND-LOSS ACCOUNTS

Dec.1976 Dec.1977 Dec.1978 Dec.1979 Dec.1980 Dec.1981 1. Loan interest 300.4 355,4 447.4 421.2 392.1 448.4 2. Bank development interest 0.0 9.0 19.1 16.2 31.0 27.1 3. Govt. security interest 24.6 24.9 20.2 16.2 15.9 15.9 4. Dividends 71.5 59.6 112.3 171.8 173.9 62.7 5. Income from investments 395.5 448.8 599.0 625.6 612.9 554.0 6. (2:5)t/(1:10)tl 0.116 0.154 0.142 0.143 0.135 7O Other income 30.7 32.7 35.7 42.0 97.5 91.2 8. (5) + (7) 426.2 481.5 534.7 667.6 710.4 645.2 9. Loan interest 94.4 125,6 160.2 169.6 211.8 281.6 10. Administrative expense 254.5 289.8 354.4 357.2 391.1 506.0 11. Total expenditure 405.8 462.3 56902 611.1 690.0 823.9 12. (2:11)t/(1:I0)t-j 0.045 0.054 0.048 0.061 0.060 13. Profit/loss on operations 20.4 19.2 65.5 56.5 20.4 -174.8 14. (2:13)t/(l:l0)t-l 0.005 0.017 0.013 0.005 -0.044 15. Provisions 24.4 90.9 -226.1 826.3 -517.6 502.6 16, Profit/loss -4.0 110.0 -160.5 -769.8 -497.2 -681.4

Source: Annual Reports of the National Development Bank, 1977-80. ANNEX C Page 5

- 74 -

TABLE C.3: NATIONAL DEVELOPMENT BANK: SUMMARY BALANCE SHEETS

Dec.31 Dec.31 Dec.31 Dec.31 Dec.31 Dec.31 1976 1977 1978 1979 1980 1981

1. Debtors 111.6 133.8 155.1 224.6 241.2 128.0 2. Staff loans and advances 37.0 43.2 34.1 25.9 17.1 10.6 3. Loans repayable 242.9 133.0 4. Interest receivable 384.3 412.2 274.1 218.1 157.6 271.9 5. Treasury bills 192.3 197.5 99.6 0.0 0.0 0.0 6. Cash 59.1 456.1 455.0 225.7 553.7 949.7 7. Current assets 1025.3 1375.9 1017.8 694.2 969.7 1360.3 8. (7)/(12) 0.127 0.257 0.185 0.137 0.188 0.177 9. (6)/(12) 0.051 0.122 0.101 0.045 0.108 0.124 10. Investments 3864.3 3897.9 4376.6 4827.1 4078.5 4214.2 11. Fixed assets 76.0 70.6 96.0 89.9 101.3 2102.5 L2. Total assets 4966.6 5344.4 5490.4 5071.2 5149.5 7677.0 13. Current liabilities 136.4 107.2 133.8 502.5 650.3 772.1 14. Unsecured medium- and long-term loans 2788.5 2944.5 3563.7 3481.4 3375.2 4701.8 15. (14)/(16) 1.56 1.41 1.71 1.67 1.33 1.03 16. Share capital 1781.8 2081.8 2081.8 2081.8 2543.5 4545.3 17. Provisions 215.8 56.7 104.8 169.1 241.3 18. Reserves 44.1 105.9 105.9 105.9 105.9 105.9 19. AccuLmulated profit/loss 48.2 -499.6 -1269.5 -1766.7 -2448.1

Source: National Development Bank Annual Reports TABLE C.4:

CUMUILATIVE ANNUAL LOAN APPROVALS BETWEEN 1971 AND 31ST DECEMBER 1981

1979 1980 1981 Total Industrial: 1971 1972 1973 1974 1975 1976 1977 1978

53 Sanctions 2 4 2 6 6 6 2 4 8 7 - 6 - 39 Projects 1 3 1 4 4 2 1 4 8 - 6,770,842 Loan 18,000 346,500 140,000 778,000 338,000 182,781 356,061 428,500 1,065,000 3,041,000 1,016,990 Equity 9,850 - 24,000 140,000 38,940 8,700 470,000 - 250,000 - -

Agricultural: 3 1 63 Sanctions - 3 8 4 11 15 4 6 8 2 1 53 Projects - 2 8 2 10 10 4 6 8 151,000 3,600 1,803,582 Loan - 32,000 362,235 131,790 278,237 429,550 152,410 112,160 150,600 282,000 Equity - - 90,000 - - 100,000 - 92,000 - - -

Commercial: - 32 Sanctions 3 1 1 3 7 6 1 6 3 - - 29 Projects 3 1 1 2 6 5 1 6 3 - 902,940 Loan 230,000 15,000 44,000 62,000 371,000 90,200 15.000 68,400 7,340 - 261,000 Equity 115,000 - - - 50,000 - - - 75,000 - -

Service: 8 3 48 Sanctions - 2 2 2 2 6 2 1 14 6 2 40 Projects - 2 1 2 2 4 - 1 14 180,000 1,908,903 Loan - 40,000 20,000 45,000 440,000 178,160 7,713 300,000 363,130 232,000 - - 115,000 Equity - - - 22,500 22,500 5,000 - -

Total: 18 4 196 Sanctions 5 10 13 15 26 33 9 17 33 14 3 61 Projects 4 8 11 10 22 21 6 17 33 183,600 11,386,267 Loan 248,000 433,500 566,235 1,016,790 1,427,237 880,591 531,184 909,060 1,586,070 3,424,000 1,674,990 Equity 124,880 - 114,000 140,000 111,440 131,200 475,000 92,000 325,000 - -

Source: Annual Report of the National Development Bank, 1981, Schedule IV.

xcl - 76 - ANNEX C Page 7 NDB's approvals went to rather large projects, and the remainder went to medium-size rather than small-scaleenterprises. Some of the NDB's larger loans went to finance ventures that could, and should, have been financed elsewhere. A loan of Le 1,200,000, for example, was provided to the local brewery.

(c) The NDB has had severe difficulty in recoveringits loans. The recovery problem has affected the whole portfolio, though the agricultural portfolio has been a particular problem. Some of the larger financingshave gone to unsuccessfulenterprises, as mentioned above. Many reasons are given for the NDB's recovery problems. It is clear that the NDB's loan supervisionhas been inadequate and that some of the loans may have been misapplied. A separate "follow-up" department was not set up until 1978, and by then the diminished resources available for its operationmade it difficult for the NDB to do this task properly. There are six people--includingthree agriculturalofficers -- available for follow-up work, which is an insufficientnumber. The NDB has no engineers on its staff. Some people have argued that the NDB has been either unable or unwilling to use the legal recourse available to it to recover its loans.

(d) Among the larger loans, the NDB has had few successes. The Mabole Fruit Company was an agro-industrialenterprise, carried out under a Dutch management team, producing canned goods and preservatives. Problems with both production and marketing rapidly proved fatal to the enterprise. The InternationalFurniture Company, set up to exploit local timber resources,was a partnershipinvolving German capital. The Forest IndustriesCorporation was a local venture. Both the furniture and the forest enterprisesfailed, and although the NDB recovered the loans (from sale of assets and from the Government guarantee respectively),a large quantity of the NDB's resources failed to produce proceeds during many years because of them.

(e) The NDB's accumulatedlosses total Le 2.45 million. Before it was augmented by the acquisition of the Leone House property, the NDB's share capital was Le 2.5 million. Given these figures, it is fair to say that the NDB has lost virtuallyall its original share capital.

12. The financial tables, Tables C.2 and C.3, offer some insight into how this happened. Some people have argued that the NDB's rate of return from its investmentswas inadequate. The average rate of return on the investment portfolio was on the order of 13 or 14 percent a year. The interest charges on loans were on the order of 5 or 6 percent. It is true that the NDB's asset rates were generally below the going rate of inflation. On the other hand, they were some 8 percentage points above the borrowing rates. Thus, while the investment yields were probably not as high as they could have been, it does not seem appropriateto blame them for the NIDB'sproblems.

13. Examination of Table C.2 shows that up to 1981 the NDB always managed to make a slender profit on its operations. The substantial loss i n 1981 came about because investments (hence investmentincome) fell off, while interest - 77 - ANNEX C Page 8 and administrativecosts rose significantly. The NDB had losses after 1976 because it had to provide for its irrecoverableloans, and its operating profits were too small to cover these. The figures suggest first, that even if investmentsgenerated what might be called an adequate return, their volume has been barely adequate to cover the overhead.That is, the NDB's portfolio is too small relative to its administrativecosts. Second, the NDB's recovery problem has proved overwhelming. In sum, the low volume of business meant that the NDB could not generate profits to increase its capital, while the recovery problem consumed its existing capital.

14. Some believe that the NDB's problems stemmed fundamentallyfrom undercapitalization. Suppose that the capital of the NDB in 1979 had been double what it actually was, and that the additional capital of Le 2.08 million had been applied entirely to investments. If the rate of return on these investmentswas also 14.3 percent (Table C.2), income from investments durinig1980 would have provided an additional Le 612,900 to the NDB, which would more than have sufficed to cover the provision for irrecoverableloans for that year. Consequently,there is some merit in the argument that the capital base of the NDB is insufficient.

15. However, two further points should be considered. First, if the present staff has found it difficult to manage the existing portfolio,it should not be supposed that a doubled portfolio could have been managed without incurring additional overhead costs. Second, it is not certain that Sierra Leone, in its present economic circumstances,offers additionalviable investments that the NDB could take up. Of course, the NDB's capital would not have to be increased if it could borrow additional funds from which to make the new loans. The NDB's leverage,well below two, is relativelylow (if the share capital is not adjusted for accumulatedloss). A developmentbank, as a general guideline, ought to have leverage on the order of three so as to ensure an adequate business volume. Obviously, the NDB will find it difficult, if not impossible,to bring its leverage up if it cannot reduce its recovery problem.

16. During 1981 the capitalizationof the NDB was increasedby over Le 2 million through the acquisition of Leone House. It is obvious that this transactionsolves very little of the NDB's capitalizationproblem. The NDB needs liquid capital, that is, resources that it can convert to earning assets. Leone House cannot fairly be describedas such. It is regarded as unlikely that the building could be sold for its stated value and there is no way that the building could be mortgaged to raise cash. The principaloccu- pant, besides the NDB, is the Lebanese embassy. The building is partially vacant at present. It could produce a cash income for the NDB through rentals, but maintenance costs could prove a substantial burden.

17. We can summarize the NDB's present condition as follows. The institution has made an insignificantcontribution to Sierra Leone's capital formation. Its resource base was never sufficient. What resources it had were consuimedby irrecoverableloans, too many of which were unsuccessful,large- scale loans that were not consistentwith the original conception of the institution'spurpose. The poor rate of loan recovery made it impossible for the institutionto attract additional resources. As a result, it failed to - 78 - ANNEX C Page 9 build up a sustainingvolume of business. Its staff is poorly paid and in any case is insufficientto manage the existing portfolio. As a consequence,the portfoliohas deterioratedfurther. The NDB's problems of loan recovery, undercapitalization,inefficiency, and unprofitabilityshould not be seen as separate but rather as integral parts of a viciouls circle.

B. "What is to be done?"

18. Outside experts have made several studies of the NDB. The World Bank made an earlier report; an expert from the French Caisse Centrale wrote a brief report in January 1980; the EEC Lome Convention mission in Sierra Leone discussed the NDB in its recent report on Sierra Leone's economy; and the Bank of Sierra Leone has drawn up a brief report on the NDB. In February 1982 a high level TechnicalCommittee was formed in Sierra Leone, consistingof seven people from the Ministry of Finance, the Bank of Sierra Leone, and the NDB itself, and was charged with making recommendations. This committeehas produced a report which records essentiallythe same findings regarding the NDB's condition as were made in section A above. The findings of the earlier reports on the NDB also coincide with those here, although they were written earlier and therefore did not take account of the most recent developments.

19. That the many reports written about the NDB's problems come to broadly the same conclusion suggests that the NDB's problems are quite obvious. It seems difficult for directorsand managers of national financial programs (such as the RCS CooperativeScheme) in Sierra Leone to take necessary decisions rapidly and efficiently. As a consequence,financial institutionscontinue to sustain heavy losses until their capital is completely consumed and the only step left is liquidation. When a bad situation continues in a financial institution,there comes a point at which the true problem becomes the unwillingnessof the Board of Directors to take decisive action. The NDB has long passed that stage. The NDB's fundamentalproblem now is that its Board of Directors has been reluctant to act decisively.

20. The Board of Directors must immediatelyhire a firm of independent accountants to examine all of the NDB's books. The accountantsmust be asked to determine, as rapidly as possible, the true financial situationof the NDB; in particular,what its investmentsand fixed assets are truly worth. The NDB's capital must be adjusted accordingly. Once this has been done, the Board of Directors must convene to decide: whether the NDB should be wound up and liquidated before the capital is eroded any further, or whether it should be continued on the basis of a fresh injection of capital. To take the first decision will obviously be very difficult for the NDB Board of Directors, since a Board of Directors that allowed the NDB situation to deterioratethis far will find it very difficult to order liquidation. The appeal of this course of action is that a new institutioncould then be started, with a clean slate. The NDB's problems would be turned over to a receiver and his bill collector. - 79 - ANNEX C Page 10 21. If the NDB is not wound up, it will have to seek fresh capital. It will obviouslybe difficult to secure private capital. Even the Produce Marketing Board would probably be reluctant to contributeunless it is given a far stronger voice in the NDB's affairs. As a result, it is safe to conclude that the only possible sources of increased capital are the Governmentand the Bank of Sierra Leone.

22. If a new institutionis established,some private capital might be attracted, although the new institutionwould have to be manifestly different from the present one.

23. There are clearly argumentsfor and against both courses. The important thing, however, is that a decision one way or the other must be taken rapidly. Once the NDB has been either reconstitutedor replaced, the institutionmust then form a core portfolio, that is, a set of investments that will provide it with a reliable flow of income sufficient to cover overhead expenses. We cannot say here preciselywhich assets should make up this core portfolio. We can, however, outline some of the principles that should guide its size and composition.

24. The size of the core portfolio is simply whatever quantity of assets is required to generate an income flow equal to the institution'srequired basic overhead expenses. Thus, if the required basic overhead expenses come to (say) Le 700,000 per year, and the average rate of return on loans is (say) 15 percent, then the core portfoliomust have an approximatevalue of Le 700,000/0.15,or Le 4.67 million. This implies, of course, that before the size of the core portfolio can be determined the overhead budget must be established. This, in turn, dictates that the staff requirementsbe determined; they must at a minimum be sufficient to manage the core portfolio. Thus the staff structure, the overhead costs, and the core portfolio must be planned to be mutually consistent.

25. What kinds of assets should go into this core portfolio? The principal purpose of the core portfolio is to provide a reliable income flow to the NDB. Therefore, even though a developmentbank generally ought to acquire risky, even somewhat speculativeassets in the course of promoting the nation's development,the assets that make up the institution'score portfolio must meet far more conservativecriteria. From the present point of view, the purpose of the core portfolio is to sustain the institution.

26. A good rule of thumb for evaluatingassets for the core portfolio is that they must be the sort of assets that a conservativecommercial bank would find acceptable. They must be well secured. Since they must yield an income flow for the institution,they cannot have a lengthy gestationperiod.

27. In the selection of its core portfolio, the NDB should work in close coordinationwith the Ministries of Agricultureand of Trade and Industry, particularlywith the small-enterprisegroup. Nevertheless,the NDB must exercise firm and careful judgementin selecting projects to finance. - 80 - ANNEX C Page 1

28. Although the NDB has generallynot done commercial banking business, some exceptionsto this rule might be worth considering. In particular,the NDB could take time deposits from its clients, and the NDB might do a limited amount of letter-of-creditbusiness for them. This would enable the NDB to earn the fullest possible returns from its own resources. In the section followingwe argue that the NDB might reasonablydo a limited working capital business.

C. Some particular issues for the NDB

(a) Agriculturalfinance

29. Should the NDB provide financing for agriculturalenterprises? If so, should the NDB provide financing for subsistenceagriculture? Some influentialpeople in Sierra Leone strongly believe that the NDB should provide financing to the entire range of agriculturalenterprises, from small to large scale.

30. The question must be discussed in terms of two frames of reference. First, the NDB is itself bankrupt; therefore its first priority must be to save itself. The question must then be, if the NDB goes into agricultural financing, will it help or hurt its own chances to survive? Second, suppose that the NDB ultimately survives and prospers. Would it then be sensible for it to engage in agriculturalfinancing?

31. In its present circumstances,the NDB can take on agriculturalfinancing only with extreme care, and then only the simplest kind of financing of existing commercial crop (coffee and cocoa) plantations. In forming its core portfolio, as we have noted, the NDB must acquire only secure assets, with at most a brief gestation period. Certain kinds of plantation enterprisemight satisfy these requirements. There can be no question of providing loans with a long grace period to set up plantations, particularly :if there is apprecia- ble risk associatedwith the technical aspects of the project. It may be possible, however, for the NDB to provide loans to established,well-managed plantations.

32. Unfortunately,in its current circumstancesthere can be no question of providing loans to subsistencefarmers. The record of loan recovery in subsistenceagriculture in Sierra Leone is simply too dismal to permit risking yet more capital. Moreover, it is clear that lending to small farmers requires intensive supervision. The NDB is incapable of providing this. Therefore, even if ideally it might be good for the NDB to provide credit to subsistencefarmers, the NDB is at present simply incapable of providing such credit.

(b) Provision of working capital

33. The NDB's Articles of Associationspecifically rule out its engaging in any commercial banking business. In addition to preventing the NDB from doing such business as checking accounts, discountingof bills, and so on, the Articles also prohibit it from providing loans for working capital. This has caused various problems. In the first place, the NDB has made a large number - 81 - ANNEX C Page 12 of loans that were plainly for working capital purposes, sometimesexplicitly so. Second, the NDB has sometimes approved term loans that required complementary working capital financing. The NDB worked with the commercial banks, particularlyBarclays, in these instances. The trouble was that the commercial banks tended to insist on reviewing the entire project before providing the working capital credit. Not only was this time consuming;in some cases the credit was denied because the NDB had taken all eligible security for its loan and there was none left for the commercialbank. It was reported, for example, that the NDB financed acquisitionof tractors,but the tractors could not be operated because there was no credit with which to purchase gasoline.

34. The principle that the NDB should leave working capital and trade credit to commercialbanks is a sound one, because the NDB's capital should be used to the extent possible for the basic capitalizationof developmentven- tures. But the principle should not be applied too strictly. A useful distinction may be drawn between permanent and revolvingworking capital. The basis of this distinction is the fact that commercial banks rarely provide all a given enterprise'sworking capital needs. At least some part of these needs is expected to come from the enterprise'sown equity base. This is what we call permanentworking capital; the part that is supposed to come from the commercialbank is what we call revolvingcapital. The practical policy appropriate for the NDB is to provide a working capital fund as part of the enterprise'sequity capitalization.

35. What is to be done in those instancesin which the NDB approves a loan, but complementaryworking capital credit is not forthcoming? This is a delicate problem. In no sense should commercialbanks ever be pressured into providing credit against their better judgement. Two suggestionsare offered here that might alleviate the problem, even if they do not quite solve it. First when the NDB considers a proposal that requires a substantialworking- capital input, it might, with the consent of the persons who submitted the proposal, seek the views of one of the commercialbanks before the stage at which the loan is approved. Second, a "working-capitalconsortium" might be formec.with the participationof all the commercialbanks of Sierra Leone. The consortiumwould meet, say every one or two months, to examine loans approved by the NDB. This consortium could then see that the NDB's approved loans have their working capital needs provided, to the extent possible.

36. Developmentbanks might sensibly be organized in a great number of ways. It is important that the chain of command and the areas of responsibility be as firmly and precisely delineated as possible. As long as this principle is observed, the best organizationis a matter of local practice and of the precise objectives of the developmentbank. Here we offer several brief and somewhat miscellaneoussuggestions. - 82 - ANNEX C Page 13 (1) During its reorganizationphase the NDB staff will inevitablygo through considerableuncertainty. It is obviously importantto let the staff know as early as possible what the NDB plans to do and what is likely to happen to each person.

(2) The NDB must ensure that it has appropriatestaff for whatever projects it finances. For example, if it finances the acquisition and installationof machinery, it must have a staff of engineers. For some projects, of course, appraisa:Lwill require an outside consultant. Even so, there must be NDB staff people capable of understandingand evaluating the consultant'swork from an appropriatetechnical perspective.

(3) The NDB must train its staff. Loan appraisers might serve a period of apprenticeshipwith experiencedloan appraisers (with the commercialbanks, if possible). Follor-up specialistsmight serve a period of apprenticeshipwith men already in the field. The NDB might also ease its staff's work by providing proceduresmanuals.

(4) Credit operationsof the NDB in various sectors (such as commercial agriculture,industry, and small business) are often so differentin character that the appraisal, supervision,and follow-up staffs should be divided up by sector. Each of these divisions should have a division head who would report directly to the chief executive of the institution.