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Madagascar Financial Policies forDiversified Growth

The World Banm Washinglon, D.C Copyright © 1993 The IniternationalBankk for Reconstruction and Development/THEwoRLD 1818H Street, N.W. Washington, D.C.20433, U.S.A.

All rights reserved Manufactured in the of America First printing July 1993

World Bank Country Studie are among the many reports originallyprepared for internal use as part of the continuing analysis by the Bankof the economicand related conditionsof its developing member countries and of its dialogueswith the governments. Someof the reports are published in this series with the least possibledelay for the use of governmentsand the academic,business and financial, and development communities.The typescriptof this paper thereforehas not been prepared in ac-cordanicewith the procedures appropriate to fornal printed texts, and the World Bankaccepts no responsib3ilityfor errors. The World Bank does not guarantee the accuracyof the data included in this publicatio and acceptsno responsibilitywhatsoever for any conLsequenceof thei use. Any maps that accompany the text have been prepared soley for:the convenienceof readers; the designationisand presentation of materialin them do not imnplythe expressionof any opinion whatsoeve on the part of the World Bank,its affiliates, or its Boardor member countries concerningthe legal status of any country, territory, city, or-area or of the authoritiesthereof or concerningthe delimitation of its boundaries or its national affiliation.. The materia in this pDublicationis copyrighted.Requests for permisson to reproduce portions of it should be sent to the Officeof the Publisherat the address shown in the copyright notice above. The World Ban-kencourages dissemination of its work and wfl normaily give permission promptly and, whenithe reproduction is for ncomrilpurposes, without asking a fee. Permissionto copy portions for classroomuse is granted through the CopyrightClearance Center, 27 iCongressStreet, Salemi, Massachusetts 01970, U.S.A The complete backlist of publicationsfr-om t.he World Banikis shown in the annual Indexof Publication,which contains an alphabeticaltitle list (with full ordering infomation) and indexes of suibjects,authors, and coumntresand regmmIosThelatest edition is availablefiree of charge fr-om the DistributionUrnit, Office of the Publisher,The World Bank, 1818H Street, N W, Wasbington, D.C 20433,U SA., or from Publications,The World Bank,66, avenue d'Ina, 75116Paris, France.

ISSN:0253-212

Library of Congress Cataloging-in-PublicationData

Madagascar : financialpolicies for diversifiedgrowth / [issued by] the World Bank. p. cm. - (WorldBank country study, ISSN0253-2123) ISBN0-8213-2473-X -1. --Madagascar. 2. MonetarypoUlicy-M.adagascar. L Internatonal Bank for Reconstructton. IL Series. H0187.5.&M28 1993 336.691--dc2O 93-8403 OIP liil

This stdy is the product of clos ll betorn the World Bank and the Govrent of Madrsca to fonrmu a stat for Uiedvdopmmt ofthe countr's finacial sector. The anais in hs sdy is based on two misio to Madasc led by Govan Nair (tas manage) and comprsing: L Karngl ad P. Pbpid (AFTEP), Band Bdkmhol LO), and Bernard Count (consutm) in Jaumy/Pebruy 1991; a wel a A. Op de Beme(M). P. Berglundand L. Lindro (consultas) in May 1991. e coupietd studyw dicussed with th Governm ein anry 1992. The support of . Govamine of MadaCar is grtifullY ackwledged. Te Buk misin exrs their tak speciay to the any staff mmbers of 4h Centra Bnk of Madagasa ad the Trasuy wbo colaoated in ths study.

Notwisanding te collaboratie nature of this study, db uions are utimately the responsbilityof te Bak team In aIion to Govdn Nir, pdui4l atowr of the study,and the membersof boh missions.the owing indivia is Bankpved subtntial advice, comments ad iqput:Mdual Sa, Philipp Ls Houero Geard Capio, ad Legardo BariaraL The concusion ae also eresu of cose lab of the DIF. Ms. Judite Femandes pwvided secar and p

The sudy hs not bem updd sine is compleio in October 1991. Hower, in recogntion of the useuns of the stuyo aoingthinkWin on fiona l secr refims in Madagcar, the Governmt bas requese itspuiatdi in its presS fowmwih a view to its wider disemination. nr

CURClW BOALE

Cmu.y Unit - Malag fy.fc (PF1G)

US$*1 1800 UG (ad 1991)

Mabic Itratiml Sbtad Syata

I (me) 3.3 fet 1 ect, (ha) = 2.47 acres 1 klobmer (k) 0.62 male I qkliomen = 0.39 sqmile (uqmi) I kilopm (kg) 2.2poud (lb) lilor (1) = 0.26 US pl (gl) I eic t (mtn) = 2, 204 lb

UrOFBRKflAU

AON Appal d'Offns Ndgptives AOP Appal d'Offra Positive. APB Asaciaion Pmfouomell des B BA = Bank Accptnces BCEAGO BUique Catrle ds flas do rAfuique de ICO*mut BCRM Baque Cahule de Madagsa B Z Baty UP=ado y Vart DMO1 = Baquis Malgachede 1'Oc&nidim EMM Bmkmgn'yhndosria BTA Ban du Tro par Adjudication BTC Ban du Trsor C _ BTM B"yTnn pakt CCBEF = do ContrOl.des BEques at dtabhlihments Fina CCP - Cobt des aidquesPostaux CD = Cificates of depost CEM = Caise d'Epa de Madagascar MNAPS = Caie Natinale do Pdvoyanco Social. CM = Carer, Price KIne ECGS Export Guate Scheme EPZ Expot Procsig Zoe FLARO F Pmoici ARO IFG F-m Ma%w

NGO N<&gvzm qnmi rAPTA rential Tnin A_mmt m S Pos and Timseve SA Sod&Aaci p SARL SodakRqsbfiLmM SELI - Sys& d%qmb&m U169W SME S ad M

Janay 1 to December31 V

GLOSSARYOP FINANCIALTERM

Aeynge Cost or Funds: A weightedaverage of the interestcost of a bank's depositsand own fumds, based on the composidonof its depositsat a point in time.

IWtalMarket The marketin whichlong-term financial instuments, suchas equitiesand bonds, are issued and traded.

Clearin In the contextof the paymentssystem, refers to the transfer and recording of payment instructionsmade by a payor to a financialinstitution. can be done on a gross basis i.e. transactionby transactionor, if channelled.trough a specializedcleaing organizationsuch as a clearinghouse,on a net basis wheretotal receipts of one institutionare offsetagainst payments to be made by that instiutin.

Cmnmffm Falls: Mort-termdebt insames that are used mainlyto financetrade. Examplesare promissorynotes, by whichdebtors commit themse[ves to pay to creditorsor to their order a statedsum * a specifieddate, and bills of exchange,which are drawn up by creditorsand acceptedby debtors. Commercialbills that are also accpted by are knownas bank accepances. Promissorynotes issuedby large corporationsto meet their generalfinancial needs are knownas commercialpaper.

Conlractual &Jo titom Occupationalpension funds, natona providentfunds, life insurance plans, and similarinsttutions that collectfiancial savingson the basis of long-termfinancial contracts.

DRirectimuments n connectionwith monetary policy, refrs to actionsaffecting monetary conditions which direcelyforce bans into portfoliopositions they wouldnot voluntarilyaccept such as aggregate and indiidal bankcredit ceilings, rate cotrols and directedcredit policies.

Dhmunt: A reductionfrom the face valueof a financialcontract.

Disintermediado: Usualy it refers to the removalof funds from interest-bearingtime acounts in savings institutionsand commercialbanks for the purposeof reinvestingthe funds at higher rates in market instume. In other cases, ordinarysight and saving deposits are removedto increasethe demandfor durable (e.g., land, gold) or consumptiongoods, or to be lent direcdy by surplus agents (nouseholds)to enteises, bypassingfmancial intermediaries.

Equits Finanoe: Theprovision of financein a formthat entitlesits ownerto sharein the profits and net worthof the erise.

EMdLinlh DTheextent to whichsavings an economyis channelledthrough the financialsystem. Usuallymeasured as the ratio of broadmoney (MU) to GDP.

Da resstr:Usually refers to the sharpdeterioration of a groupof fiacl indicatorsresuling in changesin the behaviorof the agentbefore its restrucuring or bankruptcy.; When such distress reaches crisisproportions and is widespread,it usuallyleads to a rush out of real or financialassets into csh.

FVinancalinhtatm lhe frameworkof laws, regulationsand wounting pracdtes goveming financi transactionsand the logics and practicesof the paymentssystem. vi

Pinnuddatw The suc of em in economywhich facilitates the conductand growth of real economictransaction though the ou of mony for paymet, saving and investmet his structure of n Ieiclude money and egulatoy policies, inrastructure, institutions, instuments and marketswhich arwela to enabe dte tranifer of finacial resourceswith minimal possibledsk and cost from payes to recipi of fds and fom sves to borrowers.

E4ninal E:w. The inins, inments nd marketsin the fimcia sector. The portionof totl walithheld in theform of financialsse.

Fisal eidt: Definedon a cash basi as the diffierewebetween total Govenmentcash oulays, indudig interest outlaysbut excludingamortzion paymat on the outing stock of public debt, andtota casihrecpts, inluding san nonta revenuend gas but excudingbornowg proceeds. Girobat An institutionfor handlng ffinanialpayments ad asfers. It receivespayments from individualpayers which eaverl paymentobligation (eg. utility and taxbms) or frm a fim or public entity makng payroll transfers. The girobak the- aI these payments by individualpayes who receivea lump s-u settlementfrom the girobankfor obligafionsdue from a group of a group of cients (eg. the utility,company).

Hg*ftng: Te acuision of a finacia contract designed to pro the purchser or the seler agaist a future change in the price of a commodiy or secuity in which te purchaer or the seller has am interest.

J[ndexdon: A mechanismfr periodicaly adjusting tie nominal value of conacu in line with moements in a specified price index.

IndireLatlrstnmens:In connectio with monetarypolicy, refrs to policy actionsaffectng monetary conditons such asinterest rates ad -nlceelsthroug us of marketforces and financfilmarkets. Luidd liabifltes: Moneyplus hi_bly liquid moneys ust, mca a saving deposits.

LI;iditMnm n In coection with mnetar policy, refers to actions taken by a centr bank to ensure that the banking system can flexibly prvide in the short-rnm fr the cash and payment needs of society.

Monebr=poli: Refesmto acto take by central bas to Set monetaryand other financia condidonsin puut of the brader objectivesof susaina grwth of red output,high employmentand price stability. D u d fom fiscal poliy whih affects these brader objectives through Govemment expndiur and (s. dfree hInms ad ndit).

MK2: Currency and other liquid asst. Narow definitin such a MI refer to money used as a medium of ehage. Broader definiton such u DO or M3 add tD MI money used as a store of value.

MoniM marker: Markets i which flaciaU with a tem oaone year or less are issued amd h-aded. These insmmmm usually inchude eterpris bl commercial pae, bakers, Treasuy bils, ad negale cate, of depost.

A on which contual oblan (for example, Interest or amrtization payet) are ot beiq . - vii

Qn market tm dos: A tool of monetarypolicy trough whicha cetal bankcan affectresrve money throughpurchas or sale of sewrities.

PllgNts system: The systm of logsdcs and practicesinvofved in settlingeconomic obligations and transferringresourc tigh financialpayments. Cleaing and setement are the two majorsteps in the paymentsprocess. The inutiona elementsof this process include,for example,the systemof checks, cl e ,girbm and automaticdeposit and paymentorders executedby fimancialinstiion includingthe postal system. (see cleaing grbank, and setanit)

wrodendalRcgWadm: Refersto the set of laws, rles and regulatons which are designedto miniize the risks banks assumead to ense the safety and soundnessof both individualinstitutions and the system as a whole. Examplesinclude lending limits, mmum capital adequacyguidelines, liquidity ratios,-etc.

Ou :si-riscalActivides: Refes to activites undertakenby the that are outsidethe strict ambit of monetarypolicy and which are nomally undertakenby the Government these activties c affectthe profit and lass accout of the cetal bank or initiallyshow up only as a changein compostn of centralbank assets.

Ouasi-fiscalDeridt: Refes to the losses of the cencralbank that arise from activitiesnot specifically relatedto monetarypolicy and hat wouldbe normaly undetk by the Government(see fiscal defcit, quasi-fiscalactities, menry polcy).

Reserve Mg= Curny i circulationnplus deposits (of bank and other residents but not the Govermen) with the monetay authorities.

urites:Fmancial insrumen whichcan be readilytansferred throughsale from one ownerto anotr either directly or trmgh the intrmediary of specializedistitutions and markes.sThe term generally refers to ihares amdbonds speficay.

Sewwiffzdtion:The process of confering the uradeabledcaacri cs of secrities to a financial instrument.

Seii = MwThenet revenue deved frommoney issue.

&ttlemIent:In the contt of the payments system, refers to the actual waDsferof value based on paymentsinstruction trogh the use of acwunt balances at a financialinstitution which can be bat balancesor on the bools of the centralbank.

Tenn ilnance: Equit or medium-ad ong-termdebt f inn

WritQfs: The act of removingan et fom the books of a companyor bank, acknowledg and chargingthe loss againstloan-los provisionsor capial. ix

CQNThNTh

CHAPrTER1: FINANCEI CHANGINGNALAAGASO 1wWI

Objectivesand Organizationof the Report 1 EconomicGrowth and RecentPolicy Developments 2 ExtemalSector Developments, 197G-1990 5 Future Challengesin ResourceMobilization and Allocation 10 Overviewof the MalagasyFinacial Sector 16

CLAPTER 2: SJREtLGTHENINGMONEI ARY MANAGEMENr OF THE CENTRAL BANK 25

GovernmentFinance: Fiscal Deficit and Quasi-FiscaOperations 25 MonetaryDevelopments and Sourcesof 32 RecentTrends in MonetaryManagement 39 The Future Role of BCRM 45

CHAPER 3: SYSTEMDEVELOPMENT 49 Legal Frameworkfor FinancialTransactions 49 Accounting,Auditing, and FinancialDisclosure 57 The DomesticPayments System 60 The Exteral PaymentsSystem 65

CHAPTER4: PROMOTING THE EFFC IENCY OF BANKINGINS'TUTIOI'S 67

BanidngDevelopments Since 1975 67 Main OperatingFeatures of the Baning SystemSince 1987 73 Overall BankingPerformance Since 1989 77 Future Challengesof the BankingSystem SD Regulationand PrudentialSupervision in the New EconomicEnvironment 82

CHAFR 5: ISSUES IN TEM 1NANCE: CCtN1CTUAL SAVINGS ANDIOUSINflNAG KE 37 The MalagasyInsurance Market 92 The MalagasySocial Security System 97 Future of Contactual Savingsin Madagascar 102 Problemsof HousingFinance 103 K

CHAPTER 6: FR E3CONOI

Nature of Small-Scale Finance 105 Key Areas of Government Policy 108 Revitalizingthe 113 The Role of Venture Capital 117

CHAPTER7: FlNhNCIAL lNNO&A OR I ON, ENMEMMIPSOMOTTON, AND}EmiNANCu NAIta 119

Developing International and Domestic Trade Finance 119 Enhancing Regional Trade and Cross-BorderTrade in Fncial Services 124 Accelerating Domestic InvestmentThrough Leasing 127 Promoting Development 128

CHIAFTER8: TOWARDS A F-INANCIALSECTOR 135

Strengths and Wealmessesof the Malagasy Financial Sector 135 The Agenda for Financial Sector Development 136 Sequencig Policies for Financial Sector Development 139 ComplementaryPolicies for Financal Sector Development 148

Anno

1.1 Survey of Financial Needs of Malagasy Enteprbes 151 2.1 Direct versus Indirect Monetary Controls 159 2.2 Aspects of Central Bank Independence 163 3.1 Overview of the Domestic Payments System in Madagascar 166 3.2 Costs of Existing Delays in Payments and Transfer System 172 3.3 A DecentralizedRegional Cleaing System 174 3.4 Towards an Inproved System of Checks in Madagascar 177 3.5 Concept and Functions of a GirobankSystem and Applicabilityto Madagascar 181 3.6 Overview of the External Payment System in Madagascar 185 4.1 The Cost of Intermediation I88 5.1 Contactual Savings in a Worldwide Perspective: Applications to Madagascar 189 6.1 Postal Savings Banks in Africa: Lessons for Madagascar 195 7.1 The Foreign Exchange Retention Scheme in Mauitius 197 7.2 Capital Market Development in Mauritius: Lessons and Pifls 199 xi

1.1 Summaryhiternal Accun, 1931-1990 7 1.2 FinancialDepth ad Finacal Price Indicators,1985-1988 Average 18 1.3 Prposed Fiancid SectorStrategy 23 2.1 Cer GovernmentBudget Deficit and Financing,1981-1990 27 2.2 Sourcesof Exmsion of the MonetaryBase, 1935-1990 33 2.3 QuasiFiscal Deficit and its Financig, 1984-1983 36 2.4 Seipng and Infltion Tlax,1981-1990 38 4.1 Deterio ion the Qualityof CommercialBank LoA Portfolios,1984-1986 69 4.2 Revaluationsof Fixed Assetsof CommerciaBan 69 4.3 Cleaning-upof the CommecialBak Loan Portfolios 70 4.4 Effectsof the Cleaning-upof the Loan Portfolios 71 4.5 BranchNewrk, Staff and MarketShares of Mal Banksin 1990 72 4.6 GovemmentNet CreditorPosition with Banks, 1987-1990 73 4.7 CommercialBank: Ratioof to Deposits,1987-1990 74 4.3 Commeiral Banks:Relative Increase in Term Loansand runeDeposits, 1987-1990 75 4.9 CommercialBank: Sectoa Breakdownof GrossLoans, 1987-1990 75 4.10 CommerciaBanks: Agregate Profit and Loss Account, 1988-1989 78 4.11 Elementsof the Costsof Inte n 79 4.12 Ratioof dte Mals BankingSystem 84 5.1 Compnare Shareof TermD ost in TotalBk DeWsis 1987-1t9T 89 5.2 Life Iwur e emiumsin Develping Countries,193" 93 5.3 Life Inance Fundsin IndustrialCountries, i96-1988 94 5.4 Malagasy nsuanc Sector Findia Result, 1987-1989 96 5.5 Malaa Inuance Copany Investmen, 1987-1989 98 5.6 SocialPension huance SystemsContrbuon Rates 100 5.7 CNAPS:Evoludtonf Resrves, 1985-1988 101 5.8 Assetsof Life Insurancecompanies and PensionFunds, 1987 103 8.1 Near-termFinancial Policy Measures 141 8.2 Medium-and Long-temFinancial Policy Measures 44

1.1 Madagascar.Inflation Rate 1980-1990 4 1.2 Madagasa Merandise Termsof Trade and Price Indicesof Traditional Exports, 1985-1990 8 13 Extal Debt by Typeof Crditors, 1988-1989 9 1A. CompaativeGross Domestic nvstment Rate, 1984-1989 12 1.5 Compara GrmssDomestic Saving Rates, 1984-1990 13 1.6 MadagascarThe Resorce Gap, 19841989 16 1.7 Entreprners' Ranig of the Mai Co ins t Growth 20 2.1 Fial Expmire, Reveue and Deficit, 19841990 26 2.2 BCRMAdvances to Tresury and StatutoryLimi 28 2.3 Evolutionof BCRMBalance Sheet 29 2.4 BCRMAnnul Oprting Loses, 1980-1990 31 2.5 MadagascarMajor Sources of Changesin Monetay Base, 1988-1990 34 2.6 Evolutio of GovenmentCounrpr Fund Depositswith te CentralBank 36 xii

3.1 Flows of Goods, Senices, and Moneyin the DomesticPayments System 61 4.1 Effectsof PortfblioClean-up, 1986-1989 71 4.2 Sectora Breakdownof GrossLoans, 1987-1990 76 4.3 Elementsof the Coat of Intermediation,1988-1989 80 5.1 Share of Term DepositsIn TotalBank Deposits, 1987-1989 88 5.2 ComparativeShare of Term Depositsin Total BankDeposits, 1987-1989 88 5.3 ComparadveShare of Tam Lendingin Total Bank Lending,1987-1989 90 5.4 RelativeShares of CommercialBanks and Contractual Savig Ihstiutions In Total FinancialResources 91 5.5 ContractualSavings Contibution to CommercialBank Term Deposits Breakdownof nsurancePrmiums, 1987-1989 92 5.6 Breakdownof surancePremiums, 1987-1989 96 5.7 Investmentof Lnsurancebdustry Resources, 1987-1989 98 1

Ityesand O _ ofothe Rand

1.1 ObiectIvesof dIhe Report: This Ro has dtre objective:OQ to ideniufy s gths and weaknessesof Mad s finanl system; () to formua policy optios which could enable the financil system to better serve the cory's objocties of stiable ad divenified growth; and (iii) to recommend an appropriately sequeced srategy for financal ytm developmen d coud be hnplemated within dte 1990s. As in most low-ihcome COuntrie, Mdadagascas financial system i narrow andi low, compriing a small rag of s iomnsnd inuments for mobilizmg financial svig and cannlig credit. Fincal d ening and broaing can fcilitao the ecozcic otrsikionfrom e adjustment nd stabIln policie of the 1980sto a periodof sdf-sustainedgowth. Thiswould entail macing existin financialinstitution, instumentsand marketsmore efficiaet d developingnew - as neededto progressivelyrespond to die grwing needsof a incrasingy maket-oriented ecnom. What corstin an appropriat fiancial system for Madagscr and hot tdevclop such a systemis th subjectof analysisof thisReport 1.2 Imgd of nance to theonml TIastinA1 :NM apprpiatefinancial sytemis eential to Madagascarfor severa reasons. Fst, anefficient financial system can play a majorrle in expansionof domesticnd foreigntrade, stiulation of domsdc savingsad qFfnpmwpchanling of availableresources to productiveuses - fumctionsessential to the Increainly markt-oriented Malagasy economy. Secod, a ystemof Waropriae finac Istitions, insuments andmarmets enables eonomic age t pool,pric andtrade the rios asociatd with varios economicactivities which individua entreprInmarSma not wish to bta entiy - a keyise whichwil emere withincreasing economic divei io Thd, a well- developedfinancial system with adequate depth and rage of fiancial instrmentscan over time help address the concer of Malagasypoicy make to more effetvely conduct policyand adjust to interal andexna hcks. 1.3 QverallQMranjizafon[oftbheR: Thisfirst atofe Reportitoduce th financialsecor in Madscar in thecontext of rect devlpment bothin thedomestc and extenal ssectoof the economy.h thenfiousses on te y economicchaenge of resour mobiizaion and allocatmin whichthe financialsector is assum an inceaingly impartat aleAfter rmewing ther- snn ad salie dtni fath systemin Madagascar,the first chapterconcludes with an outlineof howthe remainderof dais Repo idenfi imprvementsin re ch mobilizaonand aocaton tough the financ&i stem. To developthe analytcal undepin of a fancial sectorsrtegy in Madagscar de finci sector is viewedin this Reportas cmprsing dares se of elementswhih are sucsvey aalyzed in Capers 2 through7. These ar st of elme of th ficial secor arethefrmeworkof O uiclkad (ii) w swos 6 Chapter2 and3 of theReport respectvely eamine theframework of maz- fn scpolicies and the relqat, lega, accountingand paymen mechanismswhich prVidle the badc infastructurefor financialtransactions. Subsequenty, Chapt 4 trouh 7 em 'tha co elments of t financial syste institutions,b istrme and markes. Tbes chap cov rcent devdopments and fiuure chaeges of the banking (Chapter 4); iss in

. . _~ 2 term fimnce, particularlyin regards to conmrac sav instipttionsand housing finae (ChapterS); the specialissues pertaining to small-scaledepositors and entepreneurs (Chapter6); and the scope of new instruments,institutions and markets to meet specializedtrade and investmentneeds (Chapter 7). The concludingchapter of this Reportoutlines a financialsector developmentstrategy based on the analysisof the precedingchaters.

Economic ;GrowthAnd Rect PolicyDeveloiments

1.4 atteres in Gr h: Madagascarspost-independence economic record is mixed and can be roughlycharacerized by four periods:modest growth from indeendence in 1960tD 1970;stagnation from 1970to 1980;shap deteriorationbetween 1980 and 1982- dming which period real GDP contracted by 10.0 percent; and almost a decade of stabilization and adjustment beginningin 1981 and with signs of real per capitagrowth emergingtowards the end of the 1980sfor the first time in decades.

1.5 - Policy Shifts in the 1970: Duringthe 1970s,the county followedan inward- lookingdevelopment strategy which resulted in declininggrwth and imately in large cument accountand fiscalimbalances. This strategy emphasized a predominm role for the publicsector, with industrialiationas the centralobjective and agrculdtre in a supportingrole. Neveriheless, until 1978,the authoritiesalso pursuedcautious financial policies that keptthe fisca deficitlow, held the balmceof paymentsdose to equilibriumand resultedin a debt serviceratio of only4.0 percent Between1978 and 1980however, the Malagasyauthorities embarked on a policy of massivepublic investment. It was poorly coordinated,concentrated on economicallyinmiable projects, and financedmainly with external borrowingon commera tam. This policy, combinedwith decliningtems of trade and stgnant domesticrevenu increasedconsiderably the fiscaldeficit, fueledinflaion and resultedin a large externaldebt burdenthat subsequently consotainedeconomic growth.

1.6 Stabifltion in the Earl 1980: Beginnig in 1981 and until 1986, the Governmentembarked on a policy of financialstabilization centered on demand adjustment. During this period, the fiscal deficit was reduced substntaly mainly by curtaing public expenditres, notablyin investment.Largely as a result,the annualexpnsion of domesticcredit fail sharply and anmualinflation dropped from about 30% in 198142 to about 13% in 1983-86. On the externalside, the currentaccount deficit was reduced in half, withthe brunt of adjustment failing on imports.

1.7 Structural Adjustent In the 1980: While finacial stabilizationmeasures helpedalleviate immediate macroeconomic imbalances, a numberof struual rigiditiesand p ditortions remainedembedded in Madagacrs economy.From 1985, as stabilizationmeasues implementedin the fist part of the decade were showing steadyig results, the audxtoites tuned their atetion to adjustmenteffrts on the supply side. These efforts comprsed some early adjustment measrs followed by the first large-scalem c structural adjustment proA launchedin 1987. This first stage of adju s focussedon quantitativeand price coatols. Under this program, a large devaluationof the Ma fianc brought the red effectiveexchange rate to less than half its 1978level, protectiveimport quotaswere relaced by tariffs and a non-discretionaryopen generallicenws systemof foreignexchange albocatn for merchandiseimports was established.These refims wereextended to administatve export 3 restrictionsand state agriculturalexport monopolies which were eliminated and to remaing price controls which were lifed. In the next phase of adjustment,from 1988 onwards, reformswere broadenedto public sector managementwhere sgthening of the public investmentand budgetaryformulation was initiatedalong with reforms of the public enteprise sector. At the same dme, financialsector reforms were undertakenentailing the clean-upof loan portfoliosof stt-owned banksand the entry of privatecapital into the bankingsystem for the first time since nationalizationof bank in the 1970s.At this stage, somesystematic attention also beganto be given to the socialaspects of the adjustmentprocess.

1.8 Evolutionof Prices In tbe 198X0: Until 1982, Madagascarmaintained a comprehensivesystem of price controls at both producer and consumer levels. Under the stabilization,and later the adjustmentprogms virtly all domestic price controls were eliminatedbegining with agricuilua producerprices in 1983 and endingwith prices of goodsin 1989. Recentanalyses condude that the impactof price dereguationupon the evolution of the price level was positiveand contrbuted to the decreasingof the inflationrate. Duringthe 1980s' inflationshowed a camel-back p n with two major bumps in 1982 and 1987-88 (see Fig. 1.1). As measuredby the yearly averageof the combinedCPI, the rate of inflation incrsed from 18 percentin 1980to peak at 31.0 percentin 1982 and declinesharply to a low 9.0 percent in 1985. I rose againin 1986-1988,reaching a secondpeak of 26.3 percentand droppedthereafter. For 1990,inflation was estimatedto be nearly 12 percent. 1.9 Effects of Money Sup and E chameRateo-nflaton Regressionanalysis ows dt throughoutthe 1980s', prices in Madagascarwere very sensitive to vaiations in mney supply and the eichange rate [/. The consumerpnce index laed by one-qer showedan elasticityof almostunity to moneysupply. In contrastto this generalpattern whereby moneyspply led inflation,during te 1987-1988period of high inflationtriggered by the large devauation of the FMG, moneysupply lagged behindprices.

1.10 lgajonjandjDisintermedinjatj:Maceconomic instability and high inflation led to disintediation in the first part of the 1980.. From 21.9 percent in terms of the GDP in 1980, MI droppedto 15.4 percent in 1985 and M2 from 24.6 percentto 18.8 percent. The stabiization and adjusm programs initated in the first half of the decade steadied the macroeconomicenvironment and brought inflatfondown with the rest disintet mediationwas arrsted and the financialsystem began to deepenag. In terms of the GDP in 1990,Ml was abbut 19.0 percnt and N2, 22.7 percent The experienceof the first part of the 1980sappears to have significantlyaffected the "depthWof the financialsystem in Madagascarcompared to other owuntries(pa 1.38)

11 Rgrssing quarterlyCPI data on quarterlybroad money (M;2)data, an X coefcient of 0.9 nd R-squaredof 0.95 are obuined with 40 observations. 4

Figure1.1: Madagascar InflationRate 1980-1990

Cho

0-

0- I I S U

GIDPOsator - CPI

Now,:Mmo CMI sb based on a 1972 basketfor Uadionalhoushols ad e ores. orelative weights of theco CPIa 75.0percent for aditona bousds nd 25.0 perceat fo moden households. Ih CP coven pric in

1.11 iaga Icar: The of M 's ajustmet prorm in th 1980 reflectsa fi-damentalchoice by th Goverat to reorit th ecoimy tward makt signo rte ta mandatedaocaton of reewes. of diepbic sor rolein own ip andproductiv actvit ha ban way ky prc iacluhlg mp ad ieret rat hv beensis y or omplddy iiend; and go hIta and extd s of the eady 19s have been significay redresedTis chokceledoto a able bwvement in o ic pe c aoh st S faling short of generatinga broad based and durablesupply response. Real GDP gew by 3.8 percentfor 1988and by 4.9 percentin 1989;growth for the year 1990 howeverslowed to 3.5%. Tams of trade deteioration have kept domesticdemand sluggh and per capitaconsumpion continuesto fall. In the last yea of the 1980's, private aggregateconsumption stabilized, whereaspublic consumptioncontinued to decline. As a result, total domesticsvng began to grow reaching 8.0 percent of die GDP in 1989. 21 The fragility of the recovery however becameevident in 1990 when declinein taditional exports and stagion of non-trdonal exportscoupled with a dramaticsurg in credk-financedimports led to a rise in infaon and a sharp fall in externl reserves. The ecnomy sfillremains highly vulnerble to exernal shocks whichput the - to sustnable growthat rist

EIwm Sector Develots 1970-1990

1.12 E&chang RBtakCervaluation: Although,Madagasa lft the fran zoe in 1973. tbe Malagasyfranc (P1MG)remained fixed at 50 FMG per Fren:chfranc unfil 1982. Duringdie 1970s'Maidagascar allowed its exchangerae to appreciateconsiderably in real curs the real excne rate apprc by abou 26 pert between 1977 and 1982. A similar course was followedby many developingcountries and was enabledby availabilityof foreip financeto coverresuting currentaccount deficits and in somecases, by relativelyfavorable te of trade. Thisreal app on othe exchangerate favoredproduction of nontradedover traded goods and encouragedreiance on importedinpu. Fiancal institutions,accordingly, teded to allocatea larger share of financialresources tD firms in the non taded goodssectr. In Madagascar,public enrprises accountedfor muchof the acivity m noniradedgoods dmurg the period of ehange rate overvaluation.Their suwbs borrowing from the financialsystem posed, later in the 1980' a major risk for commercialbanks portfoliosas the Government initiatedmacoeconoomic adjusmen and trade liberalizationmeasures which confoted public entepriss with a muchmore competitiveenvioment ta the one they wer facingformely.

1.13 fl n Rate Adjuwments: In 1982,the Magsy frac was devaluedand peggedto a basketof currenciestrade-weighted according to the distrition of Madaasc trade during the period 1973-1980. Smitingin 1984,the authoritiesadopted a flexic exchangerate policy, wherebythe exdcangerate relve to the basketwas indedto the domesticprices inx, ensurig in the subequent yean a gradualdqepciation in real te. As a reslt the nominal Se:tive exhange rate depreciaedculadvely by 73.5 percen be 1984and 1990and fte corespondingreal effetive ehg rate by 59 peret, withone fourthof tbis to devauaon occurringin the perod 1987to 1988.

1.14 hnp .f& gtRateCbangm: Thesuccessivedevaluationsduetookpice principlly in the secondpart of the 1980s are reflectedin the financialsysem im two ways. Direy, the bale sfeet of the centralbank showed increasig accumuatedecap rate los tough its wrevaluationacc%mtW, placi the financialstructure of this institutionon a unsoundfootig, contibuting to money creaton and constining the conduct of monetary

2/ Domestic vings are substantallyhigher th natonal savingsbecae of a lage negative -e fctor nmcomefrom abroadwith ex l ierest paymen absorbingmore ta e half of domesic -. 6 policies (see Chapter2). In contrast,Malagasy publicly owned commercialbanks had few tabilitiesin foreignexchange and wherenot affecteddirectly by the devaluations.However, they wereaffected indirectly through the financialsitation of manyof theirborrowes. The devalua- tions affectedMalagasy enterprises which bad liabilitiesin foreignexchange. These enteprises were mostlyparastatals which had no or litle foreignexchange asst or revenue. As a result their financialsiuaion deterioratedand this deteriorationaffeced in turn the commercialbanks which,as mentionedsbov-, had a large credit exposureto parastaals. This contributedto the financialdistress experienced later by these banks(see Chapter4).

1.15 New Systemof ForeimnExchange Allocation: In 1988,a new, lieral system of foreignexchange allocation for foreigntrade operationswas set in place, while controlof capitalaccount transactions was maintained.Under the new system, the Liberlized ImportSystem SL) introducedin July 1988,all economicagents may importand receivethe tot amountof foreip exdcmgerequested for merchandisetransactions at the prevailingexchange rate. No restrictionsapply to the openingof creditor the meansof financingimports; importers may freely use their ownresources, borrow from the bankingsystem, or availthemselves of externalloans, inuding supplier'scredits, to financeimports. Servces and the captal account ansactons, however remain controlled. Under this control,the Treasuryauthorizes and supervisesall paymentsfor invisiblesand borrowingand lendingabroad by resident and outwardand mward invesments. Commercialbanks are not authorizedto maintainan exchangerate positionin any fDreigncurency althoughthey may hold trade billsas foreignassets. Thereare no awrangements for forwardcover againstexchage risk operaing in the officialor bankingsector. There is scopefor the financialsystem to help stimulatecapital flows from abroadand facilitatetrade, by developingnew mechanismsfor servicingforeign loans, paying suppliers,providing for dividendad capitalrecovery for non residentrisk an managingexten financialrisk (see Chaptr 7).

1.16 The extenal paymentcrisis of the early 1980s,although stemming from the 1979-1980public investment boom, was precpitated by a markeddetioration of termsof trade and a sharpicease in internationalinterest rates. To meetthe crisis, the Malgasy autorities tghtened fiscal and monetarypolicies in additionto the series of devaluationsdiscussed previously.

1.17 Ba.nce oftys Despitea prudentdemand policy in the later part of the 19W0s',Madagascar's balance of paymenthas remainedunder considerble pressure. 1990 was the fourdhconsective year of deteriorationin the exra terms of trade(seefigure 1.2). Also, in the secondhalf of the 1980s,a numberof mesouresaimed at trade liberalization releaseda pent-Wdemand for imports,furter deepeningthe trade deficit At the smmetime, the wcr accountremained burdened by heavy interestpaymens related to the large exenal borrowing on non-cocessionalterms in the 1970s. Thepeormance of the extenal setor was alsohurt by a cydone in 1986and a droughtin 1987-1988.Against these constrain, a major positv ftr was a subsati incr in the levelsof grants and concessonalloans whih graduallystengthened the country'sexrnal position,even allowing for a modestbuild in the lvel of net intational reservestowards the end of the 1980sbefore this beganeroding in 1990. However,a 38 perce increasein importscombined with a 12 percentdecline in eort eanings shiftedthe smalltrade accountsurplus in 1989ino a deficitof 2.5% of GDPin 1990which was PDedenteddwr since the early 198s. 7

Tale 1.1: SUMMARYINTERNATIONAL ACCOUNTS ( in percentof the GDP)

1981-1983 1984-1988 1988 1989 41 :990 4/ Current Account 11 -12.6 -10.9 -14.2 -13.2 -13.5 Trade Balance -4.4 -0.7 -1.8 - -2.5 Interest21 -5.1 -6.8 -9.3 -11.0 -7.6 OtherCurrent Account31 -3.1 -3.4 -3.1 -2.2 -3.4 CapitalInflow 0.6 5.5 6.1 4.5 5.9 Arrears(-decrease) 2.5 -0.5 -0.9 -1.4 -1.5 Reserves(-increase) - 1.6 2.1 0.9 1.0 I Includingnet official tanss. ZVIncluding moratorium interest on rescheduleddebL a, Non factorservices royalties, remittances. 41 Provisional.

Soure: World Bankand IME Data.

1.18 Shifting Structre and Continuing Burden of External Debt: Madagascar borrowedmosdy on concessionalterms duringthe 1980s,in contrastwith the 1970s. However, owingto the difficultbalance of paymentssituation, the outstandingdebt inheritedfrom the past and contacted on non-concessionalterms, had to be rescheduled. Therefore,the overalldebt continuedt rise, refecting concomitantlythe substantialdepreciation of the Malagasyfrac. At the same time, the stockof externaldebt as a ratio toGDP incresed from 90.0 percentin 1984 to 142 percent in 1989. The compositionof the outstandingstock of external debt changed, however, considerablyduring the secondpart of the 1980s. Debt reschedulingwith official creditors and positive net capital inflows from multilateral organizationsled to increased outstandingexten debt fromthese sourceswhile the outstandingexternal debt to commercial banks and oustanding enal payments arres decreased on account of net repayment by Madagascar.Since 1981,Madagascar has signedseven -rescheduling agreements with the Paris Club and four with the LondonClub; the countryalso benefittedfrom a USS516million debt cancellationfrom France in 1989.Despite the highlyconcessional terms of debt contractedaftr 1982and the successionof debtrelief agreeme, debtservice continues to s ly burdenthe economy.In 1989,debt sevice after reschedulingand cancellationsrepresented 59% of exports of goodsand non-facor services.Unless this burdenis substantiallyeased, the economicfibture will continueto be mortgagedand resourcesthat couldbe mobilizedfor growth will insteadbe preemptedby debt payments. 8

Figure1.2: Madagascar:Merchandise Terms of Tradeand Price Indices of TraditionalExports 1985-1990 160 20

100, - 100_ 140 so _ _ 6~~~~~~~~~~~~~0

80 60 40 40

20 20 0 0 1985 1986 1987 1988 1989 1990 1985 1986 1987 1998 1989 1990

120 2

1OG 100 sovs-

60 60

40 40

20 20

0 S 0 I I 19635 1986 1967 1988 1989 1990 1985 1906 1987 1988 1989 1990

Scunae:Governvmnt Data

Now: i tmdklo.duio referreohmccDwwdft Aout 55% of MAIgy bs| I -W 195L9.O 9

Figure1.3: Extemal Debt b Type of Creditors Millions 1lJs 1988

BilatealCredItors 1857.9 63%

\ . . / l l 1PIK%%redeC5357 \ . / . . ~~13%

Mukha" lrIsL634 24% 1989

60% t.------*-*.

'~~~~~~~~~~~da Cmt 30C31

NMuftla IML1l28 31%.

Sauce GovwnmsmDam 10 Futu-e Challengs In Reource MobilizationAnd Allocation

1.19 Mad_mrla,nU teu: Owing to both domestic and external developments,eoonomic peformance in Madagascar has historically not beencommensurate with its humanand physicalendowments. Today, with a populationof 11.6 milliongrowing at 3% per year and a per capita income of $230 in 1989, Madagascarremainsone of the poorest counlriesin the world. Relianceon a narrow exportbase has been associatedwith a secular declinein terms of trade (see Figure 1.2) and has led to a patternof economicgrowth whichis sluggishand vulnerableto ernual developments.Yet, Madagascar'sphysical and human resourcesafford unusually promising economic potential particularly in comparisonto a majority of couontiesin Sub-SaharanAfrica. Its exceptionalecological and climatic diversityallow cultivationof a varietyof tropicaland temperatecrops. This agriculura potentialcoupled with the availabilityof a significantvariety of mineraldeposits and of an indutrious, relativelywell- rined and competitivelypricedlabor force offer a strong basis fbr a diversifiedeconomy includinga varietyof non-traditionaleconomic activities and exports.In the services sector, considerable al exsts in turism for whichMadagascar's unique environment, cuture and coasdineconstitute valuable assets. Most of dtis potenti howeverhas been unexploited.

1.20 Challenes in a NewEconomic Environment The shift in policiesduring the 198s, particularlysince 1985, has begun to profoundlyalter the domesticeconomic environment and the incentve structurein whichthe Malagasyprivate sector opeates. Thesereforms have helped lay the base for reitalizig traditionaleconomic activities and stimulatingnew ones. Nonetheless,the supply responseto these reform to date have been limited and are evident mainlyin the highlandsof the country.Traditional activities such as rice productionhave been revivedwhile some new activitieshave been sfimulatedinmn-traditional areas as textiles,agro- induries, aquacutureand seafoodprocessing, and gemstonecutting and polishing.Yet, while the domesticincentive structure appears more faorable for sustinable growthin the 1990sthan yime in the prus two decades,outsunding domestic constmints are now compoundedby the challenagesof an increasinglycompetitive international economy. These ernal chalenges incude the emergenceof rapidlygowing newlyindustrializing cuntries (ICs) notablyin East Asia;greater difficulties than in the past in atractingforeign capital; and greater demand in world marketsfor rapid technologicaladaptation and timely deliverywhich in turn requires more flexibility and responsiveness in production and greater atteion to maddeting and transport logistics.These factors leave the Maaay economytoday at crossroadsas it facesthe challenge of restructuringand diversifyingin order to survivein the new market-orientedsystem.

1.21 Impotnce of Resouc Mobilizationand Allotion: Ensuing sustainable growth in the 1990srequires several coainu to be overcome.Among the mostfimdament of theseconstraints is the mintence and depenmigof the stockof physicaland human capitad. Given the need for increasedeports to sustain gwth, Maagasy businsses, which in the past refrainedfrom investingin certainactivities pardy becauseof the smalldomestic market and unfavorablepolicy environmen,must now begin to investand increasinglyproduce for global markets.A necessaryelement for an increasedinvestment rate is the availabity of bothdomestic and freign resourcesto ensurethat the existingcapital stock is adequatel)replaced, maintained or expanded.To ensuretdht these resources are used as efficientlyas possible,the traditionaly preponderantole of publicinvestnt mustbe reorientedto allowproper private sector response to market signals. 11 1.22 PublicandPrIvteSecorRoles:Mobilizing and efficiely alocatingresources for futuregrowth is a twofoldchallenge in whichthere are importantand complementarypublic and privatesector roles. On one hand, more efficientpublic sector management and fiscalpolicy sbould ensure tha tax and other public revenues are raised in the least disordonary manner and that public investment is based on well-definedpriorities and carefilly appraised projects that themselves facilitate and induce further economic activity. At the same time, resource mobilizationand allocationthrough the financial systemhas to be improved to facilitate enhanced private sector roles in the economy. In contrast to the government which mobilizes and allocates resources through its taxing and spending authority, the financial system, particularly dposit- taking institutions, depends on voluntary decisionsby private savers and borrowers to place and use finmcial resources. The efficiency of resource mobilization and allocation crucially depends on how well financial institutions, instuments and markets address thejoint needs of savers and borrowers.

1.23 Maintaining Investmentfor Growth: An adequate overall rate of investment is a critical although not a sufficient condition for sustained growth. Madagascars investment rate in.recent years lies below the average for Sub-SaharanAfrica. Gross domestic investme averaged 10.6 % of GDP during 1985-89against 14.6 % for Sub-SaharanAfrica. This level of investmenthowever is unliLelyto be adequate for sustained and significantreal per capita growth in income. For example, among Sub-SaharanAfican counties, the minimum nvestmentneeded to replace depreciated capital alone is estimated at about 13 percentof GDP. ft is also estimd that the investmentrate in these countries has to be in the region of 25% of GDP in future years if a minimum growth rate of 5-6% is to be attained.

1.24 Efficiencl offAneteInvestment: As Madagascar's experiencewith the cash public investmentprogram of the late 1970s has shown, a high rate of investent alone does not ensure economic growth. An adequate aggregate investment rate must also be matched by efficiency in investment. Empirical studies confim that less dtan half the growth in output can be attributed to increases in labor and capital; higher productivity explains the rest. Accordingly, increases in labor and capital inputs must be accompanied, for example, by improved health, education and work effort which increaselabor productivity while capital productivityis increased by techical progress and more efficient allocaton of investible resrces. Efficient irvestment in the aggregaterequires that all economicagents be able to makesound investm dedsions in responseto undistortedmarket signals. Overall investment encompasses a widerange of decisions including, for example, govermnentinvestment in infrastructure,enterprise invem in productive capital, household invesmt in shelter, and investmentby individualfarmers to build fences and improve pasture. Individua econonic agents tend not to make their ivestmeit decisions in isolation from investment decisions by others, notably that of the public sectr. lTerefore, notwithstandng the increasing market-onentation of the Malagasy economy, the role of public investment will remain crucial.

-t .- . : - 12

FIu 4: CompwrIV Own Dometic mtnvmentRats ( of GOP) Pyeent

50

1984 1@B6 t8| 1U18 tlE4lo MOM.momwa CO weeOhiAa

m amfl ArSm E Lo Irnas Comtrlu

12S gSai: A major constraintin incrsing dte leve of investmentin Mapscar, pardiuay the level of private inesment, is d low level of dome savings. Despite its recent increase to 10% of GDP in 1989, Mad_ sc's gross domesticsving rate is below the avea for Sub-Sahara Africa (12.4%).Aggrega savion can be raisedfom domesticsources conssti of publicand privatesaving (whichineract in important ways) as well as savig from abroad. Uni now, concessional (and essnialUy public sectr) capitl inows from broad hve providedthe bWk of resouces fr (argely public) hwaemnt While such public capital inflowswil remainnecssary and are lidy to contin in the - tem, it will be crucial for domestic souces of savings and private f g capil to incra their absolute and relative contributions to financing agregate invemment Each of d sources of saving tha are alternaives to foreip public capial inflows is discused bdow. 13

Figure 1.5:Comparative Gross Domestic Savings Rates (S of GDP)

Percent 25 -

16-

6

1984 1985 1986 1967 1988 1989

_ Mcagsaooer EO Sub-SaharanAlrlas EM south Asia E Lowincome countrls

Source:lNbrId Bank Data

1.26 Public and Pkivate Sehr Rots In Saying: In paralel with an appmpriat publicfprivatemix, in invesmentthe public and privatesectors have complementaryroles in savings. The mosthomediate way to raise domesticsaving is to increas saving of thepublic sector (compreheively definedto encompasscentral and localgovaeme as well as public entrpises and the cetral bank).-Goverments abilityto mobilizelarge amountsof resources lthoughits poweasto tax and createmoney make it a key sourceof investmentfinance, whethr or not it udetkes tis ivestment direy or channls resources to other enies. Chages in publi savins however result not only from the discretionary and dire effects of tax and expendiurepolicies but also from the impactof cxcage rate changeson feign-de revene and expeditures. Notwihtnding the impoance of public savings,it is th priva sectorin M ar, as in mostcouies, whichandrtakes the greaterpart of domesticsavig. Governmentresource mobilization eforts aimed at improvingtax yield should therefore not discouap privateincentives for saving, investmentand production. At the sam time, rrvenmt policy can readilyalter the disposableincome of the private sectormainly t 14 tax policies,in a marketeconomy it has onlylimited influence on the shareof disposableincome that the privatesector saves. Increasingthe private savingsrate usually takes longer than the publicsector and dependsmainly on growthin householdincomes through economic growth.

1.27 MobilizingHousehold-Savings: The mostimportant source of privatesavings are households,the basic economicunit of any society.The principal motivations to saveamong householdsinclude: to investin children'seducation; to meet large unanticipatedexpenses such as weddingsand funerals; to enable consumption.. ir retirementfrom the work force; and accumulatefunds for a major purchasesuch as a house. The fundamentaldeterminant of the savingsof a householdis its levelof income. Cr. one hand, given that Madagascar'sper capita incomestands amongthe fifteen lowest in the world, there are limitationson increasesin the averagelevel of privatesavings in the immediatetem. Yet, the significantdisparities in income distributionin Madagascaralso suggestsscope for mobilizingadditional savings from better-off segmentsof society. Additionalfactors can influencethe householdsaving rate dependingon what margin its incomeprovides over and abovebasic subsistenceneeds. These includethe objectivesof savingsand altemativeways of satisfyingthem which are in part influencedby the securityand terms of availablefinancial instruments. A major source of private savings in Madagascar'spredominantly agriculturl economyis the rural sector which is typicallya net saver albeit not necessarilyin financialassets. While transformingunmonetized wealth into financialsavings alone does not increaseaggregate savings, it cangenerate more efficientuse of resources.

1:2S Enhandng Enterrise Svings: The other sourceof domesdicprivate savings is the enterprisesector. After earning incomes from sale of outputsand payingfor capital,labor and intermediateinputs, enterprisesgenerate profits which are partly paid out as taxes and incomesto their owners(thus contribytingto householdincomes). The residualconstitutes gross savingsof an enterprisewhich canhelp financean enterprise'sown investment,form a reserve against possiblefuture losses, acquire financialassets (therebytransferring savings to other economi_entities) or providefor depreciationof existingmachinery, equipment and buildings. Thesavings level of the enterprisesector depends on overallprofits and in turn on overallgrowth of the economy. Given the limitationsof the domesticmarket, one crucial determinan of enterpriseprofits is the competitivenessof Malagasyenterprises in exportmarkets as the economy restructuresand diversifies.Given this profit level, the savingsdecision of an enterprisedepends on the rate of retunnon availableinvestments, uncertinty of futureincome, volume of existing accumulatedreserves, and the qualityof availablefmancial assets.

1.29 Delorn chic Factors and Savi: The future evolutionof savings in Madagascarwill also dependon a combinationof demographicas well as growthfactors. In any given country, the larger the active population(conventionally defined as the proportionof individualsabove fifteen and belowsixty-five years old), ihehigher the potentialsavings rate. In 1989, about 52% of the Malagasy populationwas estimated to be in the "active" age group; this proportion,which is comparableto otherdeveloping countries, is expeced to rise dtroughout the 1990's,especially among the rural population.Faster growthin Madagascarin the 1990'scan lead to a higher aggregatesavings rate given macroeconomicstability and oDnfidenceof savers in the economy. Ibis is becmasethe aggregatesavings rate wouldmove closer to the savingsrate of activeworkers, widening the gap betweenthe lfetim incomeof activeand retred workers. Therefore,if economicpolicies in comingyears succeedin providingproductive employment to nw job seek, this should favorablyinfluence the level of overall savings in Madagascar. 15 H_ower, the impacton fia smainpcoud be nelil nless d financalsysm is fher devloped in orde to capue thes somces, p laldy in ruraie.

1.30 . Salim from Akmad: In addiion o dometic source of prae savin savins from abroadcan be an i atn- sourceof fina for ivestman One such sour for Madagascaris the opaiatio ofli cil hldt abloadby Malasy resid . Tlh oher sorce is the direc*hiest pwvidedby fomin eeprss In Yadgac. On ane hand, gowing ainroaiza of worldproduction coupled with ava m technology, padcuay telecommunications, Ily tD lead tD highe direct esme f indusria contries to deveoing countiesin the 1990s.Hoer, mostof dtisinst is likelyto be amukated i middle-nowmedevepg wo ies withgood r ucure - b eea 1981and 1990,for example90 per cat of die lo wentto jut twentydeveoping ecnomies, mainly in Asia and Lati America.Neverlss, for smal ,F ' u ecoomie mrdbn Madagac, ev modest icreases i direct foreg mvestmt can hav a mieamable hbpact n gowth Whaes lare cative domesticmarks used to undepi muchof foe direct _nvtmin developig oties, these capital ows ae now inreagy drnvenby -t a icentive structurewitin individal conres. Both apatra of flight capit and direct dgn investmet depend primar,iy on peceptios of economicuncetinty, politicalEsabiity and fte retory env ent The strgth of domesic pbic ad prvate intuiws6 inludg the finail system,in providingsuppoting inrastructr ad servics for productve activitiescan also pmvidea stimulusto such capitalfs fx abrad. 1.31 h k of : Thefinancial systm, picuardy fina imtons withi the fmal legd and reglat firmework,is Seray not diety ivolved In the majorpar. of prive svin indvesment,especially in ecoom dmiaed by rual houshods and family-ownedenteprises. IL most develdpingcnies impartca, fiMa and housholds rely siniauy on self-finance,udsng their own amvg tD finane their ivestmenL However, i inesmmu oppxunkies of a bousold or a fium may wt be matded by its resource and may be inefficiUly limd by der. Therefore,in order for an ecoomy tD deveo and divers*, the role of the financ systemcan be xpectedto grw relativeto those of sef-fiance, relative, frIends d n. At any gve point in tme, surpls reso rcar generatd by ceai economicus thancan be n. effidenly used by ohe econmic unis. Therole of the fiail sysm is to ee datifrp stvings m surpluseconmi unks are officey mbilized and dshed to high-yildg inve ents in deficiteconomc nits with awpriate balance of risk and return. 1.32 Smoothyfnct financ systms lowr cost of 8tansferringresouc from DversID borrws, whichraises te re paidn sauve ad lows the cotoD borrwe. ITe adequay of financialist instrumeats, ad madkts ca affexthedvome of f mal savis mobiizedand the efficieny wit whichty arweslocd producie use. in de et mhdlngerm, te fian s shoulddev cofidence srs ad Inv alike. The W betwe domestc savigp d invesImt (se Fig. 1.4) shouldbe increasInglyfinanced by foep privat biw. In reen yeas, the blk of the eacco deicit ha ben fanced by lo08nd grnts fom fored biater ad m -ulateldown wth ooncessi-nal privateilkw (loa aid diree estme) playn a relavy minorrdle. .ltuh coessioal publicin li tlynoura ihora in theseeable fture, th base sbstatl inflow of pvae resoes sould begin t be estb1ishd Ibi would req adeate legal proctio for provid of frxi capital, whethr the form of debt or 16 equi. Growlhin Mdagasc couldbe sustainedif tere arealso appropriate policies to deen and developthe fiancial ser in order to servicethe growingneeds of an incraingly diversifiedreal ecnomy.

Figure1.6: Madagascar The Resource Gap (%of GDP)

20

*15

10

0 1954 1985 1988 1957 19 19 1990

- Stags AW g ha" As Not*t Lhds Ut inmc pp h bss.tatste as acutt bdu- hiud its al r pinw)m Std b eSaTx ddals_rAng.

Ovview ateMa U 1 33 US fiimpf uucl&dr AspreviouslymentionedSefancialsetor in Madagac ca beviewed aconsing of fina l poicis ad finacial nracr which supp e nanciaLystm FRmancialpolicies rzebla maiy to-monesply, intee ra, pblic de finag andt provisionof fimia seic. Thesepolicies are defore ky aspe of money, fiscalmd exchg raemanagement as walvi regltors ad soa polices.Fi infrastructea consissof the institt l uppotfor the financil sys ixmd in th legd a relatr frmeworkgovae g finanl transa n he p a suzouulg audi, ac t andfinancial dislosure and the oprations of thepayme systm BSodtu ape= of te finan_a systemare examinedin the subsequaet two chpte of thisUqorL As in ay couty, dtecore of thefinancial sector in Madagascarconsis of to theebsic dlents of thefinancial sysm insttuto, instument and marts. Theseelements of the fnaial 17 system, which are summay reiewd below, are examinedin the fAurthtough seventh capters of this Report.

1.34 Financial institultionscover a variety of entiies induding deposi-taking instions (banks,postal s informalsavings schemes), conaual sanW institutions nurace and socialsecurty) and specializedmstilutions (eg. vem capital,leasing). The insituons providevial sec for economicgrowth and developmet Besidesthe important functionof servig as a paymentsmecham for eonomictnsactions, dteseinstituio are an importan althoughnot exclusivechannel thogh whichfinancial savings ae transferredto borrowers. In Madagascar,financial institions in the formalsector are presentlylimited to the CentralBank, four banks, a postalchecking and savingssystem, two insurancecompani, the Soi SecurityFund, and two venure capitalfinns.

1.35 mancistruments representclaims to real resources.The claimsare againt financialinsti ns or againstborrowers of these instons or Ci the case of equity)to the resid value of an enteprise. Ihe holdingsof financial assets in bMadagscarmust be viewed in the contextof otherforms of wealth.G its predominanysmaliholder agrarin economy. livestockand landloom large as prevalentforms of wealth,possibly along with home owners*. Financiali _tumentsprovide an alterwativeto real assetsas a storeof wealthand are important vehidlesfor helpingallocate surplus resources in their mostefficient use. In Madag , fthe instrumentsfDr financialsavngs are currencyand demamdand time bak depi; insurane, socialsecurity and pension fund claimsas well as a smallvolume of localshares and Treasurybils makeuri the renainderof financialclaims held againstresidets in Madagac. Fianci resourcesarm maily uansferreddtrough a rangeof bankcrei produ and the smal Treasuy bill market

1.36 marketsfacilitate cnancialthe voluntary transfer of resources from savers to investors,both individualand instittional, by poolingand pricingfinancial resources accordn to citeria of risk, returnand liquidity.They compris primarymarets for n nedgtiable debt scrties or equitiesand secondarymarkets for tg theseinoments. The onlyfonal financialmarkets m Madagascarare: an embryomicmoney market restricted to commerci banks and comprisingan inter-bankmarket and a recently-aunchedliquiity windowoPerad at the Centra Bank;and a smaUlmonthly auction of Treasurybills.

1.37 The financialsystem of Madag is stfillat an ealy stage of developmean Fianc instuons are dominatedby the bankingsector and their trnsactions are subsially foused on the formal,urw segmentsof the economyand population.A rage of spelized instituionsfoundin developedfinancial systm do not exist in Madaascar, for eampie, in houng fimace, leasmgor discountingof trade bills. Fmancialintruments mi are aso rdimeny - the share of financialassets held by private savr in foms other ta currencyand dWositsis minimnlwhile mall-scalesaving in the rural and informalsectors substatialy u etzd Like most low-ince coutries, lacks fiancial instume suchas mutualfimds, quasi-equity inst entusor corporaebonds. Financial madre ae lagely undeveloped:the moneymarket is embryonicand a wellorganized and activecapial maket doesnot yet exist Besidesthe formalfinancial system, an informal financial system exi th largelyoperaes outsidethe ambitof for inanial sectorreguato tle is knownabout the impa of dtis informalsystem nor the efficienc of its operation. 18 1.38 Depth of the Malamsv Fndal Stn: One of the basic indices used to gaugefinacial sectordevelopment in a countryis financialdepth Empiricalevidence suggests a strong correlation between financial depth, dficiency of invesmen, and ecownomicgrowth. Ilvestment productivity, as measured by the raio of the chnge in GDP t inve is significantlyhigher in countries which have deeper financial systems. Financial deepening, through higher financial saving, should figure as a top priority for the Malagasy authorities as the experiece of fast developingoDuntries suggests a strong link between financial development and growth. However, the depth of Madagascar's financial systom has not been significantly different since its early post-independencehistory. The M2IGDP ratio, one of the leading indicators of financial depth, has hardly changed over a twenty-year period (1968-1988), remaining below the 25% of GDP. Table 1.2 compares Madaar's financial depth with that of a number of industrial and developingcountries.

Table 1.2: FINANCIALDEPTH AND FINANCIALPRICE INDICATORS (1985-1988avenp)

MIG;DPRafio G;DPr tr% PD Capita IncomeUD Indtrial Countries -United Staes 69 3 18.190 -France 73 3 12,813 4-apan 175 1 15,245 -UnitedKingdom 67 5.2 10,230 ]DevelopingCountries .-lndia 46 7.1 308 .-Mauritius 54 6.8 1,410 -Nigeria 29 16 575 -Ethiopia 43 1 120 -Malawi 26 13.4 158

Madgascar 2235 16 215

Soure: World Bank Data 19 1.39 Reasonsfor low financialdepth: Severalfactors may explainthe low M2/OGDP ratio for Madagascaras comparedto otherdeveloping countries like Mauritiusand India. First, Madagascar'sGNP per capitastands among the lowestin Sub-SaharanAfrica and has beenon the declinesince 1980, whenit reached its peak of $350. Second,high infladon,particularly double-digitinflation as recentlyas the mid-1980s,has been a major disincentivewhich has adversely affectedpeoples willingnessto hold financialassets. The experienceof other countries shows that oositivereal interestrates favor fiacial saving over other forms of saving and thereforepromote financial deepening. Reducing inflation and maintaininga stableprice levelis as an essentialprecondition for increasingthe size of a counws financialsystem and thus promote the economic efficienciesassociated with bank financial intermediation.Third, Madagascar'sfinancial network is mainlyconcentat in the urban areas, therebyfailing to capture the surplus resources of the rural areas. Financial deepening will require a decentralizationof financialactivities from the urbanareas to the rural areas.

1.40 PerceivedImportance of Finance: In additionto theoreticalinsights on the importanceof financeto growth,the importanceof the financialsystem can be directlyassessed by investigatingthe perceptionsof Malagasyenterprises. The latter perspectivehas been examinedin this Report pardy throughin-depth interviews with a sampleof 104 Malagasy enterprisesof varyingsizes and representinga rangeof agricultural,industrial, and comniercial activities(see Annex1.2 for a detaileddescription of the enterprisesurvey and results).When askedto rankthe relativeimportance of finance,generally spealng, to their growthcompared to sevenother constraints (mcluding market size, accessto rawmaterials and labor, and axation), 44 % of theseentprises rankedfinance as the predominantcontraint Financewas especially a;n as the majorconstint to growthamong small and medium-scaleenterprises. In addition, Figure 1.7 showshow the enterprisesranked the relativeimportance of four typesof financial consuaints- high interestrates; inadequateworking capital; insufficient equity; and scarcityof foreignexchange.

1.41 Inadequaciesin Servidur FinancialNeeds oftheRealEconomy: Theanalysis of the Malagasyfinancal systemwhich is developedthroughout the rest of this Reportpoints to at least five major inteelated inadequacieswithin the financialsystem as a wholeemanatig from both the supplyand demandside. First, the ovrl financialsystem is heavilybiased towardsshort-term finance with ,ry littlemedim and long-termfinance available either as debt or equity.Second, the attractiverzss of holdingfinancial assets as a primaryform of wealthhas untilrecently been eroding because of uncertaintyamong economic agents with regard to inflation and the real exchangerate. Third, many economicagents find it difficultto get accessto the resourcesof the formal financialsystem because of their smallsize (smalland medium-scale industriesand smallholderpeasants) or the natureof their activities(notably, in agricultureand to some extent in construction).Fourth, the financialsystem is not widelyregarded as an effectivemenism for dischargingfinancial obligations and transferringresources in a timAely and secure manner;partly as a result, basic paymentsinstuments such as checkshave not acuired universalacceptance. Fifth, both suppliersand users of finmcialservices suffer from a lack of adequatefinancial information such as lending tems ad credit risks which is compoundedby varous inadequaciesin either obainingor adequatelyenforce legal protection necessaryto ensureconfidence among lenders and borrowers.This has conuted to a pattern of fimancein whichtransacdons tend to be limitedto short maturites and to borrowerseither personallyknown to dhelender or able to provideeasily attachable collateral.

.. . .-.-.-A -: : .. : RPXA8

U]E A 21 1.42 Potential of the Malas] finandal system: To vayin degrees, virtualy aDI low-incme countries share the above-mentionedinadequacies in Madagascar's fiancial systms. At the same time, the range of availablefinancial institutionsappears more narrow in Madagascar an seveal Sub-SabaranAfrican counties which have, for example, leasing companies, housing finance institutions, a large network of informal grassroots-level savings institutons and embryonic capital markets. Furthermore, a narrow and shallow financial system is, in one seuse, even more constraining in a large island such as Madagac than it would be a smaler island ecowomysuch as Mauritius. Owing to its unusually large size - the world's fourth lgest island with an area larger than France - weaknesses in the financial system tend to papeuate the poor linkages among product marwkesin various regions of the country by not affording adequate payments services. Realization of the full potential of developing an export-oriented economy is hus constrained. Yet, at the same time Madagcar's econmy shows promising potential in areas such as agriculture, mining, and as a resut of its human and physical endowments coupled with its unique flora, fauna and range of dimates. The scope therefore ests for developingamong the most dynamic export-oiented economies and financial systems in the Africa and Indian Ocean region. The absence of cetain financal institutions that may exist elsewhere can also be seen as an opporunity to avoid the mistakes of financial policies since many of these instutions in Sub-Sabaran Africa are themselves riddled with problems. Notwihsanding the increasingmarket-orientation of the economy, governmentpolicies will have a key role to play in fiacial sector development as discussed below.

1.43 Shifthrg State Inlvennyt in the Finandal Sector: Although the role of the state in ownership of ficEal instittions generaly makes a dubious contribuon to financial sectr development, approprate state roles in macroeconomic na _ and r y policies are essential to financial sector development. Govemnmenthas an imprtn role to play in the financial sector in providing a sound macroeconomicframework which mainta positive real interest rates, does not unduly prempt investible resources for public expndite and enes that the borrowers of financial insutions opate in a undistortd eco environmen. Government also needs to provide a regulatory frameork which balances effiiency in the financial system, which requires freedom of financial managers to act, with prude managementof financial institutionsand safety of deposir and investorfunds, which in tam requires some degree of government regulation. The me shift away fiom gover ownership in institutions must now be matched by a strengthened gvernment role in appropriate macroeconomic management, financial sector reglation and prudeal supevision.

1.44 Towards a Finaclal Setor Stratef: A strategyfor fiture financialsector developmentin Madagascarmust determine how the policyand ins_ttional frameworkaffecting financialtsrnactions can provideappropriate stimuli for s ng existingand developing new financial institions, instuments and markets. This strategy must also be grounded in - assessment of the needs of real sector activities. At the sme tme, a review of the experience of financial development elsewhere - in both developingand indusal countries - can provide usefiu lessons for Madagasr (icluding an aprecan of pitfalls of cetain policies). Especilly useful insights can be gleaned from neighboring counties such as Maumitis which has undegoe a signitficant evoluton of its financial system in the last decade together with a dramatic ransFormationof its economy. All these perspectives are developedin the chaper which foLow which provide the analytical underpinnings for identifying options and priorities for a fianid somr sta i Madagascar. 22 1.45 The atachedTable 1.3 summariz howthe discussios in Chapter2 dtrough7 are aimed at identfyingimprvements in dtree closelyrelated areas:

(i increasingthe level of finandal savings:Measures to increaseconfidence of savers in the value and safety of financialassets can increase the share of savings in Madagascar,(much of which is unmoneized),that is dhanneledtrough the fiancial system.Furthermore, there aears to be promisingpotena in two areas to encourage saving throughfinancial asses: (a) amongthe vast majorityof small-scaleeconomic agentswho have not yet accessedthe existingfinacial system;and (b) dtrough long-term fiancial contract such as insuranceand socialsecurity.

Cii)increasing the efriden gro investent: As the key ingredientfor incsing efficiencyof investmentand promoting rapid ecownomicdivesification in Madagascar,increased private investment requires that finacial saningsbe effectivelychanneled to its mostproductive uses. A well functioningfinancial systemwill help promotehigh-yielding projects by: (a) fstering competiton amonglending instituions which disciplinestheir leadig decisionson whiuch thir profis and suvial depend,and (b) ensuringthat risks and res of investnentsare apprpriately balancedtrough financialmarkets which help price the cost of capitaland distnbutethe risks of invstnenc and

(i lowerinu the costs and risks of finanial transations: Effective of savings and invtment dtrough the faial system i Madascar depends fundamely on reducing the costs and risks of transfring resourcesfrom saversto borwwersand from payers of financial obligation to recipien of funds. Improvementsin the legal, accountingand paymess systemare neededto lowerthese costs and risks, therebyencouraging wseof the finncial systemto settleeconomic obligations, to duanelsavings and to fina investet

Followingthe aboveanalysis, Chapter 8 outlinesthe basic elementsof an approachfor implementingthe varous proposedmeasures and instuion buiding measres. 23 Table 13 ProposedFiancial Sector Srategy

EY OBJECIM XEY MEASURES DErAIL.D RECOMMENDATIONS INCREA9NG Increased credibilityand Chapter2 (para2.48-2.53) FINANCIALSAVINGS effectivenessof Centld Bank monetarypolicy Operationalgos: Strengthenedsuperision Chapter4 (para4.36-4.42) Increase real returns on and regulationof fiuancial rnanxa assetsand institutions confidenc of depositors Revampingpostal chekng Chapter6 (para6.26.34) Small-scalesa and savingssystem mobilization Improvingoperating Chaper (para5.26-5.2S) Boostingcontractual Incentivesand regulatory saving frameworkof insurance and socialsecurity ENEANCING Avertingcrowding out of Chapter2 (par 2.54-236) EFFICIENCYOF privateinvestment from INVESTAENT CentralBank losses

Operational goals: Enhancig competiion Chaptr 7 (par 7.44) witin financialsector Increase share and level indcudingdivestite of of private inveshnent Ing govenment shareholdings Chapter4 (para4.28-4.30) Promoting high-yield Chapter7 (para7.29-7.46) investments Buildingmoney and capital markets to price and Improving pricingof dismbutefinancial risk capital

LOWERINGCOSTS Stgteing legal Chapter3 (art 3.3-3.37) ANDRISKS OF fmework to protect mANCa financialcontrut TRANSACTIONS Improvingaccountag, Chapter3 (para 328-3.35) Operationalgoas: auditingand financial disclosure Improvingracnial Luternedlationand Increasingspeed, acucy Chapter3 (pan 3.42-3.54) paymentservices and reliabilityof finalcial Annexes3.3-35 paymentsand tansfs 25

NGTBENINGMONEI=RY 1AN&OMMN OF TBE BFfANK

2.1 Tndeveloping and iduial cmoutriesaike, thema functionof cenralbanks is to ensuorethe integr of the naional rrncyand a stablepricm levd. To this end, centralbacks ar entrustodwith managementof moneyand liquidit in the economy.As auch, the centralbank is a pivota pointof the fina sysm To effively undertakeis fiuctions, it shouldbe financially sud ad independentand have well tined staffat is disposal. s chpe isprmarily conered withthe exstingrole of thectral bankin Magsc (-) in monety policyand the means foiriproving thisrole in a market-orientedecowmy. Monetarypolicy generally has two aspects- economicmanagement and liquidity me he economicmanagement aspect involepsie stabilit. This aspectof monetarypolicy is epety constrainedby avaiable &rign reserves, neal debtand inflows of foreigncapital. At th samee , andwihin a shortertie horion, doe cen-wbank has to assuredtat dte banking system can provide flexibly for cashand payment needs of society.Both these aspects of monetaypolicy iact closelywith thie outcomes of publicfimace policieswhich are also reviewedin ts chapter.The oher crucial fimcon usualy attrbuted to centrabanls is prudentialreglation and supervisn of baning institutionswhich is dissed in Chapter4. 2.2 Thischapter is orgaizeda follows.Goverment finace policies an first reviewed to pwvidea contextin whichto siuat ctan actvite of BCRMLThese quafi-scal"actvities of BCRMare nOtstriy rdted to monary mngemen. Theseacvits ae analyzedm depth beca theyhave seros implicaon for BCRMi t of its abili to ef ey playits role in monetaymanagement. Subsequenty, the vaious Inmtum of monetaypolicy ae reviewL Theconusions of tis capter suge brad dirto forfute chn BCREMto enable it so becomea moreeffective playr in thefinanci systemin Madasc.

2.3 Goveme fiance can iflnce the finadci sector trugh its impact on money sr,pply,crdit andinerest rates. The impact com tmou do meansby whih thedeficits finned. In anyzing theimpac of deiit fiancingon te Malas financialsysem, tho partcuar definitionof th fiscaldefici mustbe clarifie Thefisca deficitis nay defineds te central goverment financn gap dt is covered by net government borrowi, inldn borrowing fromdte centa bank. lhe fiancinggap reuts rm tdhecess of tta govermentcabh oudays, inudig interestpaymen but ecudig oon O pbic debt, over tot coh re-ek, inluding tax and non-a proceedsbut excludi brrowlsg. At te -w time, in Madasr - in mmy other developingconri, crtin govemen fiac actvities dth are usay undert by the ceal gvment havebees instd assigedto th centrl bat Theseoperao Which arenot sricty caried outwith he purposeof ImplmentingMonetary policy, are Jreferrd o10a quasi-fiscaloper of the centrabank The conltion of te snuloLluLit ad ifisSddiesproducesabroadermaweofpvemaotfinncin needswhichforthpurposes of thisanalysis is calledthe overl fisd 26 2.4 ConventionalFiscal Deficitsin the 1980s: Followingthe fiscalinbalances in 1978- 1980, causedby a massiveincrease in public expenditure,the Malagasyauthorities imple- meted a pmgramof fiscalausteriy. As a result,fiscal performance improved significandy during the period1911-83, during which the fiscaldeficit which had peakedat 18.4 percentof the GDP in 1980,was reduced sharply to 6.7 percentof the GDP. This reductionwas effectedmainly dmugh a reductionin expenditure.During the period 1984 to 1988, the authoritiesconsolidated this substandalfisca adjustmenteffort. Fiscaldeficit during the 1984-89period was kept withinthe 3-4 percen range of GDP and it was brought down to only 0.9 percent of GDP in 1990 (see Figure 2.1). The incra in the deficitduring 1988-1989resulted primrily from a numberof once-and-for-all e_penditures,including those associated with rehabilitation costs of the publicenterprise sector, the part write-offof doubtul and litigiousloans of the commercialbanks to public enteprises and from the impactof a sharp deteriorationin the tems of trade on export-relatedtax revenues.

Figure 2.1: Fiscal Expenditure,Revenue and Deficit, 1984-1990 Percent of GDP

20

20

1984 1965 19o8 1987 1988 1989 1990

L_F&isca Revenue M Ficl Expenditure

Source:Govrnment Data

N: Fical deficitrefr to cal goveanmetScandal operaon duing the 1984-19i period. Thea Icovdhomemlbudgs, cztabudgctazycapil outys finaocedby cueral soures,revenues and of th I urcrop stian fad (FNUP),other exrabiudgeay aet expenditur finaced bydo andrimn imports fnaced by CR. Fcl deficitis definedon a cs basiswhich equas ta l kivame wvrevemleu prmnment epen pit$u s s delaysand arra. 27 2.5 Financingthe Fiscal Dehit: Table2.1 showsthat duringthe 1980sthe shareof the cental governmentbudget deficit was financedto a decreasingdegree from domesticsources which mainlyconsisted of centralbank financing. Net extern financingof this deficit assumed increasingimportanceas a proportionof the fiscaldeficit, rising from 55.5 percentin 1984 to 225 percentin 1990and covered,on the average,more than five sith of the totalfiscal deficit over the 1984- 1990period. This contrasted with the period1980 to 1983,when its sbareof deficitfiancig was declining.In turn, domesticfinancing fell continuouslyfrom 1984onwards, corr ing to the cumulativegovenment repayment to the domesdcbanking system of approximatelyFMG 110 billionby the end of 1990.

Table 2.1: Central GovernmentBudget Deficitand Flnandng (n percentof the GDP) OverallCash Financing Deficit Domestic Foreign

198143 10.1 4.6 5.5 1984-88 3.6 0.5 3.1 1988 3.5 -0.4 3.9 1989 4.1 -. 5 4.6 1990 .9 -1.2 2.1 Som= GovernmentData.

2.6 Asmnt of Fiscal Perrormance: Having redressedprevious major fiscal imbalances,fiscal stabilizationefforts in Madagascarin the 1980s' appear on the whole quite impressive.Notwithstanding the successachieved hitherto, a more qualifieda_sssment is necessa in examiningboth the developmentalimpact and susuinabilityof this fiscalpefomance as wel as attendantpressures on seekinggovernment financing outside the genera budget Lacking the a priate marginof manoeuv and instittional structuresto tailor goverment reenues and expendituresto changingeconomic circumstances, the authoritieswere forced in the 198t' to dash to varyingdegrees all categoriesof non-interestcurrent expenditures. Consequently, civil serice salariesgradually eroded in real terms to well belowtheir levels of the early 1970swith adverse implicationsfor the motivationand efficiencyof governmentemployees. Furthermore,as the principalcategory of discretionaryspendig, goodsand servicesbore the brunt of the cuts, wit adverseconsequences for the functioningof publicinstiuons acrossthe board and the profitabit of privateenterprise. Moreover,tax to GDP ratios in Madagascar,already low by intenional standards, have steadily diminied during the 1980s reaching a low 9.4 percent of GDP in 1990. It is thereforenot surprisinglythat in Madagascar,as in many developingcounties which hv maintainedsevre fisca sterityrdrives for longperiods of time withoutimprving fiscalreveue, fisc pressureshave led to variousmodes of govement fancing outide of the budget In the cas of Madagascar,in addiftionto the financingof the conventionalfiscal deficit, other financin of Treasr has occurredthrough quasi-fiscal activiies of the centralbank describedbelow. 28 2.7 BCRMOuasiFisIcl Qptons: As is the casefor most centralbankm around the world, BCRMpefonrs a numberof bankingand agencyservices for tde Treasurywhich would be generallyaccepted as proper roles for a centralbank. For example,BCRM has a statutoryrole in mntaining account for the Treasury,keeping deits (including"counterpart hfnds' describedin pars 2.18) aMlmaking advances to the Treasury.At the sametime, BCRM has engagedin a number of 'quasi-fiscal activitieswhich entailexplicit or implicitfinancing of GovernmentLike BCRM, centralbanks in many otherdeveloping counies havegone beyond their strictlymonetary functions by undertakingsuch quasi-fiscaactivities which tend to evenally ureatecentral bank losses. These losseseither aloneor togetherwith other centralbank financingof the deficitoften end up being monetzed. Centralbank quasi-fiscal activities have a potentialfor adverseeffects on liquidityand moneysupply. Moreover,sch monetizationmay quicldyget out of hand and underminethe ability of the centralbank to controlmoney supply, wih threateng consequencesfor macroeconomic sability and creditavailability to the privatesector. Suchquasi-fiscal activities include negative real returnson financialoperations related to the net financingof the Treasuryand publicenteaprises, subsidizedcredit, rescue of distressedfinancial institutions, finmancing of the servicingof the extnal debt and assumingthe accountingand cash lossesresulting from foreignexchange opations. It appearsthat losses of BCRMwhich have been chronic and sub tial since 1980can be principaly, althoughperhaps not exclusively,traced to the two last type of operations. Theseprincipal quasi fsc activitiesof BCRMare analyzedin greaterdetail below.

Figure 2.2 : BCRMAdvances to Treasury and Statutory Limits BillionsFMO 1200-

1000 -...... _.._-

O40--.0 200- = m f>zy0fJJ: . tsr ises1" lag

Actual advances = SbttutoryLimita Note Under artile 54 of the SCRMStatutes. advance. to the Treasury are llmited to 15 percent or ordinary budget revnue of the previous fiscal year. S r D .1 . N.~~~~~~~~~~~~~~~~~~~~~~~~~~t

I~~~~~~~~~~~~~~~~ It~~~~~~~~~ck1 a a

tohr' 3 IIaW ea,~ ~~luA

______r~~~~~~~~~~~~~~~~~~~~~~~~~~~idj~F 30

2.10 Ceal Bank's 12MRelated med-Fiscvities: Aoodierquai- fiscalfinction of the centralbank is the performanceof 4breignexchange operations and transactios on behalfof the governmentand the servicingof the externaldebt withoutfidl compaton by the Treasury. This functionbecame very importantdurng the 198)s after BCRM assumedextenal liabilitiesfrom the Governmentand the privatesector iz the contextof Paris and LondonCub debt reschedulingagreements. As Figure2.3 shows,the financialrepercussions of this quasi-fiscalactivity have dramaticallyreshaped the centralbane's balancesheet ind income accunt The accountingand financialresults of theseoperations are reflectedin the wrevaluation'account and accumulatedlosses accountsof the centralbank balancesheet whichare discussedmore fully below.The evolutionof these two accountsshown in Figure2.3 resultfrom a fundamentalmismatch witin the balancesheet of BCRM. On the liabilitiesside are foreigncncy denominatedliabilities aginst whichthere is the domesticcurrency denominated'revlWuation account' on the asset side which is in practice unremuneratedby the Government. Every time tire is a devaluation,there is initiallyan equ- increase.in the domestic currencyvalue of both accauntson the liability and asset side. The discussionbelow however shows that there have subsequentlybeen asymmetricmovements in both sideson the balancesheet leadingto BCRMoperating losses.

2.11 Te Revalion Accountof BCR The revaluationaccount originated from the need to accountfor the changesin value of net foreign assets followingdevaluations. Since, net foreignassets (mcluding medium and longterm ones),as shownon the centralbanks balancesheet, have been increasinglynegative during the 1980s, their increasedvalue in domestic currency consequem.to devaluationshad to be reflectedon the assetsside of the centralbaks balancesheet by an offsettingentry calledthe wrevaluationaccount". Over time, this 'revaluationaccount began to recordother foreig exchangeoperations and transactions.Today it recordsa mix of accruedand cash results from servicingof externaldebt and sundryoperation and tmrsactions. Under normal accountingpractices however, only losseson an accued basis should be induded in dtis account; once these lossesare realized,they shouldbe movedto the profit and loss accountand be set off yearly agant net worth. The revaluationaccount also recordsdifferences i postedvalues resulting from tume value nmsmatchbetween outflowsof foreign exchangeand conrsponding donmesic curency inulowsfrom the Treasury. his mismatcharises in paymentsfrom the TreasurytD BCRM in domesticcurrency equivalent to debtservicnmg on the originalmaturity schedule and out payments by BCRM to service externa debt accordingto the maturityproffle of reschedulmgagreemeom. Under the 1983 amendmentto BCRMstattes whichwas relatedtn its assumptionof n external debt sevicng fanctions,the Governmentwas to guaranteeany resultingvaluation losses that have now been recorded in the revaluationaccoamt In practice, no Governmentcompensation on this accounthas occurred.Hence, the revaluationaccount which now reflectsthe yearlytotal value of a numberof both accrualand cashforeign exchange operatons and trnsactions, representedin 1990, 40.2 percentof the assetsof BCRMin 1990without generaig any incomefor BCRM.

2.12 The accumulated losses of BCRM: BCRMhas consistdy incurred subsntial operatinglosses thoughout the 1980sas shownin Figure 2.4. It appearsthat the foreignexchange operationsand transactionsdescribed above are by far the main sourceof CentralBank losses. The changesm the revaluationaccount descrbed abovecan rema unrelizd and not have any impact on BCRM incomestatement. t is only whenBCRM has to purchaseforeign exchangeat a new devaluedrate to serviceold debts acquiredat an overvaluedrate that an impactoccurs in terms of BCRMoperating losses. Thisis becausepayments from the Treasurydo not fily compensateBCRM for valtioon losses, leadingto operatinglosses as the valuationcharges are realized. Since 1985, these operatinglosses have averaged3 perct of the GDP a year and have accumulatedto the 31 eqialent to 9.6 percentof the GDP in 1990.According to BCRMstates, the Govermnt is to fuly compensateBCRM for such losses.Since the cental bankconsiders t these loss rqesmt a daim on the Government,it accoun for them in its balancesheet under 'other assu ratherta on the liabilityside as a reductionin net worth.

Figure2.4: BCRMAnnual Operating Losses % of GDP P.rontage of GDP 4 - ,

0 9so _01911982 198 16 1935 1986 1957 1968 oSD 190

AnnuaOera Loses

locust BCRSDat

2.13 Agrete rmlt of quaIfscal activities:When induding the caims on Govenmentreqrsented by the revaluationacount withBCRM's opeatg accountnd BCRM advancesto tho Trasr at dte end of 1990, he rulting claimson Govemen rrate about 607per cent of ordinarybudget revenue esmated for 1990.Ihis percenge is abo forty times * actualpercetae limit of 15 percentprescribed by BCRMstaes (see para 2.8) for BCRMcredit to theTreasury. A m- carul studyis neededto fly darifythe origin,acuntng practicesmd magitudeofhe quasi-fiscaac i of BCRMdesribed here. Althoughthe quasi-fiscal operations of the centrabank merit fart investigation,the availle iformationsuggsts thatthe opera- don, particulaly a reflectedin the revaluationand other assetsaccounts, have a majorimpact on moneybase creationand the finacial stabiliy of the Centrl Bank. Ihe monetarysignficace of centralbank opeati lossesis that they lead to reservemoney eation.Depending the sizwof these loss, they my susly intefer with monetay policy. 32 2.14 In Maagascar, these losseshave becomevery large, amountng in 1990to 60.5 per ct of the stockof reservemone at the end of 1990.In other words,BCRM in its reserve money managementhad to compensatefor a 60.5 per cent autonomousincrease of reserve moneyor accept the inflationaryconsequences. However, as discssed below, such compensation did not occr by desip between1984 and 1990but rather inadvertenly. As the discussionbelow points out, during this periodthe poenaly inflationaryconseqences of BCRMlosses were compensatedby large net inflowsfrom the Treasuryto BCRMarising from the mismatchof debt servicingunder the origina and rescheduledpayment profiles and the substantia1accumulation of counterpartfund deposits. his situationundecores the precaious positionof monetarymanagement if and whensuch offseting factorscease to compensatefor the inflationaryimpact of BCRMopatng losses. As the discussion below shows, continuationof exiting exte debt servicingaragemets into the 1990sis likldy to resut in increasedinflaton or crowdingout of the privatesector if BCRMis to attain its tgets for monetarygrowth. In additionto operatinglosses, there are the accrued losses found in he revaluationaccount which, as noted above, will even ly be realized as operaig losses. The monetaryimpact of these quasi-fiscalactivities are reviewedin depth below. A side issue, but also an importantone, is that these quasi-fiscalactivities should be of concemfrom a fisca stadpoi By obscuringdte fill magnitedeof governmentfinancing needs, the importanceof these actvities camot be properly weighee agamst that of odter activities competingfor limited resources. Accountingfor these quasi-fiscaloperations significantly dhanges the pictureof fiscalpefirmance and monetarystability and raises a numberof key issueswith regad to both fiscal and monetary policies.

2.15 Durin the perod 1984to 1988,the mainobjective of monetarypolicy was to limk the increae in M2 or broad mony in line with that of projectednominal GDP so as to avoid inflationaypressuresand strengthenhe extenal position. As exlained above,a nuber of develop- ments, some of which reflected direct credit and monetary control, retrained cesive money sply withthe resut that broadmoney increased in line withnominal GDP, the latter increasingat 18.6 per annumduiing the periodand the former at 185. percene,thus implyingan almostconstant velocityduring the period. In 1989.financing of the quasifiscal deficit incre sharplywhich led to an increasein basemoney and accordinglybroad moneygrew by 29.8 percentagaint 15.4 percent for the GDP. his monetaryslip causedin turn, a dramaticdecrease in foreignreserves - as trade policiesand foreignexdcange allocation had beenliberized - forcingthe authoritiesto tightenanew credit ceilingsand limit drasticallyimport financing.

2.16 Imact onaseMoneCreation: A centralbak createsliabiities in the fom of curency and reservesagainst its assets. Togethercurrency and reserve firm base money. Base moneyis intmediated by the banicngsystem. Thisintermediation produces a nmutipliereffect and adds to bank depositsand to curency in the hands of the public. To analyzethe proximateorigins of changes in the money base using centrl bank balance sheet, the moveme in inlterona reservescan be viewedas a residualvariable. Table 2.2 below showsthe five main sourcesdtat influencedchanges in the moneybase in the 1980s: medium-and long-termliabilities; rvaluaion account;losses of the centralbanks net claimson Governt; and net short term foreignass. Fiure 2.5 graphicallydepicts the majorsources of changein the moneybase in Madagascardming 198890. Theseinfluences on the moneybase and their significanceare dicussed below.

... - . . ; ~~~~~~~...7 33 Table 2.2: SOu of Easion ot the Monetr Bae (in billion of FMAG) 1985 1986 1987' 1988 1989 1990 hat Reservesnet -11.1 45.0 132.1 149.0 55.5 -176.5 Claimson Gv. net 26.3 24.3 6.6 -25.2 -65.8 -19 ClaimsonfBanls 4.1 4.6 5.2 5.2 1.3 115.7 Reevaluationaccount 19.4 185.5 653.1 227.6 126.8 76.6 CentralBank losses 50.0 55.0 105.0 100.0 160.0 49.0 Foreigpliab. M. & L.T. -75.2 -230.7 -818.5 -368.7 -179.1 -87 OtherItems -1.1 6.8 -44.3 -79.3 -9.0 9.6 SubTotal JL La 322 Il7 Akney Base B1 322 Rh 171M _-1

(Err and Omissions) (0.6) (0.3) (0.1) -

Not The abovetable analyzes hangmmin the monetarybase in termsof chn in the other items of the centr bank balancesheet.

2.17 E _pansonarand Contacinaa Influences on M Three of these developmentshad an expansionaryeffect. Theincrease in the revaluation accoun"had the strongest expansionaryeffect It was followedby the graduallyrising losses of the centralbank and marginaUlly by poste movementsm net iteatonal reserveswich, as mentionedabove, can be considered as a residual. Ihe main contci effe camefrom the expansionof mediumand longtem libilites followedby the declinein net claimson the governm Expansionaryand cotrctoary efcts offseteach other before leading,ftrough monetarycannel to an increasein demandfor the monetay base ta in tun led to an expansionin ftis moneybase everyyear from 1985to 1989.

2.18 Key Feature of Base Money Evolution: There are three notablefeatus in the developmes mentionedin the paragraphpreceding and depictedin Figure 2.5. First, medumand long um liabilites increasedfaster than the reevauaton account. It appearsthat this diparity is ainly due to a sipificant discrepancybetween the time value of payment in domesticcurenc madeby the Tresury to the centralbank to finane the sericing of the externaldebt and th. time value of acualmpayments in foreip exchangemade by the centrl bank to debt holders. This discrepay arises by the two insttutons using diffrent debt servicingschedules related to the mutiple rescheduing of the eenal debt (see paa 2.1 below). In fact, the Goverment makes paymentsin donmeticcurrency to BCRMbased on the originalextal debt schedulewhile ECM rvices aternal debt based on reschedulingagreements A secondfeature of base moneyevolution is tat totallosses of die centralbank over the 1985to 1989period are moreta four timesgreater than the total moneybase creatim duringthat period. Hence, consideingcentra bank's lossesas a policyvaiable, these lossescan be viewedas accountingfor morethan tota mo on Th, t caims on government (iLe. BCRM lending less total government deposits) exed a ontra-onary influencelargely becase of the accumulationof unspentcounterpart funds (discussed in parm2.20 below)rather thambecase of a majorfiscal efft. 34

Figure2.5: Madagascar:Major Sources of Changesin Monetary Base Percent of GDP 8 6- 4 . 2 -

---40-,_ ------,-

1888 1989 1990

I Net Clims on Owl. IL. < ForeignLLE InL RservesNot Ei Rudb-vatlouAco 1 Central bank Loee

NofteTIm graph abow nhmzg in theatock of do.above vaniables which inc idad Is gbE inzi the PsitimFbum changeszcpame an epansmy influeneon themon day bae whilen_g;ive ~change. rqiruo a o tu.ay ince. Totaldng. in ncty bos, us a peR of G;DP,o i fDot: 1988:0% , 1989:2.3%and 1990:-0.7%.

2.19 Mon:tr rok of the revcatio aa=t: As noted previously,t revuation account reports both accrued as weIl as cash operations. I therefoe canot be fiWyreated to money base creaion at a givenpoint in time (pas. 2.10 and 2.11). However, accud vaton chanes in die stockof extal liabilitiesbecome realized when paymen e due andmade. These cash aions thenconbute to basemoney creadon. Mhm predominant co oy influence,with regad to basemony evoludionhave been dhe movements of mediumand long term liabilities. Uhe appare timedicrepancy beween the reording andthese movements on the liabilityside of the baae sheetand the posting of offsettingmoves in t 'revaluationaccount' on th assetsside has gemeratedon its owna cr influenceon the demandfor the monetuybase. 1hm wouldappear to resultfrom inflows from the Treasu o DCRMcesponi to debt service 35 paymentsas the originalmaturity schedule exceeding outflows from BCRM for debtservice payments correspondingto reschedulingagreements. However,as discussedabove (para. 2.11), valuation lossesultimately become realized and are reflectedeventually in the mountinglosses of the central bank. When there are time lags betweenreceipts and paymentsor if different exchangerates are appliedconsecutively, then the net result of these cash operationscan result in a contractionor expansionof basemoney, depending on there relativesize. Until 1990,inflows from the Treasury exceededoudlows from BCRM;this situationis likelyhowever to be reversedin the early 1990s, leadingto potentiallysignificant inflationary consequences or severe crowdingout of the private sector. To effectivelymanage the monetaryconsequences of existing exteral debt servicing arrangements,the time profile of future inflows and outflows accordingto the original and rescheduleddebt agreementsshould first be fully identified.Only then can future monetaryimpact of the revaluationaccount be systematicallymanaged through adequate compensation of ECRMby the Treasury.

2.20 Monetary role of goveemmentdeposits and counterpart funds: AlthoughBCRM advancesto the Treasuryhave not decreasedin volumein recentyears (see Figure 2.2), net claims on governmenthave decreased on accountof increasingvolume of Governmentdeposits with BCRM. The increase in governmentdeposits in turn is due to a rising volume of counterpartfinds. Counterpartfunds are the proceedsin domesticcurrency of the salesof foreigncurrencies or goods originatingfrom xtnal loansor grants. Generalythese funds are earmarkedby relateddonors for specificprojects. Mostcounterpart funds are depositedby the Treasuryat the centralbank and have accountedfor an increasingpercentage of total governmentdeposits at BCRM(see Figure2.6). They are now equivalentto well over FMG 500 billionor more than twicethe amountof domesticdebt repaidformally, hiterto, by the Treasuryto the centralbank and morethan half of totalgovernment depositsin BCRM.These deposits do not bear interest In the contextof the ongoingmacroeconomic stabilizationfbfrts, the use of counterpartfunds in Madagascarhas in effectbecome an instrument of macro economicmanagement The accumulation,over the past six years, of unspentcounterpart fimds helped the Governmentto containmoney supply. Had these fimds been depositedin the commercia banking systemmstead of BCRM, they woud have had an expansionaryimpact by allowingbanks to fimd firther credit to the economy. From a monetaryviewpoint, that is not consideringthe problemssuch accumulationmay entail for the public investmentprogram, the- accumulationof bounterpartfunds allowsadditional quasi fiscal deficit financing and corresponding monetizationto be delayed,to the extentthat an offsettingfiscal effort is not taken.

2.21 'On one hand, the accumulationof counterpartfinds withinBCRM may be seen as positive, given that it has helpedcontain inflation and helpedincrease the share of creditavailabie to the private sector by allowingthe Governmentto effect net repaymentsto BCRM. Yet the phenomenonof accumuatedcountexpart funds alsounderres the problemscreated by a longfiscal austerit period unsupportedby measuresto structualy increasefiscal revemneand enhancethe elasficityof fiscalrevenue to economicactivity. It is a reflectionof the transferof the fiscalpressure from the fiscalto the quasifiscal area. Thehuge sizeof acmulated counterpartfunds indicatesthat they are unlikelyto be able to be releasedquicldy for governmentexpenditures. One possibleway of reducingthe potentialvolatility of counterpartfunds on governmentdeposits would be to usepart of these fundsfor offsettingGovernment claims on the assetsside of the centralbank's balancesheet. Such an approachwould however need to be donein the contextof a comprehensivesolption to the problemsof BCRMrelations with the Treasuy and their impactof BCRMbalance sheet and would necssitate the agreementof al donorsand other parties involved. 36

Figure 2.6: Evolutionof GovernmentCounterpart Fund DepositsWith The Central bank Porcentage

"a- 43 EMFy

40-I 20-I -0 1988 1989 1990

Counter-PartFunds Note: The above graph represents counterpart fund deposits an a pereentage of total governent deposits with the central bSnk. Souro: GovernmentDate

2.22 Magitude of Ouasi-F0scalDefrit: Table 2.3. shows thz. quasi-fiscalopations of the central bak that are dlose in magnitude to the conventionallydefined fiscal deficit. Tee quasi- fiscal operations of the central bank in every year of the period 1985 to 1990, entaied some form of cental bank financing as the losses of the central bank are greater than the Treasury net repay- ments. Had the Treasury been required to fmance losses of the central bank, it would have bad to find additional fiscal resources equivalent to about 3.0 percent of the GDP, on average, during the period 1985-1988 and to 4.0 percent and 1.1 percent in 1989 and 1990, respectively.

Table 2.3: Oussi iscal Deficit and Its Finanigg (in percentof the GDP) Convenfional Quasi-fiscal Overall Domsic Fioreign Fscal Dericit Deficit of Fscal Deficit of Treasury ECRM 1\ 198448 3.6 2.9 6.5 3.4 3.1 1989 4.1 4 8.1 3.5 4.6 1990 .9 1.1 2.0 -.1 2.1 R i i srpeerteoerugtse fs&1adare ully tinanceddomestically.

=: Goverment DatL 37

2.23 Imad of Ouasi-FlscalActivities on BCRM Income: In 1990, the revaluation accountrepresented 40.2 percentof centralbank's totalassets. Accumulatdlosses represented 1 1.5 percent TIhismeans that at least 51.7 percentof the centralbaniks assets in 1990yielded no income, althoughthey are or originatefrom claimson the government.The counterpartliabilities however generateexpenses for BCRMwhich underlie the centralbank's chronicoperating losses. Ihis has very serious implicationsfor the independenceand the financialsiuation of the cental bank and thereforefor its capacityof performingits key fimctionsof monetaryand liquiditymanagem . In addition,for a giventarget of moneygrowth, increased Central Bank operating losses in fure imply increasedfinancing needs of the publicsector, which can reducecredit avaiable to the privatesector. In view of the importanceof boostingprivate investment discussed in Chapter1, the quasi-fiscal activitiesof BCRMmust be haltedand the correspondingfinancing needs be resolvedin the context of overallpublic sector financing policies in a transparentmanner.

2.24 Revenuesfrom Seigorage and naliflon Tax: Owingto its uniquerole of issuer of basemoney the centralbank in anycountry benefits from implicit revenue from this monetzation. This revenueconsists of seignorageand inflationtax. Seignorageis literallydefined as govrenment revenuefrom the manufictureof coins, calculatedas the differencebetween the face value and the metal value of the coins. A broader and more cont y definitionis that of an inrease or decreasein the real stockof base moneyrelated to movementsin moneysupply. The net revenues from changesin the real base moneyare reducedby the cost of issuingmoney. In the case of base money, seignorageaccrues to the cental bank InflationoperAt like a tax on money and other financialassets. Moneyand asset holderspay the tax by losingpurchasing power o&their money holdings.Intitutions that have issuedmoney liabilities, usually cental or commercialbanks, collect the tax in the fonn of a reductionin the real valueof their liabilities.To the extent,however, that interestis paid on these liabilities,some of the tax is retured to asset holders. Inflatiomtax is calculatedas the productof the inflationrate and the real stockof money.1L the case of basemoney, the inflationtax accruesto the cental bank.

2.25 Whileincuring operainglosses, BCRM has benefitedfrom sigficant but unstable revenuefrom seignorageand inflationtax. Estimatesof these revenuesare shownin tems of GDP in Table 2.4. The estimatesinclude seignorage and inflationtax accruingfrm base money and govemmentdeposits (which are essentally unre unedwith BCRM. Base mowe and these depositsgenerate the bulk of monetzationrevenme for BCRM. Revenuefrom th iflation tax has been iversely corrated with revenuefrom seignorage.When infion increases,the red stockof base moneydecreases in generalless thanproportionally. This means that the tax base(the real stock of basemown) declinesas the tax rate (theinflation rate) goes up. Hence, the inflationtax revemnes increaseas inflationrises, but less than proportionally.Of the tot revenue,7.5 percentcomes fiom banks resves, excessand required, 17.5percent from currencyholders and 75.0 percentfrom the Govement deposits. 38 Table 2.4: Seignorapeand Inflation Tax Cmpercent of GDP)

Seinlao TotalRevenues 198143 -. 2 4.0 3.8 198448 1.5 1.7 3.2 1988 -0.2 3.1 2.9 1989 4.2 1.2 5.4 1990 -0.2 1.6 1.8

Noe: Seignorageis definedas the increasein the stockof real base money. Inflaziontax is definedas the productof the inflationrate and the real stockof base money.

2.26 Inflaton Tax, Seignorageand BCRMIFnandal Stability: The magnitudeand paten of centralbani's revenuesfrom seignorageand inflationtax has three implications.Fzrst, as macroeconomicstabilization leads to lower inflation,BCRM revenues from seignorageand the inflationtax will decrease.Second, as the Governmentreduces its net overdraftwith the centralbank ,the revenuefrom inflationtax will decreasefor a giveninflation rate. Third, if the centralbank has to pay the Treasurya depositrate of interestpositive in real terms it wil lose the revenue from the inflationtax. An increasein the overdraftrate wouldbe neceary to ensmesome posite inome to the centra bankcThis however wouldworsen the conventionalfiscl deficit Al three facors underscorethe precariousnature of Central Bank financial sbility and the necessityof finding offsettingsources of revenue; otherwisethe losses of the central bank wi11continue to increast The recaius financialstability ofthe CentralBank and the tradeoffsagainst fiscal stabilit necessy to offsetthis siuaion underscorethe problemsthat aise whenfiscal and monetarypolicies become inexticably interwoven. This sitation can undermineeffietveness of both policiesand quicidy lead to a loss of controlof the moneysupply. Unlessthis issue is addressedby separat fiscal and monetarymanagement and restoringBCRM to a sound financialfootig, the long-tem benefit of Madagascar'sadjustment process will be increasinglyjeopardized and the resumptionof self sustainedgrowth delayed.

2.27 RelIeving CR! of debt service burdens: RestoringBCRM to a soundfinancial footig will require compensationfor BCRMfor all existingclaims on Governmentand transferof all debt servzig reonsibilities on extermalliabilities to the Treasury. This wouldrender the fiacing of a goverment operaions, and specificallythose presentlyrelated to the quasi-fiscaldeficit, more transpaent. This tr of responsibilitiesfrom BCRMto the Treaury would howeverleave extenal debt servicig burdensfor the countryas a whole unchanged. The additionalcosts to the Treasuryof this arrangementassuming no furtherdebt relief or cancellationremains to be amessed ad is likely to requir some combinationof adjusmet in public expditure, firther tax mobilizationand governmentfinancing tough issuanceof securities. The benefits of the new arrangemen lie in the greater transparencyof governmentfinancial operatons and the ablity of BCRMto conductinWdependent monetary policy. At the same tint, this new rangement obviates the potenta of monetizinggovment fl?ncing needs. 39 2.28 Importance of eliminatingBCRM losses: From a purelymacroeconomic standpoint, the lossesof BCRMare a problemonly if they endangerataiment of monetarytargets. This has not yet appearedto be the case till 1990. However,this siuation is unlikelyto endure especiallyonce the outgoingextemal debt servicepayments by BCRMin accordancewith rescheduling agreements begin to exceedthe incomingpayments to BCRMfrom the Treasuryaccording to the originaldebt schedule. Thereare howeveralso less tangiblealbet significantconsequences of BCRMlosses. The perceptonthat BCRMis financiallyunsound could undermine its staturewithin the financialsystem and its ability to use moral suasion as an instrumentof monetarypolicy. Its independencein managingits internal affairscould be dilutedby pressuresto subjectthe administrativebudget of BCRMto the Treasuryto limit its losses. Exceptin such extremecases, the implicationsof the erosionof the authorityof the centralbank are difficultto gauge. Yet, it is importantfor saversand investorsalike to perceivethat the centralbank has the capaciy to conductcredible monetary policy whichassures price stability. Theimplications of thesefactors for the fiutureof BCRMare discussed in the conclusionof this chapterfollowing the reviewbelow of recentmonetary policy.

RecentTrends in Monetary Management

2.29 Monetarypolicies in Madagascarare in a period of transition. lthoughdirect instrumentsof monetarycontrol are sil in force, there is consciousnessof the importanceof shifting towardsindirect instrumentsauong policy makers (see Annex 3.1 for a discussionof these two apoaches to monetarymanagemint). Current monetarypolicy instume in Madagascarare a :ombinationof directcntrols and an emergingset of new instumentswhich, although still at a very embryonicstage of implementation,hold more promise for effectivemonetary management in an ncreasinglymarwket-oriented economy. The variouspast and presentmonetary instruments in use are reviewedbelow.

2.30 Previous Moner Porices: The monetary oontrol system as it exted in Miadagascaruntl 1990,resembled closely the systemthat existedin Franceat the time Madagascar becameindependnt. It reliedheavily on direct, adminive controlsin the form of bank-specific creditceilings (1I'encadrement du cr6dif), and prior credit authorizationsby BCRM(Qautorisation prEalable). The direct controlswere supported by reserverequirements on , the placement of interest-earningbank depositswith BCRM, and rediscountpolicies. The systemwas designedto facilitateselective credit policies. By applyingdifferent ratios to differet types of credit, and by varyingthe conditionsfor rediscountingacross types of credit, BCRMencouragd the bankmto extend credit to priority sectors and activities at below-marketinterest rates. Chaateristic, of the old systemwere the detailedregulations and the manyexceptions. For purpos of the reserverequirement and rediscountsystems, credits had to be distng ed by matriy, type of guaantee, identityof recipient,economic sector, and nature of activityfinanced. Moreover, BCRMdefined rediscount ceilins for eachbani, derivedfrom itstarget for bankingsystem liquidity, and alsofor each majorborrower, depending on their credworthiness. The uncertinty this created, together with the prior authorizaion reqi rement,resulted in heavy involvementof BCRM in coercia bank credit decisions. This was accentuad firther after de nationalizationof the baking systemin 1975.

2.31 Ky Changes in Roeent Monetr Po5lic: BCRM has now recognizedthat monetarymanagement that is bothmore efficient and moreconducive to financialsector deveopment requir market4asedinstuments. In Novewrber1990, it intrdced a mumberof majorinnvatios intendedto preparethe grund for indirectmonetary control relying prinarily on BCRYs capact 40 to influence short-term interest rates. First, banks are now permitted to engage in interbank borrowingand lendingon freely negodatedterms but with an obligationto informBCRM. Second, BCRMreplaced the old refinancesystem by a systemthat gives it more direct controlover the supply of reserve money to the banking system. The new system is organizedaround regular auctionsat whichbanks can either obtainBCRM refinancing ('Appel d'OffresPositive"-AOP) or place interest- earningdeposits with BCRM ("Appel d'Offres Negative"-AON). The auctionsare supplementedwith interimBCRM interventions at less favorableinterest rates, whichmay be at the requestof die banls but alwaysat the discretionof BC2M, and are alwaysat less favorableinterest rates ("Pensions"and Tensions speciales").Third, the reserve requirementsystem was replacedby a deposit-basedone, designedto give BCRMmore effectivecontrol over the demandfor reservemoney. Relatedmeasures included:the completeliberalization of interest rates (previouslythe six month term deposit rate remainedfixed), coupledwith the obligationon the part of the banks as of July 1991 to inform the public of their "base rate"; the annuncement that BICRM'sindicator rate ("taux directeur") vwoud henceforthequal the maximu rate chargedby BCR.Mfor auctionadrefinancing ("taux plancht"), and that the rediscountrate ("taux.d'escompte") would als be equal to that rate.

2.32 Rerinandng Auctions: While under the old refinancing system BCRM was in principleobliged to rediscountall eligiblepaper within its refinancinglimits, under the new system BCRM decides on the amount of refinancingsolely on the basis of its liquidityprojections and monetary policy stance. The complete transition from the old to the new system took place on November22, 1990: all outstandingrefinancing plus bank depositswith BCRM, includingaccrued interest, were due on that day, and the first AOP took place on November 22 with value date November22. When the new refinancesystem was introduced,the liquidityof the banking system required net injectionsof refinancing. BCRMiniially organizedrefinance auctions (AOPs) every two weeks,but changedto monthlyauctions when the bankingsystem liquidity improved in January 1991. BCRMannounces prior to each auctionthe minimumacceptable bid yield or minimumrate Ctaux plancier), and has decidedfor itself, but does not announce,the amount it wants to inject After inspectionof the bids, it decideson the maimum acceptablebid yieldor maximm rate ("taux maximum"),and acceptsall bids at or abovethat rate at that rate, uniformlyprorating them if they exceed the amount it was to inject The rates for short-tm BCRM interventionsin-between actions, either for 2 to 10 days ("taux des pensions"),or for shorter perods ("taux des pension spciales"), are fixed at respectively1.S percent and 2 percent above the weighted-averageyield resultingat the latest auction.

2.33 If BCRMperceives a need for absorbingliquidity from the bakcing systemon a net basis, it would auctiondeposits (AONs), announcing a mnaimumrate and decdng on a minum rate on the basis of the bids received. So far there has been no need for such auctionsand the only absorptionthattakes place are in the form of interiminterventions whereby BCRM accepts short-tem dposits, currently at 9 percent. The purposeof setng m and maximumBCRM rates is to sailize to some extentmarket interest rates, notablythe itbank rate. On the other hand, the room for interestflexibility is limitedby the spread betweenthe two rates (fiourchette"). So far this room has been minimal: the minimum rate has been unchanged at 12 percent and the maximumrate unchangedat 13 percent. While it is understandablefor BCRMto wantto star off the new system with a relativelynarrow spread, if contimed for too long this threatensto underminethe auction process. Confidentthat their bids will be acceptedat a maximm rate of 13 perent, banks currendy do not care much about the yields they bid; and since their bids will most likely only be partly accepted,they bid for a multipleof what they really need. The weightedaveage yield of accepted 41 bids is always 13 percent, and the interbankrate not surprisinglyis very stable at about 14.25 percent.

2.34 A wideningof the interestrate spreadseems called for at this point in time. flexibilityis criticalto the envisagedgradual shift from direct to indirectmonetary control and the attendantreliance on interestrates to constraincredit growth. A wider spreadwill firthermore restoreto the auctionstheir proper role of allocatingrefinancing, forcing bans to revealtheir true liquidityneeds, in terms of quantityand price. Thispresumes tha bids will be acceptedat the yields actuallybid.

2.35 Interim Interventions: The auctionrefinancing is supplementedby a systemof short-termBCRM interventions. In betweenauctions, ban may requestBCRM for 2-10-day refinancing("pensions") at the 1.5 percentagepoints above the latestweighted-average auction yield; in exceptionalcircumstances, banks may requestloans for shorterperiods ("pensions spdciales") at 2 percentageroints abovethe maximumrate. Conversely,banks may approachBCRM to place shorterm depositswhich BCRM may acceptfor durationsand at yieldsat its discreton (currendy at 9 percent).Theshort-term fcility is neededto correcterrors madeat the auctionsin forecasting system-wideliquidity needs. BCRMcan makeerrors in its forecastof the volumeof refimancingor depositsto be auctioned. Ihis is likelyto be a problem,specially at the beginning(see para 2.32). In principleit is alsopossible for the bankscollectively to underestiae their liquidityneeds.

2.36 Shortcomings in Uouiditv Managment: Despite much improved liquidity forecast, the possibilityof unexpecteddevelopments always exists, both at the level of the banking systemand of individualbank. Indiviual banksshoud competefor BCRMresources just as they do for other resources,access to which is neverassured. Theremay be all sortsof tecnical reasons why an individualbank is unableto meetunexpected liqdity swingsin the interbankmarket even thoughthe liquidityis there. As noted,the short-termfacilityplaces a ceilingon marketinterest rates under sich cirumstances.To encouragebanms to rely on the acions morethan on the short-term facility, the rates are less atrctve than those obtainableat the auctions. In a well-functioning baning system.this shouldbe sufficientto preventundue rliance on the short-termfcility. In addidon, utlization is constrainedby minimumand maximummarities, by the availabilityof eligible collateral,and, finaly, by the discretionaryauthority of BCRM. Neverteless, uniformly defed utilizationlimits per banis mightbe considered.They offer BCRM better protection because they are more transparentand defensiblethan discretionaryrefiisals. Such limits couldbe defined as a percentageof capitalplus reserves,which would have the side benefitof smulating banksto build a proper capitalbase.

2.37 Managing ChronicallyUliauid Banks: If a bank is chronicallyilliquid due to problemsof a struchtualnature, it is difficultfor BCRMto satisfy its needs through the regular refinancingsystem. The bids at the auctionsfrom this bank wil inevitablydrive up the generl interest rate level, crowdingout other bids. Thisrise in terest rates may not be warrnted from a macroeconomicstand point. In addition,the higher iterest rates may compoundthe problems afflictingthe iltiquidbank if it is temptedto enge in distressborrowing. The situationmay also arise that exceptfor the chronicallyilliquid bank, all banksare experiencingexcess liquidity. BCRM would want to shift from injectionsof reserve money (AOPs) to absorptions(AONs), but is compelledto contne the AOPsto providethis one bank withthe liquidityit needs. In the case of such a problembank, BCRMshould in the first instancemove towards formuating a restructuring plan for the bank. In the contextof such a restructuringprogram, the ba's accessto the ordiary 42 facilitiesshould be terminated.Additional liquidity needs of the problembank should be closely monitoredby BCRMand financed,if necessary,through an extraordinaryand limitedline of credit. Therefore,chronic liquidityneeds shouldbe satisfiedoutside the auctionprocess, throughsuch a facility. By the time the restructuringis completed,all refinancingshould be repaid, and any remainderwritten off as the case may be.

2.38 Problems of Liaulditv Forecasts: The most challengingtechnical aspect of reserve moneymanagement is makingaccurate liquidity forecasts. As a basis for the volumesof refinancing or depositsto be auctioned,the centralbank mustforecast bankingsystem liquidity during the period immediatelyahead. The major "autonomous'sources, that is, thoseover whichit has no influence, are the balanceof paymentsand the governmentcash position. Oncethe liquiditycreated by those sourceshas been forecast,the centralbank can choosesettings for its monetaryinstruments so that the supply of bankng system liquiditymoney is consistentwith the demand. BCRM is finding liquidityforecasts very difficult,mainly as a result of the lack of accurategovernment cash flow forecasts. The Governmenthas the possibilityof obtainingadvances from BCRM. BCRMhas a statutorylimit on totl gross lendingto Government,including advances, of 15 percentof ordinary revenuesduring the previousfiscal year. In practicethis limitis completly ignored(see Fig. 2.2), and the Government'saccess to BCRMfinancing is limitedonly by the credit ceilingsformulated in the contextof the ME adjustmentprograms. Thanks to this flexibl accessto BCRMfinancing, the Ministryof Financehas no urgentneed for accuratecash flows. Hence, it is insufficientlymotivated to overcome the technical and organizationalobstacles to account consolidation,which are undoubtedlyfornidable giventhe state of communicationsand the 120treasury agenciesacross the country. This suggestsanother reason for effectiverestrictions on governmentborrowing from BCRM in additionto the monetarycontrol reasonspEented below.

2.39 CQotatl tBgurenaluiaqn3fRemncng: Underthe old refinancingsystem, paper was redisoounted, that is, purchased by BCRM. For the most part these were promissory notes or bils drawn on enterpriseswhich met the specifiedeligibility criteria. Presently,BCRM no longer redisounts but extendsrefinancing credit againstcollateral. Ihe eligibity criteriafor collateal are enialy the sameas beforefor rediscountablepaper: a mixtureof objectivecriteia, havingto do with the naure of the activiy financed,and subjectivecriteria, having to do with BCRMappraisal ofthe creditwordiinessof the enterpriseand the liquidityposition of the bank. Theproper application of these criteriais timeconsuming. Therefore, once they have extendeda credit, bankswill routinely submitthe wholecredit fileto BCRMCredit Department, and ask it to determinein advancewhether the ppr in questionis eligiblecollateral. BCRMwill issue its-agrement (accord de mobilisation") whichsdpulates the portionof the fice valueof the credit it will acceptas collateral(mobilisable'). While BCRMrarely rejects paper outright, exceptfor reasonslike an incompletefile, the amount detemined eligible is usuallyless than the face value. BCRM discretionin curtailingthe eligible amountsadds yet anotherelement of uncertaintyto the regulaory environment:n whichbanks must operate. Generally,a cental bak shouldtry to evaluatethe soundnessof a bank's loan portfolio in the contextof its supervisionfhnction (see capter 4) and not inconnection with its refinance operations. If the centralbank feels that a bank's loan portfoliois impairedto such an extent that it threate its abiity to repayits loansto BCRM, it shouldnot refinancethe bank's creditoperatio whateverthe collateralsupplied.

2.40 Features of x_ulur Colluterllzadon: The credits submittedfor an 'accord usualy have a one year maturity;often, they are creditlines. The accordis grantedfor the lifetime of the credit with a mmum of one year. At the time a paper is submittedfor an accord it must 43 reflect iheirue credit to the pustomer,but subsequentrepayments may lead to a lower actualcredit; at the end of each manth the credit must again be equivalentto the face value of the paper, or the paper withdrawn. For convenience,one credit may be divided into more papers. In additionto credits which are submitted with their files for an maccordde mobilisation", banks may every month subnit lists of small credits, to professionalsand to agriculture,for agreement("billet global de moblisations"). This list onlycontains names, credit amountsand the type of credit. After scrutiny BCRM may acceptthe credits as potentialcollateral, but only up to 80 percent of face value, as is usually the case. Every form of BCRMrefinancing, obtained at the auctionsor via 'pensions' in betweenauctions, must be collateralized. Instead of depositingthe collaterl paper with BCRM, banks are allowedto draw up lists of collateralin their possessionequal to the amountof refinancing sought, and submitthose. At BCRMCredit Departmen the lists willbe verifiedagainst the records. If a bank discoversat 4:30 p.m. that it needs a "pension"to balanceits current account, as happens regularly,this process must still be completedthat workingday.

2.41 BCRM wants to expediteand simplifythe current process of scrutinizingprivate sector paper to determineeligibility as collateral. For instance,much of the appraisalof enterprise balancesheets to determinetheir creditworthinesscould be computerized("centralization de bilans"). However,improving the currentsystem would mean continuingthe undesirableconfusion of centra bankingand commercialbanling tasks. Preferablewould be the adoptionof a collateralsystem that places the responsibDityof appraisingcredit applicantssquarely with the commercialbanks as discussedbelow. BCRMshould discontinue refinancing against private collateral. However,prime private paper might continueto be used for short-term interventions("pensions") on the money market

2.42 Alternative Collateral Mechanisms: BCRMcould have at leasttwo alteatives for collateral:government securities, or bankers'acceptances. In many countriesthe centralbank insists on government securities, the idea being that these are essentially without risk and therefore most appropriatefor a central bank. In Madagascar,the supply of governmentsecurities is insufficien at present, but with a more activegovernment debt managementpolicy (see para 2.56), an adequate volume and market for these instrumentscan emerge. Bankers' aceptances (BAs) can emergeas alternativecollateral at a later stage. A BA is a draft or demandfor paymentdrawn on a bank, askingthe bank to pay a stated mount to a stated firm or its assigneesat a definitedate. Whenthe draft is "accepted"by the bank on which it is drawn, it becomesa BA and is a paymentobligation of the bank . Each of the acceptingbanks guaranteespayment on the due date, for which service it will of course exact a price. Effectvely guaranteed by a number of reputable banks, the creditworthinessof the underlyingenterprise has become practicallyirrelevant. Centralbanks can evaluate BAs as collateral as a natral extension of their traditional task of prudential bank supervision. OnceBAs have becomepopular because the centralbank acceptsthem as collateral,an interba market in them may develop. The developmentof markets for BAs and government securitiesare more filly discussedin Cbapter7.

2.43 Rqr.ed Reserves: Requiredreserves are compulsorydeposits made at the cental bank by commercialbanks. Reserve requirementshelp a central bank forecast reserve behavior, especiallytowards the end of the reserve maintenanceperiod. Requiredreserves are usuallyused in conjunion with ind&-ectmonetary instrumenats to alter the financial structure of bank and other financialinstitutions. 'equiredreserves should be used sparinglyand should not be a day to day tool of liquiditymanagement. Requiredreserves above same minimumithat banks wouldusually hold anyway(usually 2-3 percen of deposits)should generally be remunerated.Excess reserves however 44 should generallynot be remunerated. An importantcondition for the efficientuse of reserve requiremets is that BCRMsbould have availableinstument to mopup excessliquidity when this occurs in the bankdngsystem. Such instrume indude securitiesissued by the Treasmuryor by BCRMitself.

2.44 In the caseof Madagascar,the requiredreserve system introduced in December1990 is a step forwardin movingfrom direct to indirectmonetary control. The new reserverequirements applies to a base consisting of sight and term deposits, and CDs ('bons de caisse). The ratio was set uniformlyat 6 percent. ITe base is measred as per the last workingday of the monthbefore the last Half of the requiredreserves are to be mained in a non-remuneratedblocked deposit with BCtM, whilethe other half is to be met by the averagebalance over the maintenancemonth in the bank's curren accountwith BCRM. The limitedperiod averaging gives the banis considerable room for managing their liquidity. A patter which has already started to develop is for banks to "save' by accumulatingexncess balac in their curet accountsduring the first half of the month, which theythen run downduring the secondhalf. BCRMshould begin to collectcertain data from banks, such as the key elementsof their balancesheets, on a bimontly or weeldybasis. This wilt set the stage for calculating,at a laterphase, the requiredreserves on an averagingon a bimonty or weeky end-of-perioddeposit base ratherthan end-of-periodmonthly data. However,as long as the delaysin the payment systemremain extended (see Chapter3), bankswill be forcedto always keep lage precautionaryreserves.

2.45 Direc Mon mConflrol: The direct controlsof BCRMconsist of globalbank- specificcredit ceilingsplus sub-ceilings,and the prior authorization(Cauthorization prdalableW). BCRMhas decidedto retain them for the time being, while it is gaing experiencewith its new indirectmonetary insumen. A gradualshift from direct to indirectcontrol is envisaged. Thrugh greaterreianc on indirectinstuments, the creditceilings will eventually become inehffeive and will be dispe sea wih. As noted before,essential to this process willbe greaterinterest rate flexibility.

2.46 Mechanigsf Direct Controls: The globalbank-specific credit ceilingsare derived from the permissiblecredit expansionfor the year decidedin the contextof the Fund adjustment prgram. The end-yearceiling is distributedover quarters,and then dividedamong the bankson the basis of depositmobilization, except for the new bankwhich receives a moregenerous ceUing duing its start-upperiod. While BCRMoriginaly wantedto abandonthe subceilingsearly on, it decided to retain them after the mepected credit epansion during the second half of 1990 which was connectedto the import surge. The subceilingsapply to commercal rediscounting(l'escompte commrcial"), advanceson merchandiseCavances sur mnardandises),and overdt (Cd6couvertsm, dme types of creditswhich tpicly finamceimport. The prior autoron reme t applies to all short-termcredits tD enteprises whosenet borrownngfrom the bankingsystem exceeds FMG 5 billion. Thisrequirement wil be abolishedshordy. Bank-Specific credit ceilings based on deposit mobilizationduring the previousperiod are preferableover ceilings based on outstandingcredit The latr tecbniquetends to freeze marketshares and discmates againstnew and/or dynamicbankm. However, the periods used for determiningdeposit mobilizationshould be relativelyshort (one quarter insteadof one year) so that the link to credit ceilingallocatins is an effectiveincentive to banks. It is importantthat the banksare well awareof the linkto depositmobilization, and BCRM mighttherefore consider issuing a circularto the banksdescrbing the procedurefor computingthe L 45 2.47 Problem in ManagingDired Controls:The subceiling are bound to causeeven more distortionsthan global credit ceilings. In the gradual shift towards reliance on indirect instruments,a high priority should thereforebe accordedto abolishingthese ceilings as soon as possible. The impressionmust fiuther be avoidedthat it wouldnot be in order for banksto seekout the most profitablelending opportunities,including import financing.The enforcementof credit ceilingsdepends on timely infoxnation and effectivesanctions. In case of a first violation,the sanctionis the obligationto placea non-interestearning deposit with ECRM equal to one half of the excessfor the durationof one month. In case of any further violations,a depositmust be placed equal to the excess, on which, fiuthermore, intemst is due equal to the *taux des pensions. Banks are requiredto send their monthlyreports to BCRMby the 25thof the nextmonth. However,in tho case of one bank, accountingfor some40 percentof credit,a completeand reliablereport takes much longer to reach BCRM. Enforcementof direc controlsunder such cirm es is difficult. lt serves to underscorethe need for more relianceon interestrates in stmaning credit since their impactcannot be avoidedaid is felt rapidly. Furtihrmore,given that informationon bankingsystem credit and monetay aggregatesis subjectto such seriousdelays, BCRM should select an operating target from its own balancesheet, for instance,net domesticassets of the centralbank or reseve money.

The Future Role of BCRM

2.48 ClarifvingResponsibilities for Moneta Polic: BCRM's objectives(according to Artide 30 of its stat) are to executWthe monetary,credit and exchangepolicies decided by the government. In this capacity,BCRM is to guardover the intnal and xerna stabilityof the currency and to ensure the deployment of all productive resources of the country in the contet of the developmentplan decided by the goverment. The objectvesof BCRMshould be morenarroly definedas ensuringprice stability.This woud be in linewith recen trends in centralbaink legisaion worldwidewhich tend to limit the centralbank objectivesto iheman nance of the domesticand ex al stability of the counry's curency. This provision coud be strengthenedby assigniag to BCRM not only responsibilityfor implemetationbut also for formulationof monetarypolicy. Consultationwith the governmentcould be prescibed, includingappropriate conflict resolution proceduressuch as wihin the NationalAssembly where both the govemmentand centralbank coud presenttheir case, if there is a seriousdivergence between them whichcannot be resolvedby mutual discussion.

2.49 Indeuendenceof BCk . The problemsof BCRM arising from its quasi-fiscal operationsare part of a larger issue of the independenceof the centralbank (see Annex2.2 for a discussionof the growingattenton worldwideto this question). The fiure role of BCRMmust involve a greater degree of independenceto effectivelyconduct monety management. Of fundamentalinportance is a workingrelaionship between the centra bankand the goverment wbich givesthe centralbank a day-to-dayoperational role in maconomic managementfree of political intrec. To ensurethat BCRM can play an effectiverole in economicand liquiditymanagement, a numberof operatingand legalchanges must be envisagedin additiontD a appropriateprogram of manpowerdevelopment A number of such changesare alreadybeing envisagedand discussed. Theseand other changesshould ensure the legal, financialand operationalindependence of lCl. 46 2.50 Central Bank Statutes: Central bank independenceshould have a strong legalbasis. Since BCRM's statutes of 1973 (as amended in 1983) 2( already contain many provisions intended to safeguard its independence, the first priority should be to implement those statutes. A solution must be found to end the flagrant violation of the limit on lending to Govement. Also, in the interest of accountability, BCRM should resume publication of annual reports, including balance sheets and profit and loss accounts. While the major threat to BCRMs independence consists of the violation of existing provisions of its statutes, there are other provisions that could be strengthened. A commission has already been appointed to review BCRM statutes in light of the monetary policy reforms. This review could be broadened to try to strengthen BCRMWsindependence. Two areas in particular could benefit from improvements: the definition of BCRM's objecdves, and the appointment and operation of BCRM senior management and executive board.

2.51 BCRM Management gad Board Appointments: BCRM Goveror and Board Members (accordingto SectionsI, I, and m of BCRM statutes) are appointed for four years by the Cabinet. They can be dismissed at any time. BCRM's independence would benefit from a lengtheningof the term, and inclusionin the statutes of specific grounds for dismissal. The Executive Board could further be strengthenedby giving it the right to nominate new board members, who wil be appointed by Government Monthly inead of quarterly meetings woud allow the Executive Board to play a larger role in policy formulation. Board members should only be eligible for dismissal by a majority of the National Assembly for reasons of moral tuitue and infirmity. Moreover, to avoid any conflict of interest, all BCRM Board members and staff should be strictly forbidden from any role in the board or management of any financial institution or entrprise. BCRM itself should not be a shareholder in any financial institution or enterprise.

2.52 BCRM Stratesic Develonment Plan: To prepare itself for its rapidly evolving functions under a market-oriented ecoromic system, BCRM should aim at establishing a strategic development plan. Ihis plan shoud establish the main objectives of BCRM, its organitional plan and its manpower and logistics development strategy. The plan should be based on a comprehensive review of existing organizationalstructure, systems, methods and main operAingproblems and issue observed as well as a forecast of fiture development needs. It should include an audit of the educational profile and career potential of all BCRM personnel. Such a plan could be pardy established and supported with external technical assistance.

2.53 Financial Indepnece of ECRM: Financial independence is one of the crucial dimensions of Ctal Bank independence, a general issue which is being widely debated in many countries. To fiulfilits functions effectvely, BCRM should have a sound revenue base and should not make chronic losses due to quasi-fiscal or other activities. Effective financial independence however can only emerge after a satisfictory resolution is obtained of BCRM losses, both in terms of their flows and accumulated stocks. At the same time, BCRM should be accountable for its actions and policies. As part of this ncountability, it shouldresume publicationof its annal balance sheet and income statement. Published acoDuntscould be part of an annual report of BCRM which cowldalso review economic developmentsas well as monetary policy over the previous year.

3/.Ordonce No. 73-025 portant crdation de la Banque Centrale de la REpublique Malgache," promulgated on June 12, 1973. 47 2.54 Gener-LAuprnahntoResolvAngBCRKMLosum:AresolutionofBCRMlossescould proceed in steps. First, the flow of new losse should be stemmedby amendingall BCRM operations,arrangements and accountingpractices that can be identifiedas contributingto those losses. Specifically,it would mean that, henceforth,valuation losses on accountof the foreign liabilities BCRM assumed from the Governmentare immediatelycovered by debiting the government'sadvance account. This advanceaccount should be settledby the Treasury withina statutorytime limit. Second,the flow of lossesarising from the stockof past lossesshould be dealt with. Thiswill requireimproving the returnon BCRMassets. The decisionto increasethe interest chargedon advancesto Governmentto the moneymarket level, and the paymentof interestdue on governmentdeposits to the sam rate minusone percentagepoint, was an importantstep in the right direction. Both decisionsare to be appliedretroactively to January 1, 1991. However,that still leaves60 percentof BCRMassets eaning no returnat all (i.e., the valuationadjustment account plus accumulatedoperating losses).

2.55 Remunerating Claims on Government: To reurn BCRM to profitability,the governmentwill haveto pay an adequateinterest on those claims. Oneway of achievingthis is for the governmentto issue interestbearing bonds to BCRMto replacethe revaluationacomun. The accmulated operatinglosses could be dealt with liewinse. Alteatively, in the context of a comprehensiveresolution of the loss problem,Mdagascar's intenationaldonors wuld perhapsbe persuadedto giveup their lien on the sizeablecounterpart funds and allowthem to be used to write off the operatinglosses. It shouldhowever be stressedthat irrespectiveof whethersuch exceptional resourcesare available,the Governmentshould fully compensateBCRM for its accunmlatedlosses. OnceBCRM earns an adequatereturn on its claimson govemet and is profitable,the stock of thoseclaims no longer poses a monetary problem. The stock can be reduced over time as BCRM profits are appliedto redemptionof the Govement's debt. However,a legal problemremains in that the stockof claims,together with the advancesto government,by far exceedsBCRM staory limiton lendingto government

2.56 LmgnrvedGenment Debt Management: With the intereston the advance accountraised to the levelof the money arketrate in 1991,govermment borrowing shoud no longer contnrbuteto BCRM'soperating losses. However,the absenceof an effectivelimit tanthe volume of borrowingstill representsa weakaessin monetarycontrol. The BCRMstatutes limit total gross lendingto Governmentto 15 percentof ordinaryrevenues during the previousbudget year, but this limit is being ignored.Both the oveal volumeand the variabilityof BC1M lendingto Government presentproblems for monetarymanagement. Vth effectivelyunlimited, and, until recently,very cheap,access to BCRMadvances, the Ministryof Financecould afford to be carelessabout its cash- flowforecasts. As noted,the absenceof suchforecasts are a majorproblem for BCRMin conducfting reservemoney management. To prote BCRM's independencein mattersof monetarypolicy, the Governmentmust develop the meansto cover its fimancigneeds outsideBCRM. Advancesfrom BCRMshould be used to fiance cyclicalcash flow fluctuationsonly, for whichthe satoy limit of 15 percent seems ample. The Minstry of Financetherefore urgently needs tDorationalize and activateits governmentdebt management. This requires enhancedcoordination of monetaryand governmentsecurity issuance policies. This will also involvethe creationof activeprimary and secondarymarkets in short-termgovernment securities, which willproduce valuable side benefitsin promotingfinancial market development generally. This issue alsois more fullydiscussed in Chapter 7 in connectionwith financialmarket development r .e S

|T~~~~~~ill'i;ElkltI B l 50 successivechanges in policyhave on occasionresulted in measuresinconsistent with the traditional *andconstitutional hierarchy of the sourcesof law. 3.4 Generalweaknesses In legal texts: Thelegal systemis perceivedas archaicand the machineryof justice as slow, ineffectiveand unreliable.There is a strikinglack of confidencein the administrationof justice on the part of companyofficials.One emple of outdatedlegislation which does not take into considerationpresent circumstances is the case of agro-industrywhich for certain purposes is still governedby the law regading agriculturalproduction becaue the law does not providefor industrialtransformation of agriculturalproduce and still treats the companyas acollecteur agricole"because it purchasesits raw materialsfrom farmers. Companies in Madagacar still operate under the 1867company law. The CommercialCode dates from the colonialera. Theselaws were frozen at independencebecause the old colonial texts which used at times to keeWpace with developmentsin the then metropole did not evolveafter independencein line with new thinking withinthe legalsystem from which they wereoriginally derived. Except for the 1987Plan Comptable National, the basic legal frameworkfor companieshas remainedunchanged, yet in recent years decrees have been adoptedby the authoritiesintroducing new instrumentsin the finacial sector. Thesedecrees based on modernpractices and instument availableelsewhere are being graftedon a superstructurewhich is itself an antiquatedone.

3.5 General weaknessesin auplication of texbs:Lawyers point out that somedecrees or circularesare not even publishedor are in contradictionwiti the enablinglegstion. They also complainabout te absenceof law reports (no report seemsto have been publishedsince te mid 70's). Commercial,financial and economiclaw cannotdevelop without a proper reportingof case law. It is also observedthat the commonpractice of subjectng ostensiblyliberad pieces of legisation t ad tative athorizaions which by defnition are discretionaryand which also happento rest on a very bureaucraticsystem render these legislations,in practice, anythingbut liberal. The exerciseof the discretionarypower of the bureaucracywith regardto treamentof visa applicadons for expatriatestaff is quotedas an exampleof the discrepancybetween new tes and actualpractice.

3.6 Lea issues in bankingifoeion: One of the most conmon complaintsagainst banks is that securitiesrequired by banksbefore loansand other facilitiesare grantedto enterpises are difficultto provide. Whereasmortgage ('hypotheque) is now little used in France for example, this is still the most commonform of securityrequired by barks in Madagcar. In additionto the consequentdifficultes facedby enterprisesbecause their propertyhas alreadybeen mortgagedto a bank, providingthe mortgageitself createsdifficulties. This is becausethe titles to propery are not alwaysacceptable and the cost of complyingwith fonmalitiesrequired for mortgagesis high. The availabletite may not be acceptableto banks which are not prepared to accept other forms of security.Banks complain of the difficultiesin obtainingrepayment even of securedloans because of the presentsystem of administradonof justice, the precariousnatre of ownershipdeeds, the cost of recovery in remote areas, and the tradidonal and cultal factors which impWdethe executionof judgments.

3.7 :: Banksshould be encouragedto adopt tde wide range of securitiesand financingschemes available elsewhere and m particularin countrieswhose lega sysm are deved fromFrench civil law. Tse include:(a) project fiancing (agreedproportion of incomedemed from the investmentis cor ay ssignedto thielender);(b) a combinationof 'hypotheqnesand cautionnement(instead of exclusivereliance on hypotheques); (c) delegation' (to ensurethat the nber of creditorsin relationto a particularproject is as wide as possible);(d) greateruse of shares and other tde deeds as secuiy (tids wouldbe facilitatedby prior consolidtion of the law relating to 'valeurs mobiibres); (e) title reservationclauses in 51 contractsof sale financedby loans;(t) insurancecover for loans (thiswould further developthe local insurance industry); and (g) securitization.Many of these products could probably be developed solely through agreement between the banks and their customer even before there is specific legislationcovering them. Bankswould thereby contributeto the establishmentof a modern system of law. If the overall legal systemand procedure for settlementof disputes and recovery of debts (includingprovisional measures to safeguardtde interestsof creditors)are improved,bank may be eWpectedto adopt a more liberal approachto loans and securities. The solutiontherefore does not lie only in new credit arrangementsand instrments. Banksin need of immediateliquidity or which fice newatative loan oppormities, but whichare constained by certainsupervisory ratios, should be allowedto package and sell some of their loans to banks with excess liquidity. This will allow banks to both meet the legal requirementsand reap the benefitsassociated with new loans. Such provisionswill increasebanks' leverageon loan creation and may reduce bank failures.

3.8 Recogition of Proret Rights: A debtor's propertyconstitutes a basic guarantee of financialobligations which lendershave to be able to rely on. Malagasylaw recognizesvarious categoriesof property; however,only real property for which a registeredtite documenthas been issued can be formally mortgaged.Foreigners may only acquire real estate after obtainingprior authorizationfor the purpose.The right of foreignersowning properties of over 20 hectaresto sell suchproperty has been suspendedsince 1977.Foreigners may onlybe permittedto purchaseproperty that has alreadybeen registered.These requirements should be amendedto permit mortgagingof all real pmperty and property rights whatever their situation or the category of title. Registration proceduresare complex and very protracted. This is due to the large number of challengesand owners' failure to have the required entries made, and also to the lack of personneland equipment to handlerecording, demration and extensionof the propertyrecords outside of the highlands.Ih,e same iack of means limits developmentof registrationprocedures, which are virtaly restrictedto urban areas. Strengtheningof the meansof the Registrarof Real Estate and of the propertyrecords serviceis a priority.

3.9 Problens of land laIw Land law is of major significanceto both real sector transaions and the fimctioningof the financial system. Land is also the most commonform of security required by banks. A major problem faced by foreign investors in Madagascaris the unavailabilityof fctory space. It wouldseem that at the momentcompanies controlled by foreigners and individualsresiding in Madagascarbut who do not have Malagasycitizenship are amongstthose who are prepared tD invest in i stri buldings but they arenot i a position to do so becauseof present legalprovisions (which are discussedbelow). The exiting Land Law in Madagascaris also an inhibitingfactor in economicdevelopment because the natureof the titleto land ownershipis often such that this cannotbe given as securityfor loans. IndeedMadagascar still has the two regimesof cadastre and nimmatriculationufor land. Those whose property are not yet subject to =immatricuation(which is a ccttly and a lengthyprocedure) find it difficultto have their ownersip rights recognizedby banks. As far as land ownershipby non-Malagasynationals is concerned,the law no 62.006 of 6 June 1962 provides that foreigners cannot acquire land without the prior authorizationof the Ministerof Interior. A circular adoptedin 1968 providesfor the criteria to be fllowed in decidingon applicationsby foreigners. However,an administrativenote of 13 June 1978 provides that foreignerswill henceforthbe prohibitedfrom buyingland. This means that in spite of the law still in force which enablesforeigners to buy land, subjectto approval, there is a de facto prohbition since 1978. Non-cidzenscan however,stillobtain leaseholdsor devise other meansof obtining fieholds.

3.10 I[mgng land law: Authenticationof titles to property issued by a properly organizd Land Registry which can then be used as security for loans, will grealy facilitatethe 52 processingof loans. It is evidenthowever that the cost of implementig measuresneeded to cover the entirecountry with appropriatelad registrieswill be staggeing. Therefore,for the mediumterm, the Govermnmentshould given top priority to creatingsuch registries in the major ecowomiccenters of the country. At the same time, the de ficto prohibitionon acquisitionof propertyby foreignes should be reviewedand the June 1962 law should be adheredto. The Mauntian experiencein this area is probablyuseful. Foreign investmentin Mautius does not seem ta have been hamperedby the Non-Citizens(Property Restictwn) Act which provides hat n-citzens must obtain the prior authorizationof the Ministerof tnior beforepurchasing, acquiring or holdingproperty. It should also be noted that the MauritiusCitizezthip Act provides fortshepossibility of a foreignerinvesting a prescribedamount in Mauritiusbeing naturalizedas a citizen.In Maritius, the non-citizenseeking to acquire property applies to the Prime Minister's Office under the Non-Citizens(Property Restriction)Act for permission,giving the relevantdetails. The Prime Minister's Officewill liaise with ExchangeControl as to the financial tansfers requir and, once these matters are specified,approval is given for the acquisitionproposed. The non-citizenwho so acquiresproperty is fee to disposeof k as best he think fit, includin the creationof a chargethereon. 3.11 FInancial Contracts and Mortgars: Commerciallaw in Madagascar,having its main soarce in the legislationbequeathed by France, is based on the autonomyof the contacting parties' will and accordinglyallows operatorsconsiderable freedom in agreeingon their reciprocal obligations.However, when a contct is concludedwith a foreigner,Malagasy exchange regultons limit the fieedomto transferfunds, purchaseforeign secrities and exportgoods. Real and personal guaranteesgoverned by law are not alwayspossible or effectv As noted above,mortgages can only be constitutedon registered properties and that, if the creditor or borrower is a foreigner, the trmsaction is subject to discretionaryauthorization. Banks most often use the private mortgage method to avoid the cost of a notarizeddeed (about2% of the amount of the mortgage)or else becausethere is no notauynear enough to the bank office or agency concned. Ofte, too, a mortgageis only registeredfor its date, but not enteredin the formalrecords in order to avoid cosu that could leadthe borrowerto reject the loan. This sitations warrantsa reformthat wouldlimit the cost of mortgageregistration to a reasonablefixed fee, leavingapplcation of a proportonal fee to the time the mortgagedproperty is sold, with the latter fee being based on the selling price should that be less han the amountof the mortgageclaim.

3.12 Alternatives to mortpges: There are various ways in which real property can be acceptedas guaranteewithout a mortgagebeing taken out, such as promiseor prohibitionto mortage, or deposit of tide with a bank The 'floag charge' used in English law makes it possible to guarantee a current account subject to appreciablevariations against corporatecapital, whereas a mortgagec= only be taken out for a set amount Pledging against equipmentor merchandiseis sometimesdone by means of open warehousing,or by handing over the owner's key or thwough acceptanceby a depositary. Ihe estabishm of general warehouseswell run by a thid party enjoying the confidenceof all conerned would be the most appopria means for usig the warehouse warmat system. The various warhoses opeated by the Chamber of Commercein Madagascardo not offer appear sufficientlyreliable for the warant system. Crop pledgesare used, as also assignmentof livestockmortity insace. However, in ru areasik is not guaranes that are the real problembut primarily the lack of fiuds for lending, which obligesfamers to turn to informalmoneylenders who practiceusury h a way that is sociallyand economicallygreatly to the disdvange of borrowers.

3.13 Deb R: Improvementofthe meansof debt recoverycan help lower the costs of baing transactionsin badagascar. Whena debtorfais to meet his obligationson time, or this failure to pay ocCUrs in specific ce, the lending bank must consider instituting recovery 53 measures.Debtors in goodfait willhave theirpaymenb rescheduled, or be grante additionacredit, subjectto appropriateguarntees, followingexmination of their cases. However,when bad fith or ridskof nonpaymentis evident,the bank will resortto enforcementof its clam If it holds otrized evidenceof debt, such as a mortage or bond, it caninstitute proceedigs for atachmentof the goods or propertymortgagod or given as secuity. If there is no exeory deed or intrument,tde bank must applyto the cours to havethe debtormade to pay or to acivate the guaranteesor bondsgiven. Claimsbelow FMG 125,000and for ackmowledgedcommercial claims, the bank can obtain an injunctionor order to pay, which is simple, cheapand quickLHowever, if the debtordcallenges the injunction,the case is transferredto the ordinarycommecial court, presidedover by a judge of the court of first instanceand includingtwo tradesmenappointed upon the proposalof the Chamberof Comerce.

3.14 ourt del: Localmagikrs are mostoften atins or smalltadesmn withlitle knowledgeof businessor finmanciallaw. Consideraon shouldbe givento formingspecalzed con, with judges electedby professionalcategories, so that the local magistes could then assist the presidingjudge in examiningthe documentsand customsrelating to each category.The commrcial court functionsin a fairly straig ard manner, seang short time lmits for summong the defendant,reaching settlement with the plaintff and, if necessary,appealing. A decisionshoud be reachedwithin two to four months. In practice,cases can drag on for from one to thre years, in firt instance,and for as longon appeal,since appealsare oftenfied simplyto spin the proceedis out Moreover,adjounent are frequentbecause the assessos fail to show up. Theseunhelpful delaysseem due in lawgemeasure to a shortageof judicialpersonnel and of office equipment,which holds up pwductionof the relevantdocuments. They are also due to archaicmethods and practices whichslow the courseof justice.

3.15 Exneditingcourt dions: To speed mattersup -and enhancethe quaty of the justice dispensed,the followingmeasures could be considered:

- .raiing the limit from FMG 125,000to FMG 1 million(witlhut right to eal) and settingdte samelimit for actionstD obtaininjunctions to pay.

- adjusting ithelegal rate for penaltyinterest against the debtorwhere no specificrate is set, if needbe increasedby a penaltyclause.The present rate of 5% for civilcases and 6% for commercial,which is wdl below the rate for bank loans, goes back to the periodof the French gold franc. Todayit only servesto encouragedebtos to defer payment.Taking the new Frenchlaw as a model, for iance, the applicable rate couldbe stipulatedto be the interbankmarket rate set by the CentralBank and publishedeach month. At the same time, any rate exceedingby 25% &rmore the rates for each productas fixed by the scheduleapproved by the CentralBank and publishedat reguar intvals, couldbe classifiedas usuious.

impoving of the onrt' workingmethods by means of a system of pemoat ainingas regardsmethodology and the techniqueand practiceof busie law. A part at least of this ainig couldbe done by the Departm of Law and Busines Techique of Antnanarivo University, where various bani p s, magistre sanduniversity people teac, who would be able to contribuleto d better minI undstanig. 54 providingthe Inspectorateof JudicialServices with means and instructionsto enable it to remedy or avert shortcomingsor mistakesof the judicial apparatusmore effectively.

- providingthe ourts wit more office equipment,especially word processorsand photocopiers.

3.16 Problems in enforcementof claims on groperty: Legal and officialtitles should, when duly enforced,produce prompt and specificresults to the degreethat the debtor's atachable property is sufficientto cover the prncipal, interest, penaties and costs involved. In practice, enfiorementis often blockedby the following:(i) difficultyof findingthe debtor in order to serve the ordersto pay, eidterbecause he has goneinto hidingor else becausehe has talkedthe server out of doing his job properly; (ii) third-arty claims on the property athched, challenges to the claim whenthere is no registrationdeed, uncrtnty regardingpossession ofcohabitant movables,removal of objects pledgedor of iems given as security; (iii) traditionalatttdes, which mean that rural dwellersnever cooperate in any enforcementof claimsagainst one of their number;(iv) practices dtat obstructproceedings regarding exceptons dtat can be daimed, so that delaysmount up due to ihe inefficientfimctioning of the judicialapparatus plus the debtor's use of all his connections.

3.17 Renovini sunerluous obstaces to caims enforcement: Attemptsto improve enforcementof claims in Madagascarwill necessarilyhave to be guidedby two considerations.On one hand, anyebingderiving from traditionsand attitudesvis-4vis a foreign legal systemand a diffent valuesystem can only evolve by a combinationof assimilatingthe valuesof that systemand by a reshapingof attitudeswhich result from the contactof Malagasyeonomic operatorswith a more cosmopolitanbusiness environment. On the other hand, manyformalities and cost for whichthere is no fimctionalneed could be removed.Two examplesof such changesare immediatelyevident. Fist, regardingattachment of nonregisteredreal propety, is the requireent of an order audtorizing aachment when the prosecutingparty is acting based on an enforceabletitle. Second is the superfluos requirement of a creditor holding an enforceabletitle to submit a petition for authorizationof attachmentwhen the creditor's title is manfet (bill, check, statementof account) and when it wouldbe sufficientto ensurefor the debtorthe right to challengethe attachmentif he has a plea or other groundsfor challengingthe creditor.

3.18 ams enfjent pMg= sdes: TroughToo ofte salesfollowing atachment result in the propertybeing knockeddown to the prosecutingcreditor becase there are no other bidders. This raises a problemif the creditoris a foreignersince any change in ownershipto the benefitof a foreigneris subjectto authorizatonin the same way as sale of distrainedgoods. With participationby banks, a real state companycould be fbrmedthat wouldpurchase attached property for which there are no saisfctory bidders. This companycould then developholdings of rental propertieswhich wouldserve a well-recognizedsocial need in Madagascar.

3.19 Claims enforcement through assignment: A simplificationof the guarante procedurescould prevent enforcementdifficulties by ensuringthe automaticcollection of payments whenthey fall due. The procedureslaid down by the October9, 1961 Law regardingassignment of wages shouldbe open to all tradespeopleand not just to banks. The implementationof interim proteive measuresas soonas proceedingsto enforcea claimare insed woulddeter debtrs from resortingto improperresistance. The judge shouldpromptly grant orders for deposit, receiversi or temporaryinalienability of registeredprop, ty, providedthe petition is based on an obliga videnced by regular tides and bank documents.Application of these measuresand of convendonal 55 securitieswould limit the numberof bankruptcycases by allowingaction to be takenbefore a debtor enterprisehas collapsed. 3.20 Status of companies:There has beenno modernizingof companylaw in Madagascar as was the case in Mauritius for example, in the context of the overall strategy to modernize the commercialand financialsectors. Tbe onlysipificant reform in recent years has been the adoption of the new accountingframework in 1987. Malagasy enterprisesfollow the classicalFrench law divisionsbetween parerships (socidtesde personae)and companies(socittes de capitaux). The vast majority of companies (approximately90%) are set up as S.A.R.L which offer the following advantagesover Socites Anonymes: (a) requirementsand cost of formationare lower; (b) less stringentaccounting requirements; and (c) statutory restrictions on transfer of shares. The S.A.R.L and the S.A are at present subjectto different incometax rates which favor the S.A.R.L. Though there are no statutory restrictions on transfer of shares in S.A, the constitution of these companies often provide for a 'clause d'autorisation", i.e that transfer is subject to prior approval. There is no obligation for an S.A.R.L to have its accounts audited and generally, audited accounts of companies are not easily accessible in any centrized place. The actual range of corporate stases is more complex, becase Malagasy law provides for commercialcorporate bodies which are governedby publiclaw. This discussionis limitedto those enterpriseswhich are governedby private Jaw.

321 Problms of compDnR law: Company officials express concern about the present law regardingdissolution which acts as a disincentiveto new investmentand expansion. The observations relate to: (a) the lengthyand complexprocedure which is more bankruptcyriented and not geared towardsprovisional measures; and (b) the predominantlysocial approachto what is an economic situation,under existinglaws regardingdismissa of employeesbefore a companycan be woundup. The delaysin obtainingrequired authorizations to terminateemployment means that employersincr heavy losses at a time when they are already facing financia difficultes. Though the "Code des invmestissements-now provides in its artide 5 that dividendswill be freely tansferable as far as the 'enterprises agrees"are ooncemed,transfer of dividendshas been for many years one of the major concernsof companies. In one instnce, betweenthe time that an applicationwas made and the time that the authorizationwas obtainedthe exchangerate for the MalagasyFranc had movedfrom 100 FMG to I FP to 300 FMG to 1 FF. Thoughthe lack of recourseto debenaur and other similr securties is understandablein the light of present economiccircumstances, the legal framework conduciveto the developmentof a marcheobligatoire" is lacking(see Chapter7). It shouldalso be noted that whereascorporate tax on profits is payableto the Tresor Public, incomeon securitiesis payableto the DirectionGenerae des RessourcesPubliques. The lack of viable accountingrecords makeit difficultfor companytaxation to be properlyassessed and the situationis worse in so far as indect taxationis concernedwhere companiesonly act as "collecr". Not only does this impose a heavyburden on enteprises but the poorly kept accountscan affectnational revenue.

3.22 Ymgwovincomnsa h. The Goverment comittee chargedwith revising thE CommercialCode should provide for an entity to be set up to act as Registrarof Companies.This entity should register companes, keep records of fiacial and other return and also monitor compliancewith a revampedcompany law. A scheduleto the new CompaniesAct should include model ArticlesOke table A in EnglishCompany Law which seasout the recommendedprovisions of the Articlesof a companybut leavesit to the companyitself to decide whetherit wishesto adpt these provisionsor not ) which seek to : (a) promoteharmonization; and (O)induce companiesto do away withpractices and restrictive clauseswhich are now commonin their "s'fw" regarding, for instance,trasfer of shares. The new companieslegislation should provide proper frameworkfor preference shares, debentures and convertibles. The new legislation should promote more 56 transparencyand accountabilityto encouragepotential investors though provision should be made: (a) fbr exemptcompanies in accordancewith criteriapertaining to urnover,number of employees, etc.; and (b) for gradualapplication of variousrequirements over a periodof timeor as the company grows. The mechanismfor collectionof taxes, dcargessociales and dues on share transfersmust be reviewed.

3.23 Bankruptcyand liquidation:The law in respectof collectiveprocedures only admits bankruptcyand court-orderedliquidation in accordancewith legislationinherited from the colonial period. The timelimits set by this law forthe stagesof the procedureshould not exceedthree months from the adjudicationof bankruptcy. However,it is not unusualfor the proceedingsto drag on for more than three or four years. Ihis is partly due to the legal system'sinability to give decisionsand produce the requireddocuments within the time set. The ak of qualificationson the part of mangers and trusteesis also regrable; these individualsare not greatlymotivated to try to put a troubledentprise backon its fret nor do theydisplay much efficiency in obtainingthe best possible prices for its assets. A situationof this sort calls for modernizationof tie relevantlegislion with institutionof collectiveprevention procedures which can be initiat by representativesof the personnel,bankers and other creditorsconcemed, and subcontramrs in particular.This preveion procedure would have the effec of suspendingproceedings, starting with those initated by the Treasury and the social securityagencies, and of apointment of an adviser to the manageror a qualified temporary administaor to determine and implement rings and conversions required,with all availableextern assistance,to save the enterpriseor retrain its work force. In the case of liquidationof assets,the debtorand a representaiveelected by the body of creditorsshould be able to superviseand facdie the operationsof the tustee to preventany itemsfrom being sold off at bargain-basementprices. The law on windingup of companiesmust be reviewedso as to inimize the impact of social imperatives,reduce bureaucraticprocedures and also promote reconstuactionand administration. The appointmentof professionalsdesignated as insolvency practitiors by the relevantauhiorities by creditorsor membersthemselves wil give moreconfidence to investorsand lendersalike.

3.24 Pevendon of Dspt and Reduction of Their Cost: lmprovemets in the legal system shoud also aim at preventingdisputes or reducing the costs of settlement Choice of guara s and specialdauses shouldbe madetaking into accountboth the purposeof the contract and the customers generalattitude and reputation. In this waysome traditionalinstions can find modern applications,such as the 'omby sisa mitt clause defininga joint lability, a 'fehivavt contracttt dosely resemblessale withopdon to repurchase,and the "tatok clausewhich is dose to an arbitrationclause. The currentbank contact formsinclude election of domicileand assignment of competenceto the coDurtof the Place of the contract Thereis nothingto prevent the partes choosinginstead an arbitrationclause specifyingan attemptat reconciliationfollowed, should that prove ftuiless, by referralto one or more arbitrators,with or withoutahorit to arne amicable settlement A singleconciliation or arbitrationprocedure stipulated from the start seemspreferable with regardto legal certq than intminable legal actiDosultmately endingin rnunciations or a resignationtransaction.

3.25 Arbitraonandcolinlafion: Madagascardoes notlacki jurist and exts possessng the moralauthority and intellectualcapacities to work out conciliationand arbitation settlementsor to act as mediatorsinjurisdictional conflicts. To fAirtherencourage low-cost means of settlingdisputes in financial and other tnsactions, magistr should be empoweredto act as arbitrato, on a personalbasis and withoutencroaching on their regulr duties. This wod mprovetheir sa and enhance their social standing,givmg them an oppormnityto demonstate their inddence and widom. Until such time as the judicia systemis strenghened, financialand ecowmic opers 57 to be encouragedto includearbitration clauses in their contracts and to favor recourse should of arbitrars selectedlocally on the basis of thei interity and intellectualqualities. Establishment the settlements al arbitrationunit wouldhelp to relievethe CommercialCourt and wouldfaciitate frequentlyreached after protacted legal proceedings. Such sedements would then be more equitable, being the fruit of understandingrather than resignaton. Imnrovini-the settlementof disputes: A completeoverhaul of the procedurefor 3.26 composition settlementof commercialdisputes is required. This shouldetail: (a) a reviewof the Courtshaving jurisdicdon in commercil matters;(b) better traing and greateravailability of the the active of basic documentation,law reportsetc. The law shouldalso encouragethe parties (with Court Both participationin a conciliatoryrole of the judge himself,if necessary)to setle out of Claims Court procedurallaw and substantivepovisions shouldpromote this approach.A Small flexibleand shouldbe set up to enablesmall enterprises settling their disputesin a more informal, manner.In addition,oDmmercial arbitration should be developedpreferably on a regional cheaper civillaw (as all the IndianOcean Commission (IOC) countries have a more or less common basis the region. system)and a pool of arbitratorscould be set up to servicethe businesscommunity in law reports Law reportingis a must and possibilitiesfor assistanceshould be exploredin updating will also be and ensuringcontinuing future compilation and publication.Confidence in the system by better trainingof personnel. In this area, a regionalappmach may again be appwpriate. enbanced of the IOC couldbe askedto set up a Centrede Formationdu PersonnelJudiciaire for countries The of judicial region. In additiontD better raining,measures to safeguardthe integrityand independence business penel mustalso be takensince lack of confidencei the legalsystem on the part of the colmmnityis largelyattributable to the perceivedlack of such conditions. and 3.27 Sed or 1rxeborms: Reformsof the legalsystem to facilitatefinncial tansactionswill requiretime for prepation and implementation.Steps to sensitizeand inform other to ensure ecnomic operatorsand legalprofessionals should be undertakenin order to motivatethem implementationof the renewedlaw. Pending this genea revision,some prelimiary measmes sound of disputes. couldbe takento ensureas of now better certaintyas to the law and swifterresolving theirurgency, costs and complexity,two phasesof legalrefrms couldbe envisagedwhich Basedon first initiatedat the same fime althoughwith differenthorizons for implementation.In the couldbe in the based on the recomunendationsmade above, the followingreforms could be envisaged phase, FMG 1 term: Oi new method for fixing the legal rate of penaltyinterest; CH)increasing to near (iii) equipping millionthe competencelevel without appeal and the procedurefor injunctionsto pay; of procedures of court officeswith an initialbatch of word processorsand photocopiers;Civ) easing traning for efrceement and courtseire of goodsin dipute; (v) seting up a centerfor permanent arbitration and exchanges between bankers and the legal profssions; and (vi) developing of and the Ministry conciliation.In the mediumterm, and in the contextof studiesalready undertake by the followingareas of legal refom could be studied: ) modnizan of colective of Justice, and procedures;Cii) development of legal supportsfor nwv financialproducts; Ciii) modernization and Civ) revisionof companylaw and the FinancialCode to pemit generalizeduse of mortgages; preparationof laws and proceduresto protectconsumer and savers.

Accountine. Auditine And Finandal Disclosure Img9figfnc otsould rinalnciaLlnf MnhiqM:The accounting,audiing and fincial 3.28 and reiremens and pracices of a countryare importantfor creditors, shareholders disclosure the investors. The main weaknessesin this area in Madagascarhave hisorically been potential of records obsolescenceof the accountingfamework set by law andthe poor qualityand availability by the and informationin gener on companies. Ihe first weakns has now been remedied 58 introductionof a Plan Comptablenational which is largelybased on internationalpractices. However the frameworkmust be coupledwith the adoptionof standards,general and sectoral, whichwill be basedon internationalstandards with appropriate adaptations. The needfor improvedand harmonized disclosurerequirements and access to informationmust be given urgent considemion not only becausethis will give a betteroverall view of the performanceof the economybut also to assistbanks and other lendingagencies and potentialinvestors. Indeed, if Madagascaris to attract investmentin both existingand new enterprises,the recordand prospectsof the existingenterprises must be made available in a recognizedand approved form. This is also an essential pre-conditionfor the developmentof a securitiesmarket in Madagascar. Trading in secrities whetber on a listed or unlistedmarket, can take place onlyif there is proper disclosureof information.

3.29 Apropriate rinandal information for banking oeR_tio: An accountingreport designedfor taxation purposesdoes not necessarilysuit the requirementsof a lending banker. Moreover,cez:ain features require emphasisfor particularenterprises. Such featuresmay be pointed out and worked out withthe benefitof hind sight. Nevertheless,it is importantto bear in mindthat the lendingbanker, in so far as he does not rely solely on the securitiespledged in respect of an advance,will alternativelybase the financingof transactionson bis perceptionof a firm's evolving balancesheet and amounts. For this reason,the accountsto be suppliedin respectof borrowingwill require more frequent reportingthan an accountwhich is otherwisefiled as a legal requirement. Lendingbanks should be able to use the accountsupplied by borrowercustomers to assessthe level of risk beingtake by them withparticular advances. The accountreporting form shouldenable them to form a sufficientlyclear optionon the futureprospect of the businessthey are financing. Pre- emptiveaction would thus be envisagedto avoid a port folio deteriorationof this is seen to be the case. Objectiveconduct of bankingbusiness on the lines of a good accountreporting system would also help to avert interferenceby outsidersfavoring certain advances which are clearly worthlessat the cost of others whichmay have been directly beneficial to economicdevelopment. Bankers employ a wholearray of evaluationof balancesheets, ratio and cash flow analysisin order to detmine the viabilityof projectsand their sustinabiity. Businesses'inability to providethe requisiteaccounting data on a timelybasis would tend to counteac a move towardssound banking practice based on objectivecrteria. Faflureto meet a requiredaccount reporting level wouldbe retrogradeand not much progress may be expected in tms of achieving the gener levels of sound financial managementin the Malagasy economy. To prevent lifigation and better assess the risk and opportunityin lending,bankers would like to have reliable and clear balancesheets and opeating accountsfrom their customers.

3.30 Recent prowess and outstanding accountinr issues: A modern accountncy law adaptedto Madagascarsneeds was passed in 1987(Plan Comptable). Madagascar now has a modern code of accountsdeveloped through broad consensusand involvementof the accountingprofession, teachersand businessgroups. A numberof companieshave submittedtheir accountsin accordance with the new code. Efforts to disseminatethe new code have been undertakenby local accounting firms. Still to be enactedare relatedchanges in the CommercialLaw Code, the "emsus"leading to the qualification'expert comptable."The sectoral code of accountsfor banks, insurt;ne, public works, etc. have yet to be drawnup. No new law with respect to auditng has been jassed. The followingproposals should be oDnsidered:0C) accounting stdards be prescnbedby law for different sectorsof the economy(as has been done in Maurtius) and departurefrom such standardsmust be disclosedand justified;(ii) the revised companylegislation must spell out in detai the information that has to be providedby promoters,directors and auditors and those acts which are subjectto publicityrequirements; Ciii) the need to provide for compulsry auditingof accountsby approved auditors;(iv) the regular submissionof returnsto a Registrarof Companieswho shouldlead which shouldmonitor compliance with companylaw re ir on publicity,accounting and disclosure. 59

The Registrarwill ensurepublic access to records.The law should1- wer providefor the gradual (application)introduction of new provisionsby initialy exemptingcerain types of oompanies firom the scopeof the new law in viewof theirlow turnover for example.Mandatory auditing requiement couldbe initiallylimited to majorenterprises including all thosewhich receive funds (equityor debt) from the public or any forms of financial assistance from the Goverment or from financial institutions.Small enterprises which essentiallyrely on their own funds couldbe exempted.In the same spirit, exemptionrequirements could be tailoredalong the linesof the tax codewhere a 'regime forfaitaire"is appliedto smallor ardsanalbusinesses.

3.31 Speial provisionsfor microenterrises and SMEs:Since 1989 all tradespeoplehave been requiredto use the GeneralChart of Accountsinstituted by Decree 87332of September17, 1987.This system is dearly too complexfor smalltraders and artisanswho camot affordto employ professionalaccountants. It wouldbe desirableto consideradopting a simplifiedchart of accounts, as has alreadybeen done in Francewhere three such systemsare in effect the generalchart, the more complexversion for big enteprises, and the simpleform for small and mediumenteprises (SMEs).Madagascar could also do as Francehas done and set up approvedmanent centers,to facilite bookkeepingfor small and medium enterprisesand tainingin accountingfor dteir managers.To reducethe cost of disputes,the systemof court fees ollected by the clerk to the court or registrationfees couldbe abolishedto facilitateaccess by individualsand traders to justice and save the troubleand cost of keepingsmall but complexaccounts.

3.32 Roegf uudlit: No systemof accountreporting is completeunless it is backedby auditors who are independentof the managementof the borrowingunit Auditorsare required essentiallyfor the reasonthat theyshould be ableto forman opinionon the systemof accountsbing prepared.-his opinionshould be givenfree of any constraint and auditorsshould be satisfiedthat the accountsdo give a tme and fairview-of the state of affairsof the party whoseaccount havebeen drawn up. It is the job of the auditor to point out any material informationpertaining iothe accounts which,if wt explicitlystaed by them, oDuldlead to misleadingconclusions on the accouns being presented. Unless, the auditing practice is exceptionallystrong, legal provisions may have to be inserted(e.g in the bankinglaw) protcting auditorsin the executionof their dutieswith impartiality an objectivity.

3.33 Auditingcertification: In particular,auditors vouch that all materialbalances exis, are completeand fairly stated at the balancesheet date. They should ensurethat all icome and expenditure,gains and lossesare properlyaccounted for. They should also state that all material liabilities, and commitments,confingent or otherwise, have been identified,provided for or adequatelydisclosed in the accountingstatements. While an audir's certate wouldnot be called for frequentlyin the case of accountswhich are seen to be regular and unproblematic,that should be the case speciallywhere banks are doubtfdulof recoveryon certaindebts. The diting burden would thus increase directly in proportion to degree of insecurity and risk implied by accot.

3.34 Increased harmonization with interational uractims: There is a worldwide movementoward sandard auditingpractices. TheMalagasy system will sooneror laterhave to join the mainstreamof this evolvingsituation which calls for a greater level of dialogue among acontants, managementand auditorsand fbr greater disclosureon the accountsof ididl concerns. This worldwidetrend is pardy drivenby the speed of evolutionof the intrtiona paments systemand the conseWentneeds for harmonizedaccountig systems.To the extent it Madagascarseek greater iation in world markets,it too has to move in the sam direction towardsgreater harmonization of its accountingsystem with ntrnaonad standardsand practices. This will be especially challenging given pata weaknesses in the accountig sysem which to s-me 60 etent underlaythe accumulationof bad debt widtinthe bankng systemin the mid-1980s.Given the eaistng gap betwee Malagasyand intniol accountig practices,the recentrestructuring of the baning system shouldnow be complementedby a- accelerateddrive to harmonizethe Malagasy accountingsystem with international smdards therebylending transparency znd clarityto presentatin of accoun. If the new 1987accounting plan is fully applied,such harmonizationcould be assured.

3.35 StrengtheningJthe accounta= pronfmn: No systemof accountig and anding requirementscan work without qualifiedaccountant. Madagascardoes have a small number of qualifiedaccounting firms and personnel.An accountancytraiing instion (INSCAE)produces graduateswith a practicallyoriented trAning up to the master's level; in addition, several other accountantshave been trained abroad. However, the Governmenthas yet to issue the new tat regulatingentrnce io the accountancyprofession, which has been under dicssion for five years. Withoutthis text, existingfirms are in an oligopolisticposition and wouldthemselves been unble to det the demandfor auditorswhich wfll follow fill implementationof the Plan Comptableand related xs. It is essentialfor further fiacial sor developmentin Madagsar dtat this text be issued as soon as possible.

The D mcaents tem 3.36 Rolepfjthe_meijay so : In additionto financialinteiaon, one of the essentialservices that the financialsystem usually provides to the economyof a county is the facilitat of paymentsand transfersamong vaius economicagents. Fgure 3.1 below depictsthe flows of goods, serces and money among economicagents as a result of various economic transactions.Households sell labor and capitalservices to businessesfor money; peoplespend part of this money on goods produced by busiesses; businessesget money for goods sold to the Governmentand also makestax payments;and households also receivepayments and transfersfrom the Govenment and also make tax paymets. In a market economyit is importantthat these tranSactionare carred throughas efficientlyas possiblefor the economyand the couny to develop. The most suited intermediariesto improvethe efficiencyof the paymentsystems are the banks and other financialin±tUtiou s, by meansof usinginstruments such as checks,money tanders and credit cardsin addWitont cash.

3.37 Structure of domestic uavmentssystm: Thereare three basic elementswithin the existingdomestic payments and transfer systemin Madagascar:

* a systemof inter-bankpayments among the four commerci-lbanks and the postal checkingapA savings system operaingdthgh a clearinghousein the cpital and fiften clearinghousesoutside the capital;

* inter-branchpaymnats witiin individualcommercial bank and widtin the postal savingsand checkingsystm; and

rgovemmentpayments d tsfers to and fromthe Treasury.The opations of these elementsof the systemare dscnibd in detai in Annex 3.1. 61 Fag 3.1 Fbm .f goods,_eyk ad _meey In the domic pV-nS systm

Thxpayments -x payments Gvn'tpayrdl Goverment Gvnltpurchsn

Hkusoholds 1 C ponbes|

|L Qsbo andcapitd services| L ~~~monley

>

- .-Financa tractlons (ash, cec,, mony odes, Sc) ReAd aeconomk aooomkom

3.38 __ _ n : No p=fo_ ofthe domesticpayne systemin Madagscar, as ehewhe, c- be evluoad accordingto f*or ckeria tha ar reviewed below:

sped - the clarg shouldb doneswifly ad nt tak -o thaonhre days,- msurff the -- firsare presented a loca clue -oar in uter aroa

avaialty - the custms shud be able to cah a chek wiu c a produr in hisloca bank'sbranch, s wel - whenpisesn th checkin othe bak'branch, ad it sold bepobl to cashdtck rcdved s pnwms at de reev's bans bunch witbo sendim for colcto acoracy - possibleerrrs sd be reducedto a minma nd mayto dact (eg. bocg check, wrong acconts beg debid, lost chcb in trvat); cased dck howldnot be in trsit for -m dun a few daysbdeo the accountisuatly debite, so a to recei updated baances;

amtasnee - de cbAcs should be generally acceted - a mean of paymn. 3.39 odm: Gof fte as obvou problm wit th prese domes payment symstm is the long time for mou to be Ianfereda ber th paye Is credited,particularly when cashing an Inte-branchor m*tof-t.wnchec. Themaim taum 62 for this are communicationproblems among various parts of the vast territory that constitutes Madagascar.This is exemplifiedboth by transportationproblems, as during the rainy season large part of the countrycan onlybe reachedby airplaneor by sea, and by telecommunicationproblems reflectedin the poor qualityof telex and telephoneservices. Poor communicationsmakes it difficult to easilyverify sufficientfunds on the accountsand that the person signingthe check is authorized to do so. The mostviable sign of the inefficiency(slack) in the present clearingand transfersystem is the exceedinglylong time it takes fer moneyto be transferredfrom one place to another.It can be measuredin days, but, a moreuseful illustrationto the inefficiencyobserved would be to quantify how much recipientsof funds lose throughthese delays in monetaryterms. An estimatebased on empiricalexamination of the existing clearing and transfer system and a number of conservative assumptionsindicates that throughthese delaysrecipients of funds collectivelyincur an opportuity cost equivalentto at least 1.2 per cent of G1DP(see Annex 3.2 for detailed calculationsand interpretation).Automatic transfers and automaticdeductions from accountsare in use to help speed certaintransactions. However, apparently there are no "guidelines"as to how manydays in advance a payorhas to makethe moneyaccessible to the bank, resultingin the banknot havingany possibility to benefitfrom this cash-flowwhich couldhelp defraythe costs of this paymentsmechanism- 3140 Role or postal checking:Although the postalcheckng system(which operates like the payments systems found in many countries)functions relatively well, it is still time consuming,cumbersome and can not be used as generalpayment mechanism for retailers. Onlyhalf of the approximately45,000 accountsin the CCP at the end of 1990were consideredto be active. About96% of the funds withinthe postalchecking systm are relatedto public sectortrumsactions. The Governmentholds about 15% of its depositsin the CCP. Depositsfrom individualswere equivalentto less than 1.5% of personalchecking deposits in the bankingsystem. Individualswith CCP accountsare essentiallycivil servantswho work in localitieswithout any commercialbank branchesor withan insufficientminimum deposit for a bankaccount. However,the individualswith CCP accountsrepresent less than 10% of all civil service and militarypersonnel. Despite its relativelyinsignificant role in paymentsamong individuals, the CCP has tremendouspotential to operateas a majorpayments mechanism by acting as a "girobarnk(see Annex3.5). 3.41 Availability, accurac a eace or the paymts se: The present paymentssystems does not allow the checkaccount holder to easilyget his money, unlesshe goes into his local bank's branch wherehe has his account.Checks can onlybe cashedat draweebank, otherwisethey have to be sent for collection.Ihe present clearing system, especiallybetween differentclearing house areas, and clearingbetween different branch offices of the samebank, result in checksbeing in transit for somedmesup to a month, thus not enablingeither the bank or the customerto get an updatedbalance on his account The longtimelags also makeit more difficultto possiblydetect any errors -for ecample,when documents in transitclearig disappear,it is dlfficult to find out what has disappearedand where. Wbile checks are fairly widely used by the larger companiesand the Treasury, and by individualsas payment of some bills, there is a lack of confidencefor checksas a meansof paymentfor cashpayments among a majorityof tradespeople and others.For them, checksare inconvenientin respectto longclearing, uncerainty of the ideny of the customerand sufficientfunds. Otherreasons are probablya result of the banks not marketing their productsproperly and lack of financialknowledge amongst the people. Certainmeasures have alreadybeen taken to improvethe acceptancefor checks as a means of paymentsincluding the introductionby some banks of local currencytravellers' checks. However, while such solutions mitigatethe problemof providingalternatives to cash as a meansof payment,they do not solve the problemof confidencein paper instumentssince customershave to pay in advancefor these type of travellers'checks. 63 3.42 Imurovingthe dearingand settlement sfstn: The present system of clearing payment in Madagascaris essently a documentcleanng system which is depndent on physical transportof documentsand therefre on existng mailand transportsystems. Such systenmare not likely to be substtlly improvedin the foreseeablefuture to an extentwhich would make it easily to clear documentswithin hree days. An alteative clearing system would be one where the informatonof the documentis exchaged, and nOtthe physicaldocument, and would be based on telecommunication.AlMhough this aleratve requir high-qualitytelcomnications to function efficiently,it is possibleto beginto developsuch a systemeven withthe relativelylower qualityof telecommnnicationscurrendy available in Madagascar.A proposalfor suchan informaionclearing system is describedin Annex 3.3 based on i decentralizedreoal learingsystem. A dearing system should, in order to minimizeerors, be integratedas well as automaticallyreconciled. Integrationmeans capturing of dataonly once at the collegcashig branchto be usedsubsequently throughoutthe system. Any errors shouldbe asily detectedand corrected. Infrmation learig meansthat signatureverification at draweebranch will not be possble and will, consequently,affect the designof the checksystem.

3.43 Im_oing the design of th_ oa chedc s_ em: To help improvethe clearing and settlementsystem as descrbed above,the Malagasypayments system must move amay from the present relianceon checksbased on manualvenficaton and restictions. Prvate checksshould be basedon personalizedc * forms, desgned and producedto makeforgeries practicaly impossible. This entails a checkguarantee card (standardISO plastc card) of falsification-proofquality and signedby the accountholder connected to the account,fbr identificationof the account-holderand verificationof signture. This systemfor protectionof checkswould make it possiblefor retailers to acceptpersonal checks, and to makeit safe for a branchto honorchecks drawn on other branches and banks. Proteon is carriedout by callingdrawee branch, wher the request is notified.Too many requests for protection will cause inconvenienceto the custome, and to the bank, by crerloading systemcapacity. To avoid that hapening, drawrn bmnkshould guanee paymentof smallerchecks 1 up 0o a fixedamount, without protcton. A check services_d into one type of checksguaranteed by draweebank and issuedto reliablecuomers only, and another always demandingfor protectionof the checkought to be considered.(Details of specificationsis decrd in Annex3.4.) Othr measuresto imprve checkservice for privatecustomers are an automaticteller machine,'ATM, serviceat draweebranch using a checkguaree card and PIN code, and a new servicefor regularpayments. Initiy, the ATM serviceshould only be used at draweebranch and not intrabranchor interbank withdrawals.The new servce for regar payments could be accomplishedthrough the customerswritig a list with paymentorders and handing at list and a checkto the bant Ihis wouldshift some of the worldoadto the bank's back-officeand unloadthe front-office,enabling them to deal with other matters.

3."_ _ _adnchtd:aad _t eiiain Security of comay checks shouldbe the same as.fr privatechedc to makeforgeries practically impossiblt Al checksshould be crossed (ba) and no signaturecontrol would be necessay. The crossedcheds oughtnotreally be of any inconvenienceto dte payees, since they are.likely to be other cor suWpliers.The payor bank couldfor instancesend tsaction lists to the respectve companiesevery day, for the clientsto controlall cashedchecks being correctand no flse ones being in circulation.To restore checksto their normalplace, a computcried systemshoud be set up capableof postingthe relevant dat and umbersof lost or stolenchecks wihin one hour of their loss or theft being rported. The samesystem should also post, wihin one day,the account mbers and otherdata concering person or ions that write checks witho fiuds to cover them. Tradespeopleacepting checks shoud be able to consultthis couterized recordsystem, after payingthe fee for its serices, to 64 verify that dte personwriting the checkhas not beenprohibited from usingchecks or caughtwritg bad checks, withoutwaitng for them to be formallyconvicted should they be taken into court.

3.45 Need for an imroed =emm and trnsre syse: A more efficientpayment systemwould facilitate and promotetrade betweendifferent areas in the country,and also to a cerAn extent witi local areas. Improve in the domesticpayments system would help integrae the fragmentedstructure of domesticmarkets in Madagascarand exploitthe significantinter-sectoral multipliereffects withinthe economynotably throughstronger linkages betweenurban and nrral economicagent. in the longer run, such irements are also likely to favor externaltrade by reducingdomestic obstacles to settlingpayments obligations and by increasingliquidity. To proced with improvementin a systematicway with close coLaborationbetween Government and fmancial insttutions, a tprong process is outlinedbelow which would enhancethe securt and use of checks as paymentsinstum , increasethe efficiencyof the present house system and developa girobank-basedpayments system as a complementto the existingcheck-based payments systenm

3.46 Enhbang check security and use: A new and revampedprofessional bankes' assocation (see Chapter4 for suggestionsin this area) should take the lead in designingnwr stanards for checks,.including minimum requiements for its secrity printig layout as for identificationof accountholders when checks are cashed.This shouldpossibly include the issue of a checkguarantee card by bankst its tusted accountholders. Once the standardis agreedupon and in place, the banks shouldbe prepared to sign an agreementof limited indemnificaionwhereby checks(up to a certainamount) as paymets instrumentswould be acceptedas "good cas when presentedin any bank and providedthat the standardprocedures are followedby the casingbank. This procedurecould with preference be extendedto other finamcialactors than banks such as stores, supplier and others as long as there is a srtdized pratce to be followed.With these changes, checksas paymentinstruments would over time be widelyaccepted and thereby facilistaeeasy and safe transactionsin trade-relaedmatters. It wouldtransfer responsibiity of customerbehavior to the bank handling the account instead of the financial agent acept the check as payment This will in turn make banks more judicous m issug checking accounts m dteshort run but would i the long run also have adisciplining effect on general customer behavior. The phenomenon of bounced checks would then be reduced to a relaively insignificant amount.

3.47 Inc teigi offio us:rmtio: Once the new s and practicesfor checkuse havebeen implemented,k wouldbe appropriateto consideran information- based clearn system to avoid the physical transportationof documents(see Arnex 3.3). This teleco cations based system could be implementedgradually and intially in areas where telecommunicationsis of acceptablestandard. Since such areas are likely to be where most transactionsare conducted,the new dearing systemcould have a major impactin tems of volume of transactionscovered nght fromthe beginning.

3.48 Puelo&g a kfhbjnja pnyentsf an. Alongside the improvements late checksysm, sudies shouldcommence for a gimbank-basedpaymens system(see Annex3.5 for details). This wouldbe an alternativeor complementto the exdstingcheck-based payments system which in Madagascaras in other counties has handlingcosts that tend to rise beyond cert relativelylow volumes.Developing such a systemin Madascar shouldbe consideredin the coqmt of revamping the existingpostal checking system which already acts like a giro system and restruing of the pos- savingssystem (see Chapter6). 65 3.49 Creating a nanments information citer: Whenthe new check standardsare in place and communicationsystems implementedfor a new dcearinghousesystem, a payments informationcenter couldbe set updtrough the activeinvolvement of al banks. Thegovernment could have a catalyticrole as well as be a minority partner in such a cent which would gather and maitai informationabout individualsand companes who are not able to managecheck accounts or otherwisefulfill financia obligationundeltaken.When banks consideropening new accounts, verificationshould be made fromthis preferablycomputid registe to preventmisuse of banking facilitiesand trustby unscrupulousindividuals or institutions.As the banking system grows in Madagascarand as more accountsare opened,such a facilitywill becomeincreasingly important.

3.50 Role of gnment in gayments temhe roleof the Governmentin improving the paymentssystem as describedabove severalfold. First, Goverment sbould,at least initially,play the major catalyticor leadershiprole in enuring that the variou necessarystudies are undrtaken to implementthe aboveproposals. Second, as a resultof thesestudies, the Goverment shouldinitiate any legalchanges requed govning the paymentssystem and paymentsinrmes. Third, BCRM shoauldmake the necessarychanges in the practicesof the dearinghousesystem to facilitatelocal dear and mtroductionof an information-basedclearng system This woud also reqire the cooperationof other Government departments notably the telecommunications authority.Finally, BCRMshould ensure that any paymentsinfoamation center that is established bliowscertain rules regardn its ethics,secrecy and integrityand that it is not abused.All dtree elemens of the payments system developmentstrategy proposedabove would also entail programsto increase fiancial kwledge amongstthe populationto makethem aware of the benefi of bankig and checkaccoun such as safety, convenienceand accessto financialservices. This could be done throughsavings cpaigns jointly promotedby finacial instiuons and the Government

Th-e Extema Panngts Ssstem-

351 Role of external stm: lamets-and-transferJustas for the domestic payment and transfersystem, an externalpayment system is importantto filtate importsand expors as well as investmentflows and tansfers from abroad.The salientfeaure of the presentMalagas external paymentssystem is the restrictionson any insttion other dan the CentralBank to deal in foreign curreies. As Madagasr seeksto eWpandirade and investmentflows in the comingyears, there will be occasionto progressivelydecentralize this present systemof externalpayments and foreign exchangemanagement (see Chapter?). The detailed workings of die present system of payments and transfe to and from abroad are described in Annex 3.6. The payenit system sbould be characrized by speed, avalabiity, accuracyand accepce whichare evaluatedbelow.

3.52 1valuationof the externalwIanmn sstes Thegenera opinionamong the bns, appearsto be that paymentsare for the mostpart handledrather effciendy.This observato is made apart fromthe facts that the BCRMhas to be involvedin tat onlyonce a weekpurdase ordersfor importtransactions can be sent to the BDCII Furthermore,giv tat the FMG is not convertible, the prest systemis tme consuming.There are sometime unnecesary delaysin tansacons where moneyis arriving from abroad to one bank to a payee who is client in another bank. In such a trsaction, the transferis not forwardedimmediately but is handledslighty differentbetween the banmswihout ay agreementbtween themon how to dea with such transactions.There is also a need to upgrade the telcmmnications infrastuctre in order to improve the trade finance possiities for importersand exrters in Madagasc. It is importanthat t banks he sufficient resourcesto meetthe credit of impore and exortes adeqWely,on terms whichwil esble them to competem world markets.fle prenc of Free Tde Enterpris is one way to ste capital flows from abroadand to failitatetrade. Prosely, thee is no possibilityfor 66 companiesor banlk to hedgeor secre its foreignexage need, sincethe companiesalways receive the exchangerate as of the notificationday in an exporttransaction or applicationday in an import trasaction. Thus, the importerand exporterstands the currencyrisk throughthe whole transaction. Delays in external paymentsystem does not only seem to depend on whether the transactionis forwardedby mailor telex, but also to a certainextent which other countryis involvedand how well establishedthe contactis betweenthe correspondingbank and the domesticone. It appearsthat most transactionswith France and the banks' correspondentsthere are handledmore efficientlythan transactionswith other countries, such as in North America. However, there is scope for improvementwhen the SWIFTsystem is implemented.

3.53 The need and scone ror decentralizedforeig exchangemanagement: In order to makethe externalpayment system more convenientand reliable, it is necessaryto decealize the managementof foreign curency transactionsto the banks, and not have all the transactions centralizedto the BCRM.However, it is importantthat any decenutrlzationand deregulationshould be done with the utmost care, and slowlystep by step. When implementingdecentralization and deregulation,it is importantthat a monitoringsystem be installedin the BCRM. Most Malagasy banksappear to be well preparedfor some degreeof deregulationof the currencyrestrictions and decentralizationof the foreign exchangetrade. Beforetoe commercialbanks were nationalizedin 1975,they were allowedto have foreignexchange accounts. Ihere thereforeis likelyto still be some imowledgewith the bankingsystem concermng management of foreip currency.Furthermore, since the first quarterof 1991,there are three bankswith foreignsharholdings, which impliesthat even if the banksthemselves do not havethe requiredexpertise to deal wit foreignexchange, such skills are easilyaccessible.

3.54 Opfions for uroiressive deotralization and deultion: One step towards a deregulatedcurrency market could be to give bans possibilt to only buy or sell the net amount needed in foreign currency, insteadof havingto buy and sofl foreign curncies tD and from the BCRM on a gross transactionsbasis. In this way, insteadof import applicationstaing two days, whensent to the BCRMonce a week, and exporttransactions takng three days, all transactionscould be dealtwith in two days. Anotherstep couldbe to licensethe banks to become currency banks, i.e., authorizethem to deal in foreigncurencies. Ibis should be lind to cerin conditions,such as, the banks having to prove they have the capacityand knowledgedeal in foreign currencies. Furthermore,allowing the banksto hold(imited) accounts in foreigncurrencies requires an improved reportingsystem to the BCRMand is thus tied to overallimprovement in prudenal spevision and regulation.In additionto allowingthe banksto deal in foreign currecies on the spot market, they couldbe allowedto operatein the forwardexchange market in order t hedgeaginst currencyrisks. The-dealingin currenciesshould be focusedon customerservice, and it is importantto point out, the banks shouldnot initiallybe allowedto use moresophisticated hedging instruments such as currecy- swaps and options which also places additionalstran on the limited superviion capacityon the BCRM.An authorizationfor the banksshould enable the companiesto receivedocumentary cdts. Not only the bank's head office shoud be allowedto give those documentarycredits but also the regional offices (but not aU the local offices). These regional offics would then report their tansactions to the centralforeign exchangedeparm with the bank, which would report to the BCRM.Another way to improveextenal paymentscould be to authorizethe banksto issue checks in majorforeign cences. In a deregulatedand d ized market,it is importantfor the banks to open up correspondingaccou with bank connectedto the SWIFT systemand thus eliminate unnessary delays. It is also importantfor banks to agree on how diffent transactionsshould be dealt with, such as whenmoney is arrivingfrom abroad to a clientof anotherbank, in order to avoid delays. 67

CHAP=E 4

4.1 Commercialbanks are likelyto continueto representthe preponderantsegment of the fincial systemin Madagascrthroughout the l990sin termsof their shareof fundsmobilized and resourcesallocated by the financialsystem. Ihis dcapteranalyzes the recentevolution of the banking systemin Madagascar,with an emphasison the effortsundertaken by the Governmentduring the past few yearsand challengeswhich remain to promot the sector' efficiency.The chapterfirst reviews key baning developmentssince 1975,foussing on changesin ownershipstructure, and qualityof loanportfolios and on the currentdistribution among banks of branches,staff, assets,deposits and capital. Subsequently,toe dapter analyzesthe mainoperational features of the baning systemsince 1987and in particularthe evolutionand funding of bankassets, the sectoraldistibution of creditand bank liquidity. Third, the chapter assessesthe overal pefomance of the banking system since the adventof privatebanking in 1989and examinesbank interestmargins, profitability and costsof intermediation.Fourth, the chapterlooks at challengesthat lie aheadto fiurherdevelop efficient baking in Madagascar.Finally, the chapterexamines needs for regulationand supevisionin a market-orientedeconomy.

BanidngDevelopents Since1975

4.2 Nationalizationand Mergers. Bankingin Mabdscar datesback to 1886when the ComptoirNational d'Escompte de Parisopened an officein A-ananarivo. Madagascar'smodern bankng historyhowever can be datedfrom the June 1975nationalization of thebanking system, which then consistedof a centralbank, four privatecommercial banis (with significartforeign partiction) and one develpment bank. By Januy 1977,the five bankswere restrcured into tree commercialban with the intentionof speialzing each in a major sectorof the economy: agriculure, industryand commerce.In December1976, the NationalBankc for Industry(BDN) was created by merging the industridalcomponent of the Banque Nationale Malgachepour le Developpement(BNI) withthe Banquepour le Commerceet lJndustriede Madagascar(C). A few days later, the agriculturalcomponent of BNM was mergedwith the BanqueMalgache d'Bscompteat de Credit (DAMES)to form the NationalBank for Rural Developmen(BTM). Finally, by mid-Janary 1977, the two remaiing cmmercial bans, BanqueCommerciale de Madagascar(BCO) and Banque Financiere et CommercialeMalgcho (BFCM), were merged to form the Bankof Commerce(BFV). All three bankswere 100 peren statwned, eitherdirecdy by the Govement alone(BFV), or throughthe particiationof other governmentinsttuonsY

4.3 Growth of Bank Credit. The ten yearsfollowing the nationaliationof bankswere characterizedby a rapid increasein the economy'sdomestic credit Duringthe fist half of this period (end 1975-end1980) domestic crei uadrupled,with 64 percen of the credk expansion accountedby the increasein the CentralBua..'s net lendingto the centralGovernment This was largelydue to the Govermens wall-ourpublic inestent program,which resuted in growing budgetdefi. Thesecond half of the period(end 1980-end 1985) witnessed a significantslowing down in the rate of avae annualexpansion of domesticcredit from 32 to 19 percent and a decrese in the cental Govnments share in the creditexpansion from 64 to 51 percent. These

Ii Ilbestate acqred90 percentof the sharecapital of BTM (wi the rmain 10 perct held by te Central Bank), and 56.77 perce of BN. The ohr saeholders in DM1were the CentralBank (6.67percent) the SocialSecurity Fund (19.90percent) and two s muarancecompanies (8.33 percent ead:). 68 developmentswere the result of the measures aimed at financialstabilizaton through demad managementtbat were initiatedby the Govemmentin mid-1980and reinfrcd after 1982.

4.4 Deteriorating Loan Portfolios. The Treasury did not involve the state-owned commercialbanks in the financingof its 1978-1980investment program. However,the commercial banksquicldy became heavily engaged in extendingshort-term credit to the nationalizedand newly- created public enterprises. By the end of 1985, about 48 percent of outsanding gross loans of commercialbank were to public enterprises. Since many public entprises were finacially not viable, they had limited abilit to repay their commercialba loans. Their problemswere compoundedfrom 1983onwards, by tze Treasury'sinability to maintainsubsidies and grantsto them, in the contextof its financialstabilization programs. The outcomewas a significantincease in the arrears of the public enteprises, and a serious deteriorationin the quality of the banks' loan portfolios.

4.5 RisktC ifclolanutLanroviuioing- Itwas not until 1985that the CentralBank set up criteriafor classifyingbank borrowers according to their degreeof risk,Yalthough it did not define clear-cutrules on such mauersas the treatmentof consortiumcredits, acual of intereston doubtfil loans and write-offs. Availableinformation idicated that the qualiy of the bats' loan portfolios deterioratedsignificantly after 1984, with doubtful loans (that is loans included in categoie C and D) accountingfor 40 percentof the gross loans at the end of 1985,as comparedto less an 27 percenta year earlier. Whilethe bankssubstantialy icrad their loan losspovis in 1985, total provisionswere stll equivalentto less than 20 percentof gross loans and 49 percent of doubtfulloans at year-end(see Table4.1).

2; Banis were askedto classifytheir loans into the foblowing our categones(after taking into accountthe collateraloffered by the borrowes): cateory A comprisesthe least risky loans *(inimum n") becausethey are fimuctioingnrmaly wth no arrears; cegory B pes loans "to be watchdZ becase they are nwunting some ligqt or profitabiity problemua-.d henc are sometme behindin their loan reyments; ctegory C compses loans with "probable rik", because hey are encunt seous opeaional diffties ad, at the same time, do not prvde adequatecollatral; and catory D comprisesloans with "definiterisk" tha wi entail patial or total loan losses. 69

Tab] r 4.1 Deteriorationin the Oualityof CopmmercialBanks' Loan Portfolios Cmbillions of FMG) End 1984 End 1985 End 1986 Gmss Loans Outstanding 316.0 386.8 438.7 Doubtfil Loans 85.1 154.9 173.9 Provisionsfor doubtfulloans 46.4 75.3 89.9 Net Loss Oustanding 269.6 311.5 348.8

Roon DoubtfulLoans/Gross Loans 26.9 40.1 39.6 Provisions/GrossLoans 14.7 19.5 20.5 Provisions/Doubul Loans .54.6 48.6 .51.7

C.I.F.P.B., Etude du SecteurFiacier de Madagascar:Rapport de Synthuse, 1988. 4.6 Bmlua sHu.hedof ia. By the end of 1986, the non-prforing loan portfolos of the bans were establishedat FMG 174billion, while their loan loss provisions tlled FMG 90 billion. Althoughprovisions had increasedas a percentageof gross loans beween 1984 and 1986, they were dearly inadequateto meet eventualloan losses. Given that the combinedcapital plus reservesof the thee banks was only FMG 29 billionat the end of 1986, it becameevidet that if Se bank were requiredto take additionalloan loss provisions equivalent to 7 percentof their grss lons oustndin, dheywoud becme technicallyisolvent. Cosequedy, the Ceal Bankinucted dw banks early in 1988to revaluetir fixed assetsand incorporatethe revaluationreserves in thei 1987 accuntsY As sbown in Table 4.2, the combinednet fixed assetsof the banks stood at Is than FMG 8.7 billion at the end of 1986, while the increase in valuationsof 1987 toled FMG 41.6 biln, tiereby substantiallyincreasing the banks' non-callablereserves.

Tabhle42eafations of Fixed Assets olBnksf miions of 1M0G) FEkd Assefs(n Land (192E& End 1986 adier FnsedA=st Eixod

BTM 3,509 997 19,204 20,201 BNI 3,3376 1,239 9,883 11,122 BFV 1,783 612 9,674 10,

AoumalRepoxts ofndMvdufTW-

3/ Banks were instucted not to considerthe mr uationsapri,but to rcdr them n- callablererves. 70

4.7 Clemning-Ugof Loan Portfolios.Following the instructionsreceived from the Central Bank in March 1988, the banks proceededtD cleanup their loan portfolios. The 1989 cafified accountsof the dareebanks showed cumulative wuite-offs of FM{G112 billion in loansand off-balance shet commitment. Ihe banks reliedprimarily on their interal resourcesin financig the leaning- up operations.As shownin Table4.3, theamounts written-off were financedby the drawingon the provisionsfor bad loans (65 percent)and daerevaluation reserves (16 percent),with the re 19 percentcovered by interestfree loansfrom the TreasuryA'

TableW.3

cleaning-Upof the CommercalBlanks' Loan Portfolios (C millionsof FMG)

Iank LoansTaken L anoss Inrest Frl R luation out* Pofvisions LOE Portfolios rrreasujy/CCCE BFV 44,403 37,S24$* 6,579

BNI 37,394 30,994 6,400** - BIM 30,020 4,452 7,755 17,813

Total 111,817 73,270 20,734 17,813

- Incluindggsmal amount of offbalnce sheet comets. Incluing provissionsfor accruedinterest reported separately. It is clear whetherthis amountis to be repaid, or consideredas a grant

Sss~: Informationobtained from individualbank.

4.8 Jmr=stInuLJanIafrtfnls. As a resultof thiscleanimg-p process, the quality of the bans loan portfoliosimproved dgnificandy. At the end of 1989,less tha 15 percentof the baniw' loan portfolioswas considereddoubtful (as comparedto 40 percent t the end of 1986)and lon loss provisionswere equivalentto 84 percentof the doubtfilloans, as comparedto less than 52 percentthree years earlier(see Table 4.4).

M1The Treaury usedthe French CCCE-PCAS counterpart fumds to cover the inest-fmee loan extendedto BTMand BFV which are to be repaidout of therecowveries fm the ddinqut borrowers.By theend of 1990,BTMWs repayments to the Treasurytotlled FMG2,337 million, whilethose of BFVtotalled MGF 2,130 million. 4.'

iL~i - Ci)4~~~~~~~~.' - ~~ ~ ~ I 0~~~~~~~~~C . . . ;j .j

4 0 46)8~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~R ,.. * aj I~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~...... LU~~~~~~~~~~~~ 1 ;.|, 72 Mulgachede l'Ocean Indien(BMOI). The new bank, which is managedby BNPI and controlledby two foreignbankig institutions? strted operationsin August 1989. In addition, 1991 saw the establishmentof representativeoffices in Madagascar of two foreign banks - the Mauritius CommercialBank and BanqueFracaise du CommerceExtrieur. 4.10 Divestiture of Government Shareholding. The first quarter of 1991 witnesed a substantialreduction in the MalagasyGovnments ownershipin the bankingsector. On February 20, 1991, a leadingFrench bank, the Credit Lyonnais(CL) acqired from the Malagasystate 51 percentof the shares of BNI, and assumedthe managementof the institution. On March 1, 1991, the French subsidiaryof a leadingItalian bank, flstituto BancarioSan Paolo di Torino (IBSF), acquireda minorityparticipation in BFV, buying22 percentof the share capitalwhich was increased from FFMG3 to 6 billion. While these developmentsstill leave significantstate ownershipin the bankingsystem, only one of the four existig bank - BTM-emains under the fuil ownershipand controlof the Malagay state. 4.11 Curnt Stmdure and MaSmres. At theend of 1990,tie presentbanking system comprisingfour banks, togetheroperated 83 branchesand 35 offices, employeda staffof 4,300 and had assets approachingFMG 1,200billion. The level of total assetsper employee,equivalent to FMG 279 million(or roughlyUS$169 thousand) in 1990,is verylow by itrational stndards, aDd is even below the prevailingaverage for African ountrieswhich amountedto US$224thousand in 1989. As shownin Table A., Madagascarranked 27th out of 35 sub-Sahara Africancountries with respectto the levelof commercialbank assets per employee.This suggeststhe swpe for the banking systemas a wholeto improveits employeeproductivity. The shareof eachof the four banksin tta assets, gro loans, outstandingcustor-. leposits and shareholders'funds as of end October 1990 is shownin Table 4.5.

Table 4.5 BranchNetwork. Staff and MarketShares of M;laga Banks in 1990 9IS BTM .ES BMOI 8 3Total Numberof branches 16 48 17 2 35 Number of offices 6 19 10 - 4,300 Numberof staff 1,130 1,680 1,350 140 MarketShares Assets 36.0 36.1 21.3 6.6 100.0 GrossLoans 34.8 35.7 21.0 8.5 100.0 29.8 35.4 24.5 10.3 100.0 CustomerDeposits 38.4 35.0 23.2 3.4 100.0 Sh[rdholders'Funds Aso

Source: Informtion obtainedfrom the individualbanks.

/I Each one of the two fori bang instituin, BNPI and SFOM(ociet Fmnere d'Outre-Mer)holds 37.5 prcent of the share capital,while the remning shares are held by around300 privateMalagasy investors. 73

Ma ti fng Feaue of the Banidf SySm Since 1987

4.12 The aggregationof the assetsand liabilites of the commercialbanks is undertake by the Central Bank for the purposesof the monetay survey. As such, the balancesheet presentedin Table A.2 are designedto highlightsuc variaes as liquid assets in loca arency, net external assets, net caims on goverment, grosscredits to the economy,customer deposits and otherdomestic liabilities. A reviewof the aggregatebalance sheets for the period 1987-1990bring out a number of salientfeatures, developments and trends reviewedbelow.

4.13. ijowthaonhinfgjasset: Reflectingthe rece growh of the economyPaggregate commercialbank asset incrased from FMG 742 billionat the end of 1987 to FMG 1,064billion by the end of 1989,an increaseof 43.4 percent(see TableA.2). Averagetotal assets of commerci banks during 1989were equivalentto 235 percentof GDP at marketprices (as comparedto 22.6 peret during 1988), reflectinga slightdeepening of the banig system. However,there was a slowingdown in the rate of growth of bankassets in 1990. During the fir ten monthsof the year, total bank assets increased at an anumalizedrate of 10.6 percent, barely exceeding the estimated of inflation(10 percent).

4.14 Goven ent's Net Cditor Potion. Unlikepublic enrises, the Govermmenthas traditionallybeen a net creditorto the bankingsystem with its depositsaccounig for 9-12 peet of total commercialbank deposits. Bankfinanig to the Treasuy has essnly been limitedto holdingsof a small volumeof goverment securities. A the end of 1988, the Government'snet reditor positionamounted to FMG47 bfllion. However,as a result of the banks' subscp to RAG 62 bilLionin Treasurybills during 1989,the Govern_met'snet creditorposito dwindledto FlMG10 bilion by the end of 1989. Folowing a 19 percentincrease in its depositswith bank during 1990, the govermanntcreditor position improved to FMG 30 billion by the end of OctoDber 1990 (see Table4.6).

Te 4.f Govenment's Net CreditorPosition with Banks Cmmillions of FMG)

GovmentGovernmentCradkor Poshion 1987 10,654 61,656 51,002 1988 15,042 62,246 47,384 1989 78,645 89,057 10,412 1990 (October) 30,399 110,420 30,021

Sour: CentralBank of Madgsa.

4.15 ISreamdLendlngtPkfd tSct. As shoowni Table4.9, there has notbeenmuch variton in reccfl years in the sharesof the varioussectors i total credis. The inutial secor is

: Between1987 and 1989,GDP Increasedby 47.0 perct I aney tey and y 8.9 pemcent rt real terms(at costant '1984pries). t_ V.,_a.s¾ i- . * - , : 74 he recipientof more thad onealf of the crdits extendedby the banks, withthe agriculural sector accountingforroughly one-ixth ad the servicessector (mainly commerce) acoung for less than one-fourth. The last three years bave, however,witnesed a signficant shift i lenig from the pulic to the privae sectors. With tho bank tigtening of credi to loss-makingpublic enterpises, more resourcesbecame available for lendingto the privat, sector. Cousequeny, the share of toe privatesecoor in total creditsextended by the baun rose steadilyfrm 52 percentat the end of 1987 to about 74 percentby end October 1990(see below).

4.16 HIgbIanaItoDs aio,. At leastsincet deir nationio, Magasy bankshave operated wit a high ratio of loans to -deposits. At the end of 1987, gross loas ecceededtotal dqpsi by 22.3 peent Withdeposits increasing at a fasterrate than loansbetween 1987 and 1989, the ratio of loansto depositsfell to 90.4 percent However, withthe slowingdown in the rate of inr in depositsduring 1990,the trend was reversed:by the end of October 1990the ratio had risen to 98.6 percent(see below). Thesehigh ratios are explainedby at least dree fictors. First, banks have relied on externalsources mainy foreigndonmrs - o fund part of their term loans. Second, banks had until recenty practcally no investmen opportunitiesto channeltheir uplus finds, asidefrom the segineutof the moneymarket that is managedby the CentralBaLlk? Ihid, unt recenty, banks needed to icrease earning from new loans given the high ratio of non- performingloan in their portfolios.

Ta&e4.7

Ratio of Lat Deposits

GrsLoans .s*S=DDeXoi (billionsof FMG) (billionsof FMG) Rado (5) 1987 488 399 122.3 1988 513 469 109.3 1989 572 633 90.4 1990 (October) 670 679 98.6

* Excludingcraedits to governmt S ncffldig governm deposits.

Baors: CentralBank of Madagascar.

4.17 i DwnnuifthFndiug.qs Tw.tCredl In the past, Malay bank extended trm lamonly whentheso loans were pre iantyexternally finded. More reeny, tl banks stad relyig more heavly on domesticsources of fning. As reflectedby the da below, the dsha of mediumand long-tem loans in tot lendingrose from 17.0 percen at the end of 1987to

V1 The nebu marketsmtrted fimctoning only as of March 1987,and bani were allowedto subscri to Treaq bills only as of Sptember 1983. 75 20.4 percent by Ureend of Octobe 1990. DurIaf e samebtva4l, th raio of m depoeds ncludingctficats of deoit) to totaldeposis (includinggovernmn depst) as ros from37.4 percent to 41.4 percent. As a rslt, the aio of term loan ouandig to tm, deoi actuay fidl from 55.7 pecet at the end of 1987to 48.7 pert by the end of Octobr 1990.

RelativeInae ea C( billion of FMG)

Grm L Dedi

hi flu L. 1987 405 83 250 149 1988 414 99 300 169 1989 455 117 40D 233 1990 (COo-ber) 533 137 398 291

*ncun cetficate of deposit.

TaSble 4 9

S--ra Breakdown of Gm sLo Pecent Of tDal) Sc End 1987 B 182 En 1989

Agricultue IS.4. 16.5 16.6 16.9 Thd.strya_- 58.8 56.2 55.8 54.8 Services 20.5 21.8 23.6 22.8 Not Clasified 5.3 5.5 4.0 5.5

Private 52.4 63.3 66.2 73.6 Public 47.6 36.7 33.8 26.4

* Ildes only borwers whose x cees FMG 10 million. 76 4.18 Te lqdit poson of Maags bak fucuaed widy dui 1381990. Exding th statuto resv wit de Cal BDnkde bam lquid a i local cu rty otalled FMG 49 biion at the ed of 1987,whil their net extnl uses sloodat FMG 46 biion. During1988, the bn reducedtheir cessreswu, wih liquidassels in bcal cuencq dwindilngtDalow leve of JustoverFG 8 biousti endof Octber. Despitearwe vd the la two nwts of 1988, qWd aei local cmrey ranotd a yen-ed FPG 16 bion bdeowthe levelof a year eadier. By co ,asadti bans net tal ases inreased by FMG 13 billionduring 1988. In the wakeof te sig Icres in t duing 1989,the ban' liquid asts in localcurency (exdudingmtuoqyreserv) ncrasd substiy reachin a reord levd of FMG 75 billionat the end of Decmbe. Nat ateral ss lso peakedat year-aid tomlling FMG90 bllion. 4.19 Thesiationws ag* revered in 1990,whIh mu mared by an acutelqidiy asi experienceby oneof dhebank, and anoverall rduction In t lqidit positionof the banks The -atpe r tolardyresulfrmasueIncred4fmoedx m triggeredbydieluibaiaon of te trade regime Dunth first tn mons of 1990,th ban lqud as in localcurnc deeed by FMG65 billion,while hirt exteal assetsdeeasd by morethan FMG 23 bMion. In addit the bank' indebted to th CentralBank Ineased dramally duri e inteva fromFMAG 12 tD FMG97 billion(see Table ).

Figure 4.2: Sectoral Breakdownof Gross Loans

End 1987 End 1988

Inddusty IrKlUS

25% 27%

Ed 1989 End 1990

industry Induy 88% ~~~~~~55%

,|X; :{C;Ss\ X -- :' :: --2#? ; . 28;;* A Rcufum 77

Overall BanWngPerformance Since 1989

4.20 Data Constints. The CentralBank requires the bans to submitto it monthlyda on the evolutionof thei assetsand liabilities,but doesnot requirethem to makeregular submissions on their pmfit and loss account. Therefore,the banks' publishedannual repors are the only sourceof informationon the performanceof the bankingsystem. Since BMOI (whichsurted operationsin August 1989) is yet to make public ks first annual report, and the results for 1990 are not yet availablefor any of the banks, the analysisof the recent performanceof the Malagasybanks is restrictedto three banks and covers the two-yearperiod 1988-1989.

4.21 The aggregatebalance sheets of the three banks, presentedin Table 4.3, differ slightly from those publishedby the CentralBank, evenfor 1988,although they cover the same institutions and are derived from the same ceriied accounts. The differences between the two sources naturallybecome larger from 1989onwards because Central Bank data includeBMOI as well.

4.22 Evoluion of Assetsand LIabilities. DatainTableA.4indicatethatthecombinedasses of BNE BTMand BFV increasedby 16.5 percentin 1989and a further6.5 percentduring the first ten mouthsof 1990 t stand at PFMG1,021 bilion by end October. A 33 percent increasein total deposits(mcluding the government)during 1989,enabled the banks to enlargetheir loan portfolios (by 12.8percent in grossterms and 10.4 percentin net terms), subscribeto Treasurybis to the une of FMAG62 bilion, and increasetheir balancesat the CentralBank by aboutFMG 37 billion. By contrast, a 1.2 percentdecrease in total depositsduring the first ten monthsof 1990,Zcoupled with in expansionof the loanportfolios (by 5.1 percentin grossterms and 7.9 percentin net ums) forced the banks to resort to substantialborrowing from the Centra Bank)2'

4.23 Imortan of terest Marn. Banks in Maagascar enjoy a significantadequate mterestspread (difference between the averagelendig rate and the averagecost of deposits),which averaged6.7 percentin 1989YThe interestmain or the net interestbicome (Le. interesti less interest cost) accountsfor the bulk of the gross earningsmargin or gross operatingincome of Malagsy banks. Owingto a 20.9 percentincrease in the interestmargin in 1989,the contbution of the interest margin to the operatingincome rose from 65 to 71 percent, and resultedin 10.7 percent increasein the gross earings margin (see Table 4.10). Given the limited range of fee- generatingbaning activities and current prohibitionon foreign exchangetransactions the interest margin remainsmore importantas a share of gross earningsmargin for banks in Madagascartha most Sub-Sahar Africancountries.

21 The decreasewas a direct rest of the entry of the forth bank (M1MO),that maged in just fomteen monthsof opeations to capture10.3 percen of the system's deposits.

jQI It shouldbe noted, horeer, that about 91 percentof the increasein the bans' indebtedness to the Cental Bankduring 1990was accountedfor by one bank, hat eWeriencedserious liquidity problems, the magnitudeof which is still unknown.

hi' rhe average lending rate was 12.8 percent, while the average cost of deposits was 6.1 percenL 78 4.24 PrdlhtabilyJniI Althoughtheincreaseinoperatingcosts- 11.9percmt in 1989- outstrippedthat of the gros earnins margin,the net earningsmargin increased from FMG 31.3 billion in 1988to FMG 34.4 billion in 1989. However,it is the sharpdecline in other net cow (owingpredominandy to a decreasein net prwvisionsfor bad debtsfrom FMG 26.5 billionin 1988 to FMG 20.8 billion in 1989)that explain the jump in opeating profis from FMG 1.3 billion in 1988to FMG 11.6 billionin 1989. Furthermore,owing to the significantincrease in the banks' net exceptionalincome (which is lagdy due to the recoveriesfirom the old loans that had been takenout of the portfolios),profits before tax increasedfom FMG 3.6 billion in 1988 to FMG 20.4 billion in 198, whle profitsafter tax increasedfrom FMG 1.9 billionin 1988to FMG 15.4 billionin 1989. Net profits in 1989represented a ran on averageshareholders' funds of 22.2 percen, as comparnd to less than 3 percent in 19889 This increasedprofitability enabled the banks to distbute substel dividendsin 1990,equivalent to 62.4 percentof their 1989 net proffts.

Table 4.10 Aggate Profit and Loss Accounts.1988-1989 Cmmillions of FMG)

1988 1989 InterestIncome 72,966 84,272 Interest Cost 36,647 40,379 Intrt Margin 36,319 43,893 Other OperatingIncome 19,393 17,798 Gross Ernings Margon 55,712 61,691 OperatingCosts 24,432 27,334 Net Earnings Margin 31,280 34,357 Other Net Costs 30,004 22,772 of which:Net Provisionfor Bad Ddbts (26,455) (20,835) Operating Profits 1,276 11,585 Net ExceptionalIncome 2,326 8,819 Profit before Tax 3,602 20,404 Taxes 1,681 4,958 Plrofitafter tax,2 1,4

Source: AnnualReports of individualbanks.

4.25 CAmsof Intumediat. Improvementsin bankperformance in 1989is reflectednot only by the increasein the retuan averagetota asset and averageshareholders' funds, but also by the decreasein the costs of intermediation,which are equalto the gross earningsmargin divided

Computedafter deductingdividends and paymensato Boardmembers. 79 by avege totalassA As shownin Table4.11, the oa of decreasedfom 7.37 percet in 1988 to 6.93 perct in 1939. Epecially in view of low labor costa, opeating coca, which were reatively low by developug country stadards, decreasedfirthe to 3.07 perce i 1989,therebymakingbanksminMadagscarevnmeompetii tisrespectthnsome idstria counties such as Italy nd the UnitedKingdom (see Table A.7). Ote cs, ne of non-opeating and exceptional come decreased substntly durig the intrval fihm 3.66 pect to 1.57 percent, partly due to the decrease in net povions for bad dds. Cny, profits as a percentage of average tota asseu inceased from 0.26 percen in 19 to 1.73 pme in 1989.

Table4.11

ere of average s) 1988 f M -DUS=)

prating Costs 3.23 3.07 Other Net Css* 3.66 1.57 Net Provisionsfor Bad Debts (350) (2.34) Other Items (0.16) (-0.77) Taxes 0.22 0.56 Net Profits 0.26 1.73 Costs of ItrmedIatIon 7.37 6.93

Imncludingnet exceptionalincomne. hum: Derivedfrom Tables A.4 and A.S.

4.26 Red=d Prorztubiatl in 1990. Althoughthe resuts of the bank for 1990have not yet been made public, indicatorsare dtat for the bankig systemas a wole the rflrns on ascts andt shareholders'himds were lower in 1990tham in 1989. Theentry of BMOIinto the scene,which has ntoduced a welcomeelement of competitonio the system(thogh pnce competdionsu the introductionof newproducts reating to savingand crdit) probablyresulted in a roducdonin inter margins,and consequently, a further reduction in the grosseam arginwhich is rlatvely high not onlyby inteational standards,but evenby Africanstacards.W Sinceit is unliely that the reductionin thegross eigs mar.:'nwas offset by a correspoding reduction in operatin costsand other net costs it follows tat 1990 wu less profitsbloed 198. Anotr importma reo for the system's reduced profitability in 1990 stems fiom BTWs liqidit crs. Indeed, 1990 was an remelydiffilt yearfor BIM. Theistttonsuffer froman ext employeestrikedung fl The costsof Wdiaionare generadlydivided into fom elements:operatng cost, oher netcosts (whih usualy consistmainy of net loanloss pvision anddercaton costs,but in the caseof Madaasr also include-neticome itemsresult fromthe leanig up of the bk' la portlias), tes on grossprofits, and net prfit. As sho in TableA7, the inte margn is higer in M asar (4.93percent in 1989) thanin cauties sucha Ghma(2.99 percet), Rwada (3.72percet) d Mawi (4.50 do wooindpnr, a syh.~~~~~swll - swrimsweaknes In theManages of hi Torald. IncudtIngs1 loa portfoi, dialudnobtsily remisSd In abstadlalosss.

4.27 Sine t rio of I the mid 1970s,th Magy baking systm ha uI a majo Asthe ecoomy movs i the 199Wtward greatr amphasis on private sor ivest_me ad producion, the bankng systemwill fw - dUages in aeqaey providing efficin banking rims whit miimi ris ad cal to deposai ad invetms andhelps dtn maximizerams on invesuet Giv coued -egthau. of S. tcur and m _ of Inviuaf bak ad heir regulo framework a wdl a the develpme of an idpde b profusion, thre b =uda promie for the emere of a dyai nd comipetitivebaknUg systm in Madagpscawid&thind 199W.

Figure 4.3: Elementsof the Cost of Intermediation (percentof averagetotal assets)

Oprating Costs 323

_ ~~~~NotProfitOS02

_ ~~~~~~~~Taxes 0:22

Other Net Costs 3.66

OperaUngCosts 3.07

Other Net Costs 1.57

PmftI 1.73

Taxes NhS W9 81 4.28 RedressingSvtuiD Strains fromBlT: ITheimmediate challenge facng the Malay baning systemis dheconinment of BTWs liquiditycisis. SinceBTM accoun for 36% of assets, 35% of deposits, 57% of brandhesand 39% of the employeesof the banking system, interna liquidityand other problemsof such a major bank can potentally jeopardize the liquidityand depositorconfidence in the bankdngsystem as a whole. Thereis an urgent needto dearly assessthe problemsof BTM in its accounting,liquidity and portfoliomanagement, and operationof its large brandhnetworkL This evaluationis likely to confirmthe need for a significantrestucturing of this banl. This prospecthas led the goverment to envisageopening up the capitalof daisinstuion, a gD which shouldbe pursuedonce a restructuringplan for BEMis identified.

4.29 Enhanding.NanktAmnntion: A key challege for the 1990sremains mang the bankingsector more competive. Lack of compeion has resultedin relaively highinterest mari ta penalizetD someextent both depositorsand borrower. This in tun limit the scope of the bankingsystem to increaseits depositmobilization and to reducethe coa of real sectoreconomic acvities. The presentsize of the baniing sectorcoupled with prospec for fiuue economicgrwth indicatesscope for additionof a fifth commercialbani to the finacial systemin die ne term Such a developmenshould lead to a decreasein the interestmargin, without unduly affectng the existing banis' profitability.In addition,the recent move-bythe BCRMto require all commercialbanks to post their base lendg rate and terms of their baning operationsshould favr firther compet by enablingclients to more easilychoose among banks for their needsfor various financialservices. This shouldhelp mitigatea major.problemamong users of banls servces who a presenty faing geat uncrtnty in the pricingof both their depositsand borrowingas well as other servicesfrom baits (see Amnx 1.1). This move should be accompaniedby a strengthenedframework for prudential reglaion and supervisionwhich would require mandatorydisclosure of certai basic financialinformation by banks enablingtheir clientsto better asses the _ strengts and soundnessof individualbanks.

4.30 PursuLingnrvatization of the banidng setr: Governmentownership in the banking sectorhas generallynot beenconducive to financialsector developmets sexpeience in Madagascar as well as elsewherehas shown. Madagascar'smove towards an inmcreasinglymarke-oriented economywould be firmlybuttresd by a fullyprivate commercial banking syem. The Governm shouldtherefore pursue the processof pivatizaion of the bing systemwhih beganin the latter part of the 1980s. Compettion wodd also be fivored by fiuther divesiure of governmet sharholdings in banking,notably in BFV and BNIin additionto BTMas discussedpriously. Since demandamong the generalpublic for share ownershipin the bankdigsector appeas to be high, the Governminecould use the occasionof the divsue of suc holdingsto furter broadenand deepen the shareholdinghabits of the poputaton. If undertakenthrogh public offeins organizedunder a simple embryonicfaework for capital markets,this furthr privatton of the baiking system could alsobe usedby the Govrment as a vehiclefor catalyzingthe emergenceof full-fledgedcapital makets (see Chapter7).

4.31 Strengngn- the baninf profession:There is a need to establish a new and independemprofessional banking association in Madagascar.The exist AssociationProfesionele Bancaire(APB) that wascreated in 1985supposedly represents the intest of the baking idusty. However, it does not appearto fulfill the needsof comdmcialbak and does not see-nto wor to the full potenti of such an istion, partly becase it is managedand reportsto the GovenmentL Ihe Goverment shodd thereforetake the inave to disslve the existingAPB and encouage commcial banks to ind ly crate such a new institutionwhich would not have any Governmenarticiion. Thenew bnng aoition sod be fr to t its own rules and should work in areas of commoninterest to al banks. Amongsuch common issues ar baking tics, -ducatonandrainsimgiuindudingthe ionofvakospwofeulubnker promotionOf of check (further sussed in Chapter3 ad Annex3.3) and education to! ecourage bewerfinancia and sainp habis ng th genea publc. This new

_ =,=_.s

Reulatin And Prudential SupervisionIn the New EeonouucEnvironmet

4.32 Rtulao impeaives I. banking ransacions: Even as their economies are liberalizedand perhapsespecially when they are, governmentsreain a specialrole in.regon and supervisionof banks. In contrastto most tasactions in productmarkets which are caried out on a spot basis,the operationsof banksinvolve the exchnge of in claims(short-term dposits are used to fund long-termloans). Althoughbankers tend to maintaina reserveof cash on hand to cDvernet withdrawalsthat can occur on any given day, they may be wrong in their judgmentsand maybe too optimisticwith respectto the successof project or csoers. Consequently,in addition to liquiditymanagement policies of the Central Bank (see Chapter2), pntial regulationand supevion are of paramountimportance in order to avoid the esuing problems associatedwith insufficientliquHity and insolvency. The soundnessand solvencyof a bank's loan portfoliodo not always insulate it from liquiditydifficulties. Mismatchesin the matrity sacture of assets and liabilitiescould lead to serious liquidityproblems if. for example,the duration of assets largely exceedsthe durationof liabildies. Safeguardsin the form of supeisory ratios which atemt to match the duration of assetsand liabilitiesare importantprerequisites of a safe financialsystm Bank are also particularlyvulnerable to possibleopportunistic bebha . on the part of managersand employees.Managers and employeesof all typesof enterprisesmay cmaiozally be temptedto take unfairadvantage of theirpositions. Given the relatve easewith which money can be misappropriated, comparedto the real assetsof nonfinancialer.s zprises, the scopefor such behaviorin banksand ote financialinsttations is subsntial. Experienceshows that bak faiures often results not ftm incompetet management,but from frud Consequently,appropriate supevisory measuresshould be establishedto protectsaver's moneyfrom servig the immediateinterest of managersor of loan officers.

4.33 Importance or nrdential reiulation and suerLsio: The confidenceof economic agentsin the soundnessof the financialsystem depends findamentally on the existenceof an effective regulatoryand supervry fiamewor Withinthe fElncialsystm, bak in particu hold a special position in most economiesas creatorsof money, principaldepositaries of finan saving, the principal alloators of craeit and managers of the country's paymentssystem. For this reason, governmentsestablish public policy for banksin the publicinterest Centralbanks play an import role in ensuring eflectiveregulation and supervisionof the fmancialsystem, particularlybanig insdtitions.In libelizing economiessuch as Madagascar's,prudetial regation requires central banksupervisrs to movebeyond a focuson compliancewith monetary polk; regulations,freign exchage controlsand credit allocation reUliOnS to reviewingthe overallquality of bankassets, accountingprocedures and managementcontrols. In order for BCRM!to effecdvey and crdiDly play its role as an independentmonetary institution, it must give top priority to developingan effecdve regulatoryand supervisorycapacity over fincial istitions. This fumrtionwill assumegreater importance and complexityas the fnacial systemevolves in Madagascarin comingyears.

4.34 Recet nroZs and outstanding issue: The 1988Banking Act defines supervisory tunctionsfor BCRM. This wasthe legal basis for the establishmentof the Commissionde Controle des Banqueset EtablissementsFimanciers (CCBEF) in April 1990.The legal basis of the CCBEFalso foreseesits supervisoryrole for non-bankfinancid instions. Reglar off-sitemonitoring is now akdngplace on the basis of monty staume of the bank as well as their audit reports. At least one on-ike inspectionhas tamenplIzn under guidanceof an experiencedfeign bank supervisor. Vlorkon the newaccunting plan for banksbas beenin progre sice 1987since the countrsnew accountigplan (PlanComptable) was adopted. Notwithtd thisprogress, there remainsmany outanding issuesin bankreguation and supervision. The adapton of the genal accoutng plan 83 for the purposesof prudentialanalysis of all bankcsshould be completedas soonas possibleto entable severaloutdated texts to be replaced(eg. Decmber 1973text on liquidityratios). BCRM should also makethe strengtheningof its prudentiaregulatory and supervisorycapacities one of its key priorities in the next three to five years. It shouldaim at improvingoff-site inspection and at eventualy being able to undert;akeat least one regular on-siteinspecton of eaShcommercial bank once a year. in strnghenngitscapabilities in all these areas, BCRM should considersome of the key issues reviewedbelow. 4.35 Key areas of regulagtion Among the main measuresaimed at controllingthe risks incurredby banks are regulationsof marketentry, capitaladequacy and portfolio diversification. In most.countries, regulations begin at the marketentry stage. Beforethey are authorizedto operate, banks must satisfy a numberof requirements,and sometime a mrinimulmrange of services to be offeredto customers. Also in mostcountries, banks are requiredto maintaina sufficientlevel of ne worthtoproec the solvencyof the banksagains someMinimum level of lwoss firomnoprfoirming assets. Typically,a bank's total lendingis constrainedby a maximum gearin(" ratio betweenits capital and its total assets (loans, etc.). Closely related to capital adequacyratios are rules of portfolio diversificationand risk limitation. Most countriesseek to limit risk cocntaIon- by imposingformal or informallimits are stated as a pePrcrentageof the banks capital and vary from countryto country.The 1988Banking Act coversmany of theseareas of bank regulationadequatey. However,there are specificaspects of bank superision which couldbe strengthenedas discussed tlrbw. It should be noted that the supervisoryfunctions of BCRMfcan be expectedto grow .speciallyif small-scaledepository and credit institutonsemerge to cater for needs for small-scale enrereneursa ndural area (see Chapter6), and new instuments such as banker acceptancesand negotiablecertificates of deposits(See Chapter 7) are developedin the mediumterm.

4.36 Existing caoital adequac gufidelines:Minimum. capital adequacy guidelines of some kind for banks exists in nearly all countres in order to providethe bankingsystem with a cushion againstunusua losses. Theseguidelines are usuallybased on either depositsor in some countries, on the risk structue of assetsand off balance-sheet activities.In Madagascar,the solvencyof a bank is seen as its abilityto absorbunusual losses based on its ratio of equitycapital to liabilities.Under the 1988 BankingAct, banks are requiredto observea solvencyratio of at least S per cent. Table 3.1 showsthat the commercialbanking system in Madagasca has histoically been able to comply with this requiementwithout any difficulty.Howeve, these capitaladequacy guidelines are geare more towardsmatching the equityI wvelwith the level of depositsthan towardsoffering depositor real protectionagainst massive defaults. Hligh rate defaultscan occur and can indeedlead to bank afailresand bank panics even if such a deposit-basedsolveny ratio for the overallbakin systm is high. BCRM should therefor begin considerng movingtowards a systemof capial adequacy guideline based on the risk structureof assetsas describedbelow. 84

Table 4.12 SolvencyRado Of TheMatnsy Banking System

Year Solvency Ratio, () 1981 11.8 1982 12.6 1983 11.9 1984 14.9 1985 17.9 1986 17.4 1987 16.6 1988 21.3 1989 18.7

Note: The solvencyratio is definedas the ratio of eqiLtycapital to liabilities.

Source:BC%M Data

4.37 1idsweghted pgWtalad== rgdeInes: The risk-basedcapital sadardsd by the Bankfor intea onal Settlementsand to be widdy adoptedby indstria counies by the end of 1992 should provide the Malagasyauthorities some guidance on how to reform the existing solvencyratio prescibed for banks. These risk-basedcapital stadards disnguish betweenfive difere categories of assets with different isk weightings. These range from zero weightinp for short-termcentra bankand govenment securitiestD one hundredper centweitings for commeca loans exceedingone ye2r. Thnecpital guiddinesalso disiguish betweentwo typesof capital(c'oir and supplent). Adt such guidelines tDote Malagasy commercial banking system will be importat for a mber of reasons. First, deposito need real protecio based on the actualris thatbanks incu throughtheir assetportfolios. Furthamore, as the economydeveops and divrifies, nommercibanks ca be cped to expandtheir off-baance sheet comm indcludinglom guarnte, ir cable credit stmes and eventaly inrt rae and reny swaps.Exisig capital guideines in Madgasc do nt captre the dfferent degrees of rist assoiatdwith the rnge of commercialbak actvities ihatexist ad that ca be expectedt broadenin fute.

4.38 n.: Batlr are generay requiredthroughout the worldto maintaina minimumlevel of liquid asss in order to meet depositors' demandfor immediae liquidity. In Madagascar,under a decreewhich dates back to December20, 1973, bans are requiredto comly with a coefficiat of liquiditywhich aims at mainaing a mni ratio betwoe lqd asset and shot-term liabiLities.The folowig item are incuded amongliquid assets:cash, current acconts at the centra bank shobrt-f claims on domestic depository instuto (less Dh six months) and other highlyliquid short- claims. Ihe liqudity ratio in Mhag has been fixed at 70%. At the end of 1989, all commercialbans were well in excess of this liquidit ratio. The 1973 decree should be reviewed in the context of thO new chart of accunts to make the coefficient mor- representatveof theliquidity siaon of commercabans. In partcular,BCRM should give weight in its liquty guide to short-tem liquid aset of one month matuity, rather thanmthose of six monts mity, in order th bankscomputdetir liquidity ccientc accrdingly. he 1973 8S text thereNreneeds to be reviewedwitil attion to thedefinition of highlyliqud daimsand short- tum liquidassets. 4.39 MlniMnmprudential reporting and disclosure:Confuience in the monetarysystem Is maintained,inter alia, by guarateeingdie solvency, liquidity and profitability ofthe baing system Thebanking systm wouldbe in a positionto achievethese desirable outcomes prvided it ope s in n accouotingfimework whichdoes not obscr fromview m r whichshould be dealy see into by the banis and other financialinstiions as lendingagencies.For a desireddeg of transparec to prevail,the BCRMshould have the legalpower to call from the bans all such informatonwhich it needs in orderto flfill its CentralBanking fuimction. The 1988Bankn Act empowersBCBM adequaty in thisrespect. However, the appropriatsupervisory capacity witin BCRMcomm teih thesepowers has not yet beendeveloped. 4.40 At the sametime, the public at largeshould also be ableto judgethe perfomance ad stwgt of 1idi commercialbans, notablyby way of hir publicationof their anm accounts.In manydeveloping counies, includingneighboring Mauritius, this disclosurerquien is mandatoy.Mandatory publication of annualacounts is alsoprovided for in the1988 Banking Act in Madagacarbut there are guidelinesyet on whichspecific iem of informai soud be published.Cetain incomeand ezedri-ure itemsneed to be dk losedspecifically in thiscontext: inteest andsimiar income;interest experience and similar charges; dividend incomw fee inome; commisionsreceived; g andlosses frvom freign examge trasactions; -insand loIQ from dealingin stodcs,shaes, securities(if applicable);gains and losses from investments in sauities; other operatig inmes' loses on loansand advances;general ami I ve xpazses spcfi operatngexs; andodter openg expses. Theseitems should not be rpocted on a nt basis as mportan informatonis dthrb lost 4.41 Similirly,balance sheet items of bak shoudbe listed out, prefably ia orderwhich reflectsthe liquidityof individu ims. No offsetng shoud be don sine is leadsto los Of informato In partdcular,the fllowing specfficitems require separa teponing cau md balne withthe BCRMtTlrea billsand othe commer bils eligiblefor rediscountingat dite CItk bils not eligiblefor rediscounting;Govenment and other secuties held for deaing puroe; invstmes minGoverment and other securities;placements with amd loas and aces to oter bank; other moneymarket placements; loans and advancesto custm by type; odtr asse (extenalclaims, domestic daims); deposit from other bats; othermoney maket deposi; anonb owed to other depositors;cerficates of depositsissued; promsory note md odt liabiles evideced by paper, otherborrowed fimus. Concies the aount of unsecuredadvac dshd be serately alsodiscoed. 4.42 wingsund badng rtfolh: To avoida bunchingup of badand doubtf d , bakers shouldbe urged by the BCRMto adopt continuo pwvisi g for bad ad doubtfildet. Indeed,the ECRMshould see to it that excessiveunrealized pft ar notbeWg dclared by bank becaue of lack of or under-provisioningfor badmd doubtfuldebts. This wouldhelp at that bankswould not be putunder finacia pres whensuch debts have to be prvided for or wrte off and tat ban will not carry a weakloan portfolioas if it were completelysound. Ieed, if th gualityof a banks loanis allowedto deteriate, the mor it wi geereflected in a higheravap interestrate chargeto borrowes,irpective of the rateof inter pes by the bangs to d .osirs 87

5.1 Term finance (ie. mobilizationof reources and developmentof financial asne for the medim amdlong-term) is neededin all conies to ensure dt the fill productivepotential of the economyis realized. In an ecowmy such as Madagascar' which is rapidly restructuring,term finance is becoming increasingy essential to busis, houseold and private sectors. It s neoded for expandingthe capitalstock of the enteprise scor as new machineryreplaces old, producto md distbution facltes are upgradedand new plants re built; for providingfor the devdopmentof physicali cure such as commercialbuildin, shool, and roads; and for ating reidential housingwhich is the majcr long-enmasset of households. To addrm these needs, the fimncial systemhas to meetone of its basic challengeswhich is to mobilizeresource to be transfiomd into medium and long-tm fin:anci assets with adequate attention to risk, return and liquidity. This chapter lools at ways of mobilizingsavi through long-tm finanalccontacts to provide longtem debt financeto enteis and indduals. A few isse of equity finnce, which is anoder form of term finance, are exmined in Chapter6 (role of ventureaicalp companies)and Chapter7 (developmentof capitalmarkets).

52 Termfinance diety and indirecty involvesthe enmtiree offinancia instiutin instrumentsand markt withinthe financialsystem Commerciabank have a major role to play in this respectboth in resoce mobilizton and in tm credit. Iher roles are briefiy discused below. However,dt: activitiesmust usually be reiforced by other isution whichhave an eve more specificand direct role in term face. Perhapsthe most importantof these ar contractud savgs in titu (lif insurance companies, occptona pesio shemes, ntiona prvide fiuds and fundedsocia securityschemes) which are directy involvedin mobilizingsaving through long-termfinancial contrcts. Contractualsaving stittin in Madagascarare the majorfocus of this dicussi. At the sametime, housingfiace is one of the mostimportant areas in term finanm in any country. The specificprblems in this area frm the sandpoint of the financialsytem in Madaac are also biefly rrviewedin this chapter. Finally,for term financetD operateOctivdy in any country, there must exist wel funcdoningfinancial mats whichfacili the pricig ad transr offinanci resourcesaonog indidual and insituonalnestm andborrowes. The isse of fiancial mket developmentare more extensivelydiscussed in Cbapter7. 5.3 In the nw term in Madagascar,banks wi contne to play he major role in term financewithin the overl finacidalsysem In cmparion to may developingcounties including low-mcomecounties in Sub-Sar Africa,dte Maga bankig sydem remain rdativey biased towardsth short-termin its mobilizationand lbcaton of reorces. For xample, Figr S.1 ows that term depositsin the ummercia bauningin have tended in recet ya to accul for only about one-fifthor less of toa bak deposts. Althg this proporn ha boe grwing in recent years, it is still consderablylower may or cotie, for ex le thos in the WesternAfrican Monetary Union (UMOA)(see Fiu 5.2)as well a dswhere (se Table 5. 1). Theprevalenc of double-digitiflation in Madaga duringngt of t 1980sis one of to underlyngreasons for this phenmen. Thisu w oe im of a gble oudtookto encouragesain throughlong-tem financialctac. as

Figure 6.1: Share of Term Deposits In Total Bank deposits

BDllons FMG 700

400-

300- 100~~$

1987 1988 180

- TermDeposit 0 Siht Deposits ECDe Note: Term Dsoults s percentage ot total dgpoil: 1087-17.9% 9l8e-1.3 8Surc: B1MRMData Figure 5.2: Comparative Share of Term Deposits in Total Bank Deposits Percent of Total Bank Deposits

50 - ..

30_

20- l1

0 1087 1988 1989

I - Madmasaoa E BurkiaM Fao BBsu '

Sour.. WMAA SCEA0 89 5.4 Increasedmobiliation of term resource witiin the banldngsystem will also depend on how successfullybanks developproducts and savingsschemes that are atractive to depositors. A. nmber of such products have already emergedin Madagascarwhich, for example, cuirae savings for hous finance. In Mauritius,there has been great successwith remuneratedsaving acounts wheredeposis are availableat all timesbut remunerationis appliedto Dthe minimum balae for a specfic period (generallyone month). Theseand other schemescould have muchpotntial in Madagascarfor shiftingdeposits towards ter finds. This is especiallysince demandor short-term depositsare generallyunremuneraed or have a rate of returnbelow inflaton BRan will thkerefxre incur highercosts to attractlonger deposits which they must compensatewith more profitablelending activitiesincluding term lending.

Table 5.1: ComparativeShar of Term Deposits in Total Bank Deposits (m peentage of total bank deposit)

1987 1988 1989 Sub-Saharan Africa: BurkinaPaso 32 37 35.4 Senegal 34.4 35 35 CoteD'Ivoire 36.1 36.2 35 Togo 49 44.3 46 lAw Icme Countries: ndia 81.6 81.4 81.6 Nepal 81.7 84.1 83.5 Haiti 64.7 63.2 66 Indonesia 69.6 72.4 70.8

Madagascar 17.9 18.3 19.8

Sourwc BCRM,BCEAO and IFS data.

5.5 Justs withresource moblization, term lendingby bansmin Madagascr remains below that of many other countries. Ose agai, the comparisonwt counties of the Wester African Monetry Union is illustrative(see Figure 5.3). Ehanced term lendng by baks in Madagascarrequi a combinationof facrs includingthe availabilityof viableprojecs t finance, the developmentof appropriatemt= of secuing bank lendig and monioring projects, and the acqusition of appropriatetam lending skills withinbanks. Public policies are also importan in stengthg of the legal, accundng and payments as:ructurediscusse in Chaper 3 which shouldfacili firher commerciabank activitiesin tern lending. Commercialbank have already recenty begun to build on previouslyacquired sk in term lending in the changingecommic environmentbut wouldbenefit from continuedupgrding of professionalskills in this area. 90

Figure6.3: ComparativeShare of Term Lendingin Total Bank Lending Percentof TotalBank Landing

60-

1987 1985 1989

mmadagacar Cco tDlvolrs E lbgo S baurkinasFao B Sensual

Source: BORM& SCUD Date

Soawe: BCRM & BCEAOData

5.6 In additionto commercialbanks, other financialinstitutions have an important role to play in term finace. AlthoughMadagascar lacks a developmentfnance instuion found in manyother countries,it is highlyquestionable whether such an institionshould be seenas a priority for financialsector development in the near term. Mostsuch institutons in developingcountdes have been public or quasi-publicinstitutions hat derive much of their fiuding from the governmentor foreignassice. Giventhe poorrecord of suchinstutions in other countriesgeneraUly and the still nwase stareof fcial marks in Madagascarsuggest that it is unlikelydtat a developmentfinance inistitton couldbe createdwhich could expectto be self sustning in the near term. Confidenceof both saversand investorsfirst needsto be more clearlyresored tirough macroeconomicstability and the completionof reformsto impve the incenve structurefor privateinvestment In additon, the legal and instional basis for a sustainablelong-term finance institon would first need to be firluy established.It wouldtherefore appear to be more appropriateto envisagea subsntly or possiblyeven wholly private development finance situation only once financial markets in Madagac have begun to developand the banking systembegins experiencingmore demand for long tim financefor invesmentthan it is wiling or able to accommodate. 91 £.7 Al the sametme, mostf istems feaur A leuace I1n111ysa soeM securitysystem 'Ik ogehe costtte the cotacusvi a ct of do flmucl "mom Thissub-seco Ca play a cdticalrole in Madagascarbddhin dhe moblktlaofflm resourcesad in the develpmt of financa markt. madagascarhas, like th greatw majort of devaopi counrIesand more pcificaly Sub-SaharaAfrica, a relaivdy smallcoal sving suDnt- compared to mnaorcomponnt of its financial which are its bankig Psfiwo Fiu 5.4, for eampl sost d nsuac compaes and the socia securty bsakudo in Madagaa lSer accounted for tout one-qurter of resources of de' financi system In Malagam lw bank providing th rest. N a - the small size of this sector, conuactul savinp fudado In Madagscarha a grat potet to developthe financia stem, - eir geny ileo cuh flo andpredible long-ter liabilities.A nmber of odwrdevdopi conies in Asi, Afria and Latin Ameria ad the Caribbeanhave already made great proges in develping th *cnat savn subsectorwhich In many asesprovide term fihdst o* to Gova bu also odt industial e and bousingsector. Ihese counies iclude Barados, Chile, ia, Malaysia, Tridad and Zimbabwe.

Figure5.4:Relative shares of CommercialBanks and ContractualSavings Insgtiutions In Total Fancial Resources

;~~~~~~~~~~~~sc secs 39762 FMG' CofwnmrdSaBaNst 296425 am PMG 74%

s | w E mmnat5ls-

1987

CommerchiBar" 75% WACOcm PisG

1988

So: SCRMand FinancialData fromInswrance Compwues &CHAPS.

Not: TotWlfi ial resources e the sum of commeril bank depoits, a a. sd socil '~socmtyInvestuem potfo . Iuce and socual i- - w it cM meICalid bas - sutcted frombank deposis to avoiddouble coating. 92 5.3 Fiu 5.5 shw that contactul savings stutlosih Madagasc aredy contrit almostthe-qua of term depositsof commecal bak in Madagsca. To dius contractul savin isisdtuonsin Madagascarwithin a appropripatppeatve, - ovaevie of the type of instilttions and issues involved m conactual saving, ussing on their opeaig chaateristc d ther economiceffects, and their implicatonsfor policymakes in Madagascar who nigh consideraltnadve stratees for developingoontual swing, is providedin Annex 5. 1. Ihe dission belowsuccessively lools at the inran ndustry d sod secrity systema Madagcar mainlyfrom stamdpoint of theirmobizanio andplacement of financialresources as wdl a ter potentialfor devlpig fncia makets. For conveniec this dicion also covers non-lifeor generalinsrance in Madagascarwhich is conventionallynot definedas a conacual saving acti. Followg this discussion,the specialproblems of housingfinac are reviewed.

Flgure5.5: Contractual Savings Contributlon to Commercial BankTerm Deposits

Insurance30.540 mn FMG 4_a~~~48

O t e f s ~~~~~~9,102mn FMG SocialSecuuity23,531 mn 14%

1987

~~~~Irsumance 31.M9 mn FMG

SoclalSerIty 23,279mn

OhW2Z,359 mn RUlG

19881

Source:SCRM and FinanclalData from Insurance Companes& CNAPS.

5.9 * esi fInILt d opg mn of SO SarsA i,W _Magac boWgno xce tdustry is very mu ins ay stageof deveopmen Th. rao of o imsrc prem sto GDP in dvpd couni 93 averages45 percentwhile developingcountries atain less than 2 percen. Table 5.2 below - coomprativedata for Africa and other selectedcountries, while Table 5.3 illusta life israe fimds as a perentage of GDP ii developedcounties. In developingcounti the asupplylading approach' is often apparentwhen goverments establishand control the institioonsto try to force ficial development.Insurance industry development depends on many facors such as the levd and distributionof inoDmeand wealthof a country. Socialand cultura stucur also play a major role since, as the case is in many Africamcountries, mrual communities have a lesserneed to cover risks as the extendedfamily steps in and covers the shortfalls. The efficiency,solvency and public imageof the insuranceindustry as well as the tax treatmentof insurnce prmium d beefis nd the regulatoryfamework are importantconsiderations in its development.

Table 5.2 LIFE INSUkNCE PREMITJMSIN DEVELOPINGCOUNTIRES, .192

Premiums/ Premiums GDP Per Capita Percentage USS AfLr Botswana 0.26 256 BurkinaPaso 0.04 0.53 Cameroon 0.05 0.57 Congo 0.01 0.13 Ethiopia 0.04 0.06 Gabon (1984 0.04 1.20 Gambia 0.03 0.13 Ghana (1984) 0.01 0.08 Lesotho (1985) 0.01 0.02 Madagascar(1987) 0.05 0.11 Malawi 0.6 1.22 Mozambique 0.03 0.13 Nigeria (1984) 0.25 1.75 Rwanda 0.01 0.88 Senegal 3.26 1.83 Seychelles 0.04 0.08 Sudan(1984) 0.01 0.04 Zambia (1984) 0.90 3.70 Zimbabwe 3.11 23.79

Qhr Chile 0.92 15.53 Guyana 3.01 15.90 Jamaica 2.59 44.39 Korea (1984) 4.59 93.07 Malaysia 0.99 21.35 MeXico 0.21 4.04 Singapore 0.86 61.85 Venezuela 0.67 19.60 Sorre UNCTADSecretariat (1987) and WorldBank Data 94 Table 5.3

LIFE INSURANCEFUND)S IN INDUSTRIALCOUN1TRIES

1986 1987 1988 % GDP

Switzerland 28.0 29.8 31.6 UnitedKingdom 30.8 30.9 31.1 Japan 22.4 25.7 29.0 Germany 18.9 19.6 20.3 Netherlands 17.2 18.3 20.2 UnitedStates 17.3 18.4 19.2

Includesinsured pension and burial funds

Source:National Central Bans

5.10 Role and strcture of the Industr: Theprimary functionof insuranceis to provide protecion against financal loss from unctain but predictableeves. Since israce compamesaccumulate substantial reserves which are intendedto meetfimre claims and obliton, they also play an importan roleas financialinterediaes in the mobiizationand allocationof the financialresources they have on hand. There two major branchesof the MaLaasy insurance businessgeneral casualty or non-ife insuranceand life insurance. Four companiesare preseitly engagedi the insurancebusiness in Madagasc: ARO, NY HAVANA,MAMA and AVOTRA. The fist two, being the majorplayers in the market,are stockcompanies with majority intwer held by the Govenmet while the other two are mutu companies,in quasi-liquidation,dedicated to generalcasualty business havig a limitedimpact on the totalmarket. The organizationof the present day israc sector can be taced back to the period when freign companieswere nationalized, without affectg loca Malagasyshareholdins. Marketingand distibution methods have not changedsince the times when the agencieswere dealingpurely with maitime risks. There ae regionalbureaus as well as independentcommission agents which do not have specificgeograpbical terririal limitations.

5.11 Role of state ownershipand control: The monopolisticquality of the i sectorhas effecively limitedparticipation to two companiesof viruly equalsize, ARO and NY HAVANAwho share more thanjust govermnentshareholder majority participation. AROand NY HAVANAalso have boards of directorswih nearly identicalparticipa, there is also a non- cometitive agreementwhere one companywill not take a clientthat the other companyhas rejected (as theyuse the same sourcesof infomationto evaluatediens), theyalso give a right of first refsal for business they cannot take becauseof ridsklimitation, and they also share rate stegy and infmation. These elementshave loweredthe operationalcosts of each of the two companiesand have limitedthe competitionin rates allowingthe two companiesto survivethe recent perids of economicdecline. Giventh limitedtotal marketof casualtybusiness of 26 billion FMG and of the life insuran subsectorwhich added1.7 bin FMG in premiumsin 1989 (tbout USD 17 miLion in ttD premim, both casualtyad life), it has been arguedthat it is beneficialfor the financial health of both companies ht additionalcompanies have not osen to compete. However, in an 95 expanding,diversifying and more market-orientedecowmy, this oligopolisticindustry strucnre is not likly to providethe dynamismnecessary to fully exploitthe potental of the insuranceindustry in Madapscar. As a first step to promotng more dynamic management,the Governmenthas recendy begun a process to augmentthe autonomyof these companiesby electingseparate and differentboard of directorsfor each company. 5.12 Reative size o gmneraland life Insuran e: Figure 5.6 shows the breakdown of insurancepremiums in Madagascarby major branchesof activity. General insurance,which accunts for ap imately94 percent of the insurancewritten in Madagascar,provides coverage that is limitedto short timefrmes, normallyless than a year. The short tnD natureof genera casualty policiesis dictted by the difficultyin assessingloss probabilities in periodsextending over a year. Amongthe determiningfcors that relae to the short timeframe are cyclicalnature of lossesas well as the impactof inflationan the valueof the perceivedlosses. As a result of the short term-naue of their policies,technical reserves of casualtycompanies are only a small faction of the annal premiumsand makelittle direct contributionto the generationof long-tenr financialsavings. Life insurancecovrage, whichis poorly developedin Madagascaraccounting for only6 percet of total policies written, covrentwo types of personal risks: the risk of prematuredeath and the risk of excessivelongevity. The former is coveredby vanous life policies such as whole life and term policieswhile the later is coveredby variousforms of annwtycontacts. Life insurancepolicies also providean efficientmeans for contatual savings. This includesendowment policies, which - be a fixed nominalvalue, or indexedpolicies (which are more suited to developig markes where inflationand devaluationof the currencyare of prime concem to the insuredparty). Yet, it also :puears that life insurnce is the ifastestgrowing segment of the isurance market and has much.potentialo developas the economyexpands. Life isuranc premmmgrew on avage by 25 percent amually during 19S7-1989which is about6 percentannually in red terms.

5.13 -einsuane:Certain 'large risis, as in mariime and aviationpolicies, have traditionallybeen passedon to foreignrinsurers. Each companyhas a differentset of renme and they play an integralpart in setting the premiumsfor these policies. This aspect of the insuce busmessis not under Goverment controlbut rather by mutualaccords where the insurerreceives a percentageof the premiumwhile takng a share of the risk. Anotherform of reinsuranceis the policy which coversthe risksover a certaindeductible amount. The reinsureronly comesinto play over the statedamount giving more responsibility to the local insurer. Thesepolicies serve the needs of the local marketwhile at the same time limitingthe total exposureof the local imrer. Ie key issue in the reinsurancemaret is how to transferthe risks of domesticactivities to foreigni It shoud be pointed out that by engagingin reinsurancein FMG, Malagasycompanies might be incurringa highercosthan if at least part of the reinsurancecould be undertakenin a Ilss exotic curecy by a foreign ier. Given the relativelylarge volume of reinsuance in Madagascar undertakenby foreign insuramcecompanies (between 30 to 40 per cent of total premiums),this suggess thatthe Governmentshould review the insuranceindustry reglation to considerwhedter and see how existingforeign exchange controls specifically in relationto insurane shouldbe made more flexible. 96

Figure5.6: Breakdownof InsurancePremiums Billionsof FMG 8l lions

2

Car Fire Shipping Aviatlon Llfe Other

1987 r1988 H 1089

8ouro: InauranceCamp. Financial 8tate.

5.14 Earnin p mance and Invesenit poilde: Given he limitation of the marke couped with the dmsve finmcial adjustmet program tha has beemting place in Madagscar duringthe past few yes, Table 5.4shows for scadyeams 1987 - 1989 an eanin perbmance by te M gs insrne sectorwhich is promisingfor fiture developmen

Table 5.4

ffflion EM{;

Prmiun Reserves 19.7 24.0 25.3 Fiancal Yi'eld 6.7 8.8 11.9 CbargeOffs (25.2) (16.9) (22.4) Dev. & ManagementCharges (5.7) (7.6) (8.5) GrossBane (4.7) 8.4 6.3 Balanleof Assignments 6.3 5.9 4.1 Net Bal. of Operation 0.6 2.5 2.2 BaL.of EsateOperation 0.0 0.2 0.2 Net Earnings 1.7 2.3 2.0 NetE n a perntage of PremiumsRecvey 9.% 10.%

.: 97 5.15 Thepresent insurance industry regulation require reservesof non-lifecompanies mustbe kept liquid. Figure S.7 showsthe preonderance bf liquidasse in the investme portfolio of insurance companies. Invesments ntrditionally made in treasury bills, commercialpaper (demanddeposits in Madgascar), and short-termmarketable securities. As can be seen in the table below, assets are almost equaly invested in GovernmentTreasuy Notes and commecal bank dposits withthe combinedtotal, in percentages,for the thre yearspan hoveringaround 87 percent.

5.16 Fiscal stamE for developlnglnuranc: A strategyfor fimre developmeatof the insurance industryhinges upon three aumptions that are normallyobserved for developing countrieslike Mdascar. First, insura demandis an increasingfimction of income;second, the real qualityof insurancedemand is a decreasingfunction of its real price; and, third, there exists a positiverelatonship betweenoveral financialdevelopment of a coumntyand the individual'sability and/or willingnessto buy in.aur Any poitive step towardlowerng taxes on life isuce premiums(where these fin-d are held withthe fiduciaryagent for a givenperiod of tme or until the policyholderreaches retrement age, failing which a penalty could be assessed)oould stimulate contractul savings,especially for salariedindividuals. Presently there exts a heavytax burdenon life auities; less thanthree year defeed - 20.1 percenttotal tton, and more than threeyear deferd - 18.5 percent total ation. Life insurancepolicy premium taxation is the lowest at 3 percent. Expence in otherdeveloping countries shows tiat the lost or deferred tax income, reshn from a reducedtax burden tends to be outweighedby the benefitof mobilizingfiuther Enanciasaving throughlong-twim fiancial contractsand therefoe the inmcreasdavailability of investmentfinds. The Governent mightconsider firther studyon the issueto rationalizeinsrce taxaton in order to smulae greaterfinancial savings.

5.17 fnelngjn fn_mtLpolide: To help promot overallfincial sving th insance policies,a meansof indexationof financialiuments, linkedto the infation rate and the currencyrate, could be considered. Ihis is, however,a marketinnovation which requires carefulpreparaion. k is clear that, uil restrictionson investmentin foreigncurmcy assetsare reducedand arangemes fr ward cover against exchge risk are developed,the abilitr for insrance companiesto potect policyholdersfrom this risk will be limited. As part of its reviewof tae iurce idustry, the Govemmentshould therefore also cnsider how foreignexchange controls nmghtbe adapted to enable insurancecompanies greater flexibilitym undertakingbot forign curency imvestmetsand insuranceconts. The amount and variety of Nacceptable'investment instrumentsavailable to insurancecompanies should be increasedwith greater cae taken by the Govenment not to use these vehicles as a means to finance deficits or to keep Governent eprises afloat.

5.18 Strclu otsL lsluridy In MadagLas, wag earnersare covred by two systemsof social security- a smallgovernment scheme for public sector employeesby way of the Ministryof Finace and the CaisseNationale de Prevoyanc Soale (CNAPS). For those individls who are not wage earners,there is no oronized socialprotectio A smallnumber of inmdendent entrepreneus and farmersare coveredby insrac policiesissued by the insurancecompanies. Ihe dicussion below focusseson CHAPSwhich is the main elementof the organizedsocial security sym. The ovesight fmnctionof CNAP is jointly undetake by the Ministryof PublicWor and die Miistry of Fianmce.The main officeis locatedin Antivo and regionalrerscetaion is arried out thmgh fourteenregional offices. II 1989the staffof CNAPStoted pproximatly 600 98

Figure 5.7: Investmentof Insurance Industry Resources (Billions of FMG) s0

10-

0 I3o. Trees Notes BankDsp. Fixed ~Masts Share Othwer

m 1987 = 198 9 1989

Source:NY HAANA A ARO FinancialStat.

Table, 5.5 Magasy InkeranFe Company 8nhstmers (19B7-1989)(Bilions FMG) NY HAVANAN & ARO

i SW A 13 X

Government Treasury Notes 26,980 41 39,330 48 49,280 47 Commercia Bank Deposits 30,540 47 31,990 39 41,090 39

FixedAssets 3,306 05 4,366 06 5,936 06

Shares 3,264 05 3,814 05 5,464 05

Others 1,270 02 1,750 02 2,800 03

TOTAL 6S,360 100 81,250 100 104,570 100

Source: Fia:cial Statements& other sourcesof NY HAVANA& ARO 99 and managedthe three socialsecurity fimctions: family benefits, worker compensationand retirement benefits.

5.19 Coyfe of QNAPS:In 1989the workforce(able worker.)of Madagascarwas estimad at 5,642,000 individuals,with 4,500,000in the activeworkforce and 1, 100,000seeking employment.Salaried employees, affiliated to CNAPSduring the timeframe since inception in 1969 to 1989,amount to approximately810,000 individuals. Activeemployees, affiliated to CNAPS in 1939, amountedto approximately261,000 individuals equivalent to a coverageof 5 percentof the activeworkforce. Only 8 percentof the participantsin CNAPShave less thanone year of affiliation while 44 percent have less than seven years of affiliationand the remaining48 percenthave over seven years with the program. Approximatelytwo to four percentof agriculturalworkers, which make up the bulk of the Malagasyworkforce, have sought social secrity protection. Only eight percentof localentrepreneurs have soughtsome sort of socialsecuity protectionwhile a total of only fivepercent of non-salariedworkers sought protection dtrough the purchaseof insurancepolicies from the two majorcarriers in Madagascar.

5.20 Socialpension systems, being national or at the most region instuions, have centrized management,-although their operationsare oftendecentralized. Their operating costs may be lower than underprivate and, therefore,compleely decentralized sysms. By their nature,social pensionisurance systemsare susceptibleto politicalinfluence, both with regardto the paymentof benefits and with regard to the investmentof their reserves. In may couties, such as in Madagascar,social pension insurance insttutions lack autonomyfrom centra gomermnentand they also suffer from administativeweaknesses dth affect their abilityto kee records and to enforce complianIcewith toe rues of the schemes,especially the promptpayment of the conbutions. lhe dallenge for the governmentand its socialpartners is to identdfyspecific actions that will meet the legitmate needs of the government,as finalguarantor, and of employersand workers who have ontributedto this scheme,that will simultaneouslyincrease the financiaand manageri autonomy of CNAPS and assure the required extera monitoringof decisionsand the long-termfinmcial soundnessof the instituon. Such actionsshould take into accountthe recent evolutionof Maagasy economicpolicies, and foresee managementof the CNAPSas much as possiblealong the lines of a private enterprise.As was recommendedby a recent study', the institutionof a dialogueamong aUl parties concernedwould help to move in this direcin.

5.21 (oljkutonutruture: Financialresources of CNAPSdepend largely on the collectionof the quotaspayable by affiiated members. Fourteenpercent of the worker's salary is payable to CNAPS on a quarterlybasis. A yearly ceilingof FMG 1,200,000was establishedin 1969, and has not been dcangedsince then. One logicl way to increase contractualsavings in Madagascarwould be to makea one-tim adjustmentin te ceiling,to compensatefor inflationsince 1969,and then to makeregular cges thfter. The fourteenpercent is comprisedof the worker's tip n of 1 percentof salaryand theemployer's parcpionof 13percent. lhese mounts are deductedfrm the salary by the employerand thereforethe employeeis deemedto have paid his shae whetheror-not his employermakes regua paymentsto the Government.As seen in tables 1 and 2 below, Madagascarranks high amongAfican countriesin a of its pensioncontribution rate as a whole, but the employeeshare is dispoportionate to the employercontibuto. An

Internatonal Labor Office, Madagca: Rapr au Gouvernementsur la Sitation auelle et les ftCW2W dtEvoiutionde la ProtectionSo , LReportMAG/82/005, 1992 100 addidonalfiacial resourceis the levyof penties on employrswho dday more thanone month pastthe quarterIn whichthe depositis to be made. Tbis penaltyis onlycharged at the timewhich the latedeposit is made,thereby produci an icentivefor employersto delaypayments at longas possible.This creates an accoutingproblem that translates into a financialdeficiency or discrepancy betweenbook balances and actual fiancial balances.

Tle S.6

ContributionRt (ecent of Saary Conibution) Employee Employer Total Seychelles 5.0 10.0 15.0 Sudan 5.0 9.0 14.0 Madagascar 1.0 13.0 14.0 Denim 3.6 5.4 9.0 BurkinaFaso 4.5 4.5 9.0 Caneroon 2.8 4.2 7.0 Gabon 3.0 3.5 6.5 Zaire 3.0 3.5 6.5 Rwanda 3.0 3.0 6.0 Togo 2.4 3.6 6.0 CoteD'hwoire 1.2 1.8 3.0 Niger 1.6 2.4 4.0 Source:Social Scuity Admini (1986)

5.22 CgmIlanue tad holleton:Colection problems m wver with CNAPS, sincethe declaration of paymentby employeesmus Inude the core o bk dchcksto be acceptedby theregina offices. This reatesan inte problemwith the contriuti mem whenthey ae confrontedwith finacial difficuldes.Lawt decarion conue to pileup when difficultiesarise wih the employrnand thy no lon conider dteirobliga to be a prkio . Collectionis very weakwhen leal acion is undrtak by CNAPS.A mqiordiffence bee insurac companiesand CNAPS is tha in the cae of inmo compel. a requemet of paymentof pmium is ncsary to acdvat theIsuace of the policyproL CNAPSan the othr handis requiredto provide eneft to the dvidualemployee and his fbuly If a claimis madese-it is umed thatthe paymnt Is dductedby t employeat the source.Th faultIn theaei systemofcollectionlieswit the -ex-t dtrnatIon ofamounts dueand not a 's-ante' veificat of whatshud be paid.Therefr her is no effictv corol of collection or recoveryof thissocial dbt t shouldbe stat that CNAPSfunctions throu thegood-wl of the employeasdtatic*w in the systemand not thugh anl fctdt andbalancs of their si and lea wrponsibility.Th lack of carfi l ctro Is apr when, In 1987, mre dtan 8,500teclu!_cai default of paymentsoccorred out of a tot of 15,000 uployan, wihot any

-- - -. ~~ . ~ . ~ - ,. . - * * 101 sifcant vericaon of theseacounts ad thesubsequent writ-f of a sipifict portionof tese obligations.There Is a sigificantlack of pesverance I the collectionpan estaished of thU CNAPSaccown. In all fairess to the on pea to be a legal void, with regad to the collectonproes, whch hs createdand still fsters a generl indifferen amog employe in th leg paymentof the socialobligtions they undertake as an conomicunit of Madgsa. Rsoluto of dteselegal ambiguities and the undtaking of an acuari evaluatIoi,of CNAPS- reommedd.

5.23 Govwnl resmIhhl[i: The final responsibilityof fiufillig the socia contractin Madagascrlies withthe Govenment. Any shorals betweo thea _moreceived b> CNAPSand the amounts paid out to recipient,must be overedby theGovernm Treury. Due to the uncertainnatr of the benefitstOD be disbursedannaly, a resr fiud was establishedon April26, 1969wder Article127, Decree 69-145, and is stricdyrequired to - one sixthof the amountspent or disbursedduring the year. ITis is therefre establishedon the basi of the prvious fisal year.

Table S.7

(in millionsFMG)

TechnicalReserve 5,376 S,SS 6,771 7,321 OrdinaryReserve 11,604 13,09S 13,920 19,037 TOTAL 16,980 18,093 20,01 26,30

5.24 As canbe notedin Table5.7, twotpes of rerv wereassed This i the resultof the vaguenatr of the leg code, with regardto the constiton ad maeance of satory resr. The tecncal reserveis alished underthe strictpidei of the lawad the urplusis addedto the ordinaryreserva whichhas grownto overFMG 19 bMhonin 1988.

5.25 tw. CNAPShs a stattoy oblgaton to dqsl its excess luidity withthe Trasuy. CNAPSdoes not derve ay financl benet fom thosoefds. Th investm poliy of CNAPS is emed y limted. CHAPS holds Ivesmen In both loca and breigpcons. The forign componetdates bak to thepeorid r to 1972. The dometc corportoinvesme hav be unrtake in m-u 'ares of govermtcntrolled compans. Th othr holding resultfrom paticpaion in restuctr copn0Des tha had unsoed aounts withCNAPS. The majorityof the equit portflio lieswith domestic cmpane. Accwrd to th LOsudy citedprvioy, 23 per ce ofte receivablesbmo ing to PMG38 miion - doubtf eobof CNAPSin stae companies.SIn.ary, arund FMG220 milion in the accon of CNAPS 102 reprse Mssesfiom partation in liquidatedstate enterpe. Curem aonts are heldwit local bab as longtem deposis. Long term depositsare placed with commecl bank at a set hunt rate whih is not indexedand thereforecares the inhere risk of inflatwnai currnc devaation, bothof whichhave been sgnificant since 1986. In realums the eqi of CNAPShs beenoeding at a very dangeru level which oould result in the Goverment having to cover horals at a later date as more employeesretire. As noted in p;ragraphS.12, the grwth re of 8 pere of nw membersin CNAPSis hardlyenough to coverthe perceiveddemands on the system when th. older affiliate retre. There i an urgent need to enue a positiverate of return on invenstu that wouldat least coverthe rate of equityerosion.

Futue of Contracftul Savinasin M aRas

5.26 ime relative place of Managsv contracul savimgs: Table 5.8 ranks M rdagasmwith rpect to a groupof industrialand middleand high-income developmg countr in tms of irasses of life insrance companiesand pensionfunds as a percentageof GDP. While the overallpropensity to save in Madascar is exmely low, doserexamiaton of conttual svings as discussd abovereveals that there are many disinentivesto contcta savirgs under prest conditions.The first among these is lack of an appropriate axation systm Another recurg problemto be facedis the nagginginfatio and the repeatedneed by the governm to devaue the currencyto maintaineffective intenational compeiv. Theseelements, along with a lack of domesticfmncial instrumentsand the lack of necessarycapial maet instuions has stifledthe grwth of contraca savingsin Madagascr. This in tam has led to a slowingdown of eonomic aciities. All indicationssuggest thatw under the proper conditons, greater financial savig and the economicactivity generaed tough effectivecontrctua saving mechaims are psible with appropriateicentives.

5.27 To identifyappropriate incentves, the Governmentmust engagein a thorwoh reviewof bothsegments of the contracta savingssubsector in Madagascar.First, a comprehensive review of the reguatory frameworkof the insuranceindustry that is aready plannedby t. Goverment should be pursuedwhich wouldinclude, among others, a reviewof the apprprate r }amwrkfor taxation and exchangecontrols in the insuce industry.Seconid, the Government shl enage a comprehensiveextrnal financialand organizonal audit of CNAPSwith dheview to ientifyin howto makethis institutionan autonomousand acuntable entitythat couldevenully play a major role us an instuional investor.The extrna audit of CNAPS should include- urial evaluaionand a revaluationof theassets of CNAPS.The reviewof taxtio and excange contols for the insuranceindustry should be donein conjunctionwith a sinilar reiew for CNAPS as the financialproducts involved both for mobiizationand allocationof resourcesare very mxc the samein both cases.In the courseof this reviewof conracth savings,there is a needto enmu coondinationof privateand socialsecrity insuranceto ensurethat the strngt of bothae used to them

5.28 At the sametime, the ficial systemas a wholein Madagascarmust become m- ccative in its abNikyto offerinvestment instruments to both indi an intituional investrs. Thecreation of wellfunctioning financial markets in M scar willd d greatlyon te promotio of a favorableinvestment climae whichhas for so manyyears bea neglectedthogh preWioslyinward looking policies. A specificeffort must be madeto developfinancia marks 103 which eventally lead to fhi-flldged capitalmarket in Madagascar.The scope and posible inil approachfor doingthis is more fiullydiscussed in Chapter7.

Table5.k

ASSETSOF LIFE INSURANCECOMPANES AND PENSION FUNDS. 197

% GDP 133 Netherlands 117 UnitedKingdom 105 Siare 78 UnitedStates 72 Sweden 63 Malaysia 48 Denmark 47 Caada 43 Japan 32 Gemany 29 Chie (1988) 22 France 19 Korea 18 Madagascar 4

Source:Financil Times, 12 July 1990 and NationalCentral Banks

Problem of Housf

5.29 Perhapsthe most immediatemajor challenge to term fiance in Madagscar is in prvidng finace for housing which has becomemore pressing in with tie mattd deteriorion in urbanhousing condiions. In most enomies, the sock of housingfom a mtior share - usualy in eacem of 20 per cent - of nationalwealth and is especiallydosdy tied to th internal efficiencyand productivityof townsand cities. Despiteits importance,housig financei Madagascr, as in many low-incomecounties, remain frigmentary. A nmber of studieshive already been completed whichundersoore the compleity and divsityofproblems inhou i i Madag.car Several gra conclusionscan be derived from them studiesta are of direct rdevace to the financialsystem in the nea and medium a

5.30 The crntalmart providesa mens wherebythe majort of mba houshold -m improvetheir housing. Res accountfor 50 to 60 per cent of the urbm housing ma in Madagscar andup to 80 per ct amongthe lowestincme grup. Finaci shooduld be able to attract depositsfom small-scaleprperty owners and from rea estate developer who cm pwvide adeque guaran . The key role for publicpolicy here is to allowrental hrgedto Ilw the market and possibly of pang tax exemptons for ne renls. Given the substat demad for renta properties, these policies would ensuat bank loan for hse actvit re vlablt 104 5.31 While the inherent commercialrisk in housing finance can in principle be relatively small, these risks are multipliedwhen titles are insecure or when claims cannot be adequatelyenforced. The reco d ins Chapter3 concerningimprovements in land law and titing should also facilitatea greater role by financialinstitutions in housing finace. Given the inherentterm tansformationrisk to which banks are currendyaverse, improvementsin the lega frameworkcould also help banis to package creativelyor even securitizehousing loans, thereby giventhem an additionalmargin of liquiditywhen needed. In addition,if other financialinstuments such as mortgageinsurance, mutual guarantees and other guarante are introduced,there couldbe amplesecurity for banksto more aggressivelyprovide finamce for housing.

5.32 At the same tme, the demandfor housingfinance should provide opportnides for the bankingsystem to increasefinancial savings. Somebanks have alreadybegun mobilizig funds throughsavmgs for housingschemes among the middleand upper-incomeurban households. Therehowever remains a real need to developintermediaries in urban areasfor intermediarieswhich couldchannel savings to banis, especiallybut not exclusivelyfrom the lower-incomesegments of the population. Mutual saving associations could be established at the level of a firm or goverment department,professional association or comnmity to facilitatethis process. An ideal candidatefor interfacing with these associations is the postal savings system which already has as a client every fourth inhabitantin Antanarivo. Over the mediumterm, such mutualsavings associations could develop housingschemes in conjunction wntha revamped postal savings institutionsas well as banis. Thesepossibilities are more genealy discussedin Chapter6.

5.33 Growthin housingfinace mightalso be envisagedthrough contual savings instittons. A more detailed study would however be required to determine how insurance companiiesand CNAPScould both mobilize and allocateresources for financewitiout subjectingtheir nvestmentportfolios to undue risk. It is premature at this stage to envisage, for example,the developmentof mortgge-backed securities as a vehicle for housing finance in Madagascar. Nonetheless,several schemeshave been developedin other countriaswhich could be studiedfor possible adaptationto Madagascar,where provident funds, for example,allow for individualsto wihdraw fwids to be used for fnmcing home ownership. 105

CEQPER 6

6.1 A majorityof economica in Madagcr are small-scale'both intms of thevolume of theirsavi andtheir face needs.These small-scale economic agents compiise smallholdfirmers, owners of microemeprisesor smallmd media-sae enteprises(SMEs), arsa, smalltrads, landlesslaborers and migrant worrs. Ofthe 30,845 registed andactive firmsin 1987,ody 6% employedmore than 10 peo. Over65% of thesefirms ae in the cmerial sectorwhich repest les tha ontenth of ut in thecountry. Some 1.5 miion of the 1.6miion rurl familiesMagscar work mal, mainlysubsiece rmsof aboutone heare or lessand acco for 85%of tota populatonin Madagscar.k is also estimatedthat there are will over30,000 wihit arcwidespr throughoutthe counotyincdig a vaiety of artisan andinform sectoractives andin addio t some300 SMEsin the formalsector. Together, these small-scale economic agent representhe larges nmmberof actualand potential us of fancial servie in Madasar a wl a a potetialy signficant source of financa savig. 6.2 Susainableand equitable log-tem growthin Madasr canot be envisaged withoutthe actve participa of thisonmajorit. Yet,many of themhave litfle or no wass to the citg In systm andare hro uble to effectivy conute to resource moilizaD nor to fly avail temse of paymen sevc, working capital tm loamor egui fmancefrom exstg findal istio. Oneof t. biut clleng forte ft wil be to impr fan servicesto thisctoy of thepoplat andbetter integ them wiin the overall fina systm WiafmofilSce

6.3 &OfemtoaaMdurilu. uf sMae epetr Desphe their considerablediversity, smalscale economic agen ua Srouphav cftain preponderantsoci- economic charaeristics. Mot small-se econom agn a coporat small fam, produce, trade opl, d indpeln trd. On comon c ic is that te cash balances(and pote l dqosi) ad aver fian reirents (Whetherdebt or uity)of thisgup teds to be conierably salrth avea rouc ad neewdof cusomrs of eisting nsbisWedfinancial 3_.1 plm dbtic h dicytd to represe family-bador individuay-owneduuiu (Incosutt salarid employeeor wap earner in t publc or irmal pvast setor). Thes sml-scale atvie collectivdyaccount frsignific se ofoutp md employmentin thi respective spee of producto 6.4 A majoriyof smallcaefm s ae suliulc faMer whoproduce viuay no marktablesurphls but acount fbr nery two-hrds of all frm Smalfodersas a whole (Inludngthose producing cub crp) scout fr aout 42 pe cet of ouput in the eoomy. Abouttwo-i of SMIEs(whit colletvely acct for a estdma on*-fif of indusil productioand emplome in Madagc) a man agtby ther ownes, aso reflecting*t stn famiy nar of suh buuiess a lagy idividuay-wnd busineses nonedem aroug to acut for up to haf of pmfmt In ura ar. In both rural and urban , the actve of uch r (nd -m SMEs) inude 106 pottey, ion-working,charcouing, silk weaving and small-scale processing activities such as rice hulingand grundnut oil extraction.Ladess laborersand migrant workers who are not business owners in any -c make up the remainderof small-scaleeconmic agents.The majorityof smail-scaleeconomic producers and entepris are not regsered withany govermnent office, do not maintainaccounts, and are often not licensedas businesses.A final important dicardaistc is hatmany small-scale economic Agents are already or havethe potential for being assoiatedinto grups, basedon communaland otherintests, to strengthentheir accessto financialad otherservices. 6.5 Demad and suply of lnandal services:Small-scale economic agents vary in dteir needsfor fincial services.In the normalbaning context,their needs tend not to be distingishedbygeogrphical segmentation (rur versusurban) but by end-useof finane broadly groupedinto corporate and private needs. Street vendors need short-term finance to buy stock anda depositoryfor temporarysurpluses. Small-scale producers (mainly SMEs) need somewhat largerand longerterm loans to buy equipmentand labor; although their businesses tend to be closelyhdd, theyalso ave a needfor equityfinamce to strengthentheir financial base. Among small-scalefarms (whe majorinput is bired labor), there is anoverwhelmig need for credit for land preparatonand planting,and to a lesserexten for seedsand fertlizer as well as agiculturalequipment. Many laness laborersand migrant workers seek but have no accessto capital;a numberof themwould thereby be ableown and operate their own services (examples incude -scart perator md producersof artisanalwares). Payment services usig financia Inhumen a a basicneed for all these economicagents although it variesby degee of martbility andmonetizato of theirot. Thereappears to be poten demandfor non- bankngfinancal srvices suchas insurance(fife and non-life) and leasing, although appropriate fina l prducts In de ad otheraras havenot yet been developed. Personal financg needs for th gr s as for mariages,fnera, and familytombs, are nornallymet trough contributionfrom famly members, elative, and friends. Aginst this varietyof needs, the al swly of fic ces to small-scaleoperatom from both formaland iformal Intittons, as discussedbelow, appears at bestbelow potential and is, at worst, completely

6.6 _ ThiulLflnu Thereare a nber of generalfeatures which ted to chracterie the reladonhipof mostof these small-scaleeconomic ages to formal financi markets, ntitutons and Instuments,although these featuresmay vary in degree acording to the ype of actvityor locaon of a particularhousehold or enterprise.A lage portionof the productionundertakm by th poput i believedto be u partclay amongsubsisnc farm . In addition,many of thesefme as wella saarid hedsma in the hbilands ted tDinvst dir sving in um ied fom suchas land and acatt.A ma- unf edfinancial need fr mostsmall-sae economicagents is theopportny to save in finamci aset a a men of helpingsmooth seasonal variatons in incomeand provIdig a hedge agast rik At the sm time, tO are also many small-scaleeconomic an whomainta cah balacs mainlyfor ecomlc transactions.However, for a numberof reason, theyted notto pla- fuds wihn theormal financialsystem and maily becase ( theydo not quaf for th minimumdepit necessaryfor a hecidngaccount in a commercial ban (J) heir acces to a fmad depositoryIstitutdon is poor; (il) evenif theymanage to maitain deoits wihin a fomal Insin on, they have diffcultyobtani credit,thereby discoraging r with fomal instiuto; or (iv) they lack knowledgeand expeience 107 with formal financialinstitutions. Many of these economicagents, includingthose located in urban areas, are not activelysought as clients (both as depositorsand borrowers)by formal fiancial institutionsbecause of perceivedhigh transactions costs, risks, and low profitabilityof these activities.

6.7 Informal finance:Small-scale economic agents often turn to informalfinance as an alternativeto establishedfinancial institutions.While knowledgeon informalfinance in Madagascaras a wholeis limited,a numberof basicpatterns seem evident. Although Madagascar resemblesmany Sub-SaharanAfrican countriesin the preponderanceof small-scaleeconomic agentsin its population,it does not seem to havethe variouskinds of organizedand widespread systemsof informalfinance found elsewhere(eg. 'tontines' and 'isusu' in WesternAfrica)- Informalfiance appearsto largelytake a highlylocalized form of muual help betweenfamily or friendsor, in someareas, of usury practicedby tradersor landedproprietors. lt is report that, given the difficultiesof obtainingfinance from formalinstitutions, such usury is seen as essential,being the onlysource of financefor manysmall-scale farmers and economicopeators. In somespecific areas of productionand marketingsuch as the cattlebusiness, informal finmace has takenthe formof certainprofit-sharing and prefinancigschemes, where one party lendsout a herd for fiateningby anotherparty or where herdsare pooledfor sale. However,atempts to 'formalize such schemesby integrting them to formal financialsystem ha failed.ve Sma traders are believedto some extent to fill the gap betweenlarge-scale and retail and between informaland formalfinacial serviceproviders and users. However,while informalfinance in Madagascarappears to providevaluable tbrough its flexibilityand availabilty, it appears on the whole,that its fagmentary and unorganizednature makes it an inadequate alternativeto formalfinmce.

6.8 Overallimpact@small-scale finance: Thereis much evidenceto suest diat substatl savingsexists in Madagascaramong small-scale economic agents, particularly m rural areas (wheremuch traded output is producedin contrastto the substanti non-tradedcharacer of urban production)which tend to generatenet surplusresources. However, for vanousreasons, the financia system in Madagascarhas not capturedthe bulk of savings among small-scale economicagents who tend to preferreal assetsto financi assets.At the sametime, dteirdemand for financialservices (both debt and equityfinmce as well as depositaryand paymentservices) is-high but is knownto be largelyunmet by formal financialinstitutions and believedto be inadequatelyprovided by informalinstitutions. The fundament problemremains one of access of small-scaleeconomic agents both to financial senrices and information. In addition, improvemenltsin infrastructureas well as in regulatorypolicies and in the legalframework, which wouldbe conduciveto improvingthe profitabilityof small-sce economicactivities, would in tum improve their access to finance. Much therefore remains to be done to realize the considerableproductive potential of this preponderantsegment of the population.A coherent approachby the governmentis thereforeneeded to ensurethat publicpolicies support rather thm impedethe acfivitiesof this importantsegment of the economyand popuation.

6.9 Policiestoward smallscale finance: Governmentpolicies toward small-scale fiance have not showna distinctpattem. In the past, suchpolicies have variedfrom neglectto outright interventionimbut more recendy there has been renewed consciousnessof the importanceof suchpolicies but withan approachwhich is stillnot yet fully defined.Government policieshave been compoundedby a multplicityof initiativesfrom donor agencies and fromnon- governmentl organizations (NGOs)which have not been fully coordinated. A variety of support ' C iiiiH .2~~i 'l*:~~~~~~ Rlhst IIit ;Se~~i Ii" l 2 i,~~~~~I*4| S |~~~~~~~~ 109 6.12 Sustainable and demand-drven small-scalefinance: Policiestowards small- scalefinance have traditonally been dominatedby agriculture-relatedproms. Theseprograms have a longhistory in Madagascarwhich predate its independencein 1960.The salientfeaures and resultsemerging fiom the main program, whichhave been undertakenby the government, BTM, and NGOs,are summarizedbelow. Several of the lessonsfrom dtese and other programs are also confimed by expeence elsewhere.First, the operationalcosts of many of these programscan be high and often require condtnuousinjection of donor finds or goverment subsidies.Such programsare not conduciveto sustaible smal-scalefinance and in fact may retard efforts to developfinancial instittions and instumens which can be sustained and expandedindependently of extenal subsidies.Among programs which have worked are thosethat substnilly rely on self-disciplininginc aives of group-basedlending which themselves dend substatially on the resourcesof ru up members.A secondand reated lessonis twanrual crediC aloneis not likely to result m a sustainableprogram - both resourcemobilization ad allocationshud form an integraedsmall-scale finamce program.

6.13 A third lessonis that, linkageswith formalfinancial instiutions should be allowedtDO developfreely. Full igration withinthe overal financialsystem tends to developonly over time and cannotbe forced from above. However, a "bottom-up"approach which stimulates instituionsin specificgeographic areas or withinspecific types of activities,for example,should be guidedby considerions of howthese institions couldeventually form links with die broader financialsystem. Small-scale finmce policiesshould not, for example,aim at encouraginga distinct"rural finance sstemW which implies geographic segmentation of fiancial marks and dissodationfiom the "urban"financial system. Rather, it wouldbe morebeneficial to envisage small-scalefinance programs which as a wholeeventuly stimulatealtemative finance institutions for the fil range of smalland mcale economicactivities found in all geographicareas. The clearimplication of this geographicallyunsegmented approach to smal-scalefinance is that famers gups, cooperves and producers associationsshould develop linkages among themselvesas well as becomeintegrated wihin the broaderfinancia system.k is possibleta a vanetyof suchinstituions in bothrural and urban areascould benefit from econmies of scale i tem of enal aist and mighteventuly becomemore dosely associated btrougha higher-levelapex institution (as has been,for eample, the caseof coopertivesopeating in both rural and urban areas in severZalcountries). At the same time, such intaegran redues the risk of small-scalefinmce becausethe rik of rural actives aloneare highlycovarant

614 Coage of nlscale finance pgrms: Almostal small-scalefinance programstargeted at rural areas in Madagacar, whetherundertaken by the Government,BTZ, NGOs or other donors, have to date individuallyreached less than one percen of rural households.The collectiveimpact of these progrms in terms of number of householdsor entprises serwedis also extremelysmall. lhis resultsfrom a numberof factorswhich suggests iWportantlessons. Given the sheer sizeand varety of the country,it is not only unfasble but also undesirableto atept to createa centazd national-levelsmall-scale finance program. No singleapproach of programis likelyto be suitedto all the differentagm-climatic regions in Madagas nor to the heterogeneousactves found amongsmall-scale economic agents. In order to succeed,any new programshould be etablished in areas where economicactivity is alreadyprofitable; in other areas, addioal inus such as infrastructureand other servicesare likelyto be necessarybefore small-scale fiance progrms can succeedon their own. At the same time, as furtherdisussed below,appropriate legal and regulatorymechanisms need to be put in place (and ceri odter reguatory restrictons removed) to catalyze small-scalefinance acvites. 110 Imprwvedcoordination among the various sources of outide support (Government,donors, NGOs)is essentialto enablesuitable programs to be replicatedand to avoid conflictinguses of resources.

6.15 Reconerv rates in small-cale finane rngams: Recovery rates in varo small-scalefinance programs have varied trmendously - rangingfrom extremelypoor to almost 100per cent. A numberof factorsaccount for the differences.In general,the best recoveryrates are observedin programswhere someform of group-basedlending tkes placedrawing on the traditionof communalcooperation fonmd in certainareas. Recendy developed programs by BIM based on this approachhave shown distincdygreater success than its small-scalecredit to individuals.However, the abilityto establisha legalbasis for the associationalso appearsto be importantas is the avoidanceof the risk of poLiticizationwithin a groupand controlby a handfu of individuals(smaler groupstherefore tend to work better).A seconddeterminam of recovery rates is the inherent risk associatedwith certain programs. Vagaries of weather and high transactio costs can easilyundermine a prgram. In contrast,the cerealbanks program in the Antsirabearea allowingassociations to obtainoff-season credit by pledgingrice as securityin a lockedstore illuses a low-riskprogram with a high rewvery rate. Third, experienceof BTM and some NGOsin high recoveryrate programsindicate that associatingcredit with savings appear to createstronger incentives for more disciplineduse of resources.An associatonor gmup can use the savnngsso generatedfor communalprojects. Finally, programswith high recovery rates tend tD have the foilowing key characteristics: i) trust between prviders and users, and amongusers withina group or association;Ci) easy accessto services,implying a of formalityas well as sinmpleand easilyunderstood procedures; Ciii) as few conditions anached as possible on the end-useof financeprovided, enablingusers to freely choose as needed;and (iv)timliness in the provisionof reqired fnacial srices.

6.16 SRubsiuendithuncuions a: Small-scalefinance tends to be associatd with high tansactions costs,although this can also vary considerablyby type of regionand activity. Many of the small-scalefinance programs in Madagascarconain both disguisedand explicit elements of subsidy. Considerabledebate and conhtoversyhas therefire aisen over the justfication for subsidizedfinance in such progmrams.A numberof basic principlesshould be observedto ensurethat such programs can be ustamnedover the long-termand enablesmall-scale economicactivities to grow independentlyof exten support. Sbsidies to the end-usercan rarely, if ever, be justified, whether this is represented by lowered interest rates, subsidized equipmentor any other form. Suchsubies are distortionaryand impederesources from being allocatedto their mostefficient use. In contast, subsidizingthe deliverymechanism for finance becauseof hightrasactions costscould possibly be justified.However, even in these cases, the reasons underlyingthe high trasactions cost mustbe fist examinedfully. Whereinadequate inFrasue (roads,power, water sply) is the reason,it is better to tacklethese fictors first ratherthan use subsidizedfinance because they canundermine the profitabilityof the underlying activity. Where high rik of crp failures throughbad weather is a factor, the scope for organizingan insuranceprogram aggregang a large numberof risks shouldalso be considered unlessftese risks are highlycovariant. Where transactions sts and risks result from legal or regulatoryftiors or absenceof adequateaccounts, these factorsshould be tacldedin the first instnce ratherthan applyinga subsidy. n all cases,there shouldbe a clearprogram for phasing out any explcit or implcit subsidy. All costs and subsidiesof small-scalefinance programs should be made as taspare as possibleto enable scarce reurces to be most effectively deployed.This approachtowards subsidies - essei for the long-termsuccess of small-scale 111 finace policies- callsfor carefdllanalysis, diipline and coordinationamong the goverent, donors,NGOs and other actorsconcerned.

6.17 LIl and reeultory issues: Io every country,a bost of legal and regulatory issuesemerge in th courseof buildingan effectiveapproach to small-scalefinance, Madagascar being no exception.On one hand, specific legal and regulatorymechanisms are needed to improvethe accessof small-scaleeconomic agents to finmcialservices, to facilitatethe entry of certin providersof servicesuch as NGOs,and to provideadeque securityto both providers and users of financialservices. At the same, certainlegal impedimentsor formal or informal regulationsmay haveto be revisedor eliminated(see Chapter3). The legal characterof mutual svigs groups and associationsshould be clearly establishedand uversally understoodand recognized.Access to certainfinancial services such as leasingwoud also require groupsand associationsto developa recognizedlegal charcter (see Chapter7). Simplifiedacconting rules need tD be devisedto enablesmall-scale emonmic agents to produceaccounts where these are necessaryfor establishingand operaing an enterpriseand providingnecessary information to a lender (see Chaptr 3). The present openpolicy towards the activitiesof NGOs in small-scale fnce shoud become establishedgovenment policy while at the same time the prudential practicesof such activitiesbe dearly defined from the outset. Witout adequateprudential safegurds, savers' moneywi not be adequatelyprotected and experinces withlosses at a later stae couldseverely undermine a mail-scalefinance program by damagingconfidence in new intitins.

6.18 LInkag with the orall finanaal system: One tendencyto be resistedin small-scalefinance policies is the formulationof strategiesand support of institions in dissociationfrom the operationaland regulatoryframework of the ret of the financialsystem. For efficientallocaton of resources,appropriate prudential supervision and regulation, and effetive conductof monry policy,it is importantto ensurethat small-scalefinance programs becomeintegrated wihin the broaderfinancial system. An integratedfinancial market eosures that funds can fbw freely acoss sectorsand regionsand be priced accordingto criteria of risk, liquidiq, and maturity. The prsitence of the partcularly difficult present sae of communcationsand the fragmentarynature of real sectormarkets in Mdagascar will continme to renderitegrtonof fiancial marketsimperfe in manyrespects. However, under appropnate policyconditions, greater integrtion between small-scale financial institutions and the rest of the financialsystem can and shouldprogressively evolve on seeral levelsand shouldbroaden and deepen over tme. Two aspe of such likages are discussedbelow which are especially importt: qoperationalrelaions with establishedfinancial insttutions and conformitywith the overallprudential regulato4r and super y frmework.

6.19 Qunljonalnl.tiomsith.flnandaUnglluflons Small-scalefinancentittions aturallybecome associated with established financial instituions drugh their needfor payment anddepository services. is reflectsa widelyobserved phenomenon in small-scalefinance which is thatsmall-scale economic agents first andforemost need appropriate financal savingsfacilities. Agriwlture, in picular, tendsto generatesurlus resourceswhich can be transformedinto finanal savi for use in other geraly fter growingsectors. Experience in other counties, for exampleCameroon and Rwanda, dicate hat grassroot-levelfiace institutionstend to mobilizedepositsmuch fasterdtm they are able to alocate credit. They thereforetend to have much lower loan-todeposit raios in their early years than established bankig institutions. Consequently,they needto placetheir excessliquidity within the broaderfinancial system either 112 dtroughfinancial instruments such as Treasurybills or term dposits withbanks. t is important to ensuredtat emerginggroup-based or other mutua savings nd loas assocan ca freely choose whicheverexistng financialitrmediary bes serves their needs at any given dme. Althoughsome instions (eg. BTM, the postal satsgs and checkingsystem) are especiauy well-positionedby virtueof their past experienceand existg customerrelations to serve new small-scalefinance imatihtions, there is no needto mandatea privilegedrole for any individual insdtiuonsi these areas. In orde to encouragenew saving groupsawd associations to dewdop relationswith establishedfinancial institutionS, it is importantto dispelthe naturalsuspicion that many snail-scale economicagents might harbor towards establishedfinanl institutions, especiallyif these institutionsarc perceivedto havehistorically pursued 'tp-dowiu approaches to credi allocatio or to be subjectto variousforms of governmentirferen Boththe banking industryand Governmentcould joinly conductcis to improveknowledge of varios bankig productsand legal protectionsamong die membersof grassroot-levelor group-based savings assotions.

6.20 Prudential relatr and suisory standrs R is importan gov8" ment policy not iterfe with a multifceted apprach to buildmgsmall-ae finace inst which wouldenable a multitudeof mauly group-basedsavigs and crdi acvies to emerge thro t M gascar. However, all exstig d new grassoot-level sav associaons should in pniple be subjectto the same prudenta reguly and supevsry citeria as cther deposit-takingand lendinginstitutions in the county. At the sametime, in their inial stages and especialy while their operat are solely limitedto their m ,embe,these istittons could at least partily, if not Whollybe exempt, by decee from the monetry authorities,from dt ful reportig and disosure -e of establishedistitutions untl te3y developtheir capacityfor prodcing rlar and completeaunts. However,once these situtionsmature o the point of becomingfull-fedged deposittaking and creditinstuto, and espcay when these operationsare opend to o de the membeship of the group, these institutionsshoul be subjectto Similarregulaory and prudentialsuprision stards appled to ote financi instuons.

6.21 It is thereforecrucwial that monetaryauhorites be closelyconsulted at an eady stage in the formulio of small-scalefinan policies.Otherwise, such programs tend to come almostexclusively under the purviewof sectora ministriessuch as the Ministryof Agricuture which primarily fcus on practical aspects limitedto their area of sectoralresponsiility. This can lead t neglect of issues of monetary policy and pudential supev n who importn becomes especially evident in later stages of development At the same time, is crucial for the BCRM to begin preparing itself for these ne functionsby s gheng its sup caWaiies. Otherwiseit woud be notrealistic to expectthe BCRMto extendits limitedh and other resrces to the pote y costlyad difficulttask: of superisn a lre numberof fr-flung depositoyinstions. Thisshoufrm part on an overal pwrgm of.developmentof the swrvisory capacityof the BCRM(see Chapter4).

6.22 For practicalreasons, it wouldnot be possiblefor BCRMto undertae on-site inspectionsfor al small-scaledepository institutions. However, financial returns (m as simpied form approprate)tat are mandatrily submittedwit a pcribed frequency(at least once a yearand possiblymore for lager institutions)should enable BCRM to detectany problemsthat t on-e insp . BCRMcould also examinethe posibility of delegatingat leastpart of this functionto a "fiancial extensionservicew bue that couldbe part of a tecnical 113 assiste progrm to small-scaleistittion. Inspectionof smal-ce isiuo couldbe a 'traiing ground forjunir mp oy perod of BCRMJAt somepoit in fire whenan APExinstiu is fomd out of a goup of smaler intiions, the APEXins o could becomethe prmary fc on sueisio effortswhich in tin woud faciliatesupervsion of its meo.

Revitalizingthe Pbstal Saving Ssem 6.23 otemluLtheWWIIg: TheMagsy pal saving institution (Case dparpe de M gscaror CEM)contne to opea - a traditionaposta saving -iu it wa legallytransrmned in a savingbak in 1985.GEM alrady ants thdbusiness of everyfourih inhabitant in Aa d hec, ha a goodfoundato from whichtD grow hiuther.Apart from is - oalst in dt capkil. GEMopeat 220 windowin post ofices in 208 townsthoughout Madagascar, givn it thewidest financial netork in the ounry. Thevast majoriy of its accountsare held by idividuals;the restare held by a handful of enterpis, local govemen, educationalinstitutions, and relio - well as other usscmzon.ndividua accoun howeveraverg onlyabout 40,000 FMG (much lowe thanthe minimumdepositrequired by commercialbanis fr a dcckingaccount) while enterprise account an on av fifteentimes higher. Ihat to its wieread network,the CEMcould fm an excellentbase for establithingthenecesay linkbeeen iorma nd fm fiancial activtes. With an access rateto the mat of one accou for evry fur pes m Tan it makes it a fmidable pltfom to be the lin to the frmal bankingsys A he sametime, a lge portionof the small-e finan intat couldbe bothinitiated ad oper dtough the Notwiaing thispotential however, the CEM remains firught anwd otherproblems.

6.24 En O t ThepresenGEM is weakin keymanagement areas ad provida ondyvry limted sarviceto is custmers. Its f_inanc al is hampered by its dependen on theTreay withwhich it is requid to plae al its fimdsand which pa a belowmark iteret rateon i accouotS.DelaYs m akingfius avmile to custm reducethe I of thoCEM s a inr agentfor mobiiain of resources.There is no dear-wctm_atig srate trh whichthe CM couldbeer - anddesig fici produt so as to broad its dcietele and eae its depost e. The revenuegenerating capabilit of t G i c in is prest i makn it difficilttomake he necessary i mentsfor GE to ply a more activewroe a a finacl insi 6.25 Ma_rkspaltim a! CM-: Unlk CCP, h p checkinginstion (see Chat 3), CEM ha a clienl amongwhih stms other a civl servantsare importt grou. Individualdeposiors who _mmbeabot on quart of a milln aredrawn fom atsa, trders and frme, maMilyin urb as. By offeringan inerest rateoz its paboa svig whichis about2 pecea point bow tIhecomparble rates offierd by commecialbank on tem dqeos, CE?. is handi ped n its mreting policy. Depite this handicapnd a redavelypassive prowmotion effort, CEM manages soopelS newaccout o avage every mon At the endof 1990,CEM depoib weroquivalent to 35% of all ten deo held at commercialbak by indials. Thi unerscs e0subtn scope fa deveopingCEM a a svinbun Howevr its ato depostr wll remainimited by rladvdy cmbsome servic mongother actor. For amplo, pit on passbook :1~ ~ i%~ t.8 ' iA

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II w;;Iigii;1I~~~~~iIml 4~~~*9hi 1.1E 115 facilitiesin the countryby way of productdevelopment with an emphasison the larger segments of the market,including households and SMEs. It is importantthat the marketingpolicy is geared towardsvolume products which have a chanceof a wideacceptance, thereby making it possible to take advantageof economiesof scale in the operations.It is clear that the revitalizedCEM shouldbe given autonomyin its depositpricing policies although posdng of its remunerationof variousproducts as well as competitionwith other institutions,where possible, shouldprevail. A numberof marking programscould be undertakentaking into accountthe particularsocio- economiccharacteristics of variousregions of Mada.; .car. Accountfeatures such as deposit size, remunerationand lead time necessaryto make funds availablecould be tailored to suit the particularneeds and demands of varioussegmea'ts of the CEMclientele. At thisjuncture, without the benefit of any marketingsurveys, it would be prematureto speculateon what specific productscould be marketedby CEM in future.However, among some basic ideas which might be tailoredto some customersis to qualifythem for loans after a pre-establishedperiod of time during whichthey wouldhave accumulateddeposi balancesequal to the loan amountthey seek and repayableover the sane periodof time. Anotherpossibility would be to introducea 'lottery account"remunerated at a lowerthan usual interestrate whichcould qualifyfor a prize awarded at regular intemls whendrawings are madefrom a numberof such accounts.

6.30 Financial autanomy: ft is crucial that CEM have the ability to become a inanciallyviable institution free of dependenceof subsidies. Its financialoperations should also betansparent. To achievethis, CEMrequires to be financiallyautonomous of the Treasuryand free of cross-subsidieswitiin the PTn. Financialautonomy for the CEMwould entaila review of its pricing policy for its variousproducts and services.Estimates of operatingrevenues and costs based on the existingassets of CEM and its curren oeating costs show that financial autoniomycould lead to financialviability. For example,bad CEMrcceived a marketinterest rate of 12% or more on its tltnds in 1990,instead of the below-marketinterest paid by Treasury,it wouldhave been able to cover its operatingcosts and generte a profit. The abilityof CEMto freely placefunds. in the moneymarket (including subscription of Treasurybills which acrrently pay an attractiveinterest rate) or bank depositsis thereforecrucial to its financialviability. In the near term, it is likely that CEMwill control costs by keepinginterest rates on its deposits belowthose of banks. Since its clienteleis likelyto remainsubstantially different from those of commercialbanks for sometime,such a policy may be both feasibleand necessary. However, CEMshould also eventally prepareto adaptits strategyto be ableto iullycompete with banks, especiallyonce it beginsto earn incomefrom lendingrather than just placingfunds in the money marketor bankingsystem.

6.31 Among the most promising avenues of fiuther financi viability lies in consideringrevitalization of the CEMalongside a proposalfor the CEMto operateth, existing postalchecking system (Compte des ChequesPostaux or CCP) as a girobak (see Annex3.5). The latter couldalso help improvethe paymentsand transfersystem in Madagascar(see Chapter 3). The CCP already operatesas a rudimentarypayments and transfer system in Madagascar. Thereappears to be considerablescope for enhancingis role into a true cprobankalong the lines of simiar institutionsdeveloped elsewhere in the developig and industria world whichhand[e regulartransactions such as salay, utility,rental, tax and other paymentsin additionto transfers. Experienceworldwide has shownsuch stutions can be very profitableonce they are able to manage the substantialfloat tbat is avaiable from the lags betweenpayments received and paymentsmade. Part of this float coud constue a permanentsource of fimds as the flow of fundsis continuallyrenewed by reguar paymentsinto the girobank.Itis wouldafford the scope for die CEM to becometo a becomea viale financialinstituon, capableof self-financinga substnal portion of its investmentsin domesticcurenc. CEM-couldeither own the girobank 116 whollyor possiblytogether with equitypartcipation from oDmmercialbank who would also have an interestin an institutionwhich could improve the domesticpayments and transfer system. It is important,however, that alongsidethe transforation of CEMinto a more aggressiveand properbanking institution, the Goverment makesuch provisions necessary for a moneymarket to develop, notablyin the area of negotiableTreasury bills as well as introductionof other instrumentswhich could be traded(see Chapter7). There mst existample opportnities for the CEMto investits resourcesfor longand shortterm, at zeastunfil such a time the CEM can start to opeate lendingoperations on its own.

6.32 Mangower develonht oley: The prospectsfor a greaterrole of the CEM hinge fundamently on the possibilitiesof developingadequate and properly trained staff. Followinga step by step approach,a first phaseof the manpowerdevelopment plan could cover basic management4evelskills, accountingand finance, and operatingprocedures for staff in whichtellers and other categoriesof staffshould be the primaryaudience. Marketing skills should also be developedparticularly aimed at promotingdte CEM amongclients who may not be of prime interestto commercialbanks such as artis, traders, farmers, and low-incomeurban wageearnes, either individuallyor throughappropriate 1cmmunaor soio fessionalgroups. At a later stage, if and whenihe CEMactually engages in credi operations,traditional banking- type skills adaptedto its spec fimctionscould be developed.The entire process shouldbe assisd by a technicalassitce programwhich shoud first entaildraftig and approvalof a new char for the CEM. This programcould also cover tainig needs for the girobankwhich the CEMl couldoperate as a separateentity. Staff of the post office also assignedto handled{: tM transactionsshould be given taining by CEM itself with the CEM jointly selecting such personneltogether with the Post Office.

6.33 itial relao lscale savis n : The reitalized CEMshould have such a policy and such productsfrom the begiming that it would becomena and attrctive to use this insttution as the primay finacial instion for group-basedsavings associations.Us;ng its widespreadnetwork of offices, it wouldbe possibleto servicegroups in more or less every part of the country The role of CEM shouldmainly be dta of the accou holder of group while allowingfor more than one group could use the same CE office. The individua accouns shouldbe administeredby the group itsdf and it shoiudbe possile for the groupto operatemore than one accountfor variouspurposes. One example ouldbe one account for longterm saving and another of more shortterm charcter, from which withdrawalscould be effectedin accordancewith term and rules set out by the group itself.Economic activities of the group and ncome from this actity couldbe channelleddirectly to the group throughthe CELl and distbution doneby the gru itself. Marketingof milk, fer example,and proceeds being paid at certin intervals from te dairy companyelsewhere could easilybe transferred tlrough the CEM direc to the grwup'sacount Of course,other incomeof the group couldbe channeled otherwiseand direcdyto the grup, but it is importantto have other formal channels open. kt is clear, as previouslystated, ihat there shouldbe no compulsionto use the CEM over any other financialintermediary, although it is likely that a revitalizedCEM wouldbe able to captre much of the buiness of far-flungsavings groups thrugh is wide networL

6.34 Broadening and- -eendst of CEM ases: Throgh its own tehical assstanceprogram, it is possile tat the GEMcould render some assisunceto emergig savings groups.This could notablyentail trainingin fiancial matterswhich coud benefitboth cuomer and CEMequally. Suchassistance admisturd though the CEM coud o be Ias with the beginin of loan activites fromthe CEMto tbe grop, if warated by its activiies andpst performance(a pregaalificationstep for credit activities).The bninp of CEM acives in 117 lending however should also be conditionedon adequate improvementsin the legal and accountingwithin the country. lhis is especialy given t the credit nsks amongthe CEM clientelemight be higher than those in the commercialbaking sector,particularly for lending to individuals.To managesuch risks, lendingby CEMshould primarily be seenas a complement to the lendinglikely to take placewithin the groupas part of their own activities.Such lending could, however,be beneficialif the businessvolumes coud be boosted in this manner, for particularprojects of interest to the groupor associationconcerned. Groups and associations should also be encouragedto cooperae cross regionsand financialflows resultingfrom such cooperationcoud the easilybe handledthrough the networkof CEM. A similarrole couldbe playedby the revitalizedCE withregard to cooperatives.It wouldnot seemfeasible at this stage, to envisageany cooperativebaniing institon in Madagascarand it wouldbe preferablefor cooperativesto use existinginstions to meettheir needs for financialservices.

The Role of Venture Capital

6.35 minortanceOf Venture Canital: One of the major problemsfaced by small- scale economicagents (particularly SMEs which need capital equipment)is a lack of equity financing.One potentialvehicle for such financingwhich is yet to fully developin Madagascar is venture capital. Venture capital is equity financingbased on the principle th a panership can be forged betweenthe erepreneur and the investors.This is still a relativelynew financial insrument in both industrialand developingcountries. k is significantlydifferent from bank financingand financing by passive 'portfolio investors' in ihatvenue capitalistsgeneraly add value to their investments trugh the provision of management assistace. Venture capital companiescan male a significantconribuon to the developmentof the real sector, especially throughpromotion of SMEs,by: (1 providingcapita to smailbusiness with substail growth prospectsbut inadequatesecurity to tap bank loans;(ii) supporingnew vres in the form of 'seed capital; (iii) increasingthe capitalbase of SMEsto enhancetheir potenti to mobiize resourcesfrom existingfinancial instiutions;(Qv) being an activepartner in the business(as opposedto the 'sleepingparter' stats of man other shareholders),thereby allowing te SME to benefitfrom the experienceof the VC companyin managementand maketig and itsaccess to global informationnetwork Me genrally the contributionof vente capitalcompanies to the growth of enterprisescan be more meaningfilthan banks and other leading institudons because:(i) by providingcapital or loanswhich are convertibleito equityafter sometime, they do not imposeon new or restructuringbusiness the burden of high debt servicingwhich are unbearablein the inial years; and (CH)the r of the venture capitalcompany being througha combinationof dividendsand capitalapprecaon, it has incenive to makeevery effort to ensure the success of the enterpris.

6.36 _ eiut c_l gMmnin I TheMm: first vture capital company in Madagascar,the 'FinanciereARO' (IARO) was establishedin 1988. Ibitiallya subsiiary of the AROinmsurance comany, its capitalwas subsequently opened to priv companies2 %), individuals(5 %) and intenationalfinancial institutions (21 %) and reached4 billion FMG in 1990. Up to December1989, it had takenequity in 11 companiesto the ue of 1,230MFMG (aboutUSD 850,000). For its first 18 monthsof operationit had made an operang loss of 83 MFMG. It is plannig to investbeweea 700 and 1000MEMG (USD 500,000 to USD700,000) ualy whichcould gerate 10,000to 15,000MEMG of new inemnat in te indusi and commercialsector. Of this amountbetween 150 and 300 MFM wi be used to.fiance SE. The only other venturecapital company is the *Societed'ves t pour l Promotiondes Entrepises a Madagascar (SWEM)which was launched in 1990. Inally a schemefor heipig the creationof new enterprises,udxe the - Associationpour la Promotionde Itprise 118 Malgacbe"(APEM), with the paiation of local industialists,ban and freign donors, k became a- VC Companywith shareholdingfrom local private organization (52 %) and intemationalfincial instituions(45 %). It has just started its activitiesand it is planningto makeavailable some 160 MFMG(half as equityand half as loans)to 16 SiEs on an annual basis. It wouldbenefit from some grants from intenaional agencies(LO, UNDP)inital years.

6.37 hJMt f y=fapltal mpgines: The impactof venturecapital companies in Madagascaron the grwth of privce enterpise has beenso far very limited,both generally and particularlyfor SMEs,for severalreaons. First, the volumeof finace madeavailable less thanUSD 1 mIllion)is insignificantwith regard to the enormousinvestment needs (both debt and equityfinmance) of enterprises generally and SMEsin particu;lar.Second, the bulkof the resources (83%)have goneto large establishedcompanies (SMPL, KOBAMA, NY HAVANA,etc) or to now highly credt-worthy ventures (MO1) which couldprobably have mobilized resources from other sources.Third, resorces allocatedto SMEswhich codd providemaximum beneft in ter of valueadded and employmenthave been marginal. Fourth, only part of the activitiesof existing companiesare devotedto purely ventre capital activities- FLARO,for example,is being involvedm other ivestment activities(purchase of immovableproperty and buildingof an industria oe). Tbeprospects for a more significantcontbution fromthe two existig venture capta cmpanies in fure are remoteas theyhave themselves fixed their combinedannual equity paticipationto about1000 million FMG. Undertheir mostoptimistic scenario, only some 25 - 30 SMEs wouldobtain an averageof 15 - 20 MFMG(about USD 1,000)annually. Moresuch companiesshud therefre be encouragedif venturecapital is to claima significantrole in equity financingin Mada sc.

I. 6.35 Iumidvesfor ventmrauil coLmmniesIhe developmentof venturecapital faces a doublehandicap in a developingcouny lie Madagascar(O limitedreal investmn opportuities (few busine offer a minimm secrity nd entrepreneurshiptha would attract veln capital);and (i) absene of a readilyavailable market to realizethe capitalapprecation of their investmen Venture capital companiescan only grow at the pace at which prvae enterprisethrives and matures,and a capitalmarket develops. If venturecapital compnies are artificialypromoted, the reslt wi be i companiesinveting in "blue cbps" rather than high risldgh retum ventureswih mitdevelopmenal impact(to someextent, this is alreadybeing dos by the eisting companies);and (n) loss main companieswhich investin development orientedbut very risky business(SiEs) and have to be supportedby public grants; and (iii) comaies whicd,only nominay engagein ventu capitalin order to benefitfrom any special incentives.Th main icene for venture capital companieswill come firompolicies that improvethe profitabit of red sector activitiesand which efli entry of SMEs into new spheresof actity. At the sametime, the govemmentcould also undertakespecific measures to begi establshinga basis fr a ftlure capitalsmarket (see Chapter7). In addition,wih longe tem paqpctive in view,it is apopriate to grantm inceives to compoa giventhe nature of the businessand the positiverole they canplay in the financialsector. Tax breas to veure capitalcomps irrspective of their actualactivie ted to favorabuse and createa distted incentiv system. Insteadof generalizedtax breaks,it wouldbe more proper to give allowances on ren:on specificinvestments (eg new enterprises,eension and rdhabiitation,SMFE) which need to be promoted and for which no immdiate ico can be envisaged. 119

INVESDE PROaTITON AND MUMCIA MAEIR DP;XVPAENT

7.1 To ensurethat Madagascareseconomy become incsigly diversifiedand export- oriented, the financial systm will need to be better placed to faciliae the expansionof domesticand foreg arade ald both domestic and freign investm While k is unrealistic to expect Madagascar to develop within the 1990sthe sophisicated tade fince systs which eist in industrialcountries, Madagascarcan followthe exampleof a nmber of devdping countrieswhich hve succeededm developinga strong export base in recent years, notably those in East Asia and neighboring Manutius. This chapter considersin paricular what fiancial policiesthe experienceof these developingcountries might suggest to Malagasypolicy makers for developmentof a more diveified economywith a strong export be. In addition, the developmentof fincial instrumentsand instutons to increaseefficient trade and invesmen flows is generallyone.of the key ingredientsfor developingfull-fedged financial marets - the other majortopic of his cpter.

7.2 Boththe mediumand longterm horizomns-which could exend beyondthe 1990s-are consideredin this chapteri aminig whichfanci instuments, marketsand istuons could be developedto exed trade and investmentand stimua tading of financialassets. It shodd thereforebe stressedthat several of fte fancial inaons discussedhere involve instruments, market and institutionswhich cannotbe reaisically expectedto emergein te ner twin They especiallyinclude relatively sophisticated trade flmmscei n such as banks' acceptac or capitalmarket securities and institutionssuch as an exportcredi guaranteescheme or an offshre baniing cner. These and othr relativelysophisticated innovations wil notablyrequire: O prir improvementsin the financialinucture, manyof whichare discussedin Chapter3; Ci) greaer diversificatonof real sector activitiesand especiallyexports; and Ciii)effectve operaton of more basic i=ru and marketsinlud a secondarymarket in wadeand Treasury bils and an activ inte-bank market(see also Cbapter2). Sinceit is not rlisc to expct these basicpreequites to be in place within the medium term - appropriat poicies, the more sophisticatedinnovations could also be envisagedin the longer tem once the Malgy economybegins to ralize its substntial scopefor broad dsification and exrt orentaton. As dised below,public policy will have,an importat role in the 1990sfor helping lay the grund for a mber of financial innovationsin Madagasca.

7.3 A strategyof sustainale growthin Madagscar basedon expandingand broadenig fte exportbase reuires effective Iotrade finae. Withoutthis, Maagay exorts cannot respnd effecdvely to foreig demand. hey l have tD contie tD sely y on self- financingwhich severely constrains the scopefor expadig bade and particuadyeports. Ihe surveyof MaLaasyentises conductedfor this Reportshowed that muchrmains to be doneto impmveiteraiona rade financein . For mn MalaM eterpis, paymentof importsis madegenerlly at sightwhie a goodproportin of epr is ad afer shipmenor ddivery (nrmaly 60 days). he needto flace - tradefrm domesticsources coud be reducd if the paym tem could be altered in favworo ladgsc. A cmbiao of 120 increasedsupplier credit, foreign bank trade fmanceand preshipmentfinace will be required as discussedbelow. 7.4 The discussionbelow points to at least three policy areas which are crucial to improvingfinancial system for trade expansionand investment First, it is crucial that the Govermnentrapidly exploit the full potentialof the businessinvestment and free trade zone folicies it has alreadyadopted. While the basic free zone legislationalready eists and appearsadequate, many outstandingproblems remainin the applicationof this legislationwhich is unnecessarily cumbersome.The proposedone-stop window (guichet unique) to faciitate new enterprses should also be implementedas soon as possible. Second, imrvements in the legal and accounting framework,broadly discussed in Chapter3, are neededto encouragethe developmentof a bills marketin Madagascar.A third area of attentionare foreignexdhamge controls which could be made more flexicbleto adaptto the needsof exportersand imporert.

7.5 Sufile crei Suppliercredk is genealy one of the most import sourcesof credit for importers.Foreign suppliers' credit depends on suppliers' assessmentof the credit worthinessof the Malagasyimporters and their generalconfidence in the Malagasyeconomy. .The severeextena paymentssituation which the countryhad experiencedduring most of the 1980sled to an erosionof confidenceamong foreign suppliers. With the merging liberalizationof the economyand the improvementin the financialsitato in the country,Madagascar should normally be eligiblefor more suppliers credit. The businesscommunity and the goverment have a joint responsiblitytOD promote the credit worthinessof the country. Yet, confidencebuilding is likelyto be a gradualprocess.

7.6 To acceleratethe avai'labXilof trade finance,joint veures withforeign firms can open the way for suppliers'credit on favorableterms. Almostall respondentsto the enterprise survey in Annex1.1 who indicatedthey had accessto suppliers'credit were eitherpartly or wholly foreign-owned.One such companyhad 180days creditfrom its partner.Many newly industrializing developingcounties includingMalaysia, Mexico and Singaporehave been able to dramatcally expandexports and employmentsby developig trade financethrough affliations with foreign or mltinationalcompanies. Madagascar shoud therefo continueto favorjoint ves to enhance the catalytic role that well-established foreign compai cam play in fosterig stronger trade links: strategicalliances between Malagasy arms and multinational firms couldalso be pursuedto facilitate Madagascar'saccess to foreigmexplit markets.Strategic alliance, more specifically,refrr to the associationbetween two or more companiesat apartic stageof the producodisrbutionprocess which,in general,results in synergistcbenefits for all the partiesinvolved. For instance,a Mzlagasy firm with a highlymarketable product, but withoutany prior experiencem forei marets, coud associateitself with a reputablefreign firmwhich would be primarilyinvolved in the marketingof the productabroad, in returnfor a share in profits.In this particularcase, an associationwith a firm of establishedrqetation will tell the maiet that the Mlgasy fims productis of goodquality and is a winner.Staegic alliancescan also be consideredat odtr stages of the productionldistbuion processsuch as man tg, financing,and researchand development

7.7 Fore.gn bank trade fluan" Foreignbanks, includingoffshore banis, can provide trade financeboth on importsand expots. On te exportside, an offshe entitycan discount export documentsand providethe exporterwith the expectedfreign eamrgs whih wouldbe setted on paymentof the foreignexchange by the foign importer. Thiswould be a sef-iquig operation in foreignctrrency whichaccelerates the receiptof foreignexchange and it would,therefr, be in 121 line withthe CentralBanks policyof earlytansfer of exchangeearings. The recourseto offshore banksmight be less appropriate(because of globalforei xchamgelmitation) and more risky (the importerhas to bear the excdangerisk) for imports. However,it could be very helpfulfor export enterises operatngunderthe freezone regime envisagedinadascar. The exampleof Mauritius is instrucdve where offshore bhak are already finncing the impors of the Mauritius EPZ companies. There is also the possibilityfor offshorebans to discountthe documentsof a foreign exporter enhancingthereby his Caci to grant suppliers' credit to his Malagasyimporters. Offshorebanks can also financeintenational trade hroughfactormg.

7.8 Problems of preslinent financr Bank fiance is more readily availablefor finished products which are marketablethan for products in earlier stages of production. In Madagascar,as elsewhere,producers who are at the initialstage of the productioncycle are oftenbe deniedfiancing simplybecaue the producthas not yet reacheda maretable stage. Yet it is essential that producersat this level are duly supportedby means of adequatefmancing. Producers of intermediateinputs are oftenforced to rely on their own equityor workingcapital which constains their productionconsiderably - in Madagascar,this problempartiularly affectssmal and medium- scale enterpriseswhose access to equityand workingcpital fiance is alreadylimited (see Chapter 6). In somecases, the absenceof suchfmancing may actas a severeconstaint on the volumeof fina productswhich emergesfrom real sector activityamong indirect expters.' The reluctanceof financialinsdtitons in their intrention at this 'preshipmenrstage of producim is mainlydue to the fact that there is a significantelement of risk dt finalproduction, and hencepayment, may not materalie speciallywhere there is a long tie lag betweenthe 'presbipment stage of production and the fial product Banksare worriedthat their funds may becometied up for too long and wihout much garantee of repaymentas in the case of marketedfinished pmrdcts. There is thereforea distinctpreference for fnancingthe finishedproduct due tDothe self-iquidatingcharacter of such financing.

7.9 Enlarging preshipment frnance: Preshipmentfnance, especially for indirect exporters,will become important as Madagascarseeks to increaseits exports.Enlarging preshipment fiance will require increasedsynergy between dire and indirect exportersand small and large mufacturers andadequate backward linkages between exporting enteprises opating underthe free zone regimeand the rest of the economy.The fireemovement of blls of excange shouldassist in overcomingthis financialconstraint (see para 7.7). The needfor specificallysupporting producers at the "preshipmentmlevel was identfied in the eady stagesof indus ti in Maurhius. The fear was that many potenia exp would not eventally materilize due to lack of adequate financ in the raw materialtnsformation stages. Banksin Mauriius were and still are unwilling to take the associatedrisks in this part of the market Over time, the speed and tunover of real sector activityprovided a solutionto this problem in so far as the exorting sector in Mauritius progressedat unexpectedyhigh growdLrates. Bank became willingm these circum to enlargethe overdraftlimits of thrivingbusinsse in the fast gwing phase of the exporingsector. Consequenfly,both the pre- md post- shipmentfinacing requrementsof producerswere fulfilled by the larger access to overdrafts. However,the smaler units which supplied 'pre-shipment' requirements of larger enprises were the first casualties of this evolvg situation as te larger production umitsbecame more closely itegrated vertically and arted themselves attending to both their pre- and post- shipmenmater requiementswith the benefitof the greater accessto fmds.

7.10 Develouinga bills m t In additonto the abovementoned means of faciitating internonal trade, notbly for exports,Madagascar should also strive to developa systemof trade 122 fincing usmg bills of exccangewhich could be discounted.The survey of Malagasyenterprises describedin Annex 1.1 revealsthe acutelack of a real bil marketin Madagscar. Ihis is generally attinbutableto the lack of creditworthiness of the issuersof the bils which may fail to be honored an due date. In a fiancial marketwhere tight creditlimis are appliedand where smallereiteprises in particularhad problemsin obtainingbank credit, it is qu litkly that inddual iSsuersof bills may fail to honor their obligationson due date. Better accessto creditby the smaler entepis would be part of the solutionto this problem. As transportationand other problemshindering domestictrade in goods and services are graduallyovercome, Malagasy enterprises should be encoraged to adopt bill finamcingas a convenientmode of extding credit to each other which wouldalso ease pressureon domesticcommercial banks to providetrade finance.Careful attention shouldbe paid, therefore, to the developmentof a sowndand depndable bill markeLt Wider cirulation of intal bills woulddepend on the time taken to introducethe necessary safegur regardingthe detrmination of liabilites on bills in the contex of an overalli-provemen of legal provisionsrelating to bills. Bills shouldbe a legal obligationto pay debt that is bindingon the acceptor,the drawee,and the endorser.An inadequatelegal fiamework or someinstances of defalts on bills shouldnot prevent thesecredit instruments from gaing geeral acceptabilityas quicky as possiblein order that the presentdependence on cashfor trade tansactionsis minimized.

7.11 Oncebils becomea commonfinamcing instrument, other financial products may be introdued. For example,the samebflls may be acceptedby banis so as to enablea holderto obtain fimdsprior to the maturiy of the bill. Whileit may not be appropriatefor the CentralBank to go directlyto the marcetin the first insace to supportsuch a facility,one or severa discounthouses specializedin th key sectorsmay be establishedwith the appropriatelegal backup to fiulitate direct recourseagainst drawers of bills who defalt on their obligations. The discounthouses may be refinancedin tau by the CentralBank in accordancewith the stanceof monetarypolicy. Similarly, the bartertrade whichnow characterizespart of agrcultur trade wiin Madagascarmay cometo be financedby meansof these instrumentswhich would becme negotiableand, hence, put the fimers and pes in fundsaccording to thir needs. At a more advancedstage of deveopmentof wadefinmce in ladagascar, bils can be acceptedby bank which are te aded as bankers' acceptances(BAs) as furtherdiscussed below (para7.34).

7.12 EW e lEk Cove To encourageMasy eports to expandforeign trade, they shouldbe given wider optionsfor taking and managg exchangerate risks associatedwith importand exporttracto. Thishas been the casein Maurtiuswhere foreign exchange receipts continueto be closely managedby the CentralBank, as in Madagascar,but withgreater flexibility. Mauritiusoffers yet anoher advantageto the export sector whih, uinie epr based in Madagascar,import most of their raw matals or semi-fiid inputs.The typicalMamridan genates a demandfor foreignexchange in the first phaseof is produon cycle due to hese impor which is folowed by the generationof frei exchangewhen export receiptsare ralized. Nonrally, an entrse buys the foreign cency for its importsby utiln the local curency andthen sellingthe foreignexchange eaned subsequentlyto the bans in xhange forlocal currency.A specialprovi in MmurianEx ge Contol regulatio pemits eortig entprises, however,to retain exprt eaings in de frig currecies if the latoerhave to be utilizedtowards paymentof anticipatedimports (see Ann 7.1). It is onlythe et residualexport earnings which are eveually repaiated into local cmrency. Exportig enteprs are thmscovered agaist echange rate fluctuationsand do not alwaysfeelhe needto obtainecmge risk cover againstshort or log termpositions held in particula currencies. 123 7.13 Madagascarmigt be ableto adopta similarscheme for retentionof foreig exchange earing and its managementby Malagasybans whichshould help to develop erse amongbank in foreigncurency managementAs more businessis geed by the eortes reang foreig exchange,banlk will accordigly cometo holdlarge foreignexchange balances m conformiy Wi the scale and growthof businessin the exportngsector. In addiion, Mauritianexporters have been for some time also permittedto avail thmselsvesof short-termcredis in foreign crency fom offshorebanks. Such credi is normallyprovided as a substeite for short-tm importfinancing and ihe main advantagesto the borrowerare an enlargementof accessto bank credit ouside of credit ceiings as weUlas a relaively lowerrate of intereston the debt than if the borrwing wasundertake on the domesticmarket Thereis an increasinguse by Mamriian exportersof this finacing mechanismin spite of the impliedexchange rate risk borne by the borrowingenterprises.

7.14 Near term soae for xort credit g t scheme: Both industria and indutialiing counties have had recourseto export credit insuranmceor export crdt guarantee schemes(ECGS) to promotetheir exports.Theneed for an ECGSarises whenexports and those whoprovide export fimance (banks, tg houses)have bnperfea informationon overseasbuyers. An ECGScan opennew marketsto exprters and enablethe fiancing of exportsto these marks by otherwiseunwilling financial institutions. Tis is donethough accessto informatio on ovseas markets(the economies of scale in information- gatheringare such that it cannotbe due effectively on the levelof an enterpriseor a bank) and throughpooling and reductionof risk There does not seem to be an immediateneed for an ECGSin Madagascarfor a nmber of reasons.The bulk of Magasy exportsare directed towardsindustrial counties where politicalr, inciudingdebt rescheduling,are minimal.Madagascar can expand its ewpor to prme martks like the EC (though the Lom Convention)or the UnitedStates (where it is still well belowits qu); it is therefore,mtm compelledto lookfor risldermarks at this timein orderto expandexports. Expedence shows that an ECGSbecomes viable when exports,especially non dit itnems(which are generally not exportedtO tditional market), reac a minimumlevel; tbis is no yet the casein Madagascar.The p mae establishmn of an ECGS in Madagascarwould resut in a heavyloss-making institution (thesmall amount of premiumswould not matchthe fxed cos) withoutany significanteffect on the promotionof exports.

7.15 Longtem scope for-an ECGSIf Madagascarsucceeds in developig a diversifid (manufactuing)export sector where products would have to be sold on more divesifed and riski markets,then an ECGS-miaght play an importantrole in exportdevelopment Whilethis is deadry a long-termprospect, there mightbe somelessons dtat Madagasr codd derivefrm other cwountr in consideing the establishmentof an ECGS at some fiute date. First, ther shuld be an appropratepartnership between prive sector and goverment in institutingsuch a scheme.While purelyprivate schema mightresult in too conservativeunderwriting in somerespects, purdy public schemescan unnecsarily relegatecomrcal risk to the governmentand create a moral hazard problem.Government is generallythe logicalprovider for coverig politicalrisk but pa rshipsWith the privatesector where the latter assumesat least part of the commercialrisks wouldbe a better formula(as has been the case in Mexicoand SouthAfrica). An ECOS canmotbe in deficit in the long-fm becase it wouldviolate GA7T rules which equate it to an exportsubsidy. ECG institio shouldtherefore be properlycapitalized and started so as to providea good service(duth is why they shouldnot be prematry set up). 124 Enhanng Itegimi Trade And Cres-Border Trade I nandimalServices

7.16 Madagascaris uniquelysituated in closeproxmity to the highestincome counties in the Africa and TndianOce region (with the exceptionof oil producingcountries), notably Mauriius, Seychelles,and South Africa. hL addition,ndghboring Reunion, a department of France, affordsa potentialgateway to the Eropean market Thereis particularscope to firther develop Madagascar'scommercial and financialrelations with these neighboringcountries in the regionto expandtade and investmentflows nludig tade in fiamcial sevces. Madagascar'snch physical and humanresource base is a specialatraction with its labor costs beingone-fourth or less of those fromthese neighboring oDuntries. In addition,inteational companies(notably from Hong Kong and Taiwan)operating in Maurtius are very keen to extendor tasfer part of their labor-intensive actvties to Madagascar.Further development of regionalcommercial and fnancial relations could help the existingfinancial system and the productive sectors of the ecowmy in several ways: (i) throughencouraging private direct freig investmentwhich can help meetthe capitalneeds of local entrepreneu;) throughprovision of offshorefinanc serviceswhich could improve trade fmance; and (ii) tirough futher provisionof onshorefinc servicesby foreign financialinsituons drugh partia or completeowneshbip of a finacial instittion domiciledin Madagascarwhich could help improve financialskills and develop in baning relationships.The scope and cstaints of furter trade betwee Madagascarand individualcouties whichare two of te key neighborsin the region- Maurs, and SouthAfrica- iuding prospectsfor wade in finacial services, are discussedbelow. This discussionilustrates demonstats how, during the 1990s, Malagasypolicy makers will increasingly face ches on whetherand how to exploitthe considerable potentil for increasingtrade and investmentflows from these countries. Also discussed below is the relatedissue of the scope and prospectsfor establishig offshorebaning witin Madagascar.

7.17 Maf rilius: In the nearm, the greatest poteal for Madagascar to enhance trade and imvwstmentflows within the regn appears to lie with Mitius. The low cost and relative abundance of qualified libor as well as the abundace of land are major altractions to M;aurian investors. The governmentof Maurkus has waived the 15 % tax on rnsfer of capital for approved investment projects in Madagscar within its strategy to encourage labor intensive industries faced with severe labor shortages to traisfer part of their business there. Already, some half a dozen Mauritian companieshave already mvested m Madagascar or are in their pre-operationalphases. Continuedinvestment fom Mauriian and M bas aies in Madagascarwill createa need for more regional fmancial services. One leading Mauritianbank already maintainsa representativeoffice i AMadapscar.T NationalMua Fund, a Mauitmn uni trustvery similar to the FrenchSICAV, has been autoized to invest40 % of its resourcesin foreignassets and could be prepared to considerinvesting some of its funds in Mdagascr. AlthoughMauritian offshore bankingis stll in its infancy,at least one offshorebank in Maurifus has intervenedboth in favorof a Maga financialintu by prviding a fori loan and Malagasyenterprises by flnning thir imports and exports.

7.18 South Afria: Smce rdaons improvedbetween the two countries,there have been several major trade missionsto Madagascar. Most taders and fiacial ;astitutio saw the adability of exportcredit inurance facides as vita t the developmentof trade and investment with Madagascar. In South Africasuch aciies are offeredby the Credit Guaantee Insurance Corporaton (CGIC)which undewtes export creditrisk in co-opeaon with the SouthAfrican Government.According to the ExportCredit Ren-isurance Act of 1957,the Govemmentundewites the politicalrisks componentwhile the CGICassumes the other risks. The CGICoffers two major 125 typesof cover:shoriterm (upto 180days) and mediumto longterms(180 days to 10 years). Given the lack of reliableinformation on the tradig communityin Madagascar,the CGIC is proceeding cautiously.Ithas in principleaccepted to provideboth commercialand political risk cover for short term creditand it has actuallyundwrten sometransactions. However, it has not yet providedany coverfor mdliumto longterm risk as it feelsthat guarantees on paymentsconditions are inadequate.

7.19 SouthAfrican interest in direct investmentin Madagasr is still at an exploratory level. The most promising sector to South African investors seems to be the mining industy which has a big potentialand in whichSouth Africa has considerableexperience; tourism, construction and agro-industrycould be of interestto variouslarge groups. However,to be able to proceedfurther, potentialinvestors need to be assuredof the leal statusand securityof their intments and abiliq to obtainnecessary work permits and remit profits. Also, they need to be conviced on the real advantagesof investingin Madagascaras they are now having a wider choice of investment opportunitiesas almost every contry in sub-saharanAfrica is openingits frontes to the South Africanbusiness community. As they tend tD be risk-averse,they will prefer countries which aready have a high interational ratingas an investnentcenter. South Africa also has the mostdeveloped financialsystem of the regionwith a broadrange of servicesoffered by commercialbanks , mercha banks, discount houses, factors,confirming houses, a stock exchange (the largest in sub-Sabaran Africa), insurancecompanies and the Credit Guarante Insuranc Corporation.There could be considerablescope for furtherregional trade in financialservces includingtechnical assistance to Maagasy fiandal instuions.

7.20 Imoroving regional avmt: Madagasca's trade in the Indian Ocean was traditionallylimited because of histrical trade lins with other regions,similrities with the exprt productmix of neighboringcountdes and politicaldifferences. ITe inward4ookingdevelopm strategyof the lae 1970sand early 1980shindered furher the developmentof regiona trade and relatedfinanci services. However,the recent sigficant liblizatin of trde and the openingup of the financialsector to foreignparticipans have geneaed new intrest ad initives in sevra countries.In addition, Madagascaris a meer of the IndianOcean Commission which is still in the process of consolidation To the extent increasedtade and investmentflows results in a shift in directionof trade in Madagascarmore towardsthe countriesin the region, there mightbe benefitto Madagascarfor expandingits participationin regionaltding arrangemens.Madagascar however iS still only an observer, not a member, of the eighteen-nationPrefertal Trading Arrangement (PTA)which operatesa clearng house arrngement which enablesthe amount of hard currency supp'rt,ingregioal wadetransactions to be minimized.Exporters in a PIA membercountry received prymentsfrom a dlientin anothercounry in the exporte's localcurrency. This Utansaction gives rise to a claim and a liabilitydenominated in a regionalunit of accountwhich is recordedin the PTA claringhousein the accountsof the two centralbanks concened in a givenwansaction between two membercounties. By seting receiptsand paymentson a net basis,this sysem reducesthe amount of foreignexdhange needed to supporttrade transactionsthan it wouldbe if all transactionswere settledon a gross basis. Thissystem is due to becomea fill-fledgedautonomous clearing house for all intra-PTAtrade ransactions as frm 1992.This is expectedto be a nuclus of a proposedplan for monetaryand financal harmonizationamong PTA memberscountries. At the moment,a similuar bilateral arrangementexists betweenthe centralbanks of Madagascarand Maurits outsidethe franework of the PTA.

7.21 Nearand mediumterm scope for offshorebankior: Severaldeveloping counies have set up an offshorefancial sector. Somehave dedvedsubstanial benefits from its opations 126 althoughthe oDntributionto the longterm economicgrowth of individualcountries have been uneven, dependingon the diversityand depth of their offshorecenter. To establishan offshorefinancial cemer, any countrysuch as Madagascarshould offer at minimuma numberof basic conditionsto offshorefiacial institutions.These include: politcal stabilitywith a goverment committedto free enerprise and an outwardlooking development strategy; advanced and efficienttelecomi facilities;good supply of skilledlabor (banking,legal, accounting, information technology) preferably multi-lingal or bilingual(with a knowledgeof English);availability of officepremises and housing facilitiesat reasonablecost; convenientinternational transport facilities; healthy economic conditions; completefreedom from exchangeconarol; miimm prudentialand other regulatoryreqirements; abilityto repatriateprofits freely; generous tax incentives(on profits,income of expatriates,intere); and liberalentry of expatiate staff.

7.22 Over andabove the basicconditions mentioned above for the settingup of an offshore center,Madagascar would also have to offersome specia beefits whichwoud act bu s rom elsewhere. The classicadvantages over other counties include time zone advantagewhich woild providea strategiclink between exsting majorfinancial centers (ike Singaporeand, to a lesserexten Babrain);geographical advantage in the case of the proximityof potentialresources avaiabilities (Babrain)or investmentareas (Philippines,Hong Kong)or both (Singapore);significant lower cost of operationgocal staff, rent, licenses,other services; and better tax incenies. It is dear that Madagascardoes not fulfillmany of the basic conditionsrequired to quaify as an offshorecenter and it is improbablethat all these conditionswould mateialize in the mediumterm. Furthermore,the special advantageswhich Madagascar could offer with respect to other offshorecenters are very limited.Madagascar is only three homs aheadof G.M.T. and is in the sa time zone as Bahrain ad only an hour behind Mauitis. The possiblepotential for an activecenter in the Souther Africalldian Oceanregion is alreadybeing exploitedby Manrtius and it cannotbe excludedthat other well-suitedcountries in die region (especiallySout Africa) would follow the Mrtiam example.Madagascar can hardly improve on the alreadyatractive tax centivesin existingcente whichits competiorscould easily adjust (as, for example,Singapore did tD counterHong Kong). 7.23 T±nglmnismuf.orosho.tba.mkin On the assumptionthat over h net decade Madagascarwould be able to diversifyits economyand embarkon the pathof sustainedgrowth, the demandfor innational financialsercs wouldgrow tremendously (gven the significantpotential of the Malagasyeconomy). The volumeof f cial tmsactions mightthen atain the criticalmass which wouldmake viable an offshorecenter in Madagscar geared mainlytowards satisfying the needs of the Malagasyeconomy (on lines of the cfshore center in Manila,Phiippines). Such a centerwould have greaterchances of successand of wihstandingthe oDmpetitonfrom other canters as its drivingforce would be the Mala eonomy itself.The stategy iold, therefore,be to avoid the 'brassplatWor purely offshorecenters (whichare solely inrationaly orieed) in which Madapscarhas clearlyno advange in the regionor comparedto other offshorecenters. In order to favor the developmentof a future oshomr centerwhich could servce the Malagasyeconomy, short and mediumfinancial policies sbouldbe so deised to: (i) promote ransacbns between domestic banks and offshore financial nsu withi the global frameworkof a gdual liberlization of exchamgeand credit controls;(ii) provide ncetiveslsgkguardsto oter financal iiutions (notably nsurmce compaies, venture capital firms) to go on inional financ markets; (Iii) allow export enterwises, especiallythose operat under the Free Zone Act, to raise finance(both trade finance and loans) from offshoreunits; and (iv) developan appropriatelegidative, prdntal and regLuloryfrmework m line with the growingrelats betweenthe offshoread domestic financial system.. 127 Ac:eleratingDomeslic Ivestment Thmadg Least

7.24 CM"pandannzagtleing: Oneof the mostattrtve financialvehicles for encouragingdomestic invesnent is laing. Leasingis basedon the conceptthat assets in the form of plat and equipmentgenerate profits throughuse ratherthrough the mere fact of ownerip. It can generallybe definedsimply as a commercialagreement whereby an equipmentowner (the lessor) conveysto the equipmentuser (thelessee) the right to use the equipmentin returnfor the payment of specifiedrentals over an agreedperiod of time. Ihe legal ownerof the asse can thereforebe differentfrom the user, who canbe seen as holdingthe econmic ownershipof the leasedassets, which includesthe right to use ther beneficiallyas well as the riss relatd to the loss and obsolescenceof the equipmenLIn developingcounties such as Madagascarwith underdeveloped capitalmarkets, leasing may be the onlyform of medium-to long-termfinace availablefor capitdal equipmenton suiable terms.Leasing is beingincreasingly used in developingcoumtries as a method of fiancing eqipment-

7.25 Poicy framework for develing leasing: The developmentof leasing normaly raises a mmber of legal, accountingand fiscalquestions which have to be consideredin the context of the frameworkand stada alreadyexiting in a given county. The legal questionsinclude protectionof tite in the leasedassets, responsibilityfor m indemnityin fivor of owner, restrictionson use of the asset creationof liens or other charges,insurance, renas and defaultin payments, anl right tD repossession.Questions are also raised as to accountingprinciples applicable tD ieased assets and their depredation. Fisa questionsnotably indude the cpital allowance entitlementfor firmswith leasedassets. The fiscalimplications for the parties may also vary from cnunry to country.Thesequestions wil haveto be answeredin the first placein the lt of exidsting Malagasylaw of contractand property.

7.26 In Mauritius,no s wawere nade to the law whenleaing was introducedin the country. Eistg pwvis of the Civil Code were consideredsufficient to enable leasing tasaction to start No law reling to leasingof equipmaetwas passed when this conceptwa introduced. QuestiDowere asked aboutwhether companies would be endtiledto capitalallowance under incometax reguain, sincethey do not ownthe leasedequipumet Withoutany amendment being madeto the law, the C one of nome Tax agreodtht no objecdonwill be made to capital allowancebeig claimedfor leased qipmenat. If such an administrativemeasure is not possibleelsewhere, then statutoryprovion shouldbe madeto enablecapital allowance for leased equipmentso as to promoteleasing. Malagasy law wouldalso seemto be adequatefor init leasing transactions.Expenence wfll indicatethe directionin whih the law needs to be amended to accommodatethe actual developmentof leasing.

7.27 Features ofl nkhmujnat: Leaseequipment may be providedto both self- employed or to firms. The leasecon maytypically range fm O threet sevenyear dependingon the type of equipmentinvolved. However,the minimmnvalue of equipmenteligible for leasingshoud be specified.It wouldbe the responsibilityof the dient to maintin and servicethe leased equipment. The client wodd also have thresposibility of in g the equWipmemand assignin the insurancepolicy to the leasing company. This factor impliesthe developmentin parallelof the insurace sector. Leasepayments could be arrangedon a monthlybasis. In ceruin case,thes paymentsmay be effectedon a quarterlybasis; eachintament wouldinvolve a composite servicig of bothte interestand pricp elents. The conceptof leasingwould carry moreweight as a financingmechansm for overcomingother financial constraintsprovided it is properly 128 monitored. Even if the inttuto of leasimgis set up, it would need geeral acceptanceand the proper enviroment for its feasibility. As state earier, a leasedequipment would be valid if its usefulness has been demonstrated. Even so, the debt servicing aspect will be directly linked to the maretability of output, seasonalityof productionand the prevalece of facilitiessuch as 'fisac valoir or advancesto farmersagainst standing crops. Withoutthese, the dmelypayment of regular itallmes wouldbe avoidedand that, it turn, may stat affectingthe generalscope for providing lease finance.

7.28 Iig gusmaiment undfarmem: Although leasing ofequipment exists for qui sometime in Maritius now, it has not beenvery popularwith smal enterpris nor with individualfarmers. The difficultycomes from the side of the lessor of equipmentin that althoughit is insured,as required,the lessoris unwilingto simplytake the leasedequipment as securityfor his stake in it It is also likelythat in Madagascarthat a groupingof lesseeswould become useful as a meansof promotingthis notion. The groupwould need to be attunedto the conceptof joint liability on the equipmentand should explicitlyendorse this conceptbefore embarliog on the venure. Tedhnicaloperators of the equipmentrather than individualfarmers tend to use leasedequimet. They provide the servce of land improvementby use of the mechanicaldevice leased from the leasingcompany. Someelement of groupingof famers is a pre-requisitein popularizingthe demnd for this type of fiancial facilityamong famers in Madagascar. The group shouldhave a legal characterfor itto opeate the leasedequipment on non-personalpreference basis. Theetent of work to be done by the leased equipment,its turnover,the ready avalabilityof pensivespare parts equallyon lease shouldall be consideredbefore engagin a lease.

7.29 Role and nicm of finandal markets: Incring trade and invmnt flows both faiiae and are favoredby the developmenoffinnmcii marketswhich allowfor variousdebt and quityinstruments to be issuedand traded.Traditonally, the are twosegments of fincial markets whichcan be diiset moneymakets wheredebt intuments of up to one year in matmityare issuedand aded, and capitalmarkets, which coverlonger-term debt ad equityinumentsJn the immediateterm, fiacial marketdevelopment in Madagascarshould focus on the shortersegments of the market Thekey elementto this is the developmentof a well-fnctioningTreasury bill market, an issue ta also relatesto governmentdebt managementand to monetarypolicy (see Chapter2). Furtherdevelopmens to the marketcan occur through other intuments used in the inter k market and the dicounting for instrumentsrelated to self-liqudatingtransctions (asdissed in the section of domesdctrade finance).

7.30 Currenty, banks in Madagascartend to rely excessivelyon the liquiditywindow providedby the CentWalBank which in principleshould be a last resort. in a well functioning finmcial system, commercialbanks hould first adjust their overal position by recouse to the inerbankmarket It is onlywhen banks' porffolioneeds are inuiently fiudedby theirown overal reurc that recoursemay be had to the cetral bank as a lender of last resort This not only impos disciplineon commercialbanks in their treasur cznct but also avoidsdeveloping an inflationar tendencythat can result from extesive indiect CentralBank financingof the private sector.Reviewed below are someof the key moneymarket instruments that coulddevelop over tme in Madgcar giventhe app incenive and sueviory fiamework Also outined belowis 129 a basicstrategy for developingcapital markets wherein debt instument of longermaturity than one year as well as equitycould be issuedand traded.

7.31 .the presenltgnox nmt tiesmajrke: Presenty, the governmentissues two typesof debt instumments.The first - 'Bons de TrdsorClassiquer (BTC) - is sold with a couponat face value with denominationsof FMG 1,000. It exists in two forms. CategoryA BTCsbasically representsa state lottery and is usuallysold in scrip form (deliverancede titre), with a maturity of one year. Every six months, 20 BTCs in this categoryare awardeda prize of FMG 10,000. CategoryB BTCshave maturitiesof up to five years on which coupon rates have been unchanged sinc 1987. The fimdsraised by these BTCs are negligible.The other type of governmentdebt insuument- 'Bon de Tresorpar Adjudicadon(BTA) - is also sold witha couponbut at a disoount. BTAs are available only in book-entry form ('compte courant") and in minimum denominationsof FMG500,000. They are isued at the beginningof each month in mahtutie of six and twelve months. Subscrptionscan be enteredwith the commercialbanks which act as agents and are centalizedby the CentralBank which consults the Ministryof Financeon the maximumdiscount acceptable.With couponsof 15 and 15.5 percentrespectively for six and twelvemonth BTAs, the effectiveyield is aroumd20.5 per centfor 6 monthsand 18.5per centfor 12 monthsBTA (February 1991).In pracdce,the outstmandingvolume of BTAshas been constantfor a long time withPMG 1 billion in 6 monthBTA and FMG 0.5 billion in 12 monthBTAs being woledover every month. Thus,govenment securities are presentlya very marginalmeans of ficing the govemmentdefiit comparedto CentralBank financing, amountng to less than one percentof the latter (see Chapter 2).

7.32 Revampingthe Treas bill market: Since the Treasurybill mart can be a conduciveelement in promotingfinancial market development, it is iportant for the Gov ent to careully reviewhow it couldrevmp this market.Despie their lucrativeretun, ivestor interest in Treasurybills has remainedminimal. Ihe Ministryof Financeshould consult with financial instutions to invesdgatewhy there is such a poor responseamong investors. The Governmentcould also begin undertang various measureswhich could help increase confidenceand interst in Treasurybills aong investors.First of all, all referencestD obligationsto investin Treasurybills shouldbe removedfrom eistig legisl To saveon tive s andfor tansparency, these bills shouldbe sold at a straightdiscount with no coupon. A singlebut importair. tep would be to ensurethat the resultsof Treasurybll auctionsare annomcedand published immediately after each auction. It is crucialthatthese bib becomefreely negotiable. Increased liquidity of Treasury billswould also allowBCRM in duetime to conductopen nmrket opaons using theseinstruments. Futu Treasurybill suanceshould be carriedout in the contextof transformingpart of the existing domeic debt of the Governmentand of reducingthe dependenceof the Treury on adammesfrom the BCIRM(see Chapter2). The Treasuryshould attempt to selllarge volumesof bils in matuties whichsuit investorsliquidity prefernces. The objectiveshoud be to deepenthe short-zetasegment of the governmentsecurities marskt The agencyarrangement of the Trasury with shod be reviewedto ensurethat they contin ade incives. 7.33 The organizationof issuancepolicy for Tesury bils shouldbe strengthened.As in other countries,BCIRM manages Tres bil es. Conseqendy, it should establishand maintainan infomationsystem on the domesticpublic deb Thissystem sh&ld irclude statistical dat on totaloustaing notesby holderand the maturityprofile for Treasurybils. Such a system woud help the BCRMt predit the net flowsof reservemone injectedinto the bankingsystem due 130 to governmentoperations (see Chapter2).Centralizaon and comp of the present manual book-entrysystem should also be considered. 7.34 Bankers' acceptances: Banker's acceces (BAs) are an extensionof domestic trade fiance that facilitatesself-liquidating transactions. They couldbe introducedonce Madagascar has an adequatelyfunctioning market for trade bills. BAs are also the cornerstoneof moderntrade finance. They represent a securitybacking commercialindebtedness of a borrower whose bank accepts a bill of exchange, issued as a result of a tradetransacon. n counties where these instrumentsare activelyused, they are tradedin the markltplaceat a margin(basis points) over the mostliquid and highestgrade instrumentsavailable in the local market(treasury bils). While these instramentshave the fill credit worthinesso, -e bank acoeptingthe bill of exage, as well as the underlyingtrade transactionwhich renders the trnsacin self-liquidating,supervisory authorities shouldbe carefil to understandthe nature of the contigent liabities whidhbanker's acceptc representand shouldmake sare that the balancesheet of the bankreflects these contign liabilities and the bank's total exposurein the marketplace.

7.35 Certificates of deposit (CDs?: Oftenused to generategeneral purposeshort and mediumterm fundingfor commercialbanks, these instument can also be traded in the money marketsif they are classifiedas negotiable.Nonnegotiable CDs ('bons de caisse) are alreadyin use by banks in Madagascar.Negotiable instments could be used espeay once an activeTreaury bill markzt is developed.Negotiable insuments normallytrade a few basis point below non- negotiablecertificates of depositfor the simplereason that they can be tnsferred as manytimes as necessaryduring the life of the document.Rates will vary amongbans as perceivedrisks are evaluatedby the itvestors. In geneal the ension of CD issing power to non-bankfinancial institutions,when such instrumentsare oftendesignated Certificates o vestmentif theseistiuto are prohibitedfrom ting deposits,shoud be closelyspervised by the montary authrity which normallysupervises financial institutions. Depending upon the skill atd powers of the monetary autority, a gap may existbetween the publicperception of the degreeof oversigt exercisedby such authorities, and the reality, which may lead to over-borrowing and entu default by nn-bank financialinstitudons which wouldeventally eroidethe pubies confidenceito financialmarkt in general.Adequate supervision is thereforeessential in this and other aspectsof fiancial mark.

7.36 Con:arcial "perIn a mnuberof counies with emering seuites markets, investorand corporate preferences have combined to allowthe issuanceand secondary market traing of short-termcorporate debt, otherwiseknown as commercialpaper. Commercialpar involvesthe secunization of debt which would, in other cim es , be proffered to such issuers by commercialbanks. Onefrequently observed feature of devloping countrieswhere commercial paper flourishesis a shortageof suitablebank credit However, this is a money market inrument ta generallydoes not appearat an early stage in the developmenof finamceas is presentlythe case i Madagascar.Nonetheless, over the mediumand long tefm and wit an appropriatesupervisory frameworkand other financial ructure, commercialpaper couldbe issuedby majorenterpises in Madagascar,particularly those Ihatare also likelyto becomeissuers in an evetual bond market, such as publicutilities (power and . It s eal dat, where a publicmarket is establishedwhere commercial paper may be issuedand traded,that (madditionto normal supevisr controlof aUfinancial instruments by an independe supevisry commission)an independentrating agencybe establishedto establishcredit worthiness of the issues. This wouldprovide investors with criteria for the rate structureto be appliedto varous financialinsuments in relato to each other.

4 - -,; X 131 This in turn requires that Madagascarbegins to fiurter strengthenthe eisting frameworkfor accounting,audit and financialdisclosure discussed earlier (see Chapter3).

7.37 Capital markets development:A well-functioningcapital market is one of the pillars of a developedmarket-oriented economy. The size of an economy, its savings rate, business environmentand structureof ownershipare importantdeterminants of how feasibleit is to develop a marketfor debt securitiesand equities.With an economywhich wil remainprimarily agricultural in the nearfuture, many economic transactions which are not monetized,domestic savings rate below 10 per cent of GDP,a per capitaincome only over $200,and more than three-quartersof household consumptionspent on basicnecessities (food, housing, clothing, fuel), there is no immediateprospect of establishinga full-fledgedcapital market in Madagascar.In comparison,other developingisland economieswhich have developedfledgling stock markets such as Jamaica and Maritus are economieswhere only about 6D and 40 per centrespectively of householdincome is devotedto basic consumption.At the sametime, Madagascarenjoys the advantageof being able to carefullyprepare developmentof capitalmarkets and therebyavoid the pitfallsthat have'.'en experiencedelsewhere Such a plannedapproach to capitalmarkets development can help avoidsome of the difficultiesfaced by newlyemerging stock markets in some developingcountries. The expenenceof Mauritus where a Chamberof Brokershas existedfor almosta century,provides some lessons for Madagascar(see Annex7.2). By takdnga long-termview of financialdevelopment in Madagascar,one couldenge a rudimentarystock exchange in the mediumterm for whichpreparatory measures could begin soon. It shouldbe stressedthat confidencein the economyand in the famework for secrities transactions is essentialfor a viable securitiesmarket to emerge. The fiscal and legal fiameworkcan be made to evolvein a way to promotethe emergenceof a capitalmarket which generates confidence.

7.38 Obiecives or caital marke develonment: Beforeembarking on a progrm to prare the developmentof capitalmarkets, the goverment should be dear on the objectivesfor capitalmarkets development These can generallybe staWedas the followmg:to increasedomestic savings;to improvethe efficiencyof the allocationof savimgsto inrvestmentin the public and private sectors; to broadenthe base of ownershipof real and fIanzial assetsand thus to indirecly improve the distributionof income;to makeinvestment capital available to a broader rangeof the population; to ensure the availabilityof long-termfinancial resources, while minimizingthe risk of financial instability,by lengtheningthe term of fimancialassets acceptable to saversand establishinga proper frameworkfor term tansformation by financialinstitutions; and tD widen the range of fimancial services avaible thrugh financialinstituions and to improvetheir operationaleffectiveness. A preliminaryfeasibility stdy shouldalso be undeaken to moredefinitively establish the potentialand nature of an embryoniccapital market in Madagascar.The stu shouldassess, among other things, the poteni breadthand depthof investorinter in securitiesand the ratve importanceof variu motvations for holdingshaes (e.g. control of an enteprse, dividends,capital gins). The study shouldexmine the poteial demandfor secrities amongboth individualand istiional investors, the latter includingbanks, insurance and socialsecurity plms andpotendal unit trusts or mutualfunds whichmight be established.On the demandside, potentialissuers of secrities shouldbe identified amongventure capitalfirms, enterprses and utilitycomanies (IRiAMAand FIT) who might e equitiesand bonds.

7.39 _ _ _ ; ._f_ Once the feasibility of a rudimentarycapital market is clearlyestablished, a nmmberof prepaatory steps can take place. As a fir step, a commie (an embryonicCOBOTA- Commission Boursiere de Antanaivo) sbould be set up with the followingmain tms of referenc: (I) to recommendmeares tD be tae to 132 establisha mechanismfor the purchaseand sale of securties; (i) to promotetoe conceptof secriies trading amongsavers and investors m M sr); (i) to be responsiblefor the developmentof the legal, regulatoryand supervisory amework and (iv) to oversee the developmentof a stock exchmgeover time. The mainplayers in the capitalmarket should be involvedin the process from the beginning: io the Ministryof Finance;(i) the CentralBank; (i) the commercialbanks; (iv) the insurancecompanies; (v) venture capital firms; and (vi)vari employe', buiness and profssional associations.Externl tenical assistanceshould be sought at an early stage to help guide the comittee in its technicalwork- The commitee wouldbe responsiblefor elaboratingthe rules and regulationsunder whichtrading wil te place. It wouldalso have to enu that enough Malagasy are wainedabroad in boththe insdtional aspectsof a stockexcage and in stockbrokingactivities so that by the time a stockexchange is officiallylamuhed there will be adequatetrained personnel. Ihis has been a major pitfall of the }maitin expeience where scnt atention was given to the trainmg of stocbrokers who, were dus in the init months, umwMingto play an active mle in promotingthe stockexchange which was in fact their institution.

7.40 Sunerision o'securities markets: Supervsio of trading in the securitiesmarket is essentialif sharesand bondsare to becomeatrctve assetsin Madagascar. Otherwise,the public mayjustifiably feel too exposedto the risk of marketmaniation and other abusesand may decine to invest. The objectivesof reulatin and supervisionshoud be: to prvie for ful disclosureand wide disseminationof accae informaionabout the companieswhose stocks and bondsare traded; to prevet varous formsof market ggg to protct the interestsof minorty shareholders;and tD encourage ithedevelopment of specialzed financialservices and tchniques. It Is dear that the ii,rnvemnens in the leg al se and the frameworkfor aconLu adiftl and flmadal disclosure di'scussedin alater 3 are absolutel crucial rerequ peelm of cagital markets in M la. For the puposes of adequatelegisatio for disosure and shareholderprotection, some sort of supeviso body is ncessary, For Mdagasr, such a body shouldially be relativelysimple and inxensive, given gm.embryonic nature of the ma that is expectedinitially.

7.41 CoA of ap markets develop Whilethe costsof supervisionin a capital marketare normlly born by the government,the opating costsof the maet shouldbe bore by the private entises who ae involved. lhese costs need not be high, given the reatively simple mnrketone couldexpect in Madagascar.For example,feats of sopisticed and well-established stock exhanges such as an expensivebuilding on a separatelocation, electroic price boards nd automaticcearimg and setdementsystems would not be necessy unti perhps a much lt stage of mauration of capitalmarkes in Madagascar.An embryonicsecuities marketwould require only a few key elementssuch as a periodicmeeting place, accuraterecording of asactions, and basic communiions linis among broke and investors. h prelimiy feasibilitystudy mentioned above should esablish that privateenep s wit an int nm capia mares developme are willingto incur such basic costsof operatinga rudimentarysecuriies market 7.42 WRijaLogfing- nsdures: Initially,the bank and financialinstuos couldac as dealers In securities.Enterprises wishing to obtan long tem finmce shouldbe encourged to sek equity finance. Bank activies in the capitl market shold, however, be insulatedfrom noma credit and lending actviEtesm order to minimizepossible conflicts of itest The BCRMshould carefiullymonitor commrial bans' involvementinte serties markt ad appopriate supeviy ratios shou1d be establishedto ensure tht bak are not overty exposing depositors'money to speculive practices. The reponsibi of deales can be ensmed if they are made to undewrite 133 first issues. Tradingcould initiallytake place once amonth until activitpicks up, usingthe cs system used in Mauritiu, describ below. As the marketgrows, its insdtiuonalfeatures could be progressivelydeveloped to handle a larger volume, broader range and greater frequency of tansactions. The possibilityof forming a twinningarrangement with a more establishedstock exchangecould also be consideredto improveknowledge and practicesof marketparticipants.

7.43 Demand and supnly-related ineentives:The governmentshould help ensurethat there is adequatesupply and demandfor seurites to encouragedevelopment of an activecapital market On the demandside, the followingincentives could be given, so that securitiesare traded throughthe authorizeddealers:(Q) tax exemptionon dividendsearned for the first three years; (i) exemptionof stampday; (iii) exemptionof registratin dutieson trmsfer of shares;(iv) tax exemptionon profits earned from the sale of securties by idividuals (a celing wil have to be determined). However, such incentivesshould only be consideredonce there is a thoroughassessment of the taxationof nai finacial instruments. A fudlment principleis that all facial instumen shouldbe effecively taxed evenlyto begin with. Only once this is the case cantemporary tax inceives be considered. 7.44 On the supply side, the governmentshould give serious onsideraton the prospect of using public offering of viable state entprises as a means of acceleratingcapital markets developmentThis was successfullyused in Britainand France in the late 1970sand early 1980sto popularize shareholdingamong the general public and has also been adopted in a nmber of developingcountries sudc as Chileand Jamaica.The privatizationprogram in Nigeria has created over a half a million shareholderswho have interest in over twentyprivatzed entprises. The programgenerated a side benefit in euhancng the professionalexprse of legal, accountng and financial firms in the country. Smlarly, a handful of viable public shaeold in bakig, insurance,utilities, industry, and commercecould be ientified im y and prepared for an veal publicoffing to the M ;aageneral public. Thesepublic offerings should be preceded by a well-plannedmedia campaignexplaining the nature and -benefi of shholdings and should seek to eure as broad participationin the stockmarket as possible. 7.45 nitial trading ste: Under the a casier" system,stocks are dlassifiedin price-related groups and prces are not allowedto vary beyonda certain (about4%) betweentwo trading sessions.This systemserves a two-foldpurpose: @)gradually developing a stockmarket culre in te countty until a full-fledgedstock market is established;and (i) preventng the market from succumbingto too much initial speculadon.As the volume ic substantially,more meeting could be held unil a full-fledgedstock maret finally emerges.The mert of this apprach are: @i it allowsproper planningand sequencing;(ii) a 'securtes tading culture' is graduallydeveoped; (dii)it is a flexibleapproach which moves in step wMithe geeal economicdvlo and (iv) it is easy to implement Commercialbanks couldplay severl roles m t securitiesmarket as O) brokers, trough the setting- up of separe su iary coMpanies,seatly capitaled; CH) underwrite; (iIi)issuing houses; (iv) holdersof seuities; and (v) fund m 7.46 Isusnonn cofgra bonds:Bonds could also at a laterstage be tansactedalon thesame lines as indicatedfor equies especiallyonce de is a relativelyactive money market in whichshort- term instrumentsare tradedas describedabove. Ihe best prospectsfor isuers of such bondswould appeart lie amongutilities (wer and tunicatios companies).Recent expriece in the telecommications sector demonstra te significantwiness witiin the priva sect& to paricipate in the finaing of bady-neededinrasructlure.Experience in other developingconries suggestthat there is therefore scopefor the utilitiesto developappropriate m finai 134 n which coud be sold to the same idus or enrprise who sube to utility sevice. Ihe Govementshwuld patlarly considerdie inoduco of such new insumen in the con of restuctmingi PIT whereinit shouldsewk financeand invesimentstmaegies for sr. developmentof. teecommunicationsnetworl 135

8.1 The precedingchatr of this reporthave reviewedthe main fares ofthe exn financialsystem in Madagascarand analyzedthe key aspectsof futurefinacial sectordevelopment policies,infirastrcture, institions, isrume, and markets. In order for the governmentto arrive at an appropriateand coherentstrategy for financialsector development for the rest of the decade, an overallagenda of key ises and reated govemmentpolicies must be established,followed by a definitionof priorities,and identificationof an appriate sequencingof policyactions. At the same tme, financial sector developmentin Madgscar cannot be exp o Dfolow a TblueprinC establishedby the govement. The speed wih which new inaumats, imitations and markes emergewil dependcrucially on other macroeconomicand sectoal policieswhich directly affect the real economyand the responseof the privatesector to the incentivestrcture which is created. The pace of any financia sectordevopment strate shouldtherefore be contully reviewedin the light of these developments.Reviewed below are the main directi for an initialfcial sectorstrategy for the rest of the 1990swhich are suggestedby the analysisof the precedingchaptets in thisReprt

fIg[ and W eskeo of the Ma Finncd-S edzo

8.2 MmitWma LUberalimo Afteralmost a decadeand a half of socals econmic policieschaacizd by heavy sta irvent both the finac and rea secftos, Madagascarbegan showingthe begining of significa financi libin the latter part of the 1980s. Amog the key aspectsof this lalizat ws the open of the bankn sectorto prvate capital in 1988, resulting in the entry of a new private bak and subsequentpartial pnSv aon of two of threegovment-owned ban. Therebasalso bee progressivehlaizan of interestrates which,since November 199O, have been fuly fired. Selectivecredit policieshve also beenprogressedmantled. At the -m tme, substa l restructing and cleanp of lok portfDlioshas movedthe bang systemfrom its state of quasi-insolvencyin 1986to Oneof overall soundnes and profitability.Madagascar also bees one of the pioneer,g countre in the Afica and IndianOcean region to beganmoving away from direct to indirectinstuments of monetarycoal. In addiion it doesnot showany unduly dr yuxation of the financialsector found in some ote couties where high reser requrements ar coupled with explici fom of

8.3 Orall Weak In nd ca's fin l system operatesin an economywhich has one of the lowest aving rate amowgdevdoping cotrie ad wbosefinancial dept is among the mt shallow. Part of this is simply due so the faicttat M adagascar _enniamong tf fiftee poorestcounties m t wod. However, a amber of othe counies of similarincome levels in Afica and especialyin Asia, exhibitmarkedly hgher levelsof aggrgt md financialsving. Whilenomial iterest rates on both depst and lendingare now fredy set b commeial banks,real i t raes for mostdemad ad shorten depost (clud g CDs) are sal negaive, reflectn a inflatio rate whichhas hovered siy above 10 per ce in recen year and nomin depos rae averat 9 per cent The maority of the popuation st sffer-s from very limited or w acces to fiancida svices NS. the clarly visible reformsof recent years, there persi a problemof confidenc in esting fia iuto ad istuments, party reflecting conined suspicions and fa of the financial system by past policie. 136 8.4 Inaduades in Poriciesand Ihn : Monetary,regulatory and supervisory policiesremain inadequate for the market-orientedvocation that the Governmenthas now chosenfor the economy. The CentralBank's move toward indirectinstruments of monetarycontrol remains hamperedby its continuedivolvement in fincing activitiesthat shouldnormaly be borne by the Goverment budget. An adequatesupevisry and regulatoryframework for thefinancial system has not yet beendeveloped, reflecting the long-standingpast neglectof this key policyarea. At the same time, the basic infrastucture for financialtransactions, notably the text and practicesof relevant laws, accounting,audit and financialdisclosure, requires substantialimprovements before new financialinstitutions and instrumentscould be expectd to operateeffectively.

8.5 Stutrl Imbalancesin Financial Sector Flows: Significantimbalances persist beween the demandand supplyof financialresources. Theseimbalances are compoundedby strong biases in the sectoral allocationand term structure of lendig. Between 1987 and 1990, the consolidatedbalance sheets of banksshowed high credit-depositratios, generally in excessof 90 per cent Suchhigh ratios havebeen symptomaticof highrates of non-performingportfolios in the past and contined over-strtching of bank resources. To a significantextent, this situationreflects the inabilityof banksto place theirresources in alternativesother than customerloans becauseof poorly developedfinancial markets. As the economyis furtherliberalized and increasedgrowth stmnulaws demandfor financial resources, this imbalancewil growunless the financialsystm ipwrovesdeposit moblizaon and the financialsystem is widenedand deepened. At the same tme, the marity stmcture of both bank dqeosits and lending remainssignificntly biased towards the short-tem, ma term financeless developedin Madagascar han many other Sub-Sabara or low-income cotries. Pardy as a result,bank leading fvors commercialand tadig acttes much more thian activitiesin primary and industia sectDrswhih require longer-tem funds. To some aent, a prious bias towardsallocation of financialresources to the publicsector has been mitigatedin the latter half of the 1980s. However,continued improvement in public expenditure em t and resourcemobilization should improve the scopefor releasingmore financial resources for the private sector. Credit is a key constaint for a majorityof firms in the country-none but the larger firms have accessto formal credit sources.

8.6 kadgmuadesitiohe FinanuialSvte: Theexstg financialsystem in Madagascar is heavilydominated by bang insotins which by tiemselvescannot be expectedto sasy the ful range of needsof an expandingand divrifying economy. inaddiion to banks, there is usually a need for an intemediate layer of fiancial instui and instuments which can also evenaly actas a bridgebetween the short-tern moneymarkt and the lo -term capitalmkets. Wihout this contnous amyr of financialinsdttions and instrumentsacting for the diversematities of fimds on the financialmarkets, the free marcetdeternation of equilibriuminterest rates and actioning of Treasurybils, for example,camot be completelyeffective. At the s-m tine, the surveyof user of financialneeds conductedfor this Report(Amex 1.1) and the eaminton of the fincial system conirms that several specialfianing needs are not being adequatelymet These needs mainly pertainto individu sectors(agriculture and housing),tem fiace (mediumand long-termfinamce), and cerain other typesof finance(trade finance, leasing and equityfinanng. In all these and other areas, adequatefinancial se to small-scaleeconomic agents ar espeialy lacking.

Ada nb for MI andal Secor Deelhopmm

8.7 anheg the Thrust of Public Polcies In minoe: Giv the present tst on maret orientaton, finacial secor developmentin Madagscar shouldproced larely throughthe 137 initiativeof the private sector. As is now becomingtie case, the previous emphasis on state ownershipof financialinstitutions, selective credit policies, interestrate and other controls, and privilegedaccess of publicinsiuons to financiadresources should now giveway to a new strategy for financialsector development. An importantnew role exists for the Governmentin terms of providingthe necessarysupportng policiesand iucture to ensure that the supplyof financial servicesis commensuratewith demand, iat the financialsystem effectively mobilizes resources and allocatesthem efficienly by pooling and pricing of risk in accordancewith retuns and liquidity. This implies a findamentallydifferen set of policies toward the fnancial sector than pursued previously,just as is the case for real sectoractivities.

8.8 PriorityIssues florrlnl Acsons: Giventhe ongoingtransition from an essentially socialistto a market-basedeconomy, the agendafor the new approachto financialsector development is wide-ranging.Based on the analys of precedingchapters of this Report,five broad policyissues can be identifiedwhich should be given priority conside in formuating a financial sector strategy. First, the resourcesof the financialsystem as a whole shouldnot be subordinatedto the needs of through captive financingfrom the Central Bank, post savings and conractual savings instuions. At the same tme, as a major user of finacial services, the Governmentshould reorient its depository,borrowig, leading, invesme andpayment operations so that these favor rather than iede the developmentof financialinstitutions, instuments and marketswhich can more effectivelyservice the needs of the real economy. Second,key aspectsof macroeconomicmanagement essenial to financial secr developmt should be reviewed and strenged In particuar, inddepece and g of the BCRM shouldbe pursued to ensure that tfie central bak is capble of formulat nd executinga credible role in monetary management. At the same tme, exdcangeconrols and tax policiesneed to be carefiulyreviewed continuallyto ensure adequateincentives for developing,among olher things,dynamic contractual savgs institutions. Third, adequatesafeguards in he regulatoryframework and other aspects of financialinfrucu need to be rapidlydeveped to protectsavers and lenwersalike and to ensure dt the financialsystem can be deepenedand diverified. Fourt, the govemmentshould maxmize effectiveuse of privatizationand free z-e developmentas two poottial vehiclesfor accelatng financialsector developmentwhich simu oy enhanceprive sector roles in the econmy. Fifth, long-tm traig for releva public agenciesand the pre secr as wel as sensidzation of the generalpublic to financialissues must be iv promience in a financialsector strategy. Each of thesepolicy issuesis reviewedin greaterdepth below.

8.9 ______:a Presey, public finance m Madagascarreies significantlyon sevea sources of captivefinance with the financialsysteam Theseinclude the CentralBank (throughits advane and qusi-fiscal operatio), the postal savings and checkingsystem, and contracthalsavings instiuation msurae and socialsecurity). To ensure monetay stabilityand avoid pre-emption of resomcesfrom the privatesectDr, the.Government should aim to free these institutionsfrom eitherfomal or implickobligatios to financethe public sector. It shouldinstead improve its own domesticresource moblization trgh taxationpolicies and user charges. This copled withgreater budgetary disciplin and efficencyin publicexpenditures shoud help control inflation,mailng financil assetsmo attractive. Domesticpublic borrwing should be inmcreasinglydone trough he issue of govement seuries. The lte wouldbe a lincpin ifor developing financial mare in Madagsa which normaly use govermt securies as a b cmarkfor pricingother debt intrumfl. Alhough tiis reduceddndence of the publicsector is crucial,it is clearthat it is amongsiera actionsthat cn only be filly reized over the meim term oncealternative financig n wetapped. At the sametime, governmentexpendures 138 and invstment finced rough these alternativesshould complemen private investme which wouldbe increasinglyfinanced by the financialsystem. Furthermore,rather dtan engagein equity partcipation in enterprises,the Governmentshould increase the potentialsupply of equitiesthrough continueddivestkre of state shareholdings.Payments to and from the Govenment could also be chnneled tirough a moreefctive and largelypria-operated paymentssystem which coud include a girobank

S.l10 Srfghening magr,mmlhjtj fugamt. A first priority for strengtening macroeconomicmanagement for financialsector development is to ensure that BCRMdevelops the capacity for effctive and credible monetarymanagement. This implies an independentrole for BCRMfomulation and execoton of monetarypolicy which reqi re-establshingits fiances on a soundfoting and modifyig its ste accordingly.At the same time, BCRMmust establisha sttegic planto acqure the techical wherewial to play a credibleleadership role in financil sector development.Other aspectsof macroeconomicpolcies whichshould be reviewedinclude xchage controls an.t taxtion policieswhich might be effectivelyused to deepen the financi sector and improvedie efficiencyof fincial systemoperations. Present xchnmgecontols shouldbe reewed see how paymentsservices for exports and importerscan be imroved (see Chaptes 3 and 7 for examples)and how contacta savings instutions can further devdloptheir produt and increase -ther investmentreturns so that long-n saing ar stmulnaed(see Chapter5). It is evidentthat such chages need to be undere cautiouslyand that supevsory capacityof relevantgovernment agenciesIke the CentralBank need to be strengthenedaccordingly to mimize undue risls. 8.11 . n Iufraal A p onditifir fiu-therdevelopment of the finacial systemis the s ofaning a varety of safeguardsfor depositors and lenders alike. A keyelement is prudntial supvismn, e ay by the CentraBank whih needsto be substantiallyreiforced andshould form part of an overal programof strning the CentralBank to enableit to playa moreimportant role in macroeconomic,and especialy monety, poicy. Althoughthere is no need for an overhau of the legal and accountingfraework in MAdagascar,as is the case of many countrieswih a strongsociaist heiage, it is imperativethat legaltexts and procedus as wel as accountngrules, auditing practices and standads of financialdisclosure become modenized in order for dt fiancial systm to deepenand divsify. All theseeffts involveboth measur that could be imnedity as well as a processof chages over the mediumtermL The Goverment shoud alsojoindy undertake with financial institutions a reviewof the exstingpayments and tansfer systemand devlopmet of a programto upgade thesekey servicesto the econoW pe.trmed by the finacial sysm 8.12 ad Fe._rivtatn Zone Nelomevt Givenits considerblee potenti evidencedby its humn and natr resources,Madagacr ha great opporty to benefit from appropriaelydesigned policies towards priatzation and free zone development A significat nmber of developingand industil counies have activelypursued privazaion and free zone development,thereby benefitting from substantigaln to boh the finacial systemand real sector. Althoughmuch of Madagascarsongoig programof prvatiatio of vblestate enterprsesis likey to be undertakenthrough prive offengs, a nber of selectedentrprises can feu Ia a carefully developedprogram of publicofferings which could stntialy catalyzecapital market development in the mediumtm (see Chapter7). Pa demandfor eisig govement oldigs n banking,insrance, uiities, andpossibly oder m, is likelyto be high,as eidencedby substantal Oversubscriptinobserved in thehandful of shareisues in Madagascarin the rece two years. If viewedas a broad-basedpram fr populriigba hold, thiswould also help moderiz 139 fnancial abits amongMgasy savers and investon(succesful intatives in these areashave occurredin Chile,Jamaica MaLaysia). A the -amtime. Madagscar is wil posiionedto follow the Mamritianexample of eport devdeopmentthrough expansion of its free zone enterpisesector. Thispolicyhasa natura cornsquenceofrapidlyncreasingaccessof M anteprs to external sourcesof trade fianmceand improvingthe abty of the privatesector to assme and mage ri exchge risk 8.13 Trainng md Pui Infoatm l:The essenceo finmancialsystem development ivolves the bufldingof instutionsand asocat humanresourc, die inculcationof appropriate financal habits, ad hfaliai wit nd accessto financialinformation. Trainingand infirmation is a multiceted process that is crucial to successf financialsector deveopmet in countryliE Madagcar wheresubstanta scary of skils andinfmtion cooestwith a coideable potential. Under a mart-oiented ecoumy, privatefinancial insttionsos ds d be grivn an incentiveto leadtrig andpublic iformation programs in part wih the govement where dtis is helpful. A first stepwould be to creae a baking assocationindendent of Govermet (presentlynot the case)which could, among other tingps deveopa programfor profesinl rig of bankersat all leves. Rktaizing te pos savins systemtDopla a moredynamic role in small- scalessawigs shuld alsoentail a majorwaining pogam aimedboth at the newitiution andis potentiacientelewhich constut he maj7orityof e couny. he improm of the payments systemtrngh introductionof an mprovedchecking system should also be pa of a publicsavi cmpaig undertak jony by the Govermentand finansial st I. he fure developme of a capitalmarkets s d be faclitad by an eary programfo trining of stockbrok and securiy alys. Thisshoud be id by a publiccmpaign asscad withthe priatizain prgm to expin the nare andbenef of ownersp anddeai i secures. Tra g needs for Wgveme agenciesare also iort, pcularly in the are of supon for key istuo suchas the CentralBank, ad pilic dbtm FinaLly,the Govemen shoud ensurethat infrmati whichshould be in the puic doman is ready avable such a the reslt of all esting ad fiture Govermet securitiesauctions and c l marke ofibrgs, baselending anddeposk rates of bank nd ECIM refinacingauction rae. 8.14 _gj intoPhMnAclos: Meetdigectivdy e cheup of th substial andbrad agendasud leadto in th exstingfin ancial env nen as wellas developm of ne isftiuons, instrimentsnd marks. Eah of V!esepolicy isu in this agendain turn ental spedfic actin to be undertake by th Goverm t nd party in collaborationwith the prvate sector. It is dear thatpublic poliy actionswoul be simultaneuly requiredon severa fronts. Atentimtherefo neodsto be PM t the coordinationand squncing of these acions as the time spa for their design,imp and mart a diffemn, rangn fom te short term (witin two to dthe years),mdim n (thre Sofive yer), and beyondtothelongterm. Thercisalso dose i ee n varu fcets, of fianil s r de opm wit broademro ic ad sectoralpolicies, with ca meaues beig *pr uisitesfor ote. The sequencingplan proposd bdow is a Idicative attmt to begin devlopinga fimework for ordeing financiapdicies whichwud be muualy rnfng over time.

_dnzg Pbrides for 14nancdlSsetr Dn- 8.15 Appropriatesequencing of a financia secti dovelpmentpropsm etails mana ad coordinationof a seriesof policyreor, diagnosicand feasiblitystdie, ad htiua 140 buildingmeasures over a period of many yeas. To aeure the successof such a programand its coordinationwith other economicpolicies, it soud be overseenby a committeeat the highestlevel of the exective arm of Government In additionto stedfas Goverment commitmentand close collaborationwith the private sector, a combinationof materialand technicalassistance would be essental to realize this program Owingto its multiceted character,this programwould involve a range of policymeasures to be reaized in a series of overlappingphases. The timingand phasing of such a programproposed below is indicativesince the aual time horizonfor each phase would vary dependingon the individualtime fames of the speXic acions or policiesin each phase.

8.16 Neaterm meaures: Table 8.1 llyunesosb a series of measuresin the policy areas whichhave been extensivelyanalyzed and discussedi the previous chaptersof this Report. Most of thesemeasures could be initated if not completedwihin six to twelvemonths given hee necessaryelements. First is adequatediscussiOn and understandingof the variousparts of the program within and between varous Governmentagencies (nceably,the Treasury, BCRM, telecommunicationsauthonty, existig entityin the PrimeMinistrws Office in chargeof privatization, amongothers). Secondis a necessarylevel of dialoguebetween Goverment and the private and financialsector ( notably, oDmmercialbanm but also all contactualsavings institutions and a nuber of professionalassociations). Third is a minimumamount of exernal support,partladrly technical assistancein a number of specializedareas which requie further diagnosticor feasibilitystudies. Each of these elementsis disussed below.

8.17 Withinthe Government,there shouldfirst and foremostbe thoroughdiscussion and Iuderstiding of this program.amng key decimakers and staff of the BCRM and Tresury which shouldbe integratedinto a numberof ongoinginitiatives. Withinthe BCRM, the committee reviewingthe oental bank statutesshould complete is work taking into consideaion the proposed modificationsto strengthenthe legal, operationaland fial endenceof BCRM. At the same fime,the seniormanagement of BCRMshould engage in a comprehensivereview of the e'sting and fute objectivesof the centralbank in the coon of the formationof the proposedstrategic plan for BCRM. At the same time, the Treasuryshould actively review government debt management policies and investigatethe eisting weans in the issuance and marketingof Governmen securties. Institutionbuildig needsand measures shold be identifiedwihnthe Treasry to prepare for a more activegovernment debt Managementpolicy pricipaly relying on sile of Government securies to financeTreasury needs. A progrm for improvingTreasury cash flow forecastsshould also be identified. Witin the Government'sprivatzatiom program, the responsble entty withinthe Prime Mister's office (wstructureunique) should be dcarged with identifymgan appropriate programof capitalmarket offerings. The telsauthority shouldalso be consultedto help coordinateand help faciitate dopment pla for the natiomalpayments systeL

8.18 The first step in soicitg colaboradonwit the privateand financialsector should be the creationof a new professionalbanking association. This shouldthen becomethe principal interlocutorwith the BCRMfor the frmulation of a plan tD improvethe nationalpayments sysm The new associationshould taie the lead in engin in a new system of check design ad verificationwith BCIM providingnecessay supportin tem of changesin the legal famework for paymentsinstrumentsand in the operat ftmework of clearinghouseoperations. BCRMand the bank shouldthen jointy proceedtowards foanatiug a plan for an ifmationed cleaing and settlementsystem. Thisnew systemwould involve a pio testig stage Imitedto the capitalas wel as one or two other key provincial cl (eg. Tamata, Mahjunga) where tel'ins links can be exeed to impwvedsbortly or where alternativemodes

< f ~------:.: 141 Table 8.1: Nwtmnmfinl.fL ml memur.

POLICYAREAS KEY ACTIONS PREREQUIIE OR PARALLELACTIONS L Reglation & Adaption of PC 1987rIdefication to of manpower supervision bokng sector andlogistics plan to st banksupervision pat of Developmetof riskbred BCRMstategic devde me capitaadequacy ratios plan Updateof pydntial liquidity Finalizationof entrce guideines ire toacouncy

______~~~~~~~~~~pirofessio 2 Centra Bank stautes Developent of new BCRM Coordinationwih statesinding lengtened developmentof BCiRM tenurefor Board _en and strategicpln BCRMmndate in formuaton as wellasexecutionof pmetaypolicy. 3. CentralBank-Treasury Identificon of stepsfor lmet of nw mt finaa rlatiors compte removalof BCM ratesfor BCRM klding to claimson Treauryon ad dpoits fromTrasry revaluaio andaccumulated coorinatonwit reiew of __es a - mcmdtiesmarkm 4. Cenral Bak Sategic C h reviewof Coordinaiowith neiewof Deveqmnt l?lan BCRMorgndonal BCRMsutes ad _le, yso,m ethods, arulaion of exisemad mapow andlostics futuro of BCRM S. Monet oli Col of key cmmuercial S fghned inflOmaD bankdata on a bimontlyor temsfw monitringbanks we basis ad maagingpublic debts Elimina of an - authoziztionfoNr bank credits Discontinueuse of privat Flexiilityin itest rao collatel in refian spead (forcheu) in - ~~~~~moneymarks .wdonms 6. Govenn seecuriim Marketsvey for goveenna Formuatio of pla for secories; reviewof agency insitudonalsbuaghming of arranement of Treasurywith debt_manmnt capacityof baks; negotabity of Treasuryad acodin Treary securities wit DBCRM 142 Table 1l (cantinued

POuCYAREAS KEYACTIONS REQUSITE OR PARALLELACTIONS 7. Banking systm Encouragebmb to sablis Diuolve existig Asociatio new ad independet Profrsionulledes Basque. profesiNdnabaundng (APB) Examinefasibility of Completea estuctug pla inluding rii for BTMwith a view to Govnmt a odin i puivatison beak. in fan prgrDm of capitamarkt pubic offrng S. Payments systun Developnew systemof check Estbishmmntof new design nd eificaion; begn profesal baig idntificationof new ; coordinaon ith cladughousend- ationalniaton system;beg inasibiiydudy dedopmet pln for £ giro-basedpayments System___ 9. Postal rings Begin studyof sew corporat Promotionof .mll1-acale chater and plan for awing. groupsand lOCapital market of apprpriaste

18.CuyEbl madcis Eblfi&l joint coc_ toEEl_ o to of deveopmet study cpt markeft tecica auntnc to mst devlopmnt includingal key commissionin idfication of finamniaad profesiona rl qy pedg institutions u-wr sd traning progmgmfor capial markt PreiminSayity to MSSS deveopmt Datmad scop of invesdor deusd for _ecm IL Privatuion of public ldendficationof a selected Formatio of capitalmardks mntpriss numberof public entpriss - dep comamison candia for iture public offiinga to catye apia of data ansmission (eg. courie system,satlite _ s) could also be devloped in th nea term. Cwosul iowi e na ti l l nica s developmentplan wouldbe esseniial BothBCII and the banksshodd also be involvedin a sepaate fasbility studyfor he development of a go-based systemto complementthe extig paymentssystem based on checks.Primarily responsibiity for this study would appear to most logicaly lie with the existingpostal checking system (CCP) which already optes lie an embryonk girobank Finally, a broad range of 143 rese a win theGoveme, financialnd pri sectorsshoud be soughti thecommittee whichwould be set up to discu nd plandhe gwrdwork for a embryoniccapital market. 8.19 A rangeof extnl supportwould be neededto helpesure successof thisprogram and should be sought by the Govement at an early stage. Once it has identifiedan appropriate frameworkof near and medium term developmentobjectives, BCRM should engage extnal asistance to perform a comprehensivereview of is existing l structure, systems, methodsand acounting with a view to formulatig a strategicdevelopme plan. If needed, assistnce shouldalso be soughtto completethe adaptatio of the 1987accutng plan to bank for purposesof prudentialsupervision and for developrme of a systemof riskbsed capitaladequc ratios and new liquidityguidelines. The Treasuryshould seek experthelp to assist it in a surveyof thegovernment securities narket and idenificatio of an insttutional hning plan for improved governmentdebt managemit. Paymentsspecialists should be consultedto help identiy anddevelop the new systemof checks,the impod earighoe peratio systemand d proposedgiroba Specialistsshould also be soughtto helpthe postalsavin isttion developa new corpora charter and organzton plan to plan for its eventul autonomyfrom the Treasuryand its operationas a fill- fledgedbaning instittion, beging withits role as a deposioryespecialy for small-scaleeconomic agents. Extena expertiseshould also be used to completethe financia andog n audit of CNAPSand to assistin the reviewof the regulatoryfiamewo and tauxationand emxcage control regimesperning to coraca svgs ins . EM in capitalmarkets reglation and developmentshould also be made availableto the capitalmarkes commissiononce it Is esblished with cleartem of refeence

8.20 Completonof somneif nt all of the abovenear-term measures woud leadto a sewnd ad third phaseof the fincial devement proga whichcould respecively extend for Up to thirty six months (mediumtrn) or beyond to five ya or loger. The major eop in the fimcial sectorduing the secondand tird phas are emacally sbownin Table 8.2. Many of tese developmentsare of the nue of institutionaldeveLpment whih is necessarilya gradua Process. 8.21 A majorpolicy objective of the Govement duringthese two pses is to provde thebasis for effectiveand relativey indeendetmoneay andfisa policies.Ihis objectivewoud be achievedon onehand by providingthe BCRM with a soud financialfoting, a strongbasis for lega d dece, andthe acqdsition of thenecessary eprtise in liquidity economic forecasting,, ad otherareas of monetarymanagement ad finni policy. At the sametime, the Treary shouldhave acquired the necesary expertiset conductregular isues of governmet secuies ailored to the needs of varu istional ad indidu inve ad manaWedby a prfessional teamin with pwpriat agen withbanks and odter finncial agents. Both eistdig and e Invetors should be cosidered mnding the proposed girobk whichcould potentially bome an importantsubscrier of govemmentsecurities) in developingmor active imae of govenment s itieClo C llion betweenBCRM ad Treasurywould tm be a basuicfat of mamic mang t tD ensure an adequa quality of liquidity and m forecasts well as cohernt statistics icuding thosepertaing to bothdomestc nd extnd debt.

8.22 At te same time, a mediumterm g for BCRMis to opera an indirectsystem of monetary . Ihe necesr trainig of BCRMstaff and the cooperationbeween BCRM mtdthe Tsy arecothqwo idmn co _kent by the Governm toDmntai fiwl 144

Table 8.2an POucy AREAS KEY ACrIONS PR!Q_ E OR .______PARtALLEL ACWIONS LEutabIhsntof Adopto of nowchrte for Enformnat of itozy mand BCRM mits an Tramuq borrowing mnryyoaMs fimBCDRM

oRaba ofDOR analu S_of~~dmhd accmmudanua - rx i dudi mgatamt k accont iwj_f smna w

haft md nmi4lf =M

2. Imutittm To indude .trngth.d or - CwComqleon of diagoss md atmut OfDORM resda, upwvisionand of n 1;_1dol pnkim mt or qdm nd Shodds ii -BCwildsBCRM-. _. ad BCRM

for manpwerdvelopnst is anHkyam ofonawy

.m_..-_ _, __ 3. MoetFaft of opaen mut Cratio of actfiveprmay adl -is -d det

Requiredresrve on aweftl Inzpovuaakdmtnesdotc or bioiibly aof-period paysis sysEN

4. Govmt de Rtof fw _mpa T a _y fwoti angmmwt_rpvb au

Iqovsd cod s of Activeongoin asust of

DCRM =h.pd

MAW~ of como_md b-) dmmmtddt imkm publicationof all incasery Omatimaof a profrsdo.aI Ia iformatn o goveran deob usageS Trsy isue Wa is Trauy 145 Tae L2 (cedind)

POLICY AREAS XEY ACTIONS PUEQIIEOR .______PARAUEACrINSM S. Revibed peda wi Operasc of pou. amg - Au_omy of bo .i*udg and dc n-p a ikdopmd.t ad pariby CSMad CCP fm credit milky Twuu.uy mnviak of aue ad b- Ifmma of botb Pimadu atmsiaomarvice to antile into idniousu mPiaico md alit bodim

CooSusstovid Parale operaio of paula reerctuuing of Frr

conwow yd of C.mcbuicsof new agancyand ad duaghouuop- PoutOfficeI O.sutia. of a appiupdats d _s~a~ bbahiclSamdd~progmuSOf for -_ - - u.zdg ad inancial

P. g,zba. o xisle -on

.n* hfApS- mulct for p

______~~Offunds regultcy n.o 6. Socia Security Nmd Opmlia of an atmknu Cm$a of fbucial ad and acouuunabeSocial Security mgnialo alauiof

CwuuSaOf zuview ofan .- ondm -n Of end appeopalhlcump. - iq C-PS.mdmd

Reiew of aod ad

of a fat - V w i '--fi E

.~~~~~~I jI. 147 responsibilit and disciplinedcontrol of moneyand creLdtwhile osteiwna m orientedfinancial system Giventhis commitment,the issuesof staff taining andtechical coordinationcan be tackled trough adequateinstituion buildirg measures.

8.23 Amongthe other majorgoals for istitonal inovaion during these stages is the operationof an autonomouspostal sav instition possiblyin conjunctonwith a revampedpostal checkig inition as a girobank This objectiveshould be cosely coordinatedwith the overall restructuringof the posts and telecommunicationssector in Madagascarfor which the Government i also e rvisagingan autonomous operatng entity for tei. A now set of cooperationand agencyagreements between the Post Officeand the new postal savingsand dchking institutionshould also be in place.

8.24 Another istitional innovationwould be the emargenceof an autonomousSocial Seurity Fund whichshould play a majorrole as a dynmic elementof contaul savingsand as an inutirdtal investorin Madagascar.At the same time, the insuranceindty coud be expectedto featuregeter prvate capmitland dynamismnwi& activemaketing policies tap the potal for lif: and ote insurance products. As a prequisite, tie Government should put in place a revamped regulatoryframework for these instittons with adequat taxion incent and greater flexibility in foreignexchange controls, if appropriate.

8.25 Progress in the area of capitalmarkets development could also be expectedto lad to an embryonicstock excnge. Withthe apprpriate rgulatory frework and icenive structure in pace and an adquate levelof fmiliariy and exeri dewdepedamong s, es tading couldbe expected,initially on a monthlyor evenwedy ba th Wadedsecurities wouldbe howsof the selectedpublc enterpriseswhih wouldhave bea d eaier and pr ed for public offeringstrough prpriate valuationexrc and a well-deveoped,media campaig aimedat the creaion of as broadlybased a dass of shareholdersa possle on the lins of successful expences nmcountri such as Chile,Jamaica and Malysa.

8.26 pl ion of the abovemantioned program of financialpoi and insttion- buldn measureswil help provi the necessaryboost to aggregateinm and savings. As discussedin Chapter1, this wi be necessaryto ensurelong-tem sustinble growthin Madagas. Discussedbelow are the three major ways in which the fincil sector devdpmen stratey proposedabove can help boost aggregte swings and invet in Madagsa during the 1990s. These are: (i) increasedfianial ving; (u) imprwvedfinnca intemeation ad payments services;and (ii) increasedeficency of investmeL

8.27 Financial saving can be expeted to increase as a remit of ths policies. With gened Cetral Bankmamnent of monetarypolicy, er price bilty wMbe fclitd. Togeter with 1h recent feeing of al interet rats and with r in ss in min interest rat as necessary,this shouldlead tcreas in the real returnon fincial assets and fully recoup the lossesin fici deepeningwhh ourd durimg the first half of 198.Vt Icreased private participatonin the bankingsystem and entry of ane or mo nw commecialbak would iease competitionin tie systm and help i uce resto shwiftw boln to moneized savn. Fianc deping wouldber enhancoder thepostal saviad cheng systemis revamped md now small-scalesavEgs anodatioare develped. Furher deveopmet of contractuasaving i uons -preseny the major source of term depositsi Madac- irould rsult in a boost in 148 financialsavipng insurace companiesand the socia securitysy becomemore dynmic mobilizs of fiads andistituonal ivest. 3.28 Ie abovewwld w hep mpro f in li ad paymen sevices. The purposeof thi is tD minimize die cos and riss of trfeing financa resource fromnsavers to borrowersand fr payes of finci oblation. to recipientsof fiat. Therommendations in thisreport tD impwov the legd frameworkare therefore important these wil help ensurethat fiancial contt are adequay proxteL Simlrly, lhe imro n recommendedin the famework for accunting, auditing and financial disoe wil lowerthe costs and risks of financialin- Fmlly, increasedspeed, accuracy ad accetac of the domesticand externalpayments systm wll encouragef wueof the fiacial systemto settle econmicobligadons and to transI r resources. 8.29 W wthe increa in finci svin shouldbe matchedby imovemens in aggreate inemnt e mainstrate w incrasn tse efficiency of overallinvestment is to mnsdat he prva sectr cm assumea inreasingse of domesti investm witin a wel funtoing finacia system Reducto limti of Canal Bak lossesreated to the qaWsiiscl deficitas tf nort d_ a po sourceof crowdingout of privateinvaes durn Ue,199&. Unle as by offsting paymeentto the Centralbank from desewhe whin thepublirc somr, bak loss. m Madasc to dat reflectfiancin needsof the publicseor wih should mally be madetaparent in the goverumar budget. For a - growh of money,increases in ce l bak loss c- be inflatiry or oewise canreduce e vability of credt to thepv cr If thoCental Bak is to manin a - monetay oth t L Greer of dt Cal Bak anid crbftili yof monetary agm_ polcieswouldbecombledby eliina eir atinglosses andshod dincrease investorconfdecinteconmy. Furtherprlvddnooffinanal system wouldhep icreascompeon. Incresed ufilcincyot financalsy wod thoreby sult in resourcesbe annelledto h*h-rh b m m and, eventally,capit make, wil hp pricead dstribut dik of me investments. In turn, the increas in the level of fiacil savingsdaefcn of invet shud hep inces ncm, tereby iceasn arege suvingand histment coR 1em Polidesfor IaSIR DmkSM 8.30 A nmbe of othr polices shoud complamn Us finani slctor develPment programschematicalyoutined in Tables8.1 and 8.2 anddisc dabo Ofpa an Im ortanc arelega sfguards for dthfOil wgo of finana tsc . Refors oft. lea famewk ad thejudiry go beyod t. scopeof js dsvlopnm oft finacl scto. At t.e amtime, dthe re are esentl to t. se sslmaqua of -w finci d markt. The Govermentshod the re esu a Itso4gIn Iiatv Inrefocus of t.i legl fr wok ad - oft judicay Incde th neceary proviso to oab finaial rsOns to be cnducte in a frmwork of accepted,well udesodW ad wl enforced contraal obligats. Ang d sr u th e boeendisd intis Rport in i fegardis t. begining of a modiernlad regsbtryin t. key ecammiccars oft. cDounty,an end or tha mit aso be suport by stra assistan if nesary. 8.31 Thefisa bI cto of th prposed finana setor develpnt pmogm eds tDbe cafy managed.Sic t. bkig sy ha ow be rdsabtd wi ben nd 149 for governmentexpenditure in this area as was the case in the 1980s. However, fulln n of the BCRM for its past lossesand completeassumption by the govment of all externaldebt obligationscould create a significantburden for the Treasury, dependingon the availabBityof exteral resources. Assumingsome form of eceptional financingcould be fud to compensat BCRMfor its past losses-including use of part of the counterpartfnd depositsof the Treamsy-to the additionalfinancial burden to the Goverme wi only be te full remainingvalue of fiture externaldebt obligations.The magnitd of this financialburden remain to be detmined. It will depend on the availabEiyof fiuther debt cancellationand rdief. t is cert that somedopes of enhancedtax mobilizationwill be necesary, especiallygve. a relavely low level miMadagascar comparedw other counties. It is importantthat a carefullydesigped tax systemwhich does not upsetincenives for privatesavi, investnentand production be implementedover the comingyears in tandemwith the proposedprogram of financialsector developmet

8.32 At the same time, tbe Goverment canprovide a catayst for investmentactivities of the prvate sector by activepursuit of policiesit has already adoptedto favor free zone entrprise creation. Te successof neghboing Mauritius n developingits cade financesystem owes mcdhto its free zone policies and it is similarly lily that Madagascar would need to rey on acive developmentof supplier credit and foreign trade finame before the fiaci system can bein featurig more sophistcatedinstrumens for domesticand foreigntade.

8.33 Fialy, the Government'spursuit of policiesto imve its own revenuemobilization and expendit managementshould eazse thatpublc savigs and ive become- to those promotedwiEn the priva sectr ugh the financialsym. An efficient ddynmic financialsystem would also give the Governmenta wider range of tods to improveis own resource mobilizationand inrvestme efforts. Givensuh compi and muiual betbeen publc and private and finci and real sectors, the 1990s can become the decade where Madagascar'sconsiderable physical and humanresources can beginto be fuly harnesse for growth to substantaly and widelybenefit al segmentsof the popuLion 151

ANNEX 1.1

SRE OF FAN NEES OF _JLA

This survey was conductedfor the Report to assess the perceptions of Malagasy entrprises regardingthe importanceof financeto their businessactivities and the adequacyof the existingfinancial systemin Madagascar.The survey consistedof (i) individualin-dept interviewswith 24 businessesand Cii)responses from 54 out of 104 enterprisesto whom the questionairehad been mailed.

Interview findings

InterTiew sample and ontext: The intrviews were conductedin March 1991 in a financialenvironment characterizd by a sharp contractionin new bankcredit. As was expected, all entprises appearedooncerned maily with the immedia problemof credit, althoughthe mag_nide of their concers varied accordingto their size and sector of activity.The persons interviewed represnd vaious sectrs ranging from agriculture to precsion madhining, import and exportto soap and chocolatema ing constructionto service sectors.The size also rangedfrom smal (less than25 employees)to large (morethan 100employees). The respondents were askednot to focuson the creditproblems they were immediatelyfacing but on the general experiencewith credi in recenttmes. Most big firms, especiallytrading ones, did not appear to have any problemsto obtainloans from banks. The SMESappear to be particularlyaffected by the bankingrules and practices.Notwithstanding these differencebetween SMEs and large entrises, there was a consensuson the need to lower interestrates which were repeatedly describedas 'usury rates'. The interviewswith enterpriseswere suple d by meetingswith the commercialbancs, one of the two insurancecompanies, two consultanfyfirms, and other professionalswho are knowledgablein financ issuesin Madagascar.

TABLEA.1NUMBEROFF]URMS TE WEDBYMAND

SMALL MEDIlM LARGE TOTAL

Agriculture 0 2 0 2 Agro-inustry 0 0 5 5 Industry 1 2 4 7 Trade 3 2 2 7 Mining 0 1 1 2 Constructio 1* 2 Q 1 TOTAL s 7 12 24 152

Main uroblns dited: Broadly, the main constraints mentioned during the intviews were:

- high rates of intrest - banks refuse as secrity the asset for which loan has been taken - too long delays in processing loan applications - the bankig system is inefficient as only 40% of the system meets the needs of economic agents - baning practices are too conservativeand bans do not take idustrial risks but prefer commercial risks. - comnications gap between banks and operators - checksof clientsoften bounce - no long term credit available, especidly for the constuction industry transport problems(freighr) - agricultural producer never receives any loans; barter is prevalent and the profit motive is often an alien concept to producers

credit- is not monitored by the banks: Loans takn for one purpose may be used for another - the banks have too many unctions. Since bank themselves invest they often are biased in channelling credk - devaluation has increased the number of entrises on the verge of bankruptcy - absence of coordination between aid donors - no collaborationbetween public and private sector - 30% equity required by banks too high - low purchasing power - exchange rate control (repWaationof finds 90 days after settlement)

What entrepreneurs would like to see: During the interviews, the following were suggested as financial innovations in Madagascar which would help the productive sector

a development bank (three of the interviewees even mendoned the DBM, DevelopmentBank of Mauritius) - exchange risk cover - export credit guarantee scheme - the banks' spread on line of credits firom international istituions should be reduced - new investors should know exly the ratio of debt to equity acceptableto banks - a leasig instituton - more competition in the baking sector - a joint economic committee, that is a forum where the different economic patners (governmen, employers, and workers) meet to discuss issues pertaing to the economic development of the country. Such a committee exists in Maiius. - mutul finds

Finance problems outside the capital ar: The interiews also included oompany officils in the provcial capital of Majungato detmin whetherenterprises based outsidethe capital and its surronding areas face specificdifficulties of their own. The main problem ficed 153 by enterprisesin Mjunga seemsto be that of poor or inistent communications.The onlylins withthe capitalare by road. After a bridgewas damagedin a recent cyclone,air transportis at the momentthe only link with the capital. Telephone,telex and fax faciities are scarce and inefficient Industriesface frequentinterruption in produton becauseof power cuts. According to the companyofficials interiewed, these factorshave led to a viru absenceof bankingand insurancefaiflities. Every transactionis made via Antamnivo. In addition, becauseof the communicationdifficuldties the usual bursucratic delays in Madagascarare even longer for companiesin Majunga.The lack of confidece in the legal system and the adminisrationof justice which were noted in the inteviews in Antananarivoseem more pronouncedin Majung becauseof what is perceivedas part of a broaderproblem of instiuonal decay.

Ouetien-naire findings

Design and respoe rate of questionnaire: In additon to the individualenterprie interviews,a questio was mailed to 104 enterprises.The questionre consistedof six sections (see atchment): (i sectoral profile and production cacisics of the enterprise; Cii) method of payment used for purchasesand sales; (i sources of domestic debt and equity finance;(iv) sources of extra debt and equityfinance; (v) constraits to enterprse growth;and (vi) meansof inproving financialservices. The responserate to this questionnaireas at end of March was 52 per cent which is highlysatisfictory when consideringthe relativelyshort time given and little experienceof mostfirms withsuch surveys. The samplewas drawnfrom "Guide des Affaires (a censusof firms producedby a local accountingfirm) accordingto the reaive weightof each sectorand sub-seaorin the Malagasyeconomy . Enterpriseswere then greiped for analyticalpurposes into 5 categoriesas indicatedin the questonnaire. The distributonof enterprisesby sectorand the responserate is given in TableA.2 .

Size And Seetni Chaact stiQOfRespod : Other ch ics of the respondentswere as follows:

- 53 per cent were SMEs - 58 per cent weretotally local-owned and 13 per cent whollyforeign-owned - 50 percentimported more than half of their inputs)products - only 24 % exported their products

It must be pointed out that the enterpriseswere classifiedaccording to their main activity. However, individualinteviews with 24 enterpri showed that most of them to be highly diversified.

Eann ForaEts JIaWd= and Snaes:Local purchases are mostlypaid on delivery for 39 percentof enterprisesand aftr deliveryfor another37 percet Only2 respondentssaid they settledthe bulk of their accountson order. But the patter of paymentvaries from sector to sector:

-Agcu3tr: Paymentis madeat deliveryfor morethan 60 percentof enterprises purchases. But most sales are paid after delivery. 154

-AUDj-udusWw. Lrge businesses settled their accounts mostly after delivery while the medium-sizedfirms usually pay on delivery.Sales payments are made after delivery. -JUIflff: Large busins pay more than 60 percent of their purchasesafter delivery. In fact, out of the 14 eterprises which mentionedthey settle their accouns 15 - 60 days after delivery9 belongto the industrialsector. And of these, 6 are large, 2 mediumand 1 small-sizedfirms. Salespayments follow the same patternas for purchases.

-lask: As wouldbe expected,the majorityof traderspay on delivery.Sales also are paid on delivery. But small traders in the majorityaccept paymentsafter deliy.

Extemal ninents: Externalpayments made and received differed with respect to -mfniand exports: -Imt=: Almost 95 percent of enterprisespay their imports on receipts of documents.The next methodof paymentmost used is after shipment Very few (only 3 firms)pay afer delivery.

-ELn: No clearpatern emergedwith respectto paymentreceived for exports. About t percentmentioned after shipmentand anotherthirty percent after delivery.

Sfiueroff Dof mficunds: The overwhelmingconclusion of the questie results is that the bankingsystem is the main, if not the only, sourceof funds for Malagsyenterprises. Shareholders'finds are indeedmentioned frequently; these fundshowever are exhastble and increasedwith more diffiuly than debt fiace. In effect, banks enjoy a quasi-monopolistic situation in financing Mlagasy enterprisesfor all maturities:

-LonL-e: Long-termcredit is a majorproblem for all enterprises. Most of them pmvide for their long-termfinancial requirements from their own finds. In fact, three mechnis were mentoned in the followingorder: (i) shareholders'fumds; (O) bank loans; and iii) non-bankloans. Withinthe questionnairesample, no enterprisein the sector had receivedbank loans. Similarly, firms in the constuction idustry repored hardlyobaining long-termbank finance.The sector which seemedto have retvely easier access to long-termbank loans is industry. Nonetheless,the majorityof industrialenterprises mentioned the main source of long-termfinance to be shareholders'funds.

-^ledium-ermfinance: Bak creditranked fi amongthe instrumentsavailable. It was mentionedby more than 60 percentof the sampleand aWlthe sectorsused it as their main sourceof mediumterm fince. A fiurther24 percentmentioned sharholders' finds while 16 percent indicatedsuppliers' credit. Therefore, irrespectie of size and sector, it canbe safelyconcluded that bank credit is the single most importantsource of mediumterm finance. lSS

TableA2: Rah=B byr&UK Ssmnle Reose

No. Total Small Mediumn Largo ENDEPIE

1. Agriculre Fsberies&MNning 19 7 1 2 4 olw Agriacture 11 Fisheries 3 0 Mining 5 4

2. Agro-industry 26 9 0 2 7 3. Industry 41 21 5 4 12 olw wood& paper pwducts 11 6 Rubber& Plastic 7 4 Chemical 10 4 Texie 5 2 Machinery 6 3 Print 2 2

4. Trade&Services 15 14 6 3 5 5. Other(Consuctko) 3 3 1 1 1 Total 104 S4 13 12 29

-Short-termfhman: Bank credit is eqally the sigle most important source of short term finance, It was metoned as the fit source of finance 20 out of 30 dmes. Ihe net importantsorce is spliers' credit However,the commeral secor obtai its short-term finan firo shareholde fuds(spcualy for lag establishmens)and bak credi Bnk and supples' crdit we very importnt for sm trading cozr2nes. Ape-industryrelies foremoston supplie' credit whereas the industria sector uses bak credit As would be exect, dte constructinsector obtains its ficing from cusmers' advances.

fllma sourcesLolhimme: Thirty-two percent of respondents enjoy supplies' credit Foreign sheholding contiutes a a source offunds to about 18 percentof enteprise while another 18 percentobtain fnds frm itation fin ages 156

Costraints to gwth: Two types of constrain were specifiedin the questionnaire (i) general constraints;and CB)specific financial constai. Enterprises were asked to rank the constraints - eight choices were given. f the answers are treated as an aggregate, i.e the number of times a problem is mentioned, then the following appeared to be the major constaints impedingthe sample of Maagasy enteprises surveyed: (i) lack of finance (mentioned39 times); 00i)tax structure (mentioned36 dmes); (ill) narrow market (mectioned 35 times); Civ)freight cost (mentioned 28 fimes); and (v) access to raw materials (mentioned21 times). When the responses are considecedin terms of the ranking they were given by individual enterprises, then the order of importance changes slightly in some zases depending on sector and size. The majority (44 percent) still views lack of fiance as the first constraint. Growth is restricted in 31 perce of cases by the limited size of dhe market The tax burden prevents 13 percent from expandingwhereas 9 percent find difficultiesto grow because of scarcity of raw materials. With further disaregation, it appeared that the main constrai varies from sector to sector as follows:

SECrOR MAIN CONSTRAINT Agriculture Narrow market (42%) cnsufflcientfinance (29%)/ Scarcity of raw materials (29%) Agro-industry nsufficientfinance (56%)/Tiaxburden (22 %)/Scarcityof raw materials (22%) Industry Narow market (489%)/Insufficientfiance (38%) Trade Insufficientfinance (43%)frax burden (29%)fNaffowmarket (21%) Other (construction) Insufficientfmance (100%)

When constaiMs are related to se, the ollowingpicte emerges:

-SmallentDrises: 'Thirtyeight percent considerthe size of the market to be the limitingfactor while 31 percent suffer from insufficientfinance.

-Medium eotses: Forty two percent altogether mention both isufficient finance and limited market size and 33 percent insufficientfinance.

-I,=arfef=Drises Fifty five percent are restricted by insufficient finance; 31 percent by size of market, and 17 percent by the heavy tax burden.

Other consaint mentioned were: (i) labour law; CH)packaging co; (iii) customs duties too high; (iv) uncemtty about the market rguations wihi the country. 157

XotlLumflla: Amongthe potenal financialconstaint ficed by the sample enterprises,the rankingis as follows: (1)high interestrazes; (ii) inadequaweworking capital; (iii) insufficientcapital; and (iv)foreign exchange scarcity. A sectorwiseanalysis reveals that both high interest rates and inadequateworking capital are most often mentoned but the raning differs from one sectorto another:

-AWculture:- (a) workdngcapial (57 %) (b) interestrates (29 %)

-Agmindusr: (a) high itert rates (56 %) (b) workingcapital (33 %)

-inbstM: (a) high inert rates (57 %) @)working capital (52 %)

- :adr. (a) workingcapital (36 %) (b) high interestrates (21 %) (c) insufficientcapital (21 %)

-Qdcr (a) insufficientcapital (60 %) (Construction) (b) workingcapital (60 %)

Siewise, the rankingof the financialconstains is the sameexcept that 12 out of 25 SIES fid the high interest rates as their principal fnacial constaint, while only 38 percent of large establishmentsoDnsider this a major nuisance and 52 percent of the large enterpriseshave problemsof workingcapital.Other potential financial constaints mentionedare:

-long-tem credit is almost inexistent;this affects the constructionsector in particlar; and -in the agro-industrysector, secrity for loans is consideredan important problem-

Perceived inademes of the financial system:After the respondentshad enumerated the constraintsthey faced for growth,a questionwas introduced(Q 19)to find out what causes they perceivedto be at the root of the inabilityof the fincial systemto meettheir needs. The choicesgiven were: (i) banks' refusalbecause of scacity of loanablefunds; (n) credit ceilings; (iii) inadequatesecurity; and (Iv) any other reason. More than half the enterprpsessaw credit ceilingas the main factor whileabout 15 % thoughtit was due to scarcityof funds. SMESare evenly divided betweenpereceving insufficient gunee and refusal of banls (30 percent). Sectorwiseanalysis showsthat 80 percent of enterpri in agricultureattribute to the creit ceilingthe case of their financialproblems. This perentage goes down to fifty percentfor agro-industries,fifty-three per cent industryand thirty for trade. This tends to substntiate the prevalentopio that too much of the loanablefunds have gone to trade. Other reasons given were: 158

- in agro-industry,no credit availablefor harvesting; - iadate working capital; - inefficientbaking system;and - loans are given not on transparentcriteria but on streno of relationshipwith bankers.

Means of hnnvng Onandalswde: This secdon of the quesdonnairesought to obtainthe entrepreneur'sview on acts to be takento improvethe financialsystem to allowhis enterpriseto functionmore efficienldy.The answerswere also expectedto give an insightinto the depthof knowledgeof the fmancialsystem on the part of Iheeconomic agents in Madagascar. The results were, as expectedto some extent,the following:

- R2percent wish for a reductionin interestrtes; - 68 percentwant better accessto bank credit; - 42 percentdesire more competitionbetween banks; - 24 percentwould like tD see new instruments;and - 18 percent want new instiutons.

Whatis somewhatsurprising is the ranking. Giventhe conjuncturalproblem of credit, one would have expectedaccess to credit to be mentionedmore ofen It is not the major irovement sought although it rank first for 29 percent of firms andis 8 points ahead of interestrates. More SMES (about 40 percent of them) find it difficut to have access to credit whereas the i problemfor large firms is intert rate level. This finding strngthens the view of a banking systemcompletely biased towards large firms.

Nlew instiMudonW:New institutionsrank as the fist improvementsought for about 10 percentofthe sample. Thefact that only 18 percentof respondentspropose the sett up of new financialinstitation revealsthat many entrpreneurs in Madagascardo not have a clear idea of whattype of instiions exist However,they are awarethat they need an institutionfor long- term financing. Some call it an investmentbank, other a credit bank, others still a developmentbank The constructionsector would wish to see the setfingup of an instiMtuionlike a buildingsociety whichwould finance long-term loans (15 - 20 years) or a mortgagebank.

New instruments: The predominantconcen amongthe enterprisessurveyed is to cater for long-termfine. Leasingwas frequently mentoned as wellas factoing, chequeclearamces, preshLpmentfinance, e e risk cover,and tecical assistance.Among existing regultons whichsome would l3ke modifie are: creditceilings; reschedulig of sbort-tem loans to medium term; and the classificationof enterpris. Some enteprises asked for a graceperiod for long- term loans. Preshipmentfinaced wouldhelp 38 percent of the respondens to increase their expts. 159

ANNEXS2.1

DIRECT YSUS INDIRt CMON13:AltY O OL

In pursuingits monetry and credit objectives,a centralbank has, broadlyspeaking, a choicebetween direct and idirect instruments. Direct instuments are characteristically administrativecontrols imposed on the bans thatoperae ndirecldyon thetarget variables. They indludeinterest rate conols and portfoliorestrictions, both of which can occur in a vaiety of forms. A typicalform of portfoliorestriction are bank-specificceilings on creditexpansionL In conast, indirectinstrumens rely on market forces to achieve their objective. By regulating the liquidityof the baning system,they affect short-term and eventuallylong-term interest rates, and therebyindirecdy the monetaryand creditaggregates that serve as targetvariables.

While direct instuments appearto have theadvantage of simplicityand precision, in practice they are seriously flawed. Since they intefere with the commerciallymotivated decisions of banks and their customers,they distort the allocation of financial resources. In particular,bank-specific credit ceilings inhibit interbank competition, freeze marketshares, and encourage banks to ration credit in a way that discriminatesagainst new borrowers. In combinationwith a loosemonetary po.icy, credit ceins cause excessliquidty in the banking systemand discouragebans from mobilizingdeposits.

Direct insuments are also popular fr pursun selectivecredit policies that channel commercialbank credits to economicsectors and priorityactvities. Thesecredits, which usualy bear below-marketinterest rates, are often no commerciallysound and eventualysaddle banks withlosses. Moreover,money bes extremelyfimgible, these credit and their implicitsubsidies in manyinstances do not reach the activitythey are itended for.

More generally, direct coamls underminethe desirable division of labor between commercialbanks and the centralbank. Motivatedby a desireto attainmaxmum profits, banks shoulddevelop a dose fmiiarity withthe business of their customersand specializein appraising commercialcredit risks; the centralbank, in line with its responsibilityfor a sound financial system,should specialize in supervisingbanks on the basis of prudentialregulations it has insued. By involvingitself e-cantein commercialcredi decisions,the centralbank inevitably reduces the onus on the banksto propedy appraiseand followcredits.

Indirectmonetary contols often opera on the liquidityof thebankdng system through reserve moneymanagement. Reserve money enoompassesthe immediatelyliquid liabilUiesof thecentral bank, Le., currencyin circulationand bankers' deposits(see tablebelow). Deposits other th thosefrom banks are netted out on the asset side and not consideredpart of reserve moey because they are usually govened by institutiona or legal and not monetary considerations.Moreover, such depositsdo not creat lendingcapacity that can fuel themoney multiplierprocess. 160

Central Bnk Balance Sheet

ASSETS LIA ES

Net Foreign Assets Reea Curren Net DomtesticAssets Bank Deposits Net Crit to Goveanent Claimnsm Banks Captal and REervX

Other Itens (net)

The sources of reserve mony are to be found on the asset side of the central bank's balance sheet. They are the net changes i its foreign and domestic assets, the latter one consisingof net creditto Govement and daims on bank (assuing the absenceof centralbank lending to n-banks). These dhages can be positiveor negative, implyingrespectvely the creationand absorptionof reservemoney.

In other words,reserve money creation is a functionof the balanceof paymentsoutcome, the balnce in the Govemment'saccount with the central bank, and the central bank's policy regardinglending to banks. Vincea centr bankwould normally have a target for foreignassets, atnion focusesnaualy on net domesticasses as the source of reserve moneycreation to be mnged.

The uses of reservemoney appear on the liabilityside. To avoid the risk of hindering the paymentprocess, the demnd for currencyfor circulation(notes and coins)must alwaysbe met That leavesonly bankers' depositsor bank liquidityto be influencedby the centralbank. Hence,this is th agteg that guidesthe centralbank in its day-to-dayoperations in the contex of reserve moneymanagement

Bankshold depositswith the oentralbank for two basicreasons: because they are obliged to by reserverequirements and to have sufficient'precauonary reserves"to sette any net claims tha may be presentedagainst them in di course of their normalbusiness. Any reservesbeyond these two componentscould find a credit expansionwhich may or may not be desirableunder the circum s. 161

By managingthe sourcesof reservemoney over which it has influence,the centralbank tries to steer bank liqidity in a directionconsistent with its monetarypolicy stan. Sometimes the distinctionis madebetween 'defensive 3 and 'dynamic' centralbank opeaions. The firmer are used to compensatefor unntrolled fictorr affectingthe sipply of and demandfor bank depositsin the short m, and te latter to keep moneyand creditin line withthe growthp ial of the eonomy.

Use of Open-Market Options

In general, the shift towardindirect monetary controls has generaly eniled a greater relianceon open marketoperations. This has been, for example,the case of nearly all Asian contries during the 1980swhich movedtowards use of market-basedinstruments intead of directcontrols. However,open market opeatons in their countrieshave, at leastitialy, been limited by the absence of governmentdebt instuments and the thinness of private money markets.

Thus, the shifttowards open marketopations has been accompaniedby the issuanceof centralbanks' own debt instruments,the use of privae moneymarket securities for openmarket operations, and measures to encouragethe developmentof iterbak market and private secondary markets in government securities. These developments have often necsitated bringingthe yieldson governmentsecrties in line with marketlevels and/or disconuing the practice of forcing the Cedral Bank or commerci banks to absorb government securties. Also, more restrictive access to discount facilities and increases in discount rates were implementedto preclude fancial institutionsfrom circumentig he effects of open market operations through the discount window. In some countries (Indonesia, Korea and the Philippines) the use of centra bank discount facilities was reduced or phased out during the 1980s.

Lessons from other deveoping countries

The decisionof Malagasypolicy-makers to graduallyshift to indirect instrumentsof monetarycontrol is consiste with the increasingmarket orientationof the economy. The experence of several Asian countries in this area - Indonesia, MaIaysia, Sri Larka, the Philippines,Thaiand, Nepal, and Korea - during the 1980s can provide useful lessons for Madagascar.Generally speaking, the shifttowards market-ased monetaryinsuments and away from direct controlson interestrates and credit duringthe 1980s,allowed these Asian comnties to deregate their finacial systemsand developfinaci marketsand inst in a liberalized enviromet. The experiencewith the implementationof monetarypolicy and financialreforms variedwidely among these countries. However,the adoptionof mare-based monetaryconols wason the wholea positivefactor which helped them achievegreater monetary depth and greater flexibilityof interestrates to serve allocativeroles.

At the same time, the expience of these countriesshows that inadequatedevelopment of financialmarkets and instrumentsfor open marketoperations coupled with large domestic financingneeds of the governmentcan lead to open marketoperations which are inadequae to stabilizemonetay growth duringperiods of particulary swere disurbnc. All countriesto vanous degreesficed the chalengesof conductingmonetary policy wih openmarket and other insume whileconfroning monetary disturbances from factors such as wideningfisa deficits, 162 financil crises or large inflows of finds from abroad. In MaLaysiaand Korea, the central bank was able to use indirect policy instrments to effectively manage the growth of reserve money in the fce of significantchanges in reserve money. In Idonesia, the continuedactive use of openmarket operations during 198889 helpedcontain monetary growth despite a sharpexpansion of liquidityin the economy. The shift to indirect monetarycontrol in these countrieswas associatedwith broad financial liberaization, that is, reduced government intevnion in setting interest rates and allocatingcredit When contrastedwilh the exeience of severalLain Americancounties - Chile, Uruguay and Argentina - the Asian experienceof final lieraization provides importantlessons. First, price stabilityand, more broadly,m c stabiity is the key to successful liberalization. Second, raising interest rates has inherent limitations since dthy cannotbe increasedunduly without creatig adverseselecion or moralhazard problemsamong borrowerswithin the bankingsystem At the same ime, excessivelyhigh positivered interest rates in imperfect and oligopolisticmoney and credit markets characttic of developing economiesincluding Madagascar, can lead to arrears within the banking system Third, in financialsysms such as in Madagascarwhere there has been a longhistory of interestrate and aredit controls, the participantsin a financialsystem - whether bank managers, borrowers, lenders or civil servant - are not accustomedto new ways o dealing with a liberal and competitivesystem. Closelyrelated to this observationis the fundamentalimportance of well- plannedfinancial infastre withadequate infbumation flaws, legal and actmuting frameork and appropriateregulation and monitoringof the financialsystem As a result,Magay policy makers,while pursuing the recently-ined shiftto indirectmonetary conrol, shouldbe careful not to neglectthe crucial importanceof rovement in financialinfastructure proposed in Chapter3 of this report 163

A YqE2-2

ASIanS OF CENTRL BANE IPENDENCE

There is a great deal of interestthese days in the notio of centralbank independence. In Europe, it plays an importantrole in tbe discussionssuronding the creationof a European MonetaryUnion, and also in the fomer rlan economieswhere pope central banksare being established. Chileand New Zealandrecently enacted new laws to strengthenthe indeendence of their centralbanks in ihehope of improvig these itittons' recordsin fightinginflation. The belief that independentcentral banks are more effectivein adievg pnce stablit has spurred calls for changesin centralbank statutesand centralbank relationswith Govenme in many countries.Below is a brief discussionof the ra:tioe for and dimensionsof cental bank indence.

Rationale fix ceta_akbdnec

The theoretk,I rationalefor centralban indeence derivesfrom the propositionthat the expectationsof the publicare criticalto the effectivenessand efficiencyof monetarypolicy, and that in turn policy credibilityis criticalin shapingexpectations. The conentionis that the real costs of a deflationarypolicy are higher if the public is not oDnvhicedof the sincerityand longterm.commitment of the centralbankl This line of thoughtspawned a large lierature on the advantagesof 'rules versusdiscretion' in monetarypolicy. Inspiredby this theoreticaldebate, many centralbanks experimentedin the recent past with pre-announcedmonetary targs. Due to large, sudden shifts in the demandfor vanous monetay aggregates,those targets have for the most part been abandonedby now. What remained,however, was an awarenessof the imance of convincingthe publicof the central banks motivationand abilityto pursue anti-inflationarypolicies. Thi has led to a studyof the institutionalarrangem s most conduciveto centralbank credibity.

The conclusionappears to be that a centralbank with a narrowly definedmandate to purse rice stabilityand the abilityto implementmonetary policy without politidcal intference wil more likly be credible. Adequatemonetary policy insme, publicaab it and high quality policieshelp buiid crediblfity. The more pronouncedthese attributesare, the more the central bank is considered'independent.'

A survey of the degree of indepedence enjoyedby central bank around the world suggest that it may be usefidto thinkof hre types:in additionto centrl bans withminimal, or very substantialindependence, 2 there is the third type where the Governmentcan inmprinciple

_/France and the .

J/G.rmany, the United states, and Switzerland. 164

ovemre the centralbank but onlyaccording to a parcular conflictresolution procedure, usually involvingpublic debate.3 It shouldbe noted that in the contextof recent debatein Europe,the Frenchor Britishmodel with limited central bank independencehas tendedto be less persuasive than the Germanmodel of substantialcentral bank independence.

It should,nonetheless, be pointedout that centra bank independencein monetarypolicy can never be absolute. The political authority will always reside with the government,as evidencedby its abilityto changethe centra bank's law. ' Furthermore,govemments retain controlover fiscaland, usually,exchange rate policies,both of whichare closelylinked with monetary policy.

Dimensionsof centralbank independence

A centralbanks responsibilityfor monetarypolicy forml and impl in can range from completeformal responsbility for both (e.g., in Germanyand Switzerland)to formal responsibilityas agentfor the Minstry of Financefor implementaiononly (eg., in France and tie UK). In betweenthese extremesare centralbanks with a formal responsibilityfor policy formulationand implementationthat are obliged to consultwith the government(e.g., in the U.S.); or which are subjectto governmentdirectives (e.g., in Japan), possiblywith resort to prescribedprocedures for conflictresolution (e.g., in the Netherlandsand New Zealamd).A criticalcomponent of the conflictresolution procedur in the Netherlandsand New Zealandis an open, politicaldebate in whichthe central bank canpresent its case, and the governmentis held accountableto the electorate.

In general,central banks with lessformal policy responsibility tend to have morebroadly defmed satory objectives,covering a range of macrecoic goals besidesprice stablity, referringto the need to promotethe ountry's welfare,or speakingof meansrather than ends (such as 'regudatingmoney and credit' for the Bank of France). The statutesof centralbanks with more formal independencetend to emphasizestability of the value of the currency. Narrowlydefined objectives contribute to trasparency and accountability,and therebyenhance credibility.

To be accountable,central banik must provideiformation on their operations. At a minimumthis consistsof regularbalance sheets. In most countriescentral banks further publish annual ret includingpmfit and loss sttements. A central bank may further announce monetaryor inflationtargets against which it canbe held accountable In general,it is found th sustainedresect for centralbank independence is conditionalon tansparecy and aowuntability.

The board structureof centralbanks ca conwistof severa tiers: two tiers are commQn, for instance,an executiveand supervisoryboard, and three tiers also occur. Shing executive

j/The Netherlands, New Zealand, and Chile. j/A government may even decide to liquidate the central bank, for instance, upon entering into a monetary union. 165

and supervisorypowers between board memberschosen for their technicalcompetence bolsters the centralbank's independenceand enhancesthe respectabilityof its decisions.

In recognitionof their ilimate responsibilityfor monetarypolicy, government have the primary role in the appoinment of their central banks directors and senior management. Neveeless, the more independentthe centra bans are, the morethe appointmentand dismissal powers are circmsbed. For instce, at least some of tbe nominationshave to come from outsidethe govremment(often the existingboards play a role in the nominatingprocedure); the terms of officeare long relative to the electoralcycle, and staggered,to preven a goverment from dominatingthe central bankwith its appointees;and directorsand managerscan only be dismissedfor technicalcauses, not becauseof policydisagreements. For the least independent central banks the heads of state make all appointments,on the recommendationof or in consultationwith the ministeror the cabinet(e.g., in the UK and France).

An importantsafeguard for centralbank independenceis commonlyconsidered to be a statutorylimit on lendingto government In the stricst of casesthis limit is zero and covers all formsof lendingto government,including the purchaseof governmentpaper (e.g., in Chile). More often, the limit is not zero, and applies to direct central bank credit, permittingthe purchaseof governmentpaper in the secondarymarket for monetarypolicy purposes. Suchlimits are usuallydefined as a percentageof governmentrevenues.

Centralbanks tend to have substntial financialindependence from their governments. Undernormal ccum s they shouldalways be profitablethanks to their seigniorageincome, from whichthey can then financethe expenditureswhich they freelydetermine. Centra bank statutesusualy prescnrbearranemets for ditrution of profitsand the constiton of reserves. Typically central bank statutes are less explicit in their treatmentof losses than of profit. Nonetheless,a govenment responsibilityfor losses, such as might arise from quasi-fiscal functions,is usuallyimplicity assumed.On a microeconomiclevel, the significanceof financial independenceis, among other things, that central bnmkscan offer their staff incentivesand failities which are competitivewith the privatebanking sector. On a macroeconomiclevel, its major significanceis that it enables cental banks to avoid losses which could undemine its monetarypolicy independence.

Finally, central bank independencemay be impairedby constraintson the use of monetaryinstruments. For instance,variations of reserve requirementsare often subject to governmentapproval (e.g., in Japan and France)or to consultationwith the banks (e.g., in the Netherlandsand the UK), plus may be subjectto statutorylimits.

Note: A more extensivediscussion of dte issue of centralbank independencecan be found in *Centrl Bank (ndepeuidentby Mark Swinburne and Marta Castello-Branco; Interational MonetaryFund; June, 1991; IMP WorkingPaper 191-53). This annex drawssubstanially from the If paper. 166

ANE .1

There are four key demos of the domesticpaMya sym in Madagucar:

- paynfl betwee l (itrbnk payments);

- paymentsbetwen branchesof the aw bank (uter-brancapayments); and

- paymentstrough the postal cking aysem and

- payments to and from the gvens

A relatd issue is the ue of xatomaic tnsfes.

INTERBANKPAYMEIIS

Paymens with cek and tasfas betwe diffen bat have to go trugh th clearinouse (chambre do com a ) which is governd by n agement betweente paicipating ban. Apart from dte cle hou in ui here are 15' loca cearinghouses in Madagascar. In 1990 cearing ousde Avo accounted for 36 per cent of total dearings, whichcompaes to 3 per cen the previo yea, measuredin monetay te. This minordecine was mainlydue to tins in Aincas by 40 per ce whilst the increase in other ares was only 29 per cent The most able crease outide Ammna_ivo wasseen in Tamatavewherete acvity wasup by ovr 60 per cet in 1990.One of the reasonsfor this is likelyto be Baqe Magche do l'Ocdan ond, EMOPI,estblshing a branchthere.

In Ananarivo, BCRIt, ornizes and chair the clearingsessios, as is the cse in BCRM'sbranch in Tamatave.Whilstelsewhere hehBCMfoint one of the commercialbanks to act as its agent The aot ts are basedon the bak' relativesize in the ldcal ea Qdatf erefsdmat hec

To be allowedto parficipatein the learing,a bank must sign the Retgementdo la dhubre de apw' which therebybecomes a bindingconvento for the bank in question.

51In ttal, the BECMiss repesented in 21 towns, out of these there n fivetons withonly one bat 167

The learingstaie place on a daily basis. In Antaivo the participantsare dhefour commercialbans (BFV,BNI, BNT, and BMOI1),the CentreCheques Posmux, (CCP), and the BCRM, both as a centralbank and as agent-br the Treaury.

The cleing sess outside Antananrivo ae organized in the same mane as in Antananaivo, exceptdat as earlier menioned, the agot bank acts as organizerin the place of the BCRM.As agent,the organizingbanks keepstempoary accounts("comptes de passage) for all bank, includi the BCRM- agentfor the Treasuy. At the end of t'hecleaing, the amounts due to and from the partdiipantsare recordedin these accounts.At the end of the workingday, diese accountsare wnsoldated wih the banks' princpal accountat tde BCRMhead office, Le., the negatve or positivebalances are passed on, to be subtacted from or addedOD the balances in the pricipa accounts.

None of the BCRMagents has any telex on its own premises. However, some have accessto a telex at dzelocal post-office. Due to bad connecmonstelexes can be delayedfor days, this resuts in deays of up to 10 .daysfor consolidationof the owptes de passageand i local tranations alwaysbeing camad out for the ognal value date. If a bank, after consolidation, is in deficit, it is automaticalygranted with a UcredJ revolving. For this the bank is charged with an annual interestrate of 13 per caet on the tansacns the specificday. The interestis calculatedand chargedlat the end of every the months.

Insulfident-funds on c}edc accounts

Even hou the conventionof chambrede compensaionstaes that checkshave to be rejecd before the end the followingday's clearig, it appearsthat in Antananaivothe banks have up till 48 hous to reject a check Isuers of bouncedchecks are placed on a "bl listW which,is- sent to the Pocreur Genral for legal action, which in severe cases can mean imprisomet for two years.Furthenmore, the banksusualy witdraw the customerschecks, not neesarily closingthe accoun.

Accordingto the bankmsome 3-5 per cent of the total number of checkspassing the clearinghousesare rejected,which isn t an larmingrate. However,bank and busiesmen look Vpor bounci checksas a big problem, even dtoughthis is not evidentin availablestadsdcs from the BCI, showmingrejected checks accounting for less thm 1 per cent

Whena customerin one town has receiveda checkfrom somebodywho has an account in a differnt bank in a townoutside the loca clearingarea, the procedures,before die cstomer is actually crdid, tabe much longer time. This is mainly due to uication pblems betweendifferent areas in the country. 168

For a checkpresed in a bank in a townwere the ssuingbank is not represented,check displaced,the periodfor rejectinga checkis aetened to 20 dayscompared to the 48 hours wihin the same clearinghousearea. Ihis is due to difficultiesin co icationand ortation from sometimesvery remote areas. The rejectionperiod of 20 days evidendyapplies to any check presentedoutside the payer's clearinghousearea.

Accordingto the BCRM,checks originating from amothertown shouldpass throughthe clearinghousein the payer'stwn. Thus, the payee banksends the check to its branch officein the other town, whichthen presents it to the chambrede compensation.However, thE banks have an mternalagreement stating tat checkscan also be presentedin the chambrede compensation in te payee's town.

In addition to the 15 dearinghouses of BCRM, there are a number of "clearng zones'. This initiativewas takenby the bankswithin the AssociationProfessionelle des Banques,APB, to speed up clearanceof out of town checks. Within these geographic zones, baits have committedthemselves (n a form of signed convention)to give credit for out of town checls witin 20 days. The first suchzone wascreated around Antananarivo, and a few more havesince been established,but the total numberof zones is less than the numberof clearinghouses.

Transfers from one bank to another

Transfersfrom one person to anotier are followedout in the same manner as for checks, and usuallyare as time consuming.

Custoaer Bank Clearing- Ba= k Custom- (payor) (x) house () er (payee)

A customerasks his bank to transfera certainamou to somebodyelse's account. Ihe bank preses the transfer at the clearinghouse,the receivingbank gets the transfer and the customer(thepayee) gets his money.In thesetrsactions the payer is debitedthe amountthe day he gives the order and the payee is creditedthe amountthe day be receivesthe moneyon his account. In transfers betweendiferent clearinghousesthe payers' bank ask the local BCRM's agentto transfer moneyto the other BCRM's agent to ewcutethe transfer to the payeebank.

INTERBRANCHPAYMENTS

Transfersand paymentswith checkswitn the sa- bank can also sometmes be very time consuming,despite the fact that the clearingdoes not haveto go throughthe clearinghouse. 169

Delaysmainly refers to tasatons betweendifferet towns, and internalclearing of checksand transferswithin the -amebank can take a month. The bank whichhas thelargest coverage of Madagascaris the most exposedto delays. Abouthalf of its 70 offices are said to have accessto telephoneonly. Even though telex and telegramfacilities are accessiblethe communicationlines are that bad that it sometimestake three to four days for messagesto get through,which in certain casescan be longerthan for letters.

To improve its intera communicationBITM five years ago embarked on a decentralizationand automationprogramme of its accounting.The idea is to equip a limited numberof brancheswith personal computers and appropriateaccounting software. The branches selectedall have their airlineconnections, although, sometimes with only one flightper week. The other brancheswill delivertheir documentsto the nearest automatedbranch for processing, unless oonnectionsto Antananarivoare faster, as it is in some cases.

Presendy, BMOI has only two branch-officesoutside Antanarivo, which is an advantagewhen handling its intrabranchcommunication. The Diego Suarezoffice transmits its transactionsby satelliteover nightto Antnanarivo and the Tamataveoffice sends its transactions on a disketteby airplane.Ihe systm enablesa transferfrom an accountin Antananarivoto be executed,and thus, crediteda BMOIaccount in Tamatavethe same day. The reversesituation still is not possible.

To handleits intrabranchoDmmunication BNI has its own courier systemwhich covers all but one or two of its 22 branch-offices.

Postal checdng system

Postal services in Madar handle about 3,500 transfers ("macfatspostauxm") daily. Thesecomprise both domestic postal orders as well as inwardand outwardintemational htansfers ("mandatinterntionau payds" and mandatsintemationam emis"). The mimberof domestic trnsfers has fallenfrom almostone millionin 1985to abouttree-quarters of a millionin 1989, indicatinga decreasedimportance of the postal system in this area. Outward international trnsfers have also fallen sharplyduring this period, reflectingforeign exchangesecurity and currencydevaluations. However,inward transfers fom abroadhave trpled, maing the postal systema net generatorof foreignexchange resources for the country,of about3.3 billionFMG (USD2 million approatey). This is a complementto the extenal payments system operated by banks(see Aimex3.6). Apart fromthe bankm'transfers and checis and postaltransfers, there is anotherform of settlingdomestic payments. This system is the CentreCheques Postaux, CCP, the postalcheckdng system,which is representedin 209 post-officesall over the country. Presently,the CCP has some 45,000 accountsof which some 80 are held by banks, which use the system for its payments. The Govemmentalso opeas the largest volume of accounts. The CCP has essentiallyfunctioned as a mechanismfor the Treasuryfor paying salariesof about 10% of all civil service and military personnel and for paying vaious providers of services to the public sector. Most PIT personnelare paid throughthe CCP. On average,payments with postauxtake some 7-10 days. 170

Anyonecan open a CCP account nd there is no minimumamount to be deposited.Whe opening an acount, the ac mer receives a check-book.He can thentwrite a check on any amount,provided he has sufficent funds.The annual fee for the acount is FMG 1,200 andFMG 1,500 for eve check-bookthe customergets. TIe customersdo not get an intereston their balanceson the accounts.When transfring moneyfrom one CCP accountto amotherno fmes are arged.However, if checksare vritten on amountsless then FMG 50,000, a FMG 75 fee is charged.

GOVERNMOE PAYMEES

Ihe Treury handls the paymentsto and iburseent from the Government,eg collectsthe incme tax, dutyon goods,pays the Governmentpayrolls. As such an y, it is a large participantin the domesticpayment system in the ecnomy.

The Governmentreceives 80 per cent of its paments in forms of checksand ansfers, 13 per cent in cash paymentsand the checkpostaux account for 7 per cent The most common forms of disbursemensare also the check and transfers,which in 1990 accunted for 79 per cent of total dis. Howev, there still appears to be a reuctance to ue checks, escially outsideAntananarivo. This resultsin the moneyorders, bons do cai se,accountdig for 14per cent. The moneyordes need a ' to be valid. They are non trasferale and can only be cashedin one of the Treasury's 120offices. In additionto these formsof disb chequs postauxaccount for the remaining7 per cent

TheTreamsy execues the transfers,sends the orders to the BCRM,i.e., a checkand lists to the banks contning whom to be creditedand by how mucih.The BCRMforwards the lists to the ommercialbank's head offices, which then is to credit the customerscheck accounts. Thesetransactions do not pass the clearinghouse.

The Governments and enterprise's employeesreve ther wage net of tax. The enrprises then make tax paymentst the Governmentin the middleof the followingmonth.

The salarysystem requires the Governent, as wel as otheremployers, to submitpayroll lists in advance. Banks do not appear to have a common policy; it was said that BN receives the lists some 7-10 days in advance, whist BTM only one day in advance.

AUlTOMATlC RANSFERS

Most of the larger enterprises salaried employees receive their salaries on check acount, but most blue collar workersreceive their wagesin cash. The enteriss give lists to 1hebanks, contining inmaion regardmgfrom which accountthe moneyshould be drawn as well as receivingaccots and a_mnts. All thes trsactions are then caried out by handL 171

nho most cosmon wayto pay for tolecom,utites and vat is to, in a bank, pay the bills cuh or by duock To pay for eecticity ther is also a possiblity to settle the bills directy at Diramas,thio deltcity oompas, office. Chae ackorS holdershae yet anodher pton; to mak -m agrIembntwith the bak regardin4gmonthly deductios from the account to pay for teleomm,uftlites ad rut. Anot posTility for the ctmer is to have thr electicityand telqhonebins settled mm ally" by the bank. In such cue for insuace Jiu sends lists to the bak with,custms name, accout number and amountto be paid. Theselist are san to the b soe l5 days befo t money is due for payn k is thenup to the bankwha to withraw the moneyfiroe custom' accounts.All diesetransactions are presendycarried outby hand. 172

As ir any country, the delaysencounered in the systemfor clearing and transferring paymentsbetween economic agents result in costs that are essenIay borne by the recipientsof fumds.In order to estimatethe magnitudeof such costs in Madagascar,a calculationis madeof howmuch recipients of fundslose throughddays whenpayments and transfersare madethrough the systemof clearinghousesin Madagascar.

Based on data providedby BCRM, the averagemonthly volumes of total checlk and trmsfers presentedfor dearing in the clearinghousesystem in Madagascarare shown below (millionsFMG).

1988 1989 1990

Antananarivo 19,239 23,684 35,254 Ouide Antananarivo 21,172 26,273 33,127

Total/mont 40,411 49,957 68,381 Total/day 2,021 2,498 3.419

Four assumptionsare madebased on empiricalobservation:

1. 10% of total amountis assumedto be subjectfor delay. This is a conservative assumptionsince this is below the percentageof transactionsbetween different clearinghouses(eg. betweenAntananarivo and majorcities such as Autsiranana or Mahjunga)which in particularcan be subjectto substal delay.

2. An inernal discountrate of 13% as an indicatorof cost; this is one percentagepoint abovethe exsting referencemoney market rate used by BCRM.

3. 5 days on averagehas been assumed to be the delay and is probably a fairly conservative assumption based on the discussionswith the banksin Madagascar.

4. 240 days has been used as the numberof bankingdays over the calendaryear. 173

Usingthe aboveasumptions, one canestimate the costsfor one year witha delay of 10% of the trnsactions for day 1, fbr 5 days; on day 2, a delay of 5 days for 10% of transactins; and so on for 240 days, all at an internaldiscount rate of 13%. Thus, taig the averagedaiy clearingvolume of 3,419 FMG in 1990,the potentl cost to recipientof fiuds is estimatedat FMG 53,3306million (= 3,419 x 0.10x0.13 x 5 x 240 MFMG).This is equivalent to about 1.2%of GDP in 1990.

Ihe delays in the clearing and transfer system represeats a reditnbution of inome from payees to payors within the economy who use the financial system to settle economicobligations. The above calculabonestines how much these delays costs infLtl in terms of ewAomicopportuniy cost In reality, any given economicagent is bOth recevin and makingpaymes, and it is from the net receiptof fimdsthat the true cost could be calculatedfor an individualfinancial acmr. f a given economicagent receivs on net substantiallymore payments than paymentsmade trough the financialclearing and transfer system,:5is agentis bearingsome of the cost of delys of the sysm. Ihis cost is akin to a tax on economicagents who decideto use the finama systemto setde obligations.As withany tax, therefore,this dampensthe demandfor use of this financialservice. 174

A.N=E 3.3

Bdow is a propoa for a new paymen systembased on telecommnication place of mail service, ening chmge of tasacdon dat insead of documents.Received documens are retand and filed at receivingbranch. aCkdng of signatu at the branchkeaping the accountwill coaquety not be possible.Tradidonal signae check has to be rplaced by, for eumnle, a chpee guarantee card for personalcheques and a confirmion procedurefor corporatechpees. For onot being confirmedcorresponding documents or copiesare requestedfrom the fing branch.

Exchangeof data takls place on two leels, one on a regionallevel (mtnregiona clearing)for exchangeof data betweenbrandies of a bank withina region and betweendfferent banks, and one interregionalclearing for exchangeof data betweenthe regin of a bat A clearingcer conducted by the CentralBank ( M is ognized in ach regionalcenter city. At placeswhere the BCRMhas no branchone of the participatingbanks act as agentof the BCRM.If a bank does mt have a brach in a regional ity e bank is r!epted in the learingby awdnerbank. merbankclearin impliesa set of technicalstandads to be agreedupon and an agreementbetweeo particpaing parties regulg liabilityand compensation.Below is an ouline of successivesteps and their timing.

Transa fiond:

1. After baning hours the branchsends outgoingclarig transactionsto the regiona center oflict

TransactiondaLy hus 1:

2. In the morningat the regia center,received claring trnsactions are sorted into:

- transactionsto branchesin the rqgion - intraregionaltransactions (regional intrabrauch trmsactions); - tnsactions to other regin of the bank - intrrgoal wansactions(intrabrauch tascti betweendifferent reon); nd - other bankstansactions by participatingbank - inter tansactions

3. aIterbanktansactions are exchangedat the cleamngcenter once a day at a fixed point oftime, eg at noon.

4. Transactionsreceived in the earig are sorted into inraregional and intenregionalones and merged with correspondingt actionscoming fom the bans own branchesin the region(Step 2 above).

5. Interregionaltasactions are sent to the headoffice to be meged withtransactions frm other regions. Trmsactionday VnIs2:

6. In the mrning t s (Step 5 above)are sorsedby regionand routedback to regionalcent. 175

7. After dheinterbnk cleiing procaine at th regIonalcter trasaction from the centl officeand inteeonal trsactons (Step4 above)ar mergedto becme icoming cleanng to the branchesin the region.hinmig cerng thm consis of transactionsfrom tie rgion made yeterd and nactbons from other regionsmade the day ber yesterday.

List of us cold be madeup manally ad by meas of telfx or telex betweenthe branchesand the regionalcet, and the riona caer and dte head office. To miimz errors and maintai an accetable sauwityin the sysm, a ratherhigh integrAio and autmatio of tie process isneeded. The systemcould be basd on PC techig and gonal centers nd the head office shoud be co d at lea Intebank clearin is perfomnnedby hagi dikettes and tr tons are transmittedcomputer to computer. f rnsmision computerto oomputershould not be possile, dependingon inwfficientqult of dhe tel o stem, unaction lists producedin the systemhave to be rnsmitted by meansof telefaxor telexif PCs are equippedwith a telex interfa.

Amattlgnd * wdad

For accountig and roncilt puwoses each bankparticipatg in the leaing has accountsu withdhe BCRM, one centralacc and one at each regioa center.

Each branchhas an acou with is regionaloffice and the regionaloffice keeps an accountfor ech of its branches.An anaogou set of accountsis set up betweenthe regiona officesand the head office. (A loro-nostro acconting set up.) An acounting and reconciliato technique divided up accordingto levelscreates a neceay conditionfor a controllableand safe learingprocess.

1. Outgoing learigtansacto of the day are to the debit of the accoun of the branchwith dte regionaloffice. Transactionsreceived at the regoa offic e to the credit of the accountwith tie branch concened.

2. Outgoingtransaction to the other banks are to the debi of the regional acco with the BCRM.

3. Icommingclring from other bank are to the credit of die same account

4. ntraregionaltransactions comnag from other bans and fiom brnches in the region are mergedand sorted as per branh. Trancto are to the debt of the accountswith the braces concerned.

5. Ine inal tansaco fonm oter banks mergedwith consactions fom the regionare to the debitof the accountwith i headoffice and to the credit of head officeacount with the rego

6. Incming clearig fromthe head officeto the reanal office to be forwardedto the branches is bookedin an anadogousway.

7. The balawnesof the regionalacount with the BCRMis tnsfeed daily to central acon

. ~C A.- , - J - -- 176

Ewahbatch of transactionseither on computerdiskette or on paper contains,besides the clearing transactionsand the sum of dtem, the balanceof the senders accountas well. The receiver then can checl, with correcion for remtces i ransit, that the correspondig accounts agree, either automaticallyin the PC systemor manaly. By giving bathes sequencenumbers, reasons for possible differuces are easilydetectd.

The three-levelaccounting and reconciliationtechnique constitutes a base for conrol and safety in the clearing process. Before implementngthe system as a large scale operation it is, however, importantto test the systemon a smallscale basis to makesure the qualityof the telefaxbeing sufficient. 177

ANE 3A4

:Preme situadon

Checksare presentlyavailable to accountholders of the fowrcommecial banks iM gaa. Out of these four commercialbanks, there is onlyone bank which bas a considerablyh erm in deposit t the othes, when opening an accout One of the reasons for this is the perceived need to improv the confidencefor chchk. BMOI requi EMG 1,000,000,whit the other banks' deosits vary betweenFMG 50,000 and 150,000.

An alreadyexsting system,to make checksmore acceptedas meansof paymentsis tO have it endorsed(visC) by the bankbefore the clientsigns the chec The bankwries the amounton the check and also signs it. The checkis then gurganteedWby the bank that sufficient ftnds are waiable.

'Cheaues bleusu and Traveller Check in FMG In order to improvethe confidencein and accetan of checks,there are two banks which in 1989 and 1990,respectively, introduced two new similarchecstens. BTM issuedTraveller Checks and BNI TChecquebleu-, both nominatedin FMG.

The TravellerChecks have a fixed value, whist the Checquebleu can have either a fixed value or a specfic amount correspondingto the customers'request Ihe customerspay Uup front for the checks,which are not linkedto any account,but purelyused as a meansof paymnt Thus, it shouldbe regardedas a supplementto alreadyexisting check account, and not as a replacemet

Ihe banik have made agreementswith several enterprises,hotels, resarants, and other businesses,where the checks can be used as means of paymeLt.Of course, the checks can also be presenteddirectly in other banksand then forwardedto the cleouse as ordiary checks.Both BTM and BNI considertheir checksto have been well receivedby the market,both by users and by hotelsand other businesses,since the checksare safer than cash and, in case of loss, are reinbursed.

Notwithstandingthe usefulnessof thesenew checkinginstruments, which increase the confidence in the use of checks, these forms of checks should only be regaded as a temporarysolufion to the problemof confidencein checksas paymentinstruments. The checkscure the symptomsof the problems, but they do not solvethem, since the customershave to pay in advancefor the checks.

ELJancing the afety and - of chec

Security measures, forming part of current check sytem, consist of manualchecks and restictions in the use of the system,leading to inconveiencesoe uscoomerand couently to a low use of checks. A check system meeting the objectv of an imprved payment sym (cludig imved clearmgopeions describedin Annex3.3), camot rely on manualchecs of the presenttype. 178

A new check systemmust allowfor a mode of o accordingto the need of tie customer.The limited use of checks for paymentis maiy causedby insufficiet socurt in the System telf. Mana checks are generaly time cosuming and incoient A chocksystem for private cusme ought to be desipgeddif y from a systemfor corpoate custma. as -e nd need of servicediffer.

The checksystem recommended heo is basedon pesonlized chk foms, desgned and produced to makeforgeries practially impossile. A checkguarantee card (standardISO plasdccard) of kopro f qualityand signed by fte accountholder is concted to the account,for of the account- holder and verficationof signature.

A systemfor protectionof checksis requiredto mate it possiblefor railers to accWtpersonal checks,amd to makeit safe for a branchto hnour chocksdrawn on other brandiesand bans. Protectio is carriedout by caling draweebrnch, where the requestis notfied. Too many requestsfor proection will case convence to the customer,and to the bank, by overload sysm capacity.To avoidthat happg, dramweebank shouwdguarantee payment of smaier checks,up to a fixed amount,without protection.

A check service segmentedinto Oneqpe of checksgaranteed by drawnebank ad issued tD reliable customers only, and another always de_madn for protectio of tho check ought to be considered. Based on the aboveconid s, a new systemof personalchecks could be deised which would conformto the followingprocedurer

1. The checkform has to be regaded as a valuedocument, be printedon securitypaper, and be designedin order to hamperforgery.

2. The checkform is personalizedby iprnting ame of the account-holde.

3. Impriting of accountnumber, check number and nmi takes place in serity conlled printingshop. 4. The account-bolderis furnishedwith an identificationcard - a checkguarantee card. The card is a standrd ISO cardwith buRt-in security in orderto hampe forgery.The card is personalized withname, account mber and cad number(custm nm r). Ihecard has a limitedvaidity markedon the carLd

5. Tie account-holderwrites the signatureon the card at the space stated. Checkingrelated to encasementof checksor acceptinga check uaspyment,is in the main caied out by coring nameand signatureon card and check. The authenticityothe checkand card can be takenfor granWtedand addional checkingis limitedto baance.

At presn, withdrawalof cash withdrawalis in most cusm allwed at drawn branch. This resticon hamperst se of check. t is impor to devlp a systemallowing any branchto honor cho. It is firtheore neoary to create a system which coud a retailer payment fr an accepted checl. In the chock system proposed here, chocing of balance is the only thing which 179

necsaly has to be prfamed by draweebranch. The foElowIgsystem of pocting check woud allow al1bdnes to honor chek ad retailes to acceptchecks - payment,while keepingthe control of the accountat the draweebranch:

1. Honrg banch callsdrawee brach and asks for balancecheck.

2. If suificientbalance is avalale the checkis protected.Drawne brac gives honoringbranch a kwynmber to be wotedon the check. Mmskey number for part of followingclearing b-ranadia

3. At drawn branch, the traction to pwrct the cWk is enterd into the branch accoung system.The transacton is madeup of accoun number,check number, amount, honorn branch, key number and date for clearing.

4. Protcd amount is taken into accountwhat concer avalable balanceup to noted clearig date.

S. Tranactions are shownon the accumulatedtanaction list.

6. Protected checks ariving in clearing can be verified by comparing with he tasaction list.

The successof extendingthe use of checksdepends to a lage exnt oanthe possibilityto protec chcs but maybe hamperedby bad telephonesystems and ministive, difficultiesat the branch.For ths rason it is advisableto create a system which under controlledrisk of the drawee bank allows hnorig checksup to a ceran amountwitot beg protected. he amountshould be suffcieny large t cver 90 per cent of pyment expectedto be made by checks.

Unacceptablelosses for the banksare conditionalon followingsystem of rules and procedues.

1. Obvis misuseof cbecs is madecriminal offen (whichis aready the case).

2. The bank has the right to demad securityfor a dceckacount, eg a miniummbalance on the check account

3. Check accountswith feurs descrd are openedonly for customerbeing unequivocally .identified.

4. A cental file of Customershavg misusedchecks is set p. Banksare obligedto report any misuseto thefie. Banmcomult that file before openimga checkaccount.

5. A centralfile of blockedaccoun is set p. An accumulatedlist of the blockd accunts is ddivered to bramch-officesand retailers acceptingchecks on a month.

6. Acceptedand honord checksdrawn on blockedaccou to be found in the list are returned and are nothe resnibility of the draweeban.

...S. 180

Othermeasures to improvechek servicefor private customersar:

- an automaticteller machine,"AT&, serce at drawnebanch usinga checkgarane card and PIN code. Initiay, the ATMservce shouldonly be used at draweebranch and not intrabranchor ihterbak witdrawals.

- a new service for regula paymentswhich could be accomplishedthrough the customerswriting a list withpayment orders and hand that list and a checkto the ban- This would t;ft some of the workloadto the banks bak-office and unloadthe fot- office, enabling them to deal with other matte. (An extendedservice for regular paymentsis described,in form of a ystem, in Annex3.5.)

Cormte chdc

Thedemand for secrity of companychecs shouldbe the same as for privatechecks and should make forgeriespractically impossible. AU checis shouldbe crmssedOm* and no signatu conol wouldbe neessary. (The crossd check oughtnot really be of any ic e to the payee, sice they are likely to be suppliers,ie other companies.)The payor bask couldfor istan send tanacion lists to the payeecompanies every daayin order for the lientsto verifythat all cashedchecks are corrct and no Uaseones are in ciculation.

Education and centalized Enformation

Thereis also a need in Madacar to increasefinancial knowledge amongst the populato To makethem awareof the benfits(saMy, etc) withban and checkaccou. IThiscoud be donethrou savings campaigns,etc, frm not only the banks, but probablyalso from the Govenment. Another methodto enhancethe acceptanceof checks,and thereby also the bans' reputation,could be to introduce an "institution"were the banks can get informationon a checkaccount appLicant's solvncy, etc. 181

ANNEXIJ

CONCEPT AND FUNCTIONS OF A G3.SNK SYSTEM

AND AIUlCAIM TO A EMDAgA&K

Giro systemshave over a long periodof timeproven to be efficientsystems for handlinglarge numbers of payments. Such systems have been in use in Europe for more than 60 years and have proven their reliability and efficiency. A giro system not only transfers moneybut also provides vial information on the amounts being paid. A well fmetioning giro depends on information which is accurate and which can be handled both in the giro as well as in the payment procedures of the recipients of finds.

Bzusljpns of a Girobank Sytem

To help explain the nature of a girobanksystem, the figure below schemaiclly shows two paymentssystems with and withouta gr. In the first (solelycheck-based) system, all payors directly makeindividual payments to eachpayee to whomthey have a f cial obligation.In a giro system,dtese paymentsare aggregated y individuapayor, centralizedin the giw system and aggegated agi for paymentto individualpayees.

Payor PePaye Payt

Check based Giro Ban based payment system payment _VV_s

At the heart of the Girobak is he Giro acwunt. Here, al tanc are collectedand the balances kept To the account file systm is _ataed a system for producing and the transaction deliy systm which contains the iufri2tio, on each tnsacto te rcqie needs for the book keepig of paymens made. 182

A Giro systemis in principlebuilt up of dtre typs of payments:

* hi-payments t accunts * Out-payments from wcounts * Transfers between accounts

The efficiencyof a Girobank based payment system is bglMydependent on the number of oudtets in which payments can be made through the Girobank.

Ty of Giro Sst s

Basically Vfereare two type of Giro sysm. Ihe firstsystem is only a clearing facility in which acounts are maintained by the participat bak to which te Gir ficility is altached requir that aU banks coopeae and share the operating s for th giro (deaing cee. he beneft would be the possibility of keeping money within tie entire bakg system asi he cae wth paymes trough checks.

This Giro system, based on accounts operaed by the partidptng bans, is preferable in cases where tere are other payment systems opaing outside the bain ystem. In such cases, bank would have an incentive to design a system for paynwens, enabling then to keep tie flow within t'he baking system-

This is not the case in Madagascar. Here, there is already an embryonic institution acting like a girobank which is the postal checking systm (CCP). In combiningt Girobank facility with the post savings instituton (CaissedEprgne de Madascar), an efficien network coud be put in place to facilitate payments cover the entire country.

Procedures for an oerang MWaag uiro sysem

In Madagascar, the first area of priority would be to facilitate in-payments. Here, uilities and government payments such as telephone bills, tax payments, elecicity and other simi payments are ideal areas to start with.

An example of a Girobak in-payment utraction wold be the teleone bill. The bill is sent out a'. aormal by the telephone company to the payor. To dte bill duld be atached a payment fom of a standardized design deckdedby the Girobank The payor uses the prepritd payment fom as payment document in the Post Office (or CELl) and makes his payment k could also be envisaged that the payor could make his payment in the branch of a bak if the bans were to paticpa in the girobank s The latter would increase the possibiities for the payor to nake his payment in a convmieent place md manner.

At the same time other bills could be ped in dts mnmer In te same instance, thereby avoiding the use of several checks and/or vsits to seeral institut for diffen payments. At the end of the day all these payments Cn this example the telephone bills) are lumped together and sent to the Girobak centre for processing. Here, the communicationsare crucid dth better they fimction, the higher tie efficiency of the Girobak system. In an idea stuao te payment forms should reach tie Girobank centre the following day, which in Madapscar would be true for Anaarivo and possible some nearby 183

locationsincludig larger cities with efficientpost service (probablycoveingmore tman 50% of ai payments).

At the Girobankcentre, the Incomingpaymen farm are processeddue sme day, which is possiblethanks to standarde fm and the use of computr techiques. At the end of the procesing day, a statment is producedcaining al necssary informato to the payee such as amoun paid, telephonenumber andlor referec numberand date paid.

The telephonecompany would reeive the stae_mt the foiowing day for its own accounting purposes.ITe staement couldbe producedin virtuly any form reWiredby the telephonecompany and deliveredin any media such as magnetictape, ot-ine or paper.

The Giro a lder, in dis eample of in-payment,is the telephonecompany only. t would also be possiblefor the Girobankcentre to acceptchedcs as payment,should dis be required.

The secondarea of gibank acitvitymentioned above is the out-payments.A girobankis an ideal paymentssystem for such paymentsgoing in the odirection in larg numberssuch as pension,social sec and salary paymets. Here the giro a holder, say the pensionagency, issuesinstructions to Ot Girobankcentre to issuepaysm in the odter direction.

In the exampleof the penson, the agencyissues paymes formsand a singlepaymnt orderfor the total amountto be debitedto the Giro account The Girobankcentre processestee oupaymens w-henreceived and debitsthe account.The out-paymen ms (se are sent out to the receivers fthugh the ordiary postal sevie and the beneficiariescould cash them m any post office or bank ofice or depositthe amount io an account,whidwver is prefeablel

Thethird area of giwbnk activit wouldbe transfersbetween accounts. Ihis acivtitywould open up the gira systemtD a widergroup of accnolders, enablingprivate pesons to operateGiro accounts.

An exampIeof the use of transferscoud be a companywhich has to makepayments of bills. For these transfersto work efficientlythe use of giro accountsshoiud become widespread among co es and others to which paymentsare mat' (suppliersetc).

The payingcompany receives bils to which is preferablyatached to an inpayme form (the scandardizedversion). All bills whichare to be paid are lumpedtogether and summaizedon motramsfer paymentform. (Paymentswit wouldrequr- one checkper bil and possiblyalso a coverng letter per bill). The transferpaymet fom ad te in-paymentfom are se (or deliveredotherwise) tD the Girobankcent for processing.In the ideal siion with efficien postalservices, the insructions are receivedby the Girobankcentre e followingday for proessing the same day.

At the end of the processingday, two staments a produced;() oneto the payor indicatingthat the Giro accounthas been debited,te newbaance and dte paymentsmad ad Ci) one tO each payee indiating amountpaid, invoiceor other referencenumber (whohas paid) and date paid.

In the tansfer paymentopeaon it is alsopossible to makepayment to non-iro acount holder at the same time, using the sameprocedure as without-paymet trnsactions describedabove. 184

Advantagesand imRplmentationof a giro systemin Madaear The Girobanksystem offers a completeand efficientpayment system both to individualsand companiesalike. The efficiency is based on the use of highly stndardized routines and modern computerized tecniques. It offers subsil advantages over systems based on individual payments effectedby each fiancial agent and exploitseconomies of scale in settlingpayments throughout the economy. This would also allieviatethe burden of banks the often costly handling of many small transactionsand limit the use of checkswhich have a tendancyof strainig banks operatingcosts when their use reaches high volumes. Unlimiteduse of checkshas in many counties forced the banks to introducecharges over and abovethe normalhanling costsfor transactions.

Furthermore, a Girobanksystem offers substantialsavings and improvedeficiency for companies handling larger volumes of payments as the Girobank centre will be in a position to provide services tailoredto the individualaccouning proceduresof the companies.For individuals,payments are made much easier as the Girobankoffers a onestop solutionto all paymentsin a fully developedGirobank system.

In the case of Madagascar..there appearsto be muchpromise for a Girobankcentre based on the existing postal checing sysem (CC) which could be operated by a reconstructedpostal savings instution in order to make fuli use of the postal network. Ths could enable paymentsto be made vially everywherein the country. A fundamentalprerequisite to realize this potential is a strong commitmentby the govenment to use the CCP as the basic mechanismfor handlingsalary payments of civil servantsas well as tax, utility, and social securitypayments and other paymentobligations of the Treasury.

Commercialbank participationin this giro system should also be consideredand oDuldbe achievedin many ways. One way wculd be to allowpartial ownershipby the commercialbanks in the Girobankor simplyto have an agreementwhereby Girobank transactions can also be handledthough the commercialbanks. The Girobankwould be self sustainingand draw the majorincome from the float it will be operatingin the system.The float wouldbe substantialand could be investedin the money marketor even with commercialbanks, therebyproviding the bankingsystem with an additionalsource of short terms funds. Over time, the float would be predictableand a certain amount could also be investedin longerterm instrumentsdepending on the investmentfacilities available. The girobankwould thus have the potential of becominga sigoificantplayer in emergingdomestic financialmarkets in Madagascar.A secondsource of incomecould be a nominalfee chargedfor ihe ransactionsand fees chargedto accountholders for extra servicesrendered such as automaic ivoicing.

In Madagascar,the timing for developmentof a giro systemappears appropriate. A clear need exists;modern ompu techniqueshave begun to be introducedin manyareas; and an embryonic giro system already exists within the postal checking instiion (CCP). A giro could be built in Madagascarwith a modern,computerized design from the begiming.Some complicated systems that can be found in most EuropeanGiros, which began when.modemtechniques were not available1 can be avoidedin Madagascar.This would ensurecost effectiveness.

Further studywould be neededto more conclusivelyestablish the profitablityof a Girobankin Madagascarand defineits scopeof operations.However, the considerableexpeience of the giro systems in both industrialand developingcountries suggests that such an instiution is likelyto have a promising futurewithi the paymenXtand financialsystem in Madagascar. 185

ANNE3IA

OVI:Rli;wOFTHEEm3RAL rAYMEN SYSI'EMIN NMADGASCAR

The existingcuncy regulationin Madagascardoes rot autfiorizeanyone but the BCRM to deal with foreign currencies.Consequently, neihmer bak nor companiesare allowedto deal wit foreign exchange,or have foreip currencyaccounts, and all paymentstransactions to a foreigncountry have to go trough to BCRM. Tis has been the ca sinceto commercialbanks were nationalizedin 1975.Furthermore, the Malagasycurrency is not convertible.

Thus, wheneveran importeror exporterwants to sellor buy goods,his bankhas to apply to the BCRMto buy or sellforeign exchange, as is the case whensomebody has moneytransferred from anothercountry or wants to transfermoney to abroad.

imp=r Th. 'fllowingsteps canbe distinguishedwhen an importeris to buy foreigncurrency to pay for his goods:

--- Exporter |(M) J |()l

Central BankC

Madagascar (F) Foreign country

Day D: The importergoes to his bank, Bank (M), witi his import docments.

D + 1: The followingday the bank colecs all he importapplication belongingto its customers.The bank then once a week sends in applicadonsto the BCRMtobuy foreigncurrency, which is requested by the BCRM. Thus, if an importeris umawareof this fact, his applicationmight take an extra five workingdays before it is forwaded to the BCRM,i.e., day D+I suddenlybecomes day D+6.

D+3 to D+S: The BCRMthen takes two days to verifythat all the docments are in order, i.e., on day D+3 ( to D+8) the bank recs a notificationthat its accoun with th. oreigncrresponding bank, Bank (F), is to be creditedin egFRF.

~~~~~~.. , . . = - 186

Despie the fadctht the exchangetaaction is not aled unSilday D+3 - D+8 the importeralways get the exchnge raft - of the day the bauk sends in the application(D+ 1 to D+6).

In an exportsitation the pmcedures n more or less the reverse of those of an import transaction.

Exporter Imupo-rtan

J C~~~~~~~jT

(NI1Madag-scIr (F Foreigncountry

However,the commercal bank, Bank (MI, does not get crediteduntil three days after it has been notified by ft. corrspodn,Bank (F), that the paymentwas made. Th~eecmhange rae appld is he.rate as oft. day te bank is notified. a weekForei to. Free TradeRMd Moneytranfer in foreigncurenies toand from Madagasca ne dealt with in the same manner,as when the banks send exportreceipts or importdocmuments to the BCRIbLThe time it takes for-atransfer to reach the payee is, es for importsand exportnusactions, dependenton whetherthe transferis to go by telex or mail. A tdele is normallyhandled rather quicky. However, as previousy mentionedtelex systemsdo not alwayswork adequatey. On the other hand, transfersby mnaimay take

Free TradeEnterrisease an exceptionto te c encuncyt regdlation.Following the ¶Loisuir Ins ZonesFransohes Idustrmie, a law adoptedin 1989, domesticad foregn investor have the pobility to bves in export-orimoedindustris with consderanbletax benefith.These Free TradeEnterprises, - allowedto open and hold sown oreig currenciesabrad. Theyae a alowed to borrwoney abrad. (ter ae few limitatios to aknd of transactionsthese accunts canbe used for.) Prsnty, fth ae approxi 10-13functoning Free Trade Enterprises in Madagascar,mainy activein the tile Mindstty. 187

As from Mard 1992,Madar will be connectedto the wc :wide SWIFTsystem for dealingwith foreigncurencies. TIbs will enabledt partcipatig patrs - the commercialbats and the BCRM- to instantlyreceive and sd transfer rders. This wil to a cerain extentshorten the existing delays. However, SWIFT does not effc tie prese currenc regulation,and banks wil still have to apply to the BCER to sel or buy foreip curncies.

The SWIFTsystem will give acces to all couies connecd to SWIFT.It has in several caes been shownthat acivity to ad fom a couty connectedto SWfIT increases,siply beus of the increasedaccessibiliy o foreig bns. SWIF is not only an efficientsystem fbr dealing with foreign currencies,as there e ls other servicesconected to the systemwhich enableparticipants to seal, for example,telexes in SWIFTfrmat hroughthe system. 188

ANNE1L

THE COSr OF Il

The cost of intermediationis copted by dividingthe opeatn incomeor the gross ea ningsmargin by averagetotal asset. The gross earningsmargin is equalto the interestmargin plus other operating income(including commission income, foreign exchange profits, and other operatingincome). The cost of intmediation has te components:operadng costs, other net costs that includedepreciation cost, net loan loss provisions, and otner non-operaingcosts less non-operaig or exceptionalincome) and gross profits. In a competitivesystem, the cost of intermediationtends to be low (i.e., less than 3.5 percent in developed Dountrieswith efficientbankling systems), while it countrieswith exchangeand selecive controlsand consequently,restrictive fmancial systems, the cost of intermediationtends to be higher. 1S9

ANE .1

CONTRACTUAL SAVINGSIN A MEQPRMJD 'PERSPEt: APPLICATIONSTO MADAGASCAR

Clssifications of contractual savings insttutions Regardless of the type of contractual savings institution being discissed, there are two basic types of classifications. The first, direct contnrbution(DC) plans where regular contributions are made by the participant or on his behalf and where the final benefits depend on the total contnbutions made during the period of employment and the investment accumulationfor the same period. In this type of a program there is a direct link between the contributions made by the individual and the benefits received. This plan is completelytransparent as there are no vesting restrictions (unless the contributions are made on behalf of the individual by the employer), and there is portabgity in case of employeemobility. The second, defmed benefit (DB) plans where individuals are granted certain future benefits and contributions are made in light of investment performances of the plan and other factors. Direct benefit plans usually require certain vesting provisions and also limit the portability of benefits in case of employee mobility. Certain justification exists for these provisions, the case in point being the employee who has undergone extensive trining or has acquied job skills not otherwise available in the open market or when the employee has, through job related activities, acquired privileged informatLion.

Typ of contractual savings institutions: Throughout the world, there are four basic types of contractual savings insdtutions: national provident funds, social pensions insurance funds, life insurance companies and occupational pension funds. There are also variations on the personal pension or savings plans which are admiistered by a variety of agents such as commercial banks, savings banks, life insurance companies and certain types of managed pension and mutal fimds. Contractul finds however are differentiated by the fac-t at they are defined essentially as long-term institutions and the other savings plans are usually short-term in nature. Reviewed below are the key operating characteristics of various types of ontactual institutions, their economic implications and relevance for Madagascar.

Life insurance companies and products: Three types of companies offer life insurance products. Stock companies, owned by their shareholders; mutual companies,owned by the policyholders; and state-owned companies. Inationally and in most developed countries there are more stock companies than mutual of state-owned companies. Life companies cover the risk of premature death as well as the risk of excessive longevity. Prematr death is covered by whole life or term policies whereas excess longevity is covered by various kids of anmuty policies. An additional service is the management and the insuring of occupationalpension schemes that combine the accumulationof reserves during an individuals working life and the paymet of regular pension benefits during retirement. Life company products must also be distinguished between individual and group policies with the former incurring higher operating and marketing costs. Group policies, on the other hand, are often negotiated direcdy with the employerand are subject to lower operating and marketing costs, have fewer information problems and avoid the inefficienciescmsed by the problems of adverse selection.

Demand for lire insurance: For the most part, the life insurance business is not well established in developing coDunries. Ihis can be attrbuted to both demand and supply factors. The general level and distnrbutionof wealth and income is a key factor. In countries where inflationary epectations and foreign currency overvauation is prevalent, wealthier individuals often benefit from 190

lower premiwmsavailable in foreign markets in currencies less affected by die inflationary trends ad hie devaluations of the local curreny. This in turn camcreae an adverse selection problem for local insures who may he left covering dte higher mortality rate of the lower income segments of the populato therefore being forced to raise their premium in order to cover the addiional rsk reducing further the level of effective demand for the product. Overal demand for life insuance in low-income countries a Madagascartends to be low not simplybecue poorer peopleare unableto afford insurancepremiums, but ratherbecause they have little real financialwealth and thereforeare exposedto little risk of f1mcal loss. In manydeveloping countries, the extendedfamily or the local communitybecomes the insr of last resort by makinginform aaemes for individualswho have suffereda misfortuneor who are unableto care for themselves.

Socialsecurity sgsten: TableA showsthat most countriesin the worldhave developed some form of social securitysystem. Social security systems administera wide variety of social programs,including unemployment benefits, family allowanceand health benefits. It i s intesting to note in the followingtable the steadyincrase of socialsecurity programs beig offered worldwide.The basic differencebetween social pension systems and nationalprovident funds is that the former are defined benefit schemes, while the later opae as defined contbution plans. In many developing countries such as Madagascar, the social security plans are on an unfumded,pay-as-you-go basis. Three types of social security sysm offer old age pensions: (i universl benefit schemes which provide general pension coverage for all residents over a specified age regardless of income, assets or employmentstatus; CH)univeral social assitnce schemeslimit pension coverageto undeqrivileged residents, falling under asset and income ceiling levels; and Cim)socia pensin insurance schemes distribute pension beneft to participant under age, past employmentand conrbuti requiements and limitations. The government f Ihe finst two programs from its general revenmebudget whlee tird programis primay fundedthrough ontributionsfiom employers and employees. InLmany developing countriessuch as Madagascar,only a smallfraction of the populaionis coveredwith the majorityof the large rural populationengaged in subsistencefaming and the informalartisanal sectr in urban cents are virtuallyexcluded frm coverage.

Table A. NUM OF COUbM= WITH SOCIAL SECURITY PROGRAMS

Any Type 58 120 139 142 Old Age/nvalidity 44 92 127 132 SicknessManity 36 65 79 83 Workers' Compensation 57 117 136 136 Unemployment 22 34 37 40 FamilyAllowance 27 62 67 64

Source: Social Security Adn n (198 191

Prohtnm In a nof moa sur sM Social pensionand isrce schemeshave a hily ce izedmanagem and are mosdynational or regna insbin. Their operationsare decenraized ad admistred on a localbasis. The nat of the sociDalpensio insurancemakes it highlysuscepdble to polinterference in refenc to the natureof the investments as wellas withregard s to the mke-up of benei aod tie paymenof beneft. lIe lackof iastutiona autnomy has also createda aministatve weaknessin the abilityto eafrc complince, to keep accurat and up-to-daterecords and monitorand enforcethe promptpayment of cobutions tc the scheme. The penaltiesimposed duriqg these periods must be swift ad of suac to avoid creating incentivesfor delayingcomplince. Adminisr mustalso be wiling to pu- fu complianceso as to safeguardthe integrityof the sstem his will also kae employer. andemployees from cofluding in iheunt of was eared or by establishingan uanual amnunof non-taable frine benefits as part oft compensai pacae or in the worst case scenario,mking under-thetablepayments of wagesin cash. Thesepractices become more prevalent when there is a weaklink between contibutions and benef s.

Eoon2mkfer 2otsocialser Moment An addWonalproblem for wsunrie havingundergone periods of highinflation, as waspreviously the casewiti Madagac, recety is Ihe ezGrOnthe real valueof the benefitsor pension m s e net effct tendsto be a redistributionof benfits fromworkers with long tene andhigher incomes to thoseof shortertenure and lower inomes. Unlesssuch a situationis addrssed so as to reestablish a parity betweencontution and benefits,it leadsto a perption that contbuons are see moreas a tax on laborrather than a systemof contractual savings.It shouldalso be notedthat settingrates of contrmbtionand collectingthe contributionsare qWite a differentmatter. Complianceamg prive employersrequi consta policingand even tbis will not resiut in a timelypayment of contutns andor payrol deductions. During inflationay and/or periodsof bigh interestrates subst_at incenivesto poswtpoepayments for as long as possiblecan becometremendously acute cmai udue ste on the systemif thereis a particduarsortage of resers on hand. Ns:l mLidmLtluk: Conbuions hereare fixed by supervisoryauthorities with paymentnormally made by bohi employerand employeeunder specificrules and regulations. The benefits,which are usualy pad out in lump sum paymentsbut which ould also be convertedinto annuities,depend on the amountof contutions paid in and the erings generatedduring the duration of the wage earner's involvementin the program. A carefulbalance must be kept in the reqwired amoun of the contributionsrelave to total wagestucture since a high levelof conutions are usuallyseen as frced saving ad adverely this couldlead to the u s_of wages. However, sinceconrbutons and benefitsare mt linkedto specific employer,there is no restictive effet on labor mobilityand thereis n ditbutional effectbeeen fte and mid-careerswitchers. National provident fundsare alsoseen as paternalistic -to whicharen ubject to subuiapolitical inerfrene. The reservesgenerated by the sins are substatal and goverments have been knwn to use these reservesto fundgovarment projectsand debt Thereisa definie possibilitythat the final benefis could be less than expectedbecause the contributorundakes all risks of inion, investmentret and replacementvalue. Unwmegoverment intfrene can affect the solvencqand itegrty of the fund effectingadministative efficienc and the real rate of returnproduced by the fnd. Oiualo Pesufunus: The samearguments for definedbenefts and defined cributions hold &st in regardso occupationapension schemes. The majorsortming of the DB plansis the poorlydefined finacial contractthat the employerhas withthe employeeand the unilatera nghts that the employerreti to terminateplans and convert accruedbenefits to a DC plan. The problembeig that a certin extation by dte employeefor heirretrement benefit canbe oblitated. 192

The problemof non-fundedplans, when firms face insolvencyor are unable to meet their pension obligations,is consequentialand employeesstand to lose a considerableamount of personalinvestment. When investmentis mentioned,employee decisions must be includedin the formulabecause long-term determinationsto forego mobility,higher pay scales,advancement and other changesin the employee's career are weighedagainst presumed benefits the employeeis led to believehe will e"joy after a specific lengthof servicewith the sponsoringfirm. Vestingperiods vary from firm to firmbut averagesindicate that three to ten years is normal and that partial vesting can begin almost immediately. Further weaknesseswith a DB plan are apparent in referenceto employeedismissal prior to acquiringvesting rights for the accruedbenefit. Employerconsideration could be opportunisticin these casesbreaching the long-termagreements with employees. Immediatevesting and portabilityare the most beneficial aspectsthat a DC plan offersthe employee. There are no intentionalredistnrbutions between groups of workers and the plans are much simplerto operate. DC plans also rely on the solvencyand financial integrityof the financialinstitution managing the funds. Investmentrisks however,are borne by the individualsparticipating in the program- Regularcontributions to the programare usuallyfixed in direct relationto salaries. Pensionsdepend on the amountand the durationof time spent contributingto the programalong with the accumulationof investmentincome earned during the same time frame. In developingmarkets, such as Madagascar,DC plansshould have accessto indexedfinancial instruments, for investmentpurposes, in orderto increasetheir abilityto hedgethe portfoliosagainst inflation erosion. The same argumentholds for devaluationrisk.

Personal pension ulmns:Much the same as other pensionschemes, personal plans are definedcontribution plans and thereforedo not sufferthe vestingor portabilityrestrictions of DB plans. Individualscan choosethe institutionsthat will managetheir funds and they can transfer their funds or redirectthe typesof investmentsto suit their particularneeds. Youngerparticipants might prefer capital appreciationplans whichare more likelyto createinvestments in the equity field whileolder participants mightshift their investnentsmore appropriately into dividend paying instruments as theyare more in tune withthe particularneeds of individualinvestors and often'tailor' the portfolioto meetthese requirements. The argumentcan be madethat sincethere are no restrictionsto the timeframe of the investmentthese plans are short-terminvestments, but its has been noted in more developedcountries where specifictax advantagesapply, that these investmentsbecome long-term savings schemesin the majorityof cases. Personal pension plans can be establishedwith insurancecompanies, commercial banks, marketable securities(mcluding bonds, equity,and unit trusts) and mortgagesocieties. In many case thesepersonal pensionplans are establishedto supplementthe occupationalor other pensionfumds which were deemed insufficientto cover individualretirement requirements. In developingcountries, especiallyLatin America,the introductionof personalpension plans alongside existng socialsecurity and company-based plans, in the early 1980sseems to have receivedwide approval. In Chile, the systemof compulsory personal pension plans was introduced after the reform of the social security system of 1981. Managementof the funds is entrustedwith a numberof approvedpension companies (Administradoras de Fondosde Pensiones- AFPs). Employeesmake mandatory contributions equal to 10% of earnings (up to a specifiedinflation- indexed ceiling), thoughthey are allowedto make additionalvoluntary contributionsup to a total of 20% of total income. Employeesare also requiredto buy life term and medicalinsurance, which are providedon a groupbasis. On retirement,employees can either buy an arnuity from a life insurancecompany or come to a similararrangement with the AFP. This plan is governmentmandated but privatelymanaged adding tD its transparencyand credibility.This model could certainlyhave applicatios in Madagascaronce the financialinfiastructure is adequatelydeveloped to accommodateits key elements. 193

Redistributiveeffects in promoting contractual savins: In consideringa strategyfor long-termdevelopment of contactual savings in Madagascar,policy makers must be aware of the perceptionof redistributiveefftcts on incentivesto participatein such sciames. Strongand directlinks betweencontributions and benefitwhere there are no redistributiveeffects are viewedby the participants as forcedor voluntarysavings and not as a tax on labor. Thereis no disincentiveon labor mobilityand thus there is a limitedeffect on labor marketefficiency. Intentional redistributive effects are usuallyseen as direct taxes on the labor market and there is a weak link between contributionsand benefits. Redistributionoften reflectsthe country'sdesire to meet certainsocial equity objectives. Labor market incentiveslinked to these effectsare seen as a desireto keepmid-career switchers on boardand convert themto lifer statusand the samecan be said of slow-trackand fast-trackindividuals reference to company basedpension schemes. Unintentionalredistributive effects are usuallycaused by inflationarypressures andlorcurrency devaluations, in respectto the distributionof benefits,witiin and acrossgenerations and also due to changes,over time, in the performanceor provisionsof pensionschemes.

ComPulsor particination and risk allocation:Compulsory participation in contractual saving schemesoften times createsnegative results as participantstry to evademandated contributions and try to manipulatethe systemto their own benefit. The mostcommon example is the understatement of wagesor the partialpayment of wagesoutside traditional payroll methods. Adverseselection is more of a problemwith voluntaryparticipation schemes because individuals in a higher risk situationwill be more prone to purchaselife insurancecontracts rather ta amnity policies. Informationalefficiency makesa systemeasier and simplerto operateIhe transparencyfactor makes compulsoryschemes more likelyto be perceivedas deferredcompensation and forcedsavings rather than a tax on labor. Allocation of risk in a contractualsavings plan had alwaysbeen a primaryconsideration sice the integrityand solvencyof the plan hinge on the decisionsof the providers. The three risk factors to identifywith contactual savings plans are as follows: replacementrisk, investmentrisk and inflation risk. Replacementrisks deal with the level of benefitsrelative to needs at retirement. Investmentrisks deal with the choiceswhich havebeen madein portfolioselection and the performanceof these investments. Inflationrisk refers to the protectionlevel against inflationwhich was made during the life of the investmentprotecting it againsta loweringof estimatedor promisedbenefits at retirement. The most importantfactors concerning the efficacyof oonactal savingsplans must in the end deal withthe level of protectionthe plan has providedfor expectedbenefits. The solvencyand integrityof the plan will determinethe acceptanceand complianceof the plan on a broaderscale.

Choosing the degree of centralization: Operating costs have traditionally been lower in centralizedmanagement of contrctual savings instittions. Lower marketingand operadngcosts are sometimesoffset by bureaucraticinefficiencies which tend to createa slow and cumbersomesystem with a greater exposure to political pressures and intervention. Manipulationof assets, due to political overtones,may lower the return on investmentsand thereby causingchanges in the benefitstructure withoutreasonable necessity. Manyof these problemscan be mitigatedthrough the use of a highly decentralizedmanagement structure but this willentail higher regulatory, operational and marketingcosts. Whichevermethod of managementis chosen,total transparencyis the preferredcourse of action. There is also a definite effect on the country's capital markets orientationand the promotionof new and innovativefiancial structuresand products. Decentalizedmanagement usualy encouragesinvesments which are bottom line orientedwhile at the same time risk aversive. Centralizedmanagement on the other hand may encouragethe direon of investmentfunds through govermnentmandate thereby possibly limiting capital markets developmentwhile at the same time redirecig the funds to the government'sbenefit. Thesetradeoffs must be carefullymade by Malaghy policy makers in deciding how best to promotecontractual savings and their potenti for promotingfinancial market development 194

Mobil Inandal saying achmw. The creationof fundedpension schemescan genate substnial iong-taemf savig vea in a relatvely short period of time. In couies where labor incmes rapress 50% of nation income,a compulsoryscheme covering 40% of the laborforce and imposing10% contbution rate wouldaccutnula annally fnds -qualto 2% of nationalincome If the nominalrat of return an fund blance is equalto the nominalraz of growthof GNP, and snce in the early yeas of opeao pensionbenefits would be minimal,these pension schemes wouldaccumlate resources -quto 10% GNP over5 yea and 20% over 10 years. After the first 10 years, the pace of acmulation will be afectd by the gowing volumeof benefit payment. On the other hand, expandedcoverage and an ixn in the share of labor incomein toaincome wili tend to acceleratethe pace of accmulato he experiene in Sigao, Maasia, and, more recenty, Chie showsthat once a credibleand well run systemis in place, it can accumula long-termresources at a very fast pace.

The promotionof coDnotualsavinp will cet an effective echansm for channeling such savigs throughthe financ systemto finane an expani m the supplyof productivecapital. Efficientcontaca savig insdutionscan help enhanceinvesaetproducivity, stem,and perhps even revese, capitalflight, and lower dtereal rate of interest. Achievingthese benefitsdepends entirey on removingregulations and practicesthat use contactual saving enties as captivesources of financefor governme debt instrumentsat low interestrates, as is Dowthe case in Madagascar. Suchrestrictions not onlyaffect the financialperformance of pensionfinds, life israc companies,social secrity trust fiundsand governm owned and regulatedcommecial bank, ;At als izhibitte positivecontribution that such institutionsmake to the dwdopment of a domesticcapital market. 195

POSTA SAVINGS,EANKSIN AFRICA:LESSONS FOR MIADAGASC,AR

There is a ted in many developingcontries to 'convert Post OfficeSavings Banks into fully Hedgedbans. One such eample is in Zambia wherethe NationalSaving and CreditBank (NSCB) was formedtrough an act of parlian from the previousPost OfficeSavings BaR The NSC' was given a chartw of its own and entred inooan agreementwith the Post Offices to carry out NSCB services. It was also givendie right to isue loans fom its Head Office. Unfortuately the NSCB never took off as inteded due mainly to politcal reasons and the imstable economyof the country. Another contributingfiacor was that the NSCBdid not benefitfrom any tehnical assistanceprogram to upgrade its capacity,mainly ita manageri capacity. To this day it is still considereda very weak banidng institutionin the Zmbian baking community.The NSCBhas issuedfew loans since its inception,but on the wholethe bank is riddled withproblems sfill await to be resolved. The bank has, however, contnued to operateon its own and playsan importantrole in the Zambi;a economybut its fullpotential is still to be utilized. The lesson which can be leaed from this case is that a legal changealone does not conite the requiredpackage of changesneeded to transforn a Post OfficeSavigs Bankinto a fully fledgedbat Anotherlesso is hat the agreementwith the Post Officesalso needs carefulattention as the MCB case has denated that certainsortcon exist regardingthe remittanceof funds from the Post OfficestOD fhe NSCB. The NSCBis now pusuing developmentassistace in order to implement a taining programas well as coterizing its a ng procedures. It has also embarkedupon a programto establishbranches of its own in certa parts of the countryin order to providebetter services more in line with other bank and as a complementto the servicesof the Post Offices.

The Post Ofie Savinp Bankof Zimbabwe(POSB) is a well managedinstitution which in very recent years has experience a downwardtrend in its deposits. This has been found to be attributable to the stiffeningcompetition among the bans in Zimbabwe,whereby the POSBhas lost marketshares due to inefficiencyin its sermce. Here two fictors have been found to be of utmostimportance: i) the present manualsyst has been unableto maintain the same levels of speedand efficiencyas the other computeried banis; ad ii) POSBis not ableto provideany other sevices than its savingsaccoun and the fixed deposis accou which is consideredtoo limed in a market where other banks offer a more versatile service.

The POSBhas its own Board of Directors,its own managementand operatesits own business; it also purchasesservices from the Post Offices,including staff, and pays a cost per trnaction for these sevices. The Post and TelecommunicationsCorporation (PTC) has signed an agencyagreement with POSB to offer such services as deemednecessary to opete the POSB includingcomputer services. POSB,however, is a legal entityof its own. In recentyears, the POSB has alsoopened up branchesof its own called 'hanking halls'. Thesenow mumber11 in tDo and another 3-4 are plannedin the near fitue. In other places, the designof the Post Officeshas been madein such a way that the entranceto the POSB is from one side of the buildingand the entranceto the Post Officeis from the other.

The POSBhas now embarkedupon a plan to computerizeits operations,both in the bang halls as well as in the Post Offices(most of them). This devlopment wil make ipossible to offer the same qualityof serviceas one wouldfind in otherbans. Thiswill also lay the foundationfor a new corporate strategywhereby dication of its serviceswil be dealt ith. lt has also been recognizedthat the 196

mostvaluable asset of POSBis its networkthrough the Post Offices. This will be the futurefoundation of the new corporatestrategy to be formulated.

The Post OfficeSavings Bank in Botswanahas recendystarted to diversifyits servicesto the public. First, it has participatedin some goverment credit schemesand thereby began to learn loan handlingand processing.It has onlyone branchof its ownand operatesmainly through the Post Offices.

All these three postal savings banks are granted the right to invest their fmds freely in governmentbonds, commercial banks and/orother papers in the moneyand capitalmarkets. Botswana is probablythe mostpositive example where lending has been introducedin a successfil mannerand the postalsavings bank moreand more takes on the shapeof a fully fledgedbank. The Zambianexperience could have been more fAvorablewere it not for the politicaland economicaldifficulties within Zambia which affectedthe NSCB.

Tanzaniahas also recentlydrafted a new constitutionfor its Post Office SavingsBank aimed in the same directionas the three examplesmentioned above. One commonlesson leared is that it takes time to transforma Post OfficeSavings Bank with limitedoperations into a fully fledgedbanking operation. Also, in order to make it as swift and fast as possible,a technicalassistance program is neededto insfitutetrining neededin the initialphases and to design new operationalstrategies based upon new policiesso as to achieve a concertedeffort in the transformationprocess.

In Madscar, it wouldbe very useful for officialsof the Caisse d'Epargne (CEM) to make studyvisits to these counties in order to see in detailhow the trsformation process is workingand to draw on lessonslearned. CEMtshould also considerapplying for membershipin the Intrnatonal Savings BanksInstitute (Geneva) in order to makeit possiblefor the CEMto have accessto latestknowledge and experiencein this field andto be able to participatein conferencesand seminarsheld mainlydealing with these issues. 197

ANNEX 7.1

THE FOREUGNEXCHANGE RErENION SCIEME IN MAURTIUS

Even beforeMauritius entered its exportboom phase in the 1980s,its foreignexchange controls began evolvingfrom an automaticsurrender requirement for all foreign exchangereceipts to a more flexibleforeign exchnge managementsystem allowing exporters and commercialbanks greaterscope for receivingand managingforeign currency,Like other developingcountries, Mauritius maintains a requirementupon exportersthat foreign exchangeproceeds should be repatriatedand surrenderedin exchangefor local currency. However, this requirementhas for more than a decade been flexiby administeredto facilitateexport transactions. In practice,exporting enterprises need foreignexchange to foot their importbills associatedwith the exports. For this reason, exportingcompanies are permitted to retain foreignexchange balances in diversecurrencies with domestic commercial banks so as to meet their foreseeableforeign exchange commitments on imports. Thissystem helps the enterprisesavoid the paymentof spreads to commercialbanks on the associatedforeign exchange transactions. Nonetheless, to a limitedextent, this system,by allowingcommercial banks to take a position in foreign currency, enablesthem to generateincome from foreignexchange management.

Commercialbanks in Mauritiushave traditionallybeen permittedto maintainforeign exchange balances with their correspondentsin keepingwith their requirements. The added retained foreign exchangebalances by exportersplace banks in a positionto manageforeign exchange. They consequently take positionsin diversecurrencies and up to the amountof balancesheld by the exporters. Thereis also the fat that retentionof foreignexchange balances is permittedby ExchangeControl on the foreign exchangebalances being retainedby exportersand data reportedby banksto the CentralBank on their month-endforeign exchange positions help to keep track of balancesheld.

The Central Bank in Mauritiusstands ready to buy and sell foreign exchangefrom and to commercialbanks as required. Thus, exporterswho have not accumulatedadequate foreign exchange balancesmay purchaseadditional requirements from the Centra Bankthrough their commercialbanks. This mechanismintrduces die elementof confidencein the operationof the paymentssystem in so far as foreignexchange dealings are concerned. Even at the worsttimes, banksin Mauritiushave not been forced to surrender all foreign exchangewhich materializesto the CentralBank. Workingbalances maintainedby commercialbanks abroad have been consideredas normal. As exportingactivity gathered momentum,there was a tendencyfor exporters' foreignexchange retention to rise but the net inflowof foreignexchange from these activitiesmore than justifiedthe retentionpolicy stanceadopted.

In principle,however, Mauritian export enterprisesare permittedto engage in forwardcover transactionsthrough their own bank on interational markets. Theymay also enter into currencyoptions as an alternativehedging technques. Banksrepor their foreignexchange positions to the CentralBank at the end of each month.

The Post OfficeSavings Bank of Zimbabwe(POSB) is a well managedinstitution which in very recent years has experienceda downwardtrend in its deposits. This has been foundto be attributable to the stiffeningcompetition among the banks in Zimbabwe,whereby the POSBhas lost marketshares due to inefficiencyin its service. Here two factorshave been foundto be of utmostimportance: i) the presentmanual system has been unableto maintainthe same levelsof speed and efficiencyas the other computerizedbanks; and ii) POSBis not able to provideany otherservices than its savingsaccount and 198

the fixed depositsaccount which is consideredtoo limited in a markeLwhere other banks offer a more versatileservice.

The POSBhas its own Boardof Directors,its own managementand operatesits owu business; it also purchasesservices from the Post Offices,including staff, and pays a costper transactionfor these services. The Post and TelecommnicationsCorporation (PTC) has signedan agency agreementwith POSB to offer such services as deemednecessary to operatethe POSB includingcomputer services. POSB,however, is a legal entityof its own. In recentyears, the POSBhas also openedup branchesof its own called Tbaldng halls". Thesenow mnmber11 in total and another3-4 are plannodin the near future. In other places,the designof the Post Officeshas been madein such a way that the entranceto the POSBis from one side of the buildingand the entranceto the Post Officeis from the other.

The POSBhas nowembarked upon a planto computerizeits operations,both in the bankinghalls as well as in the Post Offices(most of them). Thisdevelopment will make it possibleto offer the sam qualityof serviceas one wouldfind in otherbanks. This willalso lay the foundationfor a new corporate strategywhereby diversification of its serviceswill be dealt with. It has also been recognizedthat the nmstvaluable asset of POSBis its networkthrough the Post Offices. This will be the futurefoundation of the new corporatestrategy to be formulated.

- The Post OfficeSavings Bank in Botswanahas recently startedto diversifyits servicesto the public. First, it has participatedin some governmentcredit schemesand thereby beganto learn loan handlingand processing.It has onlyone branch of its own and operatesmainly through the Post Offices.

All these ffiree postal savings banks are granted the right to invest their fimds freely in governmentbonds, commercialbanks and/orother papers in the moneyand capitalmarkets. Botswana is probablythe mostposidve example where lending has been introducedin a successfulmanner and the postalsavings bank more and more takes on the shapeof a fully fledgedbank. TheZambian experience could have been more favorablewere it not for the politicaland economicaldifficulties within Zambia which affectedthe NSCB.

Tanzaniahas also recentlydrafted a new consiution for its Post OfficeSavings Bank aimedin the samedirection as the three examplesmentioned above.

One commonlesson learned is that it takes time to transforma Post OfficeSavings Bank with limitedoperations into a fully fledgedbankdng operation. Also, in order to makeit as swift and fast as possible,a technicalassistance progrm is neededto institutetraining needed in the initialphases and to design new operationalstrategies based upon new policies so as to achievea concertedeffort in the transformationprocess.

In Madagascar,it would be very usefil for officialsof the Caisse d'Epargne(CEM) to make studyviSitS to these countriesin order to see in detailhow the transformationprocess is worldngand to drawon lessonslearned. CEMshould also considerapplying for membershipin the Inatioafl Savings Banks nstitute(Geneva) in orderto makeit possiblefor the CEMto have accessto latestknowledge and experiencein this field and to be ableto participatein conferencesand seminarsheld mainlydealing with these issues. 199

ANNE 7.2

CA1TAL MAETY DE-VLOPMENT IN HAURITMIS:

LE3SSONSAM PITALLS

G:eneralContv

The StockExchange of MauritiusLimited opened in July 1989with five companies on the official list. After nearly two years, the numberof listedcompanies increased to 17. In parallel, there is an Over Ihe Countermarket (marche hors-cote) which, in fact, comprisesprincipally those companies which were traded in the formerChamber of Brokers.

Althoughthe Chamberof Brokershad been in existencefor more than a centuy, its impacton the economywas isignficaut since onlya handfulof mvestorswas awareof its existenceand fimctions. The dealingswere madeon a- auctioneeringsystem where the sbares were sold to the highestbidder. Prices were thus not determied by demandand supply. What coud have been consideredan asset turnedout to be somewhatof a liability. The majorityof existingbrokers who were used to thesedealing practiceswere retice to moveto a modernstock excdange where they perceived they might lose tirough lack of familiaritywith the new medwdsof dealig in shares. Therefore,most of them adopteda wait- and-seeattide, especily smce they consideredthe stockexchange as a conceptimposed upon them by governmen

Governmens role in pushingfoward the estlishment of the stockexchange was pivotal. In June 1987, the Ministryof Finae had alreadypublished a White Paper on the Stock Exchangeto provokea debate in the public,amonglegislators and enterprises. Withoutthis politicalcommitment, it is unlikely that the StockExchange would have materiaized.

The political will was guided by hard economicrealities and was attunedto the desire to modernizete Mauritianeconmy, especialy the financialsector, so as to sustaina relativelyhigh rate of growth. The overallstrategy aimed at makingMauritius a regional offshorefinancial center and soughtto make the countrya free port and the hub of the lIdian Oceanby the end of this century. At the same time, the goverment was consciousthat inflationhad to be kept in checkif Mauritiuswere to remaincompeitive in interatonal market. The dangerthat prices might be pushedup wasquite real with the massivesalary bike awardedin 1987. The StockExchage wastherefore considered to be one instrumentwhich could attract the excessliquidity which was bound to emergein the economyas salares were increasedby 40 % on average. in additionto te economiccontext, there wasa politicaldesire to liberalizeand democratizethe economy. The governmentbeieved that shareholdingshould not be resticed to a smAl group of indduals or familiesbut that emaxmm numberof Murians shouldbe affordedthe opportuity of investing in a company of their choice. ttablislent f the Stock E ie

French assistancewas soughtto work out the rules and regulations. In May 1988,a w3rkhp was organizedon the conceptof StockExchange and was opento all those interested(existing brokers 200

as weil as bankers, the press, accountants, economistsand other professionals). Followinganother one- week training course held in August 1988,a written examinationwas held and 24 individualswere accepted.

In the meantime,the Stock ExchangeAct of 1987was passed but was to be replaced in 1988 by another Act based more on Singaporeanpractice. The Act provides for the settingup of an app;opriate institional and regulatory framework within which dealings in securitieshave to be carried out.

As a first step, the governmentset up the Stock Exchange Commission (SEC) composed of a Chainnan, a Vice-Chairman and five other members, two of whom are government nominees. In addition,the Comminsionmay co-optup to threeother members, subject to the approval of the Minister of Finance. The SEC, as an emanationof government,has played and continues to play a key role in the proper functioningof the exchange. In addition to being a watchdog (its principal function ), it has in the initial stages tak an active role in ensuring dt the appropriate framework was in place, especially since there was resistance from the establishedbrokers. It organized the training courses and the examinationsand issued licensesto 10 stockbrokingcompanies which constitutethe shareholdersof the Stock Exhange of Mauritius Limited (SEM).

The stock examge is, therefore, a private companyengaged in the dealing of shares, debentures, gilts ( govemment bonds, Treasury bills, Treasury Certificatesetc.) and bonds as well as units issued under a unit tust scheme approved by the Minister.

3'alu-twn

From July 5, 1989to May 8, 1991, the number of companieson the official listhas gone up from 5 to 17 with 21 shares being offered ( some companiesoffer ordinary as well as preference shares). Market capitalizationhas risen from Rs. 1,074 million to Rs. 4,404 milion which represents 11% of GDP as compared to 3% in 1989. Dealings take place once a week. Total transactions amountedto the following: Rs. 14.6 m in 1989; Rs. 88.7 m in 1990; and Rs. 31.9 m in 1991 .

Ihe companies on the official list are from the following sectors: (1) five from finance - investmentfirms, insurance, baning; (ii) four from industry- fertilizer, vegetable oil, printing, building materials; Ciii)four fom the sugar sector; and (iv) four firomtrade and commerce.

The Over-The-Countermarket started operatingin April 1990. The principal purpose of the OTC market is to enable investorsto buy or sell shares of public companiesat their own risks. Even if tading is regulated in this market, the companiesare not subjeccto particular obligationsimposed by the Stock Exchange authorities. Ihere are at present 68 companieson the OTC (or Unlisted Securities Market). Dealings take place once a week.

The Muridan experience of the capital market became a reality because there was a political commitmentto tLmnthe country into a financial cener. The timing of the move can be questioned when viewing the sluggishpace at which the market has been moving. One explanationfor the general lack of interest in the stock exchangeis that the general public is not well informed about dealings in shares as opposed to puttng their money in the banks. Ihe speed with which the stock market was launched did not allow for much publicity regardg the true nature and functioningof stock exchanges. In fact, a major shortcomingwas that the stockbrokerswere not sufficientlytrned in stoctbroking practices since none was exposed to the operations of a modern stock exchange.The SEC members were the ones who 201 visited other exchangesand decidedon the way the SEM wouldhave to be structured.This resultedin the developmentof a dependentattitude among stockbrokerswho viewed the stock exchangeas a parastatalbody rather than as their own private company.

Anotherpossible cause is the fact that there is a predominanceof family-ownedcompanies. Many such companiesfear that if they get listed they might graduallylose control. Therefbre, a combination of lack of commitmnt on the part of stokbrokers, uncertaintyabout the public's reactionsto the trading of shares, reluctanceof companiesto issue sharesto the public, and a generalignorance of the objectives and relevanceof the stck exchangehas led to a sluggishmarkeLt

To avoid these importantpitfalls, it is necessarythat: (i) potential stockbrokerstactorson the capital market be involvedin the process of developingthe ftameworkfrom the start; (ii) an intensive promotionalcampaign is carried out amongthe major companies;(iii) the public is made aware of the possibilitiesof capital gains; and (iv) the monetry policies are in harmony with the objective of promotingdealings on the excbange. Many of these lessonswould be applicableto Madagascarwhen it decides to establisha stock market of its own. Distrbutors of WorldBank Publications ARCWTNA lhwM Ettms KEYA -. 3M A5uICA.9 DOWANA CaHlaadr.SL 4LIShadb AMa fbOk5(JLSUw JtL Jety a Caler.Gamm CairoQara KWUS,WUSS OJdaEUSnPS_ floida 1C. 4thRosO.4/465 P.O.RaISEf S _dhehi a,NlZEsEEmaaAkaNLAND Nairobi raO 5bx1141 Abtm *uN Cap.Tonam AUSTRALIA,PAPUANNNWCUDIEA P.06Ba 133 KOREARDU tO: RJLSOLMON ISLANDS, S40101 edolni la Pan rmallookCapsd F ih VANUATU.ANOWESTW4SAMOA POR=UcI.waqw1. htmSadSc Sldcm D.A.IsAmatIonSum. FRANCE ESma! P.AQ314105 643WIaabomaRoad Woulack Pab on CmbGeU Mlhmxn3lXZ fi6EawvmtdlIn MALAYSLA Jouaast.qrg=4 VklCda 7ispam tilvsd tydt kobep o SPAIN AUSTRIA CRMANY PA!lourll227,JalPaIm Mu'Bn5fuuuauhrm!LA. Casld&adCo EINOMVeag sum Kualabmar C5S11037 Cusbn3l P5ppalulduAlleN lUS Madrid A-1it WiM D0-SIoflal MNICO W3TEC U _Sa ADCB BANCLADESH 1HONGKON. MACADO Aputsdolhaul fIU60 Cult d4 CmL3NZ bMlcIondustmODmvlopmuat Ah 2IOOLUd. 1406QTla1pmuhmu .D. 06 SaaIh. MAsvsncSdatyGaiDASl 4646WyndhwSmat NoUnS.,Road 16 WIuuIoCaq NErHERLANDS RILANKAANDTHMAWIM DhanmodIl/Arm - 2 Pd DLoor §_S-LabMounsatp Dhakath C2Gnl Houln5 P.OmBox20 P.O.ha244 7480AEHaabbuHn 100.5SrClftempdalaA. Bmkarm INDIA Catdwb_a PineView,lt i4oor AlliedPubIsbas PIvnLtL NEWZEALAND CaICEdmi 100AgrabadCommrdalArm 751MountRoad EMMCONZLIdL QrIMagoagllOO Mara-66000 PsivaiatD"agSO9M4 SWEDEN NewMae FWSINflin 7(6KfA.Avumw BiMNrkofr Arddamd Fritemsfad6hormaltap Kul=913 35J.N.Havdiarg R1guapNHnl2 D1Bo 6 BRid wa. InIGRA S1iaSmedadS BELCIUM BUmba-4DDa33 Unlmltyrm Jeanm 1t '. Thu. CrunasMailcitJerho Fcnrbaonu Ar. du Roi 202 13/14 At AllARd Prvatem Mail kS5 WAmn mSaB 10lngds NGrOdG- 1100 iban P.Q S s 17I25dm1na CANADA V1altbrmnjanpAve NORWAY LeDiffuWur Cacuma-7 Z Nurai_lahmamCm.r SWlZElAND C.P.IE150131rusAmpte BeokDoqast hskjisS soudmavilleoubmc Jad- pHomdlB g P.a. Box 612 E5ud2 LrafLPbayot - J43S6E Si MainRo..Candbiaapr N4OzROlod Ca32poaf12 Daglyra-S560 I00Z LAUCmm CI1U PAKTAN knbclCS" 34;-1=1:schlad ba- Boek Ag Forsoc" de_ Arw VepudoNcdold.1 CramRoad 6s5abruquald-A-un . LibrarlePpyat Santlap HydaraHad-50OW2 P.O.laixNt 129 S.s5 dmAhon_ma Lehomfl11 CmpoaSeliSl QNA futhaa Ram, 2ld Roar CH 3102 Laanm Cdnalhand k&Emook NarIhBakor Nrvmqp PERU PublisiftHousa Ahmadad-300S0 EdIDrialVenal. A THAIAND , OaFFOBDoqI. Apartbdo3C4 GCaaIDapa.atwAm difg P-6l!.ouss LINI RoBsmRoad iSs-A kMwg baik COLOMBIA Lucmnw-22600 PHUIJ?Uh Infoudaa Lid Iaarlmad tok CIoter TRl AD &TOBAG, ANTICA Apafr4oAt.3SW Cann Baw Road Smift101. ad10 3ARUUAIARBADO, BogobD.E. 60BHajajWNar CcmdoudaimTowarl DOMWICA.CBADA,CAAUYNA, Nagptr4I 010 AyawnA. KY.,di JAMACA.MONLATLSr. OMEMhtcoc I IIITTSNEVTTLSN .LCA, CmanudTAdloametcdiDeluaxln INION ASLA Mmi mewo l ST.VlNC(NT&CmADlNDIRlS AMOiZrcaiCEDA) I'ldiral.1culted SilutmmmUnite uflt 04IP.SQ lan Urobtr2Dl. POLAND s Wastes AbdanOSF PIam PuA8=lII IntuuaSnlPUbPublbgSUlla Curep lain 10320 ULLmSa3l/S3 Tdad. Wetinle cYimUs 0o.C7Waaw C AppieR h IRELAND TURKEY C GmColq CovenatSuplnAgas ' Fwrsnhwfhcnha Ino 6.D _9gst Easid 4-S5iaErtRoad ISjoumaa NmbbNIpSokN*I1S P.0.oa2006 Diablia ULO0sa3 Cqpln NImula 24116Wm.wa btt! ISRAEL DENMARK YnotlJbnn Lid. PORTUCAL UNTDIDNGDOM SamfurdaUttnabnr P.O.8=5605 U . Pokpi luulakL l RimaoeoeAUIG i TIAvv61560 EaD.CoW74 PflaSB3 DK-ISOPadubsgC Us us.. Altec H GpMPG ITAiLY DOMINICANREPUBLIC I.PaCcamrindeaad.SoaonISA SAUDIARAZIA.QATAR EdITrmTaDwrC A. Via DaViCIabuI JuirbookSre VENEUUA _ae11l319i 33 C*min PaulS! P.O. oaSIM LIbm¶ladi N Apazdod.CcteOS2MZ, S1 PFr Rid1 ApJde.os JAPAN SINCAPOR&T.AIWAN, ECYPF,ARA3RZPU`COF Esa NookSent. MYANMLSJMEIU AAlAham Hogs 34rome. Thkyo.ha11I3 IriounaflomPnhaims Al Gala.af kiyagwLida Cair Ccddn Wnd Deriding 4tKalngPFddhm lOSE Siwyms3 N C-

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