8 Economic Reform and Diversification 8.1 Modernizing Libya’s Financial Sector Watershed legislation in Libya such as Law No. 5 for the year 1997 concerning the Encouragement of Foreign Capital Investment, and more recently Banking Laws No. 1 and 2 which will be discussed later in this chapter, have demonstrated the seriousness of Libya’s policy makers regarding economic reform and the privatization and deregulation of its centralized economy, the legacy of the nationalization drive of the 1970s. Part of this process is a desire to attract FDI into Libya, with massive amounts of investment required, especially to overhaul the ageing and technologically antiquated hydrocarbon, refining and petrochemical sectors, the infrastructure deficit, as well as revitalizing the tourist, service and, manufacturing industries. Many studies have shown that the lack of development of local financial institutions and markets can adversely affect an economy’s ability to take advantage of the potential benefits of FDI (Borensztein et al. 1998). In simple terms it is clear that poor financial markets may mean that a country will not be in a position to cope with or absorb either short- or long-term capital flows. A study has, based on the empirical data, also shown that “FDI plays an important role in contributing to economic growth. However, the level of development of local financial markets is crucial for these positive effects to be realized” (Alfaro et al. 2004). Similarly, in an analysis of the roles of different types of financial institutions, Levine and Zervos (1996) have shown that while efficient banks and stock markets provide a variety of different financial services, both stock market liquidity and banking development positively predict growth, capital accumulation, and productivity improvements. In the following sections we will look at the Libyan government’s recent record in reforming its financial institutions. Our conclusion is that while the process has already started, Libya still has a long way to ensure that foreign investors, with every country to choose from in a globalized world, would necessarily choose to invest their capital in Libya. 8.2 The Need for Reform of the Banking Sector Since the demise of the Former Soviet Union, a huge body of literature has emerged about banking reform in transition countries, and a useful way of distinguishing and deciding on reform methodologies is to compare two basic approaches, either new entry or rehabilitation. A prominent economist has defined these as follows: 282 8 Economic Reform and Diversification The new entry approach entails the spontaneous break up and privatization of existing state banks, the entry of many new banks, and in some cases the liquidation of old banks. The approach is best illustrated by Russia and Estonia where it resulted in a rapid expansion in the number of banks, in Russia for example from 5 in 1989 to 2,500 in 1995. The rehabilitation approach emphasizes the recapitalization of existing state banks together with an extensive programme to develop them institutionally and eventually to privatize them. Break-ups and new entry are relatively limited. This approach is exemplified by Hungary and particularly Poland (Claessens 1995). In actual fact in the early stages of reform it may not be evident that a consistent financial approach at all is being practised, and the reform process may include aspects of both approaches. In Libya, as usually elsewhere, the situation is even more complicated by the fact that banking reform is not taking place in a vacuum, but is closely related to an overall reform agenda aimed at both the privatization of many inefficient SOEs, as well as a conscious effort by the government to attract FDI into such industries as tourism, manufacturing, and agriculture. This is seen as crucial in order to diversify the economy away from overdependence on reve- nue from hydrocarbons. Similarly the extent and tempo of legal and enterprise reform will also have an effect on the reform and evolution of the financial system. Banks rely on the legal system, including procedures for collateral recovery and bankruptcy, to enforce their claims and perform their roles as monitors of firms. In this respect the legal framework in Libya, based on the Commercial Code of 1953, and the Civil Code and Civil Code of Procedure of 1954, which were based on French and Italian Civil Laws, have, despite the revolution, continued to function alongside Islamic legal principles, known as the “Sharia”, to provide a fundamental source of commercial law relating to banking. In this regard another recent key piece of legislation discussed extensively in Chap. 3, the Executive Regulation of the Law No. 21 of 2001, regarding the Practice of Economic Activities, amended by Law No. 1 of 2004, has also attempted to put in place a comprehensive set of legal rules and regulations regarding contract law, covering both Libyan national companies as well as foreigner companies. 8.2.1 The Evolution of the Libyan Banking Sector It can be said that, generally speaking, the financial sector in Libya has been solidly based in law, and this applies also to the bank nationalization exercise, which took place after the 1969 revolution. Even before this, in 1963 Law No. 4 “Promulgating the Banking Law” was gazetted, and in Chap. 1, entitled “The Central Bank”, the National Bank of Libya was replaced by the CBL, and provisions for its establishment and management were laid down. With an authorized capital of one million Libyan pounds it possessed, among other things, the sole right to issue currency, with the responsibility for maintaining monetary stability and the external value of the Libyan currency, as well as for regulating credit. In Law No. 4, as defined in Article 25, “the par value of the Libyan pound is equal to 2.48828 grams of fine gold”, and the Libyan currency unit remained 8.2 The Need for Reform of the Banking Sector 283 tied to sterling until the sterling devaluation of November 1967, when the Libyan pound failed to devalue. The 92 Articles of the 22 page Law covered a wide range of banking issues, ranging from board composition, management, currency issue, sale and import of gold, its regulatory role as the watchdog mandated to monitor commercial banks and their management and liquidity and reserve ratios, as well as issuing banking licences. For its time it can be said to represent a fairly standard comprehensive piece of legislation in which the role and functions of a Central Bank and monetary authority were transparently defined and set out. The banking sector, together with all others, changed dramatically when in November 1969 the new Libyan government required that all banks in the country should be Libyan controlled, buying out the 51 per cent control of the commercial banks that had not already converted to Libyan control. In July 1970, the government took 100 per cent control of four of the major banks with foreign minority ownership. In December 1970, the government purchased outright all banks that still had some foreign minority participation and, by merging, reduced the number of commercial banks to five. The situation up to 1987 was that in addition to the National Commercial Bank, other commercial banks in operation included the Jamahiriya Bank (formerly Barclay’s Bank), previously known as the Jumhuriya Bank until 1977, the Al-Sahari Bank (formerly the Banco di Sicilia), the Umma Bank (formerly the Banco di Roma), and the Wahda Bank, formed in 1970 from the merger of five other banks. Since the mid-1990s the Libyan government has been actively encouraging the setting-up of regional or Ahliah banks, and several new banking licences were issued, leading to the situation that by 2005, there were a total of 54 banks in operation, comprising 6 commercial banks, 4 specialized banks subsequently discussed, and 44 regional or Ahliah Banks (Appendices 8.1 and 8.2). As well as these state-owned commercial banks, the Libyan government owns the National Agricultural Bank, the Industrial and Real Estate Bank of Libya, the Libyan Arab Foreign Bank (LAFB) and the Development Bank. The NAB, a specialized institution, had originally been established in 1957 to assist the agricultural sector by providing interest-free production loans to farmers. As well as this, it made medium-term loans for up to 5 years for machinery and materials and long-term loans for up to 15 years for land reclamation projects, irrigation, and agricultural construction. The NAB purchased produce from farmers at a guaranteed profit and sold the supplies at subsidized prices. The Industrial and Real Estate Bank of Libya was both a developmental bank, offering industrial credits, and a home finance agency, making loans for home purchases. In early 1972, the government established the LAFB as a wholly owned subsidiary of the Central Bank, but not subject to the Central Bank’s legislation, regulations, or exchange control, and it is the only Libyan bank with offshore status. It engages in financial and banking operations outside the country and acts as the foreign agent for the government and Libyan commercial banks. Its main purposes were to encourage regional development, particularly of countries friendly to Libya, to become active in international financial markets, and to serve as a vehicle for Libyan aid to other countries. 284 8 Economic Reform and Diversification Since its establishment it has expanded its influence and prestige overseas, with now more than 38 subsidiaries in 25 countries, where its international standing is well known and appreciated, being the only Libyan financial institution able to handle foreign accounts during the sanctions period. Reflecting the bank’s new strategy of diversifying its channels of investment and a desire to maintain a strong position in regional and international markets, LAFB significantly increased its balance sheet in 2004, growing by 18.1 per cent to $11.2 billion.