VI The Central Banking Institution in a Currency Enclave

In a currency enclave, the currency of a typically larger In both of these countries, foreign-owned commercial and more developed foreign country circulates alongside, dominate the financial systems, which are open to or in some cases in place of, the domestic issue. This situ- unrestricted current and capital transactions.16 In Libe- ation has arisen where extensive and unregulated trade ria, the central banking institution is the National of with a dominant partner, predating the establishment of Liberia, which was established in 1974 to take over the a national currency, has led to the customary acceptance central banking functions previously conducted by the of the partner's currency as a means of transaction. With Bank of Monrovia (a subsidiary of Citibank)—including such a high degree of financial openness, domestic inter- the provision of banking services to the commercial banks est rates and credit conditions in the enclave are strongly and to the government—and to initiate bank supervision. influenced by monetary conditions in the partner. More- In , central banking responsibilities are shared over, in this context, powers of fiduciary issue would be between the National Banking Commission and the particularly limited as the domestic currency (often con- National Bank of Panama. The former is in charge of fined to coinage) may have only restricted acceptability as bank supervision and is concerned with the promotion of a means of transaction. In addition, if local contracts are Panama as an international financial center. The latter is denominated in the foreign currency, shifts in exchange a commercial bank, although in part publicly owned. In rate parity do not alter relative prices. For all these rea- addition to its regular commercial banking activities, it sons, the scope for independent in a cur- acts as banker to other commercial banks and as the fiscal rency enclave is particularly narrow, and the role of the agent of the government. It also plays the role of develop- domestic central banking institution may be limited. ment bank in undertaking higher-risk loans in the public The influence of central banking in the enclave may be interest, using aid receipts to subsidize interest charges. reinforced, however, by the actions of a monetary author- Both the National Banks of Liberia and Panama under- ity in the partner country. In particular, such an author- take to supply their respective financial systems with the ity would be likely to have greater ability to extend emer- U.S. dollar notes and local coinage required to meet the gency liquidity in a crisis. A cooperative arrangement domestic transactions demand for currency. could be feasible if the interests of the two countries were Despite the formal similarity in the monetary arrange- largely compatible and if the allocation of responsibility ments of these two countries, their individual experiences to the partner were politically acceptable. Indeed, such have been very different. In Panama, an environment of an arrangement might be preferred to the alternative of financial stability has fostered rapid growth of domestic extending the fiduciary powers of the currency enclave deposits, while the combination of political security, lib- central banking institution on the grounds that an exter- eral banking legislation, and economic prosperity has nal agency would be less susceptible to undue internal helped to establish the country as an important offshore political pressures and have a more established record for banking center. By contrast, in Liberia, the financial sys- financial competence and prudence. tem has encountered serious difficulties in recent years, The case studies in this section include two countries, manifested in the contraction of the money supply and Liberia and Panama, which rely on the U.S. dollar as the private credit and the failure of a major bank. These principal form of money—domestic issue being restricted events have coincided with a deterioration in the external to coinage—but have no formal support agreement with balance as the Government has attempted to compensate the U.S. authorities. By way of contrast, the second two weakness in the export sector by increased public sector examples of enclaves, the Rand Monetary Area and activity. France d'outre-mer, have central banking institutions In the present context, it is important to note that the which are closely linked to authorities in the partner coun- Liberian authorities' limited powers of fiduciary issue tries. The earlier discussion of Bhutan and Maldives is have not screened the financial system from external also relevant in this context in describing countries that strains; rather, these strains have been revealed in an are making the transition from enclave to independent unusual fashion. Given the scarcity of foreign exchange, monetary area. the National Bank of Liberia has not always been able to fulfill its function of supplying dollar currency on demand Liberia and Panama 16Foreign exchange restrictions were introduced in Liberia in April 1980, in the aftermath of a change in the government, but were removed In Liberia and Panama, the U.S. dollar is legal tender the following month, after proving difficult to operate, partially ineffec- and the domestic issue of currency is confined to coinage. tive, and damaging to external confidence.

16

©International Monetary Fund. Not for Redistribution The Rand Monetary Area and France d'outre-mer for internal transaction purposes; the limited supply the local monetary authorities obtain seigniorage from available to it from exporters, reserves, and external bor- currency issue, responsibility for ensuring monetary sta- rowing is mostly absorbed in payment for oil imports' and bility is shared with an extranational agency. in external debt service. So commercial banks are no In other respects, the Lesotho Monetary Authority and longer necessarily able to withdraw excess reserves from the of Swaziland bear many similarities to the National Bank of Liberia in cash. While these banks the transitional central banking institutions discussed may receive some foreign exchange from client exporters, earlier. In common with the monetary authorities in Mal- they are not able to draw unlimited amounts on parent dives and Bhutan, both must be prudent but resourceful banks unwilling to increase their Liberian exposure. in promoting the gradual replacement of the foreign issue Moreover, the currency in circulation is regularly depleted by the domestic issue without threatening confidence in by direct deposit overseas. In consequence, cash bears a the new means of transaction. The Lesotho Monetary premium value against Liberian bank deposits, which Authority has, for example, maintained a noninterest- encourages commercial banks to compete for currency bearing rand deposit account with a commercial bank in and offshore resources rather than for deposits and loans. South Africa, which in its turn is willing to exchange the Indeed, banks may sometimes be unwilling to make pri- maloti for the rand at par; this arrangement is designed to vate loans that would require import finance or to cash or encourage banks and merchants in South African border accept as deposits checks drawn against other banks. This areas to do likewise, and so enhances the usefulness of the situation has led to an inefficient allocation of monetary maloti. In both countries, the monetary authorities have resources and high transactions costs. taken steps to centralize the management of foreign exchange reserves, but substantial holdings remain in the hands of the commercial banks (in Lesotho) and the gov- The Rand Monetary Area and ernment (in Swaziland). In Lesotho, in particular, the France d'outre-mer Government has continued to hold the bulk of its deposits with local commercial banks rather than with the mone- The Rand Monetary Area—consisting of Lesotho, tary authority; the Lesotho Monetary Authority has been South Africa, and Swaziland—was set up in 1974. It is important, however, in raising funds for the Government, based on the use of a common currency, the South African in acting as an intermediary with foreign banks, and in the rand, and provides for free transfer of funds within the placement of treasury bills, as well as being a substantial area, compatible exchange restrictions on the transfer of purchaser of government securities. In Swaziland, the funds outside the area, and the pooling of gold and foreign 17 Government has been a net creditor of the Central Bank of exchange reserves with the South African Reserve Bank. Swaziland and of the commercial banks. In both coun- Both Lesotho and Swaziland have subsequently estab- tries, the commercial banks, which are either govern- lished autonomous monetary authorities of their own: the ment-owned or foreign-owned, make deposits with the Lesotho Monetary Authority (founded in 1980) and the 18 monetary authorities which provide an important compo- Central Bank of Swaziland (1974). Under bilateral nent to the centralization of foreign exchange holdings; agreements with South Africa, the Lesotho and the Swazi recourse to lender-of-last-resort facilities and bank super- authorities are empowered to issue their own currencies, vision are both limited. Interest rates necessarily follow the maloti and the lilangeni, respectively, both valued at fluctuations in South African rates, and monetary policy par with the rand, to circulate as legal tender within their is in general passive. own borders. Their currency issue must, under the terms of these agreements, be completely covered by their hold- In France d'outre-mer, the ties between the external ings of rand currency, special interest-bearing deposits authority and the local monetary system are even closer. The Institut d'Emission in Paris takes direct responsibility with the South African Reserve Bank, and marketable for the monetary affairs of both the Departments (such as securities of the South African Government. The South Guiana, Martinique, and Reunion) and the Territories African Reserve Bank is given specific responsibility to act (such as French Polynesia and New Caledonia). Each of as lender of last resort in Lesotho and Swaziland through these Departments and Territories has its own currency but the temporary extension of credit to the Lesotho Monetary parity with the French franc is guaranteed by the Institut Authority and the Central Bank of Swaziland. So while d'Emission. The Institut d'Emission is particularly con- cerned with control of the volume and allocation of credit, 17Botswana was a founding member of the Rand Monetary Area, but which it achieves through its policy of rediscounting via subsequently withdrew when setting up its Central Bank. local agencies to commercial banks at prices dependent on 18The Central Bank of Swaziland was originally entitled the Monetary Authority of Swaziland. This institution's name was altered in 1979 the use of funds. The Institut d'Emission is itself subject to without substantial extension of its powers or responsibilities. the French Finance Ministry's supervision.

17

©International Monetary Fund. Not for Redistribution