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Trinidad and Tobago: Selected Issues

Author(s):
International Monetary Fund
Published Date:
May 1997
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IV. Banking and monetary topics

A. Reserve Requirements and the Spread Between Lending and Deposit Rates

105. The costs of financial intermediation as measured by the spread between deposit and lending interest rates is comparatively large in Trinidad and Tobago. In principle, high interest rate spreads can be the result of two factors. First, the imposition of high nonremunerated reserve requirements, and second, a lack of competition in the banking system. This note uses a microeconomic model to decompose the interest rate spread in Trinidad and Tobago, and tries to give an explanation of its recent rise in terms of the two mentioned factors (Figure 13).

Figure 13Reserve requirements and interest rate spread

106. A short algebraic analysis helps to clarify the method of decomposition. Banks receive a volume of D in deposits and pay the deposit interest rate iD. They disburse an amount of loans L and charge the lending rate iL. The central bank requires banks to hold unremunerated reserves of r percent of deposits. Thus, the maximum amount of loans is

107. The banking sector is assumed to be imperfectly competitive, Le., each bank faces a negatively sloped demand curve for loans. The higher the lending rate charged by the bank, the lower is the demand for loans:

The expression

denotes the elasticity of demand.26 The bank’s profits are obtained by subtracting costs from revenues. Revenues consist of interest earned on loans iLL. Costs consist of interest payments on deposits iDD, plus a fixed amount F that is assumed to contain administrative and other operating costs. Thus, profits can be written as

108. The bank chooses a lending rate iL so as to maximize profits. The first-order condition is

where μ is the monopolistic markup ratio. As noted, two factors affect the spread:

  • The reserve requirement. The spread between deposit and lending rates increases with higher reserve requirements r, and this effect is independent of the market structure.

  • The market structure, measured by the markup ratio. The lower the elasticity, the higher is the monopolistic markup. The higher the markup, the higher is the spread. The markup ratio is a direct measure of the competitiveness of the credit market. In a perfectly competitive market, η would be infinite, and the markup ratio would equal 1. A borrower could choose among a great number of atomistic banks. As the number of banks decreases, the borrower’s choice becomes more limited and η decreases. It can be shown that η and the markup are directly related to the number of banks operating in the economy.27

109. The right hand side of equation (3) shows a way to decompose the interest rate spread into its two components. The spread is just the ratio of the markup factor and (1-r). Since both the spread and the reserve requirement are known from monetary data, the markup factor n can easily be derived. Figure 14 shows the result for Trinidad and Tobago. The markup has been significantly above one in every year since 1981, indicating imperfect competition in the banking sector. Moreover, the markup has risen strongly in recent years. The market structure seems to be more concentrated and oligopolistic today than a decade ago. As of 1996, only six companies are dividing up the market for commercial banking.

Figure 14The markup in the banking sector

Note: A markup above 1 indicates market power.

110. Among the two factors affecting the costs of intermediation, market structure is obviously the slower acting variable. The entry of new banks takes place slowly. However, the ratio of reserve requirements is under direct control of the central bank and can be changed overnight. It is currently at 23 percent.

111. Holding other things constant, how would an increase in competition or a reduction of the reserve requirements affect the interest rate spread? Figure 15 shows the result of a simulation, based on equation (3).28 If reserve requirements were reduced to 10 percent, the spread would fall from currently 12 to 9.3 percentage points and the lending rate would decline to 14.8 percent. If additionally, the number of banks were allowed to increase to, say 12 (i.e., to double), the lending rate could decline further to 13.3 percent.29

Figure 15Policy scenarios: An example

Simulation showing the effects of a reduction in the reserve requirement from 23 to 10 percent (scenario 1), and an additional increase in the number of banks from 6 to 12 (scenario 2). The deposit rate is assumed constant at 5.5 percent.

B. Bank Competitiveness

Introduction

112. Bank profits in Trinidad and Tobago have risen to record levels in the past two years. The spread between deposit and lending rates has widened to a degree not explained by reserve requirement changes. The prime lending rate is close to 17 percent in an. economy with both fiscal and balance of payments surpluses in recent years and low inflation. Costsaving technological advances have not been shared with customers and the number of banks has been unchanged at six, after a consolidation from eight banks in 1993. In this note a number of indicators of market behavior are reviewed to assess the competitiveness of the banking industry in Trinidad and Tobago.

Factors affecting competitiveness

113. The degree of competitiveness of the banking industry can be gauged by several factors. First, the number of banks and their size relative to each other are important factors bearing on competitiveness. Second, the intermediation spread, or the differential between deposit and loan rates, may be large and increasing. While there is no single measure of the “normal” level of spread, this can be expected to range between 3 to 4 percentage points in a noninflationary environment, reasonable certainty of the exchange rate, and relatively low credit risk (Table 1). Third, the rate of return on bank equity should be generally within the range of profits elsewhere in the economy, given a reasonably competitive environment and normal risk. Fourth, the ability of banks to shift the cost of loan losses or taxes, such as that of the reserve requirement, to customers in the form of lower deposit rate or higher loan rate or some combination of the two is an indicator of competitiveness. And fifth, the change in banks’ cost structure over time may provide important clues to their commitment to efficiency, which is often driven by the presence of competitive pressures.

Table 1.Trinidad and Tobago: Commercial Bank Interest Rate Spread(In percent; per annum)
Local currencyForeign currency
WeightedCalculated cost of required reserveSpread excl. cost of required reservesWeighted
Average deposit rateAverage loan rateAverage spreadAverage deposit rateAverage loan rateAverage spread
TT dollars
19915.5011.776.271.884.39
19926.3412.766.422.044.38
19936.5313.086.552.094.46
19946.5013.857.352.574.783.258.765.51
19955.8813.417.532.724.814.759.594.85
1996 (First 3qts.)5.4213.548.123.464.655.0110.275.25
1994 Quarter I6.7513.586.832.174.662.858.025.17
Quarter II6.5613.657.092.464.632.928.245.32
Quarter III6.4414.207.762.844.923.308.975.67
Quarter IV6.2513.977.722.794.933.919.805.89
1995 Quarter I6.2513.977.722.794.934.649.785.14
Quarter II5.9713.287.312.664.654.969.194.23
Quarter III5.8313.287.452.664.794.899.494.60
Quarter IV5.4713.107.632.764.874.499.915.42
1996 Quarter I5.5213.538.013.474.544.3110.105.79
Quarter II5.3613.548.183.464.725.3310.304.97
Quarter III5.3813.548.163.464.705.4010.405.00
Source: Central bank of Trinidad and Tobago.

Situation in Trinidad and Tobago

114. There are six commercial banks in the country, unequally distributed in size.30 These banks face competition from numerous nonbank institutions, although the unusually large interest rate differential on deposits offered by these institutions relative to commercial banks’ on comparable types of deposits suggests that their products are less than perfect substitutes.31

115. The large size of interest rate spread in Trinidad and Tobago suggests a capacity for monopolistic pricing. The data in Table 2 show that the spread in Trinidad and Tobago is in a very high range, much higher than in comparable neighboring countries. It should be noted that the large interest rate spread may not be due entirely to a lack of competition. Factors such as high levels of nonperforming loans and unremunerated reserve requirements also contribute to wider spread. However, data show only a moderate level of nonperforming loans in banks’ portfolios in Trinidad and Tobago and, more important, its ratio relative to total loans has been declining, from nearly 15 percent in 1991 to less than 10 percent in 1995.

Table 2.Trinidad and Tobago: International Comparison of Commercial Bank Interest Rate Spread 1/(In percent; per annum)
19911992199319941995
Trinidad and Tobago
Deposit rate
Lending rate5.796.997.066.916.71
Spread13.1715.3315.5015.9815.17
Barbados7.388.348.449.078.46
Deposit rate
Lending rate6.536.684.395.325.11
Spread12.4313.538.929.0810.00
Bahamas5.906.854.533.764.89
Deposit rate
Lending rate6.726.135.194.304.20
Spread9.008.087.466.886.75
Jamaica2.281.952.272.582.55
Deposit rate
Lending rate24.6733.6327.5936.4123.21
Spread30.5044.8143.7149.4643.58
Belize5.8311.1816.1213.0520.37
Deposit rate
Lending rate8.408.208.108.609.40
Spread14.2014.3014.4014.8015.70
Guyana5.806.106.306.206.30
Deposit rate
Lending rate29.5022.5012.3011.4012.90
Spread33.6028.7019.4018.4019.20
United Kingdom4.106.207.107.006.30
Deposit rate
Lending rate10.287.463.973.664.11
Spread11.549.425.925.486.69
United States1.261.961.951.822.58
Deposit rate
Lending rate5.843.683.174.635.92
Spread8.466.256.007.148.83
2.622.572.832.512.91
Sources: International Financial Statistics; and Fund staff estimates.

116. As for other costs, the data presented in Table 2 show that banks’ cost of doing business has been increased sharply by the requirement of high statutory reserves, which are unremunerated and, since early 1996, mandatory holding of government paper as a part of secondary reserve. Calculations in Table 2 using the lending rate as the opportunity cost of holding reserves show that reserve requirements account for as much as 3.5 percentage points, or about a fourth, to the average loan cost. These data also show that banks have been able to shift fully changes in this cost, over time, to their customers. The unremunerated reserve requirement is a tax, whose incidence depends on competitive conditions and the elasticity of demand. In many countries where reserve requirements have been raised to high levels, banks have borne a heavy share of the tax which has rendered some weak banks unprofitable and even forced them into bankruptcy. For Trinidad and Tobago, recent data show a sharp decline in bank profits in 1994, which is largely attributed to the raising of the reserve requirement in that year. However, profits quickly recovered in 1995 and, based on data available through the third quarter, banks are expected to show record profits in 1996. These profits were achieved in spite of tight monetary conditions that prevailed throughout the year, which included the introduction of special unremunerated reserves, equivalent to 1.1 percent of deposit liabilities in December 1995 and, as noted above, the new requirement, effective February 1996, of holding government paper, equivalent to 5 percent of deposit liabilities, earning much lower interest than on loans.

117. Banks have tried to keep operating costs under control to the extent these may be termed discretionary. Data presented in Table 3 show that salary costs and loan write-off provisions have declined significantly. However, these savings have been absorbed by “other operating expenses” and interest expenses not reflected in higher average deposits rates. In a competitive environment, the reduction in operating costs would be reflected in lower cost to customers. However, the persistence of the large interest rate spread suggests that efficiency gains did not benefit bank customers.

Table 3.Trinidad and Tobago: Commercial Bank Efficiency Ratios(In percent)
19911992199319941995
Percent of total operating income
Interest expenses40.9044.2041.5042.8043.60
Non-interest expenses48.7046.0047.0047.0045.90
Salaries and benefits24.8023.5021.4021.7021.40
Professional; services0.800.600.701.301.20
Occupancy services4.504.104.203.804.00
Depreciation2.702.702.502.702.70
Additions to provisions0.00-0.502.702.201.40
Loan write-offs4.604.300.800.700.80
Other operating expenses11.3011.3014.7014.6014.40
Total operating expenses89.6090.2088.5089.8089.50
Percent of average total assets
Interest expenses4.205.405.204.604.46
Non-interest expenses4.505.705.604.804.40
Salaries and benefits2.602.902.702.402.18
Professional services0.100.100.100.100.12
Occupancy expenses0.500.500.500.400.41
Depreciation0.300.300.300.300.27
Additions to provisions0.00-0.100.300.200.14
Loan write-offs0.500.500.100.000.08
Other operating expenses0.501.501.601.401.20
Total operating expenses8.7011.1010.809.408.86
Source: Central Bank of Trinidad and Tobago.

118. Finally, all banks in Trinidad and Tobago operate branch networks. The substantial number of bank branches has led to the observation that the country appears to be “overbanked.” If true, such behavior corresponds to textbook predictions for markets characterized by monopolistic competition in which insiders are attempting to deter entry by outsiders. While at the margin the bank branches themselves may not contribute to profitability, their existence can deter entry, and if the potential loss of profits from new competition exceeds the cost of operating additional branches, this strategy will be pursued.

Conclusions

119. The banking industry in Trinidad and Tobago presents a mixed picture with regard to competitiveness. None of the six banks is large enough to exercise monopoly power. However, their relatively small number, absence of new entry over many years, the large interest rate spreads, and record profits suggest a degree of monopolistic market power. This situation makes the banking system appear financially sound but it carries a hidden cost for the rest of the economy by keeping the cost of capital high and the incentive for financial savings low. The measures open to authorities are first of all to lower the high level of the unremunerated reserve requirement and, second, to make clear that entry is open to all qualified candidates for entry. It should be noted that, in a situation of vigorous competition, where the cushion of monopolistic profits is absent, a heavier burden is placed on the supervisory authority for ensuring that the systemic health of the banking system is maintained and that inefficient banks are allowed to exit or be absorbed by other banks.

C. Bank Soundness

120. Financial sector liberalization has been a major component of economic reform programs adopted by many countries in recent years. While the shift to a more liberalized environment has created expanded profit maximizing opportunities for banks, this has also exposed them to a variety of risks and the potential for large losses. Therefore, to ensure that banks follow sound practices and remain solvent while enjoying more freedom, prudential requirements have been strengthened in many countries and bank performance is being more closely monitored by supervising authorities. This section describes recent bank performance and supervisory practices in Trinidad and Tobago.

121. In Trinidad and Tobago, prudential norms for commercial banks have been laid out in the Financial Institutions Act of 1993, and closely mirror those included in the Basle Accord (Box 1). Under the capital adequacy standards, banks are required to maintain a minimum ratio of 8 percent to their total risk adjusted assets; risk adjustment is done by using the criteria laid out in Box 2. Off-balance sheet items are also covered under the capital adequacy standard by applying a credit conversion factor to each such item. The capital adequacy regulation further stipulates that bank’s deposit liabilities cannot exceed 20 times its paid up capital and its deposits at the central bank.

122. Under the asset-quality standards, provisioning requirements have been set for substandard loans at 5 percent in the first year, rising to 20 percent in the fifth year; 50 percent for doubtful loans; and 100 percent for unrecoverable loans. Provisioning requirements for the part of loan portfolio not examined by the central bank have been set between 0.5 percent and 4.5 percent of the loan value, the actual percentage depending on the bank’s compliance record of prudential regulations and the examiner’s perception of its financial soundness.

123. Regulations dealing with earnings and profitability have been established, which also include guidelines concerning the treatment of accrued interest as income. For credit facilities other than overdrafts, accured interest cannot be counted as income if none or only a part of contractual payment has been received. For overdrafts, if deposits made within the three-month period are insufficient to cover interest charges on the account or deposits are irregular and insignificant in relation to the overdraft limit, accrued interest cannot be counted as income. Similarly, accrued interest on commercial and consumer loans which have not been serviced for 90 days is not considered a part of bank’s income; for residential mortgages, this limit is 180 days.

124. Under the liquidity maintenance program, banks are required to hold reserves in a fixed ratio to their deposit liabilities. For local currency deposits, this ratio is currently set at 23 percent and reserves must be held in a noninterest bearing account at the central bank; another 5 percent of deposits needs to be held in government bonds. For the portion of deposits denominated in foreign currencies, banks are required to maintain liquid reserves fixed at 25 percent of foreign currency deposits. Liquid reserves comprise selected foreign government securities of up to six-month maturity, bank deposits, and cash.

125. Finally, banks are required to observe firm limits on risk exposure and concentration of credit. Thus, limits on unsecured credit to one person or a group of borrowers is set at 5 percent of bank’s total capital. For secured lending, the limit is 25 percent for individuals and 32 percent for groups. Furthermore, banks cannot hold shares in commercial, agricultural, or commercial enterprises in excess of 100 percent of their total capital; for a single such enterprise, the limit is 25 percent of paid up capital and statutory reserve.

126. The central bank’s bank inspection department undertakes off- and on-site inspection of the banks to enforce prudential standards. Under the off-she inspection procedures, banks are required to submit reports to the central bank at regular intervals, giving information on asset quality, profitability, and capital adequacy. This information is used to develop an early warning system to identify unhealthy trends and compliance problems at a relatively early stage. In addition, on-site inspections of banks are carried out at intervals of 18 months to 2 years to determine the overall financial position of the bank and to ensure that legal norms and supervisory guidelines are followed. The scope of such inspections include the verification of capital adequacy and asset quality standards, liquid asset management practices, and an evaluation of internal control mechanisms to ensure the bank’s safe and sound operation.

127. Selected data on commercial bank performance presented in Table 4 show an overall healthy trend. Generally, banks’ incomes and profits have risen sharply in recent years. With over 15 percent after-tax annual rate of return on equity, banks are ranked as one of the most profitable institutions in the country. Their high profitability derives from various sources. First, loan applications are scrutinized more thoroughly in order to meet new supervisory standards. As a result, loan defaults are low and the share of nonperforming loans in banks’ total loan portfolio has declined from nearly 15 percent in the early 1990s to less than 10 percent in 1995. Second, banks maintain substantial interest rate spreads, part of which may reflect inadequate competition in the banking industry. Third, banks reportedly have made large investments in new technology and equipment and expanded their training programs; these have helped them improve labor efficiency and keep down labor costs. Fourth and finally, banks have diversified into fee-based businesses, such as loan underwriting, exchange market operations, and securities transactions, where profit margins are more secure and higher than in traditional lending activities.

Table 4.Trinidad and Tobago: Commercial Bank Performance Indicators(In percent; at end of period)
19911992199319941995
Profitability ratios
Ratios to average total assets
Operating income10.3012.3012.4010.9010.20
Profits before tax1.201.501.901.501.50
Profits after tax0.701.001.201.001.10
Net interest margin4.304.904.203.805.82
Non-interest income1.802.103.102.402.20
Overhead expense3.103.403.202.802.60
Ratios to equity capital
Profits before tax17.1419.8824.9520.8822.12
Profits after tax10.7112.9917.0713.3715.38
Asset quality ratios
Ratios to average total loans
Nonperforming loans14.5014.2013.2010.009.70
Accum. loan loss provi.6.606.206.705.205.40
Bankers’ acceptance12.2017.0010.23
Liquidity ratios
Ratios to average total deposits
Total loans81.0086.5081.3069.7061.50
Total liquid assets20.4021.9023.5027.7027.80
Capital adequacy ratio
Ratio to average total assets
Ratio of qualifying capital to total risk-adjusted assets13.9914.6815.71
Source: Central Bank of Trinidad and Tobago.

128. Banks in Trinidad and Tobago have maintained a strong capital position, which partly reflects a tradition of sound banking practices carried on from the period prior to independence when foreign banks dominated the country’s banking system. Although foreign ownership of banks has declined, even today three of six banks in the country operate as brandies of large multinational banks. Therefore, banks had little difficulty meeting capital adequacy standards stipulated under the Basel Accord of 1988. Under the regulations introduced in connection with the Financial Institutions Act of 1993, the Basle ratio of 8 percent was established as the minimum, with a recommendation of 12 percent or more. In order to comply with this guideline, banks have reduced dividend payments in favor of acquiring a larger capital base which, in terms of risk adjusted assets, increased from 14 percent in 1993 to 15.7 percent in 995 and further to 18.3 percent in September 1996.

129. Part of the increase in capital asset ratio can also be due to the portfolio shift by banks, largely from loans into investments. Data available since 1991 show that loan-deposit ratio declined from 90 percent to 65 percent, while investment deposit ratio increased from 10 percent to 40 percent. Because investments, including investments in government securities, are usually less risky than the standard private sector loan, risk adjusted value of banks’ assets is likely to have grown more slowly than is indicated by the unadjusted data. This implies that even with an unchanged capital base, banks’ capital ratio would improve over time if the composition of assets changes.

D. Currency Substitution

130. In the past four years foreign currency deposits in the banking system have grown from essentially zero to 26 percent of total bank deposits (Figure 16). Until early 1993, the use of foreign money in Trinidad and Tobago had been restricted by the existing foreign exchange regulations which, in particular, prohibited local banks from opening foreign currency accounts for residents. Starting in April 1993, all foreign exchange controls were eliminated and all capital account transactions were fully liberalized. Also, the Trinidad and Tobago dollar (TT$) was floated, thus ending the fixed exchange rate regime in operation since 1964.

Figure 16.Trinidad and Tobago: COMMERCIAL BANK DEPOSITS

(In billions of Trinidad and Tobago dollars)

Source: Central Bonk of Trinidad and Tobago.

131. Commercial banks responded to these liberalization measures by providing options to local residents of opening accounts denominated in foreign currencies, principally in U.S. dollar. These U.S. dollar deposits were subject to a somewhat different set of regulations than those applied to deposits held in local currency. For example, banks were required to hold 33½ percent liquid assets against foreign currency deposit liabilities whereas the requirement against local currency deposits was 16 percent. In addition, reserves held against foreign currency deposits could be invested in earning assets, whereas those held against local currency deposits were to be deposited at the central bank earning no interest. By October 1996, the latest data available, deposits denominated in foreign currency have grown to over one fourth of total deposits held at commercial banks.

Box 1.Trinidad and Tobago: Commercial Bank Prudential Requirements

RequirementBasle CommitteeIMF RecommendationsTrinidad and Tobago
Minimum capital for new banksNo guidanceMinimum US$ 1 millionTT$15 million (US$2.5 million)
Minimum capital adequacy ratioTotal capital to risk weighted assets of at least 8 percentAt least 8 percent; more in high-risk environmentAt least 8 percent of risk adjusted assets; central bank may require a higher ratio, depending on the quality of loan portfolio and loan provisioning policies
Loans to one borrowerCould be best practice, not more than 25 percent of total capitalTwenty-five percent of total capital applied to single borrower or group of related borrowersTwenty-five percent of bank’s capital for secured loans; limited to 5 percent for unsecured loans
Lending to related partiesNo guidance, but special attention neededBetween 25 percent to 50 percent of total capital applied to related parties and in total no more than 100 percentThirty-two percent for single group of borrowers; 5 percent for unsecured lending
Liquidity ratiosGuidelines on measuring and managing liquidity riskGuidelines are necessary and ratios are usefulBanks must hold cash reserve at the central bank in a fixed ratio deposit liabilities
Foreign exchange exposurePosition limits recommendedLimits necessary either as a ratio or in absolute termBanks required to hold 25 percent in liquid reserves against foreign deposit liabilities
Sources: Bank Soundness and Macroeconomic Policy, by C. J. Lindgren, G. Garcia, and Ml. Saal, IMF (1996), p. 187, and Central Bank of Trinidad and Tobago.

Box 2.Trinidad and Tobago: Risk-Weights for Asset Categories Applied to Commercial Bank Prudential Supervision

I. Balance Sheet Items

(a) Zero percent risk: Foreign and domestic currency cash; deposits held at central bank; government securities; claims on local government and statutory bodies; claims guaranteed by foreign governments and central banks; and claims backed by collateral of deposits at the bank.

(b) Ten percent risk: Claims on state-owned financial and commercial entities.

(c) Twenty percent risk: Claims on private financial institutions; on-balance sheet bankers’ acceptances; items in the process of collection.

(d) Fifty percent risk: Loans secured by mortgages on residential properties.

(e) Hundred percent risk: Loans secured by commercial and agricultural properties; all other assets not included in (a) or (d) above.

II. Off-Balance Sheet Items

(a) Zero percent risk: Unused overdrafts or credit card limits.

(b) Twenty percent risk: Self-liquidating trade-related contingencies, including commercial letters of credit.

(c) Fifty percent risk: Performance bonds; guarantees; indemnities; stand-by credit, and loans managed on behalf of Home Mortgage Bank.

(d) Hundred percent risk: Items that substitute for loans (guarantees and acceptances); loan and lease commitments and undisbursed loan funds; sale and repurchase agreements in which bank assumes the risk; and documentary bills of collection accepted by the bank.

132. Typically, dollarization or currency substitution takes place in countries that have experienced high rates of inflation. In these cases, inflation acts as a tax on domestic money holdings and, to avoid the inflation tax, individuals shift part of their assets abroad or into dollar deposits in local banks where such choices are available.32 In an environment of relatively low inflation, which has prevailed in Trinidad and Tobago over the last several years, currency substitution is not easily explained by a desire to protect real savings. Other explanations are needed to understand the factors bearing on the demand for money.

133. Exchange controls, as had existed in Trinidad and Tobago over decades, can frustrate the public’s desire to diversify liquidity holdings, which may create a pent-up demand for foreign currency, particularly for those firms and individuals with extensive foreign operations. Currency substitution may arise also from the differential rates of return available on foreign currency deposits relative to those on local currency deposits. Tax treatment of various types of instruments is another factor that can induce currency substitution. Finally, if the intermediation spread in foreign currency is smaller than in local currency, then there would be an incentive for shifting transactions into that currency. It appears that a large part of currency substitution taking place in Trinidad and Tobago can be explained by a combination of these factors.

134. As noted above, the initial growth in foreign currency deposits followed the lifting of exchange controls in 1993, reflecting portfolio choices by individuals. The change of exchange rate regime from fixed to floating may also have been a contributing factor, since the concerns about the stability of the exchange rate may have given some impetus to currency substitution. The relative rate of return on U.S. dollar deposits was not initially a factor, as interest rates on U.S. dollar deposits adjusted for the withholding tax and exchange rate change remained lower than on comparable local currency deposits until the end of 1994, even though the share of U.S. dollar deposits rose substantially in this period (Table 5). From late 1994 to late 1995, the interest premium on local currency deposits eroded; nevertheless, the exchange rate was quite stable and the growth in foreign currency deposits slowed considerably. Since late 1995, however, relative premium on U.S. dollar deposits has increased significantly at the same time as uncertainty attending the election of a new government led to a prolonged period of pressure on the exchange rate that was resisted by the central bank. (Table 5 and Figure 17).33

Table 5.Trinidad and Tobago: Commercial Bank Interest Rates(In percent per annum)
Deposit interest rates 1/
TT dollar depositsU.S. dollar depositsExchange rate index (TT$/US$)U.S. dollar deposit rate adjusted for exchange ratePremium on U.S. dollar deposit (TT$/US$)
Before taxAfter tax 2/
1994 August7.536.403.731.003.73-2.67
September7.516.383.631.023.72-2.66
October7.516.383.931.024.00-2.39
November7.476.355.041.025.13-1.22
December7.176.095.021.045.20-0.90
1995 January7.176.095.351.065.66-0.44
February7.035.985.311.065.65-0.33
March6.925.885.301.065.63-0.25
April7.025.975.601.065.94-0.02
May7.116.045.541.065.85-0.19
June7.166.095.341.055.63-0.45
July6.505.535.311.065.610.08
August6.945.905.331.065.65-0.25
September6.945.905.291.065.60-0.30
October6.685.685.131.065.42-0.26
November6.565.585.111.075.45-0.13
December6.715.705.261.075.62-0.09
1996 January7.066.006.551.077.001.00
February7.576.436.831.077.300.86
March7.776.606.761.067.180.58
April7.596.456.851.067.290.84
May7.526.396.771.067.150.76
June7.616.476.581.066.960.49
July7.646.496.771.067.160.67
August7.686.536.871.067.280.75
September7.796.626.961.087.480.86
October8.136.917.621.088.211.30
Source: Central Bank of Trinidad and Tobago.

Figure 17.Trinidad and Tobago: FOREIGN CURRENCY DEPOSIT SHARE AND INTEREST RATE

(Percentage points)

Sources: Central Bank of Trinidad and Tobago; and Fund staff estimates.

1/ Difference from previous period In percentage points

2/ Percentage rate of return on foreign currency deposits less the rate of return on local currency deposits adjusted for withholding tax and exchange rate change.

135. The differential tax treatment of interest income may also have been an incentive for currency substitution. Under present laws, interest earned from local currency deposits is subject to a 15 percent withholding tax whereas interest earned on foreign currency deposits is tax exempt. Although low-income depositors may qualify for part or full refund of the withholding tax under the allowed income tax exemptions, in practice the refund claims are rarely made and holders of local currency deposits come to bear the full burden of the tax.

136. The difference in reserve requirements on local and foreign currency deposits has contributed to currency substitution, as well. As noted in Section IV of this report, banks in Trinidad and Tobago are subject to a high unremunerated reserve requirement against local currency deposits, whereas foreign currency deposits are subject only to a “liquidity reserve”, which can be held in earning assets. To the extent that banks can shift the cost of reserve requirements to their customers, the cost of intermediation will be higher in local currency than in foreign currency, providing incentive for currency substitution. The evidence from Trinidad and Tobago shows that banks have been able to shift the entire cost of reserve requirements on to their customers, mainly in the form of higher loan rates.34 Such a cost differential is likely to induce borrowers to shift at least part of their loan demand into foreign currency and generally economize on the use of local currency.

137. Lastly, a question to be addressed is whether the foreign currency holdings appear to substitute for local currency in meeting the demand for money. A simple demand for money equation has been estimated for the period 1967 to 1992, the last year before foreign currency began to appear among commercial bank liabilities.35 The equation fits the data quite well and its estimated parameters were used to forecast money demand for the years 1993-96 to see whether it would track the measure of broad money that includes foreign currency deposits.

As shown in Figure 18, this was not the case. The equation predicts very well the broad money without foreign currency deposits in 1993 and 1994. As is typical when the forecast period is extended, errors are more likely and because of the inclusion of a lagged dependent variable these errors cumulate. In 1995 and 1996 the forecast moves toward but does not approximate broad money including foreign currency. This can be interpreted to suggest that initially foreign currency was not a close substitute for local currency in satisfying the demand for money, but instead may have been a substitute for other real or financial forms of holding wealth. In the years 1995-96, the results may reflect forecast error, or it may be that foreign currency is becoming a closer substitute for local currency, which is consistent with a growing volume of lending in foreign currency that has emerged in those years.

Figure 18.Trinidad and Tobago: REAL MONEY DEMAND 1966-1996

(In billions of 1990 TT dollars)

Sources: International Financial Statistics; and Fund staff estimates.

As in any standard model of imperfect competition, η is assumed larger than one to make profit maximization feasible.

In a Bertrand-Nash oligopoly, where banks optimize their profits with respect to the interest rate, the relation is η = σ(1-1/b), where b is the number of banks and σ a differentiation constant.

Taking the formula of footnote 28 and the latest interest rate data available (end of 1996), o can be computed to be close to 2. This corresponds closely to standard estimates in the literature.

Size of the market and scale economies of banking are major factors in determining the number of banks serving a market. The idea of doubling the number of banks is purely for illustration and to indicate its theoretical impact.

As of end of 1995, the largest bank accounted for 28 percent of total bank deposits and the smallest 5 percent. Shares of the remaining banks ranged between 24 to 11 percent.

For example, while average loan rates were comparable at about 13 percent per annum in June 1996, the average deposit rate of 9 percent paid by nonbank institutions was almost twice the rate available from commercial banks. The differential reflects greater public confidence in the solvency of banks, larger range of services they provide, liquidity of bank deposits, and easier access to services (more bank branches). Also, banks’ ability to offer higher deposit rates is constrained by the substantially larger reserve requirement relative to that imposed on nonbank institutions.

See, for example, the paper by Carlos Rodriguez, “Money and Credit Under Currency Substitution,” IMF Staff Papers (June 1993), pp.414-26.

Surprise elections in late 1995 led to a change of government. For most of the following 12 months there was downward pressure on the exchange rate which was controlled by policies of the central bank so as not to breach a threshold of TT$6 per U.S. dollar.

Depositors can be assumed to have more choices, including foreign outlets, for the placement of their funds, whereas choices for borrowers can be more limited, including an outright prohibition of overseas borrowing. It can be argued, therefore, that banks in Trinidad and Tobago operate in a global market for attracting deposits and thus have a limited power to change deposit rates. The market for loans, however, is basically local and banks can fix the loan rates more freely, including making adjustments to reflect the higher cost of reserve requirement.

For the period 1967-92 the real stock of broad money is regressed on the level of real GDP, the treasury bill rate, and itself lagged one period with the following results:

R2=.98

DW=2.02

Obs.=26

Figures in parentheses are t-ratios

where

RM = nominal stock of real broad money

RGPP = real gross domestic product

TB = treasury bill rate (in percent)

RML1 = RM lagged one period

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