VI The Central Banking Institution in a Currency Enclave

Charles Collyns
Published Date:
March 1983
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In a currency enclave, the currency of a typically larger and more developed foreign country circulates alongside, or in some cases in place of, the domestic issue. This situation has arisen where extensive and unregulated trade with a dominant partner, predating the establishment of a national currency, has led to the customary acceptance of the partner's currency as a means of transaction. With such a high degree of financial openness, domestic interest rates and credit conditions in the enclave are strongly influenced by monetary conditions in the partner. Moreover, in this context, powers of fiduciary issue would be particularly limited as the domestic currency (often confined to coinage) may have only restricted acceptability as a means of transaction. In addition, if local contracts are denominated in the foreign currency, shifts in exchange rate parity do not alter relative prices. For all these reasons, the scope for independent monetary policy in a currency enclave is particularly narrow, and the role of the domestic central banking institution may be limited.

The influence of central banking in the enclave may be reinforced, however, by the actions of a monetary authority in the partner country. In particular, such an authority would be likely to have greater ability to extend emergency liquidity in a crisis. A cooperative arrangement could be feasible if the interests of the two countries were largely compatible and if the allocation of responsibility to the partner were politically acceptable. Indeed, such an arrangement might be preferred to the alternative of extending the fiduciary powers of the currency enclave central banking institution on the grounds that an external agency would be less susceptible to undue internal political pressures and have a more established record for financial competence and prudence.

The case studies in this section include two countries, Liberia and Panama, which rely on the U.S. dollar as the principal form of money—domestic issue being restricted to coinage—but have no formal support agreement with the U.S. authorities. By way of contrast, the second two examples of enclaves, the Rand Monetary Area and France d'outre-mer, have central banking institutions which are closely linked to authorities in the partner countries. The earlier discussion of Bhutan and Maldives is also relevant in this context in describing countries that are making the transition from enclave to independent monetary area.

Liberia and Panama

In Liberia and Panama, the U.S. dollar is legal tender and the domestic issue of currency is confined to coinage. In both of these countries, foreign-owned commercial banks dominate the financial systems, which are open to unrestricted current and capital transactions.16 In Liberia, the central banking institution is the National Bank of Liberia, which was established in 1974 to take over the central banking functions previously conducted by the Bank of Monrovia (a subsidiary of Citibank)—including the provision of banking services to the commercial banks and to the government—and to initiate bank supervision. In Panama, central banking responsibilities are shared between the National Banking Commission and the National Bank of Panama. The former is in charge of bank supervision and is concerned with the promotion of Panama as an international financial center. The latter is a commercial bank, although in part publicly owned. In addition to its regular commercial banking activities, it acts as banker to other commercial banks and as the fiscal agent of the government. It also plays the role of development bank in undertaking higher-risk loans in the public interest, using aid receipts to subsidize interest charges. Both the National Banks of Liberia and Panama undertake to supply their respective financial systems with the U.S. dollar notes and local coinage required to meet the domestic transactions demand for currency.

Despite the formal similarity in the monetary arrangements of these two countries, their individual experiences have been very different. In Panama, an environment of financial stability has fostered rapid growth of domestic deposits, while the combination of political security, liberal banking legislation, and economic prosperity has helped to establish the country as an important offshore banking center. By contrast, in Liberia, the financial system has encountered serious difficulties in recent years, manifested in the contraction of the money supply and private credit and the failure of a major bank. These events have coincided with a deterioration in the external balance as the Government has attempted to compensate weakness in the export sector by increased public sector activity.

In the present context, it is important to note that the Libertan authorities' limited powers of fiduciary issue have not screened the financial system from external strains; rather, these strains have been revealed in an unusual fashion. Given the scarcity of foreign exchange, the National Bank of Liberia has not always been able to fulfill its function of supplying dollar currency on demand for internal transaction purposes; the limited supply available to it from exporters, reserves, and external borrowing is mostly absorbed in payment for oil imports and in external debt service. So commercial banks are no longer necessarily able to withdraw excess reserves from the National Bank of Liberia in cash. While these banks may receive some foreign exchange from client exporters, they are not able to draw unlimited amounts on parent banks unwilling to increase their Liberian exposure. Moreover, the currency in circulation is regularly depleted by direct deposit overseas. In consequence, cash bears a premium value against Liberian bank deposits, which encourages commercial banks to compete for currency and offshore resources rather than for deposits and loans. Indeed, banks may sometimes be unwilling to make private loans that would require import finance or to cash or accept as deposits checks drawn against other banks. This situation has led to an inefficient allocation of monetary resources and high transactions costs.

The Rand Monetary Area and France d'outre-mer

The Rand Monetary Area—consisting of Lesotho, South Africa, and Swaziland—was set up in 1974. It is based on the use of a common currency, the South African rand, and provides for free transfer of funds within the area, compatible exchange restrictions on the transfer of funds outside the area, and the pooling of gold and foreign exchange reserves with the South African Reserve Bank.17

Both Lesotho and Swaziland have subsequently established autonomous monetary authorities of their own: the Lesotho Monetary Authority (founded in 1980) and the Central Bank of Swaziland (1974).18 Under bilateral agreements with South Africa, the Lesotho and the Swazi authorities are empowered to issue their own currencies, the maloti and the lilangeni, respectively, both valued at par with the rand, to circulate as legal tender within their own borders. Their currency issue must, under the terms of these agreements, be completely covered by their holdings of rand currency, special interest-bearing deposits with the South African Reserve Bank, and marketable securities of the South African Government. The South African Reserve Bank is given specific responsibility to act as lender of last resort in Lesotho and Swaziland through the temporary extension of credit to the Lesotho Monetary Authority and the Central Bank of Swaziland. So while the local monetary authorities obtain seigniorage from currency issue, responsibility for ensuring monetary stability is shared with an extranational agency.

In other respects, the Lesotho Monetary Authority and the Central Bank of Swaziland bear many similarities to the transitional central banking institutions discussed earlier. In common with the monetary authorities in Maldives and Bhutan, both must be prudent but resourceful in promoting the gradual replacement of the foreign issue by the domestic issue without threatening confidence in the new means of transaction. The Lesotho Monetary Authority has, for example, maintained a noninterest-bearing rand deposit account with a commercial bank in South Africa, which in its turn is willing to exchange the maloti for the rand at par; this arrangement is designed to encourage banks and merchants in South African border areas to do likewise, and so enhances the usefulness of the maloti. In both countries, the monetary authorities have 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 government (in Swaziland). In Lesotho, in particular, the Government has continued to hold the bulk of its deposits with local commercial banks rather than with the monetary authority; the Lesotho Monetary Authority has been important, however, in raising funds for the Government, in acting as an intermediary with foreign banks, and in the placement of treasury bills, as well as being a substantial purchaser of government securities. In Swaziland, the Government has been a net creditor of the Central Bank of Swaziland and of the commercial banks. In both countries, the commercial banks, which are either government-owned or foreign-owned, make deposits with the monetary authorities which provide an important component to the centralization of foreign exchange holdings; recourse to lender-of-last-resort facilities and bank supervision are both limited. Interest rates necessarily follow fluctuations in South African rates, and monetary policy is in general passive.

In France d'outre-mer, the ties between the external authority and the local monetary system are even closer. The Institut d'Emission in Paris takes direct responsibility for the monetary affairs of both the Departments (such as Guiana, Martinique, and Réunion) and the Territories (such as French Polynesia and New Caledonia). Each of these Departments and Territories has its own currency but parity with the French franc is guaranteed by the Institut d'Emission. The Institut d'Emission is particularly concerned with control of the volume and allocation of credit, which it achieves through its policy of rediscounting via local agencies to commercial banks at prices dependent on the use of funds. The Institut d'Emission is itself subject to the French Finance Ministry's supervision.

Foreign exchange restrictions were introduced in Liberia in April 1980, in the aftermath of a change in the government, but were removed the following month, after proving difficult to operate, partially ineffective, and damaging to external confidence.

Botswana was a founding member of the Rand Monetary Area, but subsequently withdrew when setting up its Central Bank.

The Central Bank of Swaziland was originally entitled the Monetary Authority of Swaziland. This institution’s name was altered in 1979 without substantial extension of its powers or responsibilities.

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