V Exchange Arrangements and Liberalization of the External Sector
- Jean-Pierre Briffaut, George Iden, Peter Hayward, Tonny Lybek, Hassanali Mehran, Piero Ugolini, and Stephen Swaray
- Published Date:
- October 1998
As of the end of 1996, sub-Saharan African countries displayed wide diversity in their external systems in terms of their foreign exchange arrangements, market structures, and convertibility status. Although a few have achieved full convertibility in both external current account and capital account transactions, others remain very restrictive in their external sector practices. This diversity is a reflection of the restrictive exchange practices that most sub-Saharan African countries adopted following independence in the 1960s and 1970s and the varying degrees of success that they achieved subsequently in dismantling these practices and liberalizing the external sector in the 1990s.
Following independence, many of the countries opted for controls and restrictions to achieve rapid economic progress. This strategy was as visible in the external sector as in any other area of their economies. During this period, exchange rates were fixed, and various forms of exchange control regulations were introduced, including provisions to restrict current and capital account transactions. Foreign exchange was also largely rationed. As a result of these restrictions, sub-Saharan African countries did not benefit from the expansion of world trade and private capital flows that have occurred in the 1980s and 1990s.
Since the early 1990s, however, a number of countries have made substantial progress in applying international market standards to external transactions and in balancing policies to sustain greater external openness. A trend toward greater reliance on market forces can now be perceived in the determination of exchange rates and the liberalization of external transactions. Countries are consistently striving to strengthen financial soundness, accept market discipline, enhance the efficiency of payments systems, and develop the central bank's capacity to intervene in foreign exchange markets. (See Appendix I, Table A8 for a schedule summarizing developments in the external sector in the selected sub-Saharan African countries.)
By the end of 1997, almost all sampled countries maintained unitary exchange rate structures through either (1) a peg to a major convertible currency; or (2) independently floating exchange rates, which were market determined in auctions and fixing systems, in spontaneous market trading, or in organized interbank markets.
The regulatory frameworks in sub-Saharan African countries are now on the whole quite liberal in the making of payments and transfers on current transactions, but, on average, are still restrictive in terms of underlying transactions, particularly with respect to capital account transactions. (See Table 4 for individual country groupings.)
|Overall Convertibility: Current and Capital Account||Article VIII/XIV|
Group I Countries
External Current Account Convertibility
A number of the countries are rated restrictive in terms of current account convertibility. These are Angola, all BCEAO and BEAC countries, and Ethiopia.
All the CFA franc zone countries (see footnote 2) apply restrictive controls, including requiring the surrender of imported foreign banknotes. Moreover, financial intermediaries are granted only limited open positions, which are directly monitored by the two central banks—the BCEAO and the BEAC—with a view to centralizing holdings of foreign assets. The freedom of transfers within the CFA franc zone and, through France, to countries outside the zone is still considered a fundamental principle of the CFA arrangement. However, the prevalence of discretionary controls over transfers outside the zone significantly limits the practicability of the principle. In particular, the suspension of the repurchase of foreign banknotes in August 1993 constitutes a significant limitation on the free circulation among France and the two CFA franc subzones.
In Angola, the formal financial sector is directly controlled through restrictive foreign exchange budgets, positive import lists, and advance import deposits. As a result, an informal financial sector has developed and is abundantly supplied by free imports of foreign banknotes largely associated with the illegal diamond trade. However, this informal financial sector, which finances most imports, is almost completely uncontrolled.
In Ethiopia, although trade transactions are being progressively liberalized, direct and restrictive controls still apply to most transactions. Residents, who have been permitted to open foreign exchange accounts with the 10 percent of proceeds that they are not required to surrender, are further restricted in the making of payments.
Capital Account Convertibility
A number of countries are also restrictive in terms of capital account convertibility (Angola, all BCEAO and BEAC countries, Ethiopia, Ghana, Lesotho, Madagascar, Rwanda, Swaziland, Tanzania, and Zimbabwe). Lesotho and Swaziland differ from the other rand zone countries because they apply stricter controls over credit extended by nonresidents.
In the CFA franc zone, controls on inward flows are fairly liberal except that direct investment and its liquidation require prior approval and agreements under the various investment codes. Opportunities for foreign portfolio investment have so far been very limited, and access to money market instruments is restricted to authorized banks. The establishment of a regional stock exchange in Abidjan, Côte d'lvoire, in September 1998 may open new opportunities. Credit extended by nonresidents is practically free of restrictions. Foreign borrowing by financial intermediaries, however, also requires prior approval. Regarding outward flows, all transfers of foreign exchange funds to nonresidents are subject to prior approval, which may be more easily granted for transfers within the French franc zone. Commercial credit to nonresidents is free.
In Angola and Ethiopia, all capital movements are subject to prior approval, and inward direct investment is subject to explicit restrictions. Ghana applies indirect control over foreign inward investment in securities listed on the Ghana Stock Exchange through ceilings on foreign portfolio holdings (overall 10 percent, and individual 74 percent, of any security listed). Foreign investment in domestic money market instruments is prohibited, and direct investment, inward and outward, is subject to prior approval. All other capital transactions are directly controlled, although banks are free to borrow abroad and extend credit to nonresidents.
Madagascar, Rwanda, and Tanzania do not have capital markets, but apply liberal control over inward investments, particularly direct investments, in selected areas and activities as determined by the governments. However, the repatriation of proceeds derived from liquidation is subject to prior approval. Direct investment in Madagascar's export zone is practically free, and the repatriation of proceeds is facilitated by liberal foreign exchange regulations applied to that zone only. In Zimbabwe, most inward and outward capital movements including those going through the Zimbabwe Stock Exchange are directly controlled.
Group II Countries
External Current Account Convertibility
Botswana, Ghana, Lesotho, Madagascar, Malawi, Mozambique, Namibia, Rwanda, South Africa, Swaziland, Tanzania, and Zimbabwe are partially liberalized in terms of current account convertibility. These countries took significant steps toward liberalizing external trade-related transactions in the 1990s, although they still apply indirect controls to other current transactions, particularly invisibles not related to trade. In addition, the surrender of foreign exchange proceeds and the opening of foreign exchange bank accounts are still subject to some form of control. Except for Mozambique and Rwanda, they all accepted the obligations of Article VIII of the IMF's Articles of Agreement during 1994–96.
Botswana and Namibia, which enjoy considerable mining revenue and have a strong balance of payment position, liberalized current external transactions beyond prevailing controls in South Africa, with which they are partners in the rand zone. As required under the South African exchange control regulations, both countries maintain licensing requirements for imports from outside the Southern African Customs Union and require the surrender of foreign exchange proceeds. However, unlike South Africa, they are both fairly liberal on payments and transfers on account of “other” invisibles, the opening of foreign exchange bank accounts, and bank transactions between residents and nonresidents. In addition, exemptions to surrender and authorizations to open foreign exchange bank accounts are liberally granted to residents to facilitate external trade operations. There are no restrictions on foreign exchange bank transactions among nonresidents. This liberal regime is particularly effective in Namibia's export processing zone arrangements. Financial intermediaries may keep foreign exchange open positions, but only on customers' account in Botswana.
Madagascar, Malawi, Mozambique, Rwanda, and Tanzania have market-determined exchange rates that float independently. They made great strides toward liberalization in 1995–96 and are planning further quick progress toward full convertibility. Except for Mozambique, they participate in the Cross-Border Initiative with Zimbabwe. The Cross-Border Initiative countries do not require licensing in either export or import trade and authorize the opening of foreign exchange bank accounts by residents and nonresidents. Ghana and Malawi still require partial surrender of foreign exchange proceeds for certain commodities. Mozambique, Tanzania, and Zimbabwe do not require surrender. Payments on non-trade invisibles are practically free in Tanzania, while Ghana, Madagascar, and Malawi indirectly control such payments through authorized dealers. Mozambique, Rwanda, and Zimbabwe require prior approval of income-related and “other” invisibles. In all these countries, financial intermediaries may freely keep foreign exchange open positions within the limits of prudential requirements, except in Zimbabwe, which limits overnight open positions.
In addition to regular arrangements, Malawi, Mozambique, and Zimbabwe maintain special arrangements with South Africa to facilitate the repatriation of savings by workers employed in South African mines.
Capital Account Convertibility
Although fairly liberalized on inward portfolio investment, the five countries that have been rated partially liberalized in terms of capital account convertibility are still characterized by essentially direct and restrictive control over most outward capital account transactions. These countries are Botswana, Malawi, Mozambique, Namibia, and South Africa. South Africa is well developed in terms of its use of indirect instruments of monetary policy and secondary markets.12
In Botswana, Namibia, and South Africa, as in the other two smaller rand zone countries, all inward capital flows—particularly direct investment and related regulations governing the liquidation thereof—have been significantly liberalized. The receipt of foreign commercial credit extended by nonresidents and the acceptance of deferred payments on imports are also treated liberally although more so in Botswana and South Africa than in the other rand zone countries. Regarding portfolio investments in the rand zone, the capital market operations of all countries are conducted through the Johannesburg Stock Exchange. Local financial markets outside South Africa are small and practically limited to central bank operations for liquidity control purposes. Nevertheless, portfolio investment in Botswana is treated liberally in principle, although nonresidents are prohibited from buying Bank of Botswana certificates traded in open market operations. Financial intermediaries' borrowing from abroad for their own account requires prior central bank approval in all rand countries except Namibia, where borrowing is free.
However, the transfer of foreign exchange funds to nonresidents for outward direct and other investments requires the prior approval of the exchange control authorities in all rand countries; only in Botswana may authorized dealers grant approval within quantitative limits. Sales or issues of market securities and instruments by nonresidents are subject to prior approval, but portfolio investment abroad by institutional investors has been substantially liberalized in Botswana, unlike in Namibia and South Africa.
Financial markets in Malawi and Mozambique are still very small and do not yet offer significant opportunities to foreign investors. Although direct inward investment is practically free, most outward capital movements are subject to direct control. Except in South Africa, weaknesses relate mainly to the coordination of domestic and foreign exchange operations in financial markets, which are still undeveloped.
Group III Countries
External Current Account Convertibility
The sample survey shows that Kenya, Mauritius, Uganda, and Zambia, have achieved the highest degree of external current account liberalization, and, accordingly, are rated III in current account convertibility. Exchange rates are market-determined and independently floating; liberal regulatory frameworks have also allowed for unlimited market openness. These four countries are among those that have taken the boldest steps toward external liberalization since the early 1990s. They participate in the Cross-Border Initiative, and Kenya and Uganda are also members of the East African Community Area with Tanzania. While Kenya, Mauritius, and Uganda accepted the obligations of the IMF's Article VIII in 1993–94, Zambia continues to avail itself of the transitional arrangements of Article XIV, although it no longer maintains restrictions other than external payments arrears. However, shortcomings in the payments system affect the smooth settlement of external transactions, particularly in the East African Community Area, where adequate channels of communication for policy coordination are still lacking.
Capital Account and Full Convertibility
Kenya, Mauritius, Uganda, and Zambia have also achieved the highest degree of openness to inward and outward capital movements and to sales of assets between residents and nonresidents. The controls that remain exist only for statistical purposes, the surveillance of the securities and money markets, the monitoring of external indebtedness, and the observance of prudential requirements.
In Kenya, although stocks and secondary securities markets are just beginning, opportunities for foreign portfolio investment are offered in the Nairobi Stock Exchange. The Capital Market Authority applies overall and individual limits on purchases of securities by nonresidents—that is, 40 percent and 5 percent, respectively—of primary and secondary issues. It directly controls sales or issues of securities abroad by residents for the same purpose. Trading in government securities is based on the high real interest rates yielded by the sizable portfolios of public debt, which is equivalent to some 26 percent of GDP. The issue of securities or money market instruments by nonresidents in Kenya requires prior approval from the Central Bank of Kenya. To counteract capital volatility, the Central Bank of Kenya proceeds with open market operations and manages the flexibility of the exchange rate.
Box 3.Main Recommendations on Development of External Sector Liberalization
Countries that have not yet achieved the status of current account convertibility must take active steps toward liberalizing current payments and transfers, including removing restrictions on all underlying transactions. This should facilitate the acceptance of the obligations of Article VIII of the IMF's Articles of Agreement by all countries.
Countries should choose foreign exchange arrangements on the basis of their structural characteristics and the nature of the external shocks affecting them.
All countries must continuously improve their policy mix with respect to macroeconomic balance, bank soundness, and political stability.
Monetary operations should not substitute for fiscal policies or realignment of the exchange rate.
Coordinate external and domestic monetary operations and organize interbank markets.
Proceed with structural reforms, such as privatization of public financial institutions.
Strengthen supervision and prudential regulations in the banking and external sectors because these steps are essential for external liberalization.
Develop efficient payments systems.
Liberalize the capital account in step with progress in structural reforms.
Countries in the CFA franc zone must take steps to harmonize member countries' external regulations.
Mauritius pursues a policy of openness to offshore banking based on an easy-to-set-up “international status.” Opportunities for foreign investment are offered by the offshore banking community, which is expanding rapidly. However, control, which is essentially prudential, is still imperfectly regulated.
Zambia applies no control to outward capital transfers or asset sales between residents and non-residents. The Bank of Zambia, however, requires registration of all foreign borrowing for statistical purposes, and prior approval is required for foreign borrowing by financial institutions. Moreover, the small and shallow financial market does not offer significant opportunities for foreign portfolio investment.
Areas for Further Reform
Despite these countries' progress in external liberalization, they need to reinforce the gains by improving the policy mix with respect to macroeconomic balance, bank soundness, and political stability. Progress in structural reforms, such as privatization of public and state enterprises, recapitalization of financial institutions, and removal of obstacles to interbank trading and efficient payments systems, is greatly needed to establish the systemic resilience required to withstand financial shocks associated with capital volatility. The main recommendations for progress in external sector liberalization are contained in Box 3, page 26.
In general, with the worldwide integration of financial markets, attention has to be focused not only on the benefits but also on the risks of external liberalization. While there should be general interest in reaping the benefits of financial technologies and integration into external trading systems, countries must carefully weigh the risks associated with capital volatility. To liberalize capital markets without having laid the foundation in terms of structural reforms and financial soundness could be counterproductive.