VI Monetary Policy and Financial Sector Reform
Author: Mr. Eric Verreydt, Mr. Michael T. Hadjimichael, and Mr. Thomas Rumbaugh
Language:
English
Keywords:
OP; adjustment effort; re-export trade; public enterprise sector; enterprise; Gambian economy; flexible exchange rate system; CFA franc; cash reserves; interest rate bid; broad money growth; Monetary base; Bank credit; Exchange rate policy
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Abstract

Monetary policy since the inception of The Gambia’s Economic Recovery Program has been directed at (1) reducing inflation, which had accelerated sharply in 1984/85 and 1985/86; (2) replenishing the country’s foreign exchange reserves from their initial very low level; (3) supporting the exchange rate policy; and (4) accommodating the targeted expansion in real GDP.

Monetary policy since the inception of The Gambia’s Economic Recovery Program has been directed at (1) reducing inflation, which had accelerated sharply in 1984/85 and 1985/86; (2) replenishing the country’s foreign exchange reserves from their initial very low level; (3) supporting the exchange rate policy; and (4) accommodating the targeted expansion in real GDP.

Monetary Policy Objectives and Instruments

Consistent with the targeted accumulation of gross official reserves and the large inflows of external financial assistance envisaged under the program, the expansion of broad money throughout the period since 1985/86 has been programmed to reflect an improvement in the net foreign assets of the banking system, while the net domestic assets of the banking system have been targeted to decline steadily. This reduction was to be achieved through large net repayments by the Government to the banking system, which would also make room for an adequate expansion of credit to the nongovernment sector, within the context of a restrictive overall credit policy.

Given the limited development of the domestic money market during the early years of the pro-gram, the Government has unavoidably relied on direct policy instruments—namely, quantitative controls on credit expansion by individual banks—for influencing credit and monetary developments and thus observing the ceilings on the net domestic assets of the banking system, net credit to the Government, credit to the GPMB, and the floors on the gross official reserves of the Central Bank (in foreign currency terms). However, to enhance the efficiency of monetary control and, in particular, to support the exchange rate policy and encourage domestic financial savings, the controls on bank deposit and lending interest rates were lifted in September 1985, including the discontinuation of subsidized lending rates for crop financing;17 the bank cash-reserve requirements have been tightened;18 and an auction market for treasury bills was introduced in July 1986. After the Central Bank had gained experience and confidence in managing domestic liquidity, the system of credit ceilings was abolished and an indirect system of monetary control was introduced with effect from September 1990.19 Since then, the Central Bank has been exercising control over credit and monetary developments by observing limits on its net domestic assets and by maintaining tight domestic liquidity conditions through open market operations.

In its liquidity management policy, throughout the period since 1985/86, the Central Bank has been aiming to ensure that domestic interest rates were kept at levels that were positive in real terms and that appropriate differentials were maintained from interest rates abroad. Such a policy was considered essential for the smooth functioning of the interbank foreign exchange market, given the lifting of all exchange restrictions, including for capital transactions, and the large foreign exchange flows associated with the re-export trade.

Monetary policy reforms have been complemented by parallel efforts to strengthen the financial intermediation process. These efforts have focused initially on the restructuring and eventual privatization of the largest commercial bank, the GCDB, which had been experiencing financial difficulties (including a large portfolio of nonperforming loans). More recently, attention has been directed at improving bank supervision and revising the financial sector legislation.

Monetary Developments Since 1985/86

Monetary policy during the period since 1985/86 has been broadly successful in reducing inflation, stabilizing the exchange rate, and facilitating the attainment of the real GDP and balance of payments objectives. As indicated in Section II, deviations from the initial program targets for these variables and the intermediate targets for monetary aggregates have been caused primarily by exogenous factors—such as weather developments, regional disturbances, and shortfalls or delays in external assistance—and to a lesser extent by domestic policy slippages.

While the 12-month rate of growth of broad money has decelerated markedly since 1985/86, it has displayed sizable fluctuations from year to year. In particular, in the aftermath of the introduction of a flexible exchange rate system in early 1986, broad money growth accelerated from 25 percent in the year ended June 1986 to 44 percent by June 1987, before declining steadily to 8 percent by June 1989 (Chart 8 and Table 12). The external shocks that took place in the first half of 1989/90 induced a reacceleration of monetary expansion to 22 percent by December 1989, but the tightening of financial policies and the recovery in export receipts in the second half of the fiscal year contributed to bringing broad money growth back to 4 percent by March 1991. However, the shortfalls in external assistance (whose monetary impact was not completely offset by a lower improvement in the net foreign assets position of the banking system) and the fiscal slippages in late 1990/91 and the first half of 1991/92 led to a worrisome pickup in the growth in broad money to 25 percent by December 1991. The corrective fiscal measures implemented in response to this slippage were expected to facilitate large net repayments by the Government to the banking system, which would allow a significant contraction in the outstanding stock of broad money during the last quarter of 1991/92.

Chart 8.
Chart 8.

Monetary Developments 1984/85-1991/92

Sources: Data provided by the Gambian authorities; and IMF staff estimates.
Table 12.

Monetary Survey

article image
Sources: Data provided by the Gambian authorities; and IMF staff estimates.

The Gambia Produce Marketing Board.

Twelve-month change as a ratio of the beginning-of-period money stock.

With the benefit of hindsight, it would appear that the excessive expansion in reserve money that took place in 1985/86, 1986/87, and more recently, during the first half 1989/90 and during the period from March to December 1991 was translated primarily into a buildup of excess bank cash reserves and in part in an acceleration in the rate of growth of broad money, and thus had a much smaller impact on exchange rate and price developments. The effects of fluctuations in the rate of growth of broad money on output growth appear also to have been modest in the short term, as output developments in The Gambia tend to be dominated by the effects of changes in the weather and other exogenous factors rather than by changes in domestic demand. The observed limited impact of the sharp variability in domestic liquidity conditions (i.e., reserve money and excess bank cash reserves) on the growth of broad money and, in turn, exchange rate and price developments could be attributed to a number of factors special to The Gambia.

First, the monetary slippages emanated almost entirely from difficulty in adhering to the targeted ceilings on net credit to the Government from the banking system, or difficulty in attaining the gross official reserve targets. With the exception of occasional overruns of credit increases to the GPMB, the expansion of bank credit to the private sector and public enterprises has invariably been below target. Thus, to the extent that the slippages in the government financial performance were quickly corrected, the monetary overhang was pari passu absorbed.

Second, the weak development of financial markets in The Gambia and the associated high trans-action costs, a feature that is common to many developing countries, seem to have limited the ability of economic agents to quickly dispose of any “undesired” buildup in money balances by purchasing more goods or foreign exchange.20 As a consequence, the temporary monetary overhangs have been reflected in fluctuations in the share of currency outside banks in broad money and compensating changes in the income velocity of circulation.

Third, excess bank cash reserves could not quickly result in an increase in bank credit, as the expansion of credit to the private sector in The Gambia is largely demand determined, given the limited size of unmet credit demand from credit-worthy customers. The existence of a large portfolio of nonperforming bank loans to the private sector may also have restrained the commercial banks from taking on new customers without adequate documentation and collateral. The bulk of bank credit to the private sector in The Gambia is related to tourism and trade financing, particularly for reexports. Traders involved in the re-export trade tend to finance most of their imports from their own funds or with foreign suppliers’ credits, prompted in part by the high cost structure of the domestic banking system, limiting their domestic borrowing to the financing of the domestic currency costs of their operations.

The latter feature of the credit market in The Gambia has tended to insulate the banking system from the impact of the normal leads and lags associated with the rather volatile re-export trade, thus restraining the fluctuations in domestic liquidity conditions. At the same time, however, the lower-than-otherwise demand for domestic credit and, indirectly, dalasi-denominated financial assets by the private sector has limited the development of the domestic money market. The latter has tended to be characterized by sizable excess liquid assets held by banks, mainly in the form of government securities. Notwithstanding the increasing interest of the nonbank sector to invest in financial assets, the demand for treasury bills at the biweekly auction has been narrowly based, while interest rate bids have tended to move only modestly in relation to changes in the inflation rate and the relative tightness or laxity of domestic liquidity conditions. As a result, the interest rate on three-month treasury bills has moved in recent years within a very narrow range, of 17-20 percent, giving rise to pronounced fluctuations in real interest rates, even though the latter have remained generally at positive levels. The Central Bank has on occasion participated in the treasury bill auctions by placing bids for the purchase of a small portion of the total amounts of bills offered, so as to signal to the market, by influencing the average treasury bill interest rate, its preferences with regard to the level of interest rates in the money market. As indicated above, maintenance of appropriate margins above interest rates abroad has been considered necessary to support the exchange rate policy.

Overall, despite the lifting of interest rate controls in 1985 and the variability in domestic liquidity conditions, interest rates in The Gambia have remained rather rigid. In response to the new policy environment, the three commercial banks raised initially their lending rate structure and lowered somewhat their deposit rates, thus increasing their interest rate margins from less than 10 percent to around 12-14 percent throughout the period since 1986. The widening of interest rate margins reflected in part an attempt by the banks to offset the impact on their financial position of the difficulties faced by several public and private enterprises to service their financial obligations to the banking system, mainly to the largest commercial bank (which was owned by the Government). In addition, difficulties in liquidating collateral to bank loans and long delays in enforcing financial contracts have added a sizable risk premium to bank lending rates. Bank deposit and lending rates have tended to be even less volatile than treasury bill rates, notwithstanding the variations in the banks’ liquidity position since 1985/86. For example, the maximum lending rate on bank loans to the trading sector declined gradually from 30 percent in June 1986 to 26.5 percent at present, while the interest rate on three-month bank deposits fell from 18 percent to 12.5 percent, respectively.

The relative rigidity in the interest rate structure is attributable to a number of factors: (1) the thin domestic money and credit markets, the limited availability of financial instruments for investment, and the absence of a domestic capital market; (2) the oligopolistic and noncompetitive nature of the banking system (two of the three banks in the banking system have in fact been making substantial profits, in excess of 200 percent of their capital base per year); and (3) the weak arrangements for bank supervision.21 For similar reasons, interest rate variability has also been limited in some other African countries that have lifted their controls on interest rates in recent years.22

Monetary Policy, Exchange Rate Policy, and Inflation

The emphasis of interest rate and reserve management policies on broadly stabilizing the nominal effective exchange rate, in the context of the policy of preserving external competitiveness, has contributed to a reduction in inflation. Given the openness of the economy and the expanding regional trade for goods imported through The Gambia, the main channel for the transmission of the impact of changes in the stance of monetary policy to price developments has been the evolution of the exchange rate of the dalasi, particularly of the bilateral rate vis-à-vis the CFA franc.

The increasing importance of the re-export trade has strengthened the sensitivity of the domestic prices of consumer goods that are prominent in this trade—mainly foodstuffs, clothing, and footwear—to developments in the demand and prices of these goods in the subregion. These consumer goods are imported in large quantities into The Gambia and, for the most part, are sold wholesale in the capital city of Banjul to visiting traders from the sub-region. The bulk of these goods is included in the consumer price index (CPI) of The Gambia;23 the CPI is actually measured on the basis of prices prevailing in Banjul and in two adjacent urban areas. As a result, price developments in The Gambia are to a substantial and increasing extent determined by changes in the nominal demand for the re-export goods by consumers in the subregion and, accordingly, are less sensitive to changes in monetary conditions in The Gambia. As the prices for the re-export goods are denominated in terms of CFA francs, consumer prices in The Gambia have tended to be strongly influenced by changes in the dalasi/CFA franc exchange rate (Chart 9). This influence could more easily be discerned in periods, such as the first half of 1991/92, when the dalasi weakened markedly against the CFA franc, even though the nominal effective exchange rate remained broadly stable. The impact on consumer prices of these developments, as well as of occasional disturbances in the supply of certain key food items, has tended to be accommodated by changes in the velocity of circulation.

Chart 9.
Chart 9.

Developments in Broad Money, the Exchange Rate, and Prices

(Annual percentage change)

Sources: Data provided by the Gambian authorities; International Monetary Fund, Information Notice System and International Financial Statistics; and IMF staff estimates.1 Nominal effective exchange rate (dalasis per foreign currency unit).

Notwithstanding the increasing influence of changes in the dalasi/CFA franc rate on price developments and the relatively low inflation prevailing in the neighboring CFA franc countries, a formal linking of the dalasi to the CFA franc so as to provide a nominal anchor for price movements and inflation expectations in The Gambia has not been considered a desirable option by the Government.24 Bilateral trade between The Gambia and the CFA franc zone is minimal (in terms of domestically produced goods), while The Gambia’s tourism market and the prices and demand for its traditional and nontraditional exports are determined primarily by developments in European and other industrial countries. Accordingly, exchange rate policy remains focused on preserving overall external competitiveness. With the emphasis of financial policies on lowering inflation to a low rate comparable to that for the main trading partner countries, this objective is consistent with minimal changes in the nominal effective exchange rate. Given the link between the CF A franc and the French franc, stability of the nominal effective exchange rate would be equivalent to a stable dalasi/CFA franc rate, insofar as cross rates among the currencies of the major industrial countries remain broadly unchanged.

Financial Sector Reform

The banking system of The Gambia at the start of the reform efforts consisted of the Central Bank of The Gambia and three commercial banks: the Gambia Commercial and Development Bank (GCDB); the Standard Chartered Bank of The Gambia; and the International Bank for Commerce and Industry, which is a local branch of a Senegalese bank. A third foreign-owned bank, the Continent Bank, has recently been licensed. Other financial institutions included the Gambia National Insurance Corporation, the Government Savings Bank, and the Social Security and Housing Finance Corporation. A n Agricultural Development Bank was created in 1981, but it soon encountered severe financial difficulties that led to a freezing of its activities in 1982 and to its eventual liquidation in 1989.

The centerpiece of the financial sector reform efforts since 1985/86 has been the rehabilitation of the GCDB. The GCDB had run into severe financial difficulties in the late 1970s and early 1980s, owing to a growing share of nonperforming loans and inadequate capitalization, and thus to growing recourse to refinancing from the Central Bank. A restructuring program was carried out between 1986/87 and 1988/89 with technical assistance from the World Bank, which provided for new capital injections by the Government, the consolidation of outstanding debt to the Central Bank, and the replacement with government securities of the nonperforming loans to public enterprises and to the private sector that had been guaranteed by the Government. The nonperforming loans were passed on to a new government agency, the Man-aged Fund, which has been responsible for their recovery.

The management of the GCDB was reinforced in 1990 and, following an audit of accounts, its share capital was increased again in July 1990 and the bank was converted into a public limited liability company in preparation for its privatization. The GCDB was finally offered for sale in July 1991, and an agreement was reached in early 1992 with a recently established local affiliate of a foreign bank (Meridien Bank) for the purchase of a large share of the GCDB’s assets and liabilities. The effective privatization of the GCDB was concluded at the end of June 1992, when the remaining nonperforming assets, net of certain liquid assets of the GCDB and of its liabilities to the Central Bank, were replaced with government financial instruments. The nonperforming assets of the GCDB, together with the remaining nonperforming loans in the hands of the Managed Fund, have been transferred to a newly set up government entity, the Asset Management and Recovery Company. The latter has received a strong mandate from the Government to recover as many of these debts as possible.

With a view to updating the legislative framework and bringing it more in line with the monetary policy reforms introduced in recent years, the Central Bank Act and the Financial Institutions Act were revised during the past two years, with technical assistance from the Fund. The revised Acts, which are scheduled to be presented to Parliament during the second half of 1992, allow for the introduction of central bank financial instruments so as to enhance the effectiveness of liquidity management and strengthen the provisions for bank supervision. Amendments to the Bankruptcy Act and the Sheriff Act are also currently being considered, so as to strengthen the procedures for the enforcement of financial contracts and facilitate the liquidation of collateral to bank loans. The bank supervision capacity of the Central Bank has also been strengthened with technical assistance from donors. The privatization of the GCDB and the revised financial legislation are expected to stimulate competition in the banking system of The Gambia and help narrow the existing large margins between bank deposit and lending rates.

The sequencing of monetary policy and financial sector reforms in The Gambia has been dictated by the adjustment needs of the economy and the lengthy process of preparing certain reforms, like the restructuring of the GCDB. The lifting of interest rate controls ahead of a strengthening of com-petition in the banking system and of the arrangements for bank supervision was necessary to support the establishment of a flexible exchange rate system and the liberalization of exchange controls on current and capital international transactions. While desirable, the restructuring and privatization of the GCDB could not be completed earlier, given the complexity of the initial financial difficulties and the need to identify and adequately document the existing nonperforming loans; short-ages of skilled staff and the limited interest shown by foreign financial institutions to invest in the banking system of The Gambia have complicated this task. Similarly, an enhancement of the arrangements for bank supervision and of the bank capital requirements could not be achieved without a time-consuming revision of the existing financial legislation.25 Appropriately, the abolition of credit ceilings and the shift to an indirect system of monetary control were effected only after the Central Bank had acquired adequate experience in open market operations. The effectiveness of this system of monetary control and the development of the domestic money market would be strengthened further by the envisaged introduction of new financial instruments by the Central Bank.

17

The only control on interest rates that has been retained relates to a requirement that bank interest rates on three-month deposits be set at 3 percentage points below the prevailing interest rate on treasury bills, so as to ensure that the returns on bank deposits do not become too low.

18

In September 1985, the required bank cash-reserve ratio was raised from 6 percent to 10 percent for demand deposits and from 4 percent to 8 percent for time and savings deposits. In 1986/87, the required cash-reserve ratio for demand deposits was raised further to 24 percent, while the required total liquid assets (including bank cash reserves) were raised to the equivalent of 30 percent of total bank deposits.

19

The Gambia was the first sub-Saharan African country to shift to an indirect system of monetary control. Malawi and Ghana introduced a similar system in January 1991 and January 1992, respectively.

20

This view is supported by the fact that, while the share in broad money of currency outside banks has declined somewhat in recent years, it remains high, amounting to 33 percent in March 1992.

21

Recent developments in the economic literature suggest that under conditions of uncertainty and asymmetric information between borrowers and creditors, and as long as banks are less risk-averse than their customers, it would be optimal for banks to keep their lending rates relatively stable and below the levels that would equilibrate the supply and demand for credit, so as to avoid financing riskier projects, and thus maximize profits. For details, see Stiglitz and Weiss (1981) and Villanueva and Mirakhor (1990).

22

For a review of the recent experience with interest rate liberalization in The Gambia, Ghana, Kenya, Malawi, and Nigeria, see Turtelboom (1991).

23

The combined weight of these items in the CPI of The Gambia is believed to be fairly high. This is suggested by the fact that imported food and beverages account for 23.9 percent, and imported clothing, textiles, and footwear for another 14.9 percent of the CPI basket of goods.

24

For a recent assessment of the CF A franc zone, see Boughton (1991). A comprehensive review of analytical issues with regard to exchange rate policy in developing countries is provided by Aghevli, Khan, and Montiel (1991).

25

For the optimal sequencing of financial sector reforms, see Villanueva and Mirakhor (1990), Leite and Sandararajan (1990), and Wong (1991).

Within Same Series

Other IMF Content

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Cover The Gambia
The Gambia
Economic Adjustment in a Small Open Economy
Author: Mr. Eric Verreydt, Mr. Michael T. Hadjimichael, and Mr. Thomas Rumbaugh
ISBN:
9781557752307
ISSN:
0251-6365
Publication Date:
15 Sep 1992
Publisher:
International Monetary Fund
DOI:
https://doi.org/10.5089/9781557752307.084
Pages:
48

Monetary Developments 1984/85-1991/92

Developments in Broad Money, the Exchange Rate, and Prices

(Annual percentage change)

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