Abstract
This Selected Issues paper examines the sources of real growth in Guinea. It identifies and quantifies the impact on real GDP growth of both the exogenous shocks and the policy changes that have occurred since 2000. The paper offers, first, some empirical evidence on real GDP growth in Guinea and then analyzes the sources of growth using the standard framework of growth accounting. The paper also analyzes and quantifies the effect that some exogenous shocks and policy changes have had on growth.
II. Banking Sector Developments in Guinea7
A. Introduction
32. This paper examines the main challenges facing Guinea’s banking system resulting from recent economic and policy developments and banks’ response to them. In particular, it considers how the banking system has responded to the unification and liberalization of the foreign exchange market, accelerating inflation, and rising dollarization of the economy. Although the paper finds that the banking system has adapted to the changes, more needs to be done if banks are to remain sound and profitable over the medium term. The sector’s profitability rests on the availability of low–interest deposits, which are either demand or short–term savings deposits. But with the liberalization of the foreign exchange market and continued dollarization of the economy, the supply of deposits may dry up. The paper recommends liberalizing the interest rate structure and raising policy rates to maintain the attractiveness of instruments denominated in the national currency. It also contemplates further reforms of the foreign exchange market centered on promoting transparency and price competition among market participants. Finally, the paper suggests stronger enforcement of prudential rules to limit the risks of systemic failure associated with banks’ excessive exposure to a few prominent clients.
33. The paper is organized as follows. Section B presents an overview of the financial sector. Section C discusses the banking sector’s response to the liberalization of the foreign exchange market. Section D considers the impact of dollarization on the banking system and analyzes possible consequences for interest rate policy. The paper concludes with a summary of key findings and policy recommendations.
B. Overview of the Banking Sector and Financial Markets
Overview of the banking sector
34. Guinea’s banking sector is relatively small and highly concentrated, and is dominated by foreign capital. It consists of seven banks, all of which are majority or wholly foreign owned, with total assets equivalent to about 13 percent of GDP. About 75 percent of total bank assets are concentrated in the three largest banks. The government holds a 40 percent stake in a small bank and has recently privatized a part of its stake in the largest bank, reducing its share in that bank’s capital from 38 percent to less than 20 percent. Banking sector penetration remains low, and only about 2 percent of Guineans have a bank account.
Concentration of Assets, Mid–2005 (Share of total assets of the banking system in selected number of top banks)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Concentration of Assets, Mid–2005 (Share of total assets of the banking system in selected number of top banks)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Concentration of Assets, Mid–2005 (Share of total assets of the banking system in selected number of top banks)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.35. The banking sector is supplemented by a growing network of microfinance institutions (MFIs). MFIs provide financial services to households and small and medium businesses, mostly those who lack access to financial products from banks. In the past several years, the MFI expansion in Guinea has outpaced the rate of growth of the banking sector.8 As of end–2004, there were 10 MFIs in Guinea, with over 300 local offices and more than 180,000 clients.
Banking System Structure, Mid–2005
Data as of end–2004.
Not including central bank assets.
Banking System Structure, Mid–2005
| Financial Sector Assets | |||||
|---|---|---|---|---|---|
| (In | (Percent of | ||||
| Number of | billions of | banking | (Percent | ||
| Institutions | GNF) | system) | of GDP) | ||
| Commercial banks | 7 | 1581.6 | 98.6 | 13.2 | |
| Large foreign–owned | 3 | 1188.9 | 74.1 | 10.0 | |
| Other foreign–owned | 4 | 392.7 | 24.5 | 3.3 | |
| Microfinance institutions (MFIs)1/ | 10 | 23.0 | 1.4 | 0.2 | |
| Total banking sector and MFI 2/ | 17 | 1604.6 | 100.0 | 13.4 | |
Data as of end–2004.
Not including central bank assets.
Banking System Structure, Mid–2005
| Financial Sector Assets | |||||
|---|---|---|---|---|---|
| (In | (Percent of | ||||
| Number of | billions of | banking | (Percent | ||
| Institutions | GNF) | system) | of GDP) | ||
| Commercial banks | 7 | 1581.6 | 98.6 | 13.2 | |
| Large foreign–owned | 3 | 1188.9 | 74.1 | 10.0 | |
| Other foreign–owned | 4 | 392.7 | 24.5 | 3.3 | |
| Microfinance institutions (MFIs)1/ | 10 | 23.0 | 1.4 | 0.2 | |
| Total banking sector and MFI 2/ | 17 | 1604.6 | 100.0 | 13.4 | |
Data as of end–2004.
Not including central bank assets.
Selected Indicators of Microfinance Institutions, 2002–04 1/
Aggegate figures for the four largest institutions.
Data for end–January 2005.
Selected Indicators of Microfinance Institutions, 2002–04 1/
| 2002 | 2003 | 2004 2/ | ||
|---|---|---|---|---|
| Number of branches | 120 | 127 | 135 | |
| Beneficiaries (thousands of clients) | 139.8 | 160.2 | 161.9 | |
| Deposits (in billions of GNF) | 6.8 | 8.9 | 12.3 | |
| Loans (in billions of GNF) | 16.7 | 19.1 | 23.0 | |
| of which: nonperforming loans (in | ||||
| percent of total loans) | 2 | 5 | 10 | |
| Lending interest rate (average, in percent) | 26 | 30 | 28 | |
Aggegate figures for the four largest institutions.
Data for end–January 2005.
Selected Indicators of Microfinance Institutions, 2002–04 1/
| 2002 | 2003 | 2004 2/ | ||
|---|---|---|---|---|
| Number of branches | 120 | 127 | 135 | |
| Beneficiaries (thousands of clients) | 139.8 | 160.2 | 161.9 | |
| Deposits (in billions of GNF) | 6.8 | 8.9 | 12.3 | |
| Loans (in billions of GNF) | 16.7 | 19.1 | 23.0 | |
| of which: nonperforming loans (in | ||||
| percent of total loans) | 2 | 5 | 10 | |
| Lending interest rate (average, in percent) | 26 | 30 | 28 | |
Aggegate figures for the four largest institutions.
Data for end–January 2005.
36. As the economy’s demand for banking credit has declined, the banks increased credit to the government and accumulated foreign assets. The share of gross credit to the private sector in the banking system’s assets has declined from nearly 40 percent at end–2001 to 23 percent at mid– 2005. Even with lending rates staying below inflation, the demand for credit in the economy is low, and regular account overdrafts represent about 65 percent of total lending to private sector customers. On a net basis, the private sector is a bulk creditor to commercial banks, with its net credit having grown to as much as 50 percent of the banks’ total assets. The banks reallocate the funds raised from the private sector to credit to the government and to net foreign assets. The open foreign exchange position of the banking system has increased from less than 8 percent of capital at end–2002 to more than 19 percent by mid–2005.
Banks' Assets and Liabilities, 2002–05
(Selected indicators, in percent of total assets)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Banks' Assets and Liabilities, 2002–05
(Selected indicators, in percent of total assets)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Banks' Assets and Liabilities, 2002–05
(Selected indicators, in percent of total assets)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Guinea: Financial Soundness Indicators of the Banking Sector, 2002–June 2005
(In percent, unless otherwise indicated)
Included in the prudential regulation of the BCRG. Presented as average of seven banks.
The minimum regulatory net capital was GNF 2 billion before March 2002.
The ratio was 8 percent before June 2003.
The ratio was 70 percent before June 2003.
Guinea: Financial Soundness Indicators of the Banking Sector, 2002–June 2005
(In percent, unless otherwise indicated)
| Prudential Limits | 2002 | 2003 | 2004 | June | 2005 | ||||
|---|---|---|---|---|---|---|---|---|---|
| Capital adequacy | |||||||||
| Net capital (GNF billion)1/ | GNF 5 billion 2/ | 9.2 | 8.7 | 10.8 | 14.6 | ||||
| Regulatory capital to risk–weighted assets 1/ | 10%3/ | 18.4 | 15.8 | 12.2 | 12.7 | ||||
| Loans larger than 15 percent of capital to regulatory | Eight times | ||||||||
| capital (ratio)1/ | capital | 1.4 | 1.8 | 1.7 | 2.9 | ||||
| Number of loans larger than 25 percent of capital 1/ | 0 | 2.1 | 2.6 | 1.3 | 2.1 | ||||
| Loans to managers and insiders to regulatory capital 1/ | 10% | 11.3 | 9.3 | 7.7 | 6.5 | ||||
| Number of loans to managers and insiders larger | |||||||||
| than 5 percent of capital1/ | 0 | 0.6 | 0.6 | 0.3 | 0.7 | ||||
| Liquidity and foreign exchange position | |||||||||
| Liquid assets to short–term liabilities 1/ | 100%4/ | 363.6 | 172.8 | 214.8 | 175.4 | ||||
| Open foreign exchange position to regulatory capital 1/ | 35% | 7.7 | 11.0 | 17.2 | 19.3 | ||||
| (Number of banks respecting the prudential limits, out of | |||||||||
| a total of seven banks) | |||||||||
| Net capital (GNF billion) | GNF 5 billion 2/ | 5 | 6 | 6 | 7 | ||||
| Regulatory capital to risk–weighted assets | 10%3/ | 7 | 7 | 7 | 5 | ||||
| Loans larger than 15 percent of capital to regulatory | Eight times | ||||||||
| capital (ratio) | capital | 7 | 7 | 7 | 7 | ||||
| Number of loans larger than 25 percent of capital | 0 | 3 | 5 | 2 | 3 | ||||
| Loans to managers and insiders to regulatory capital | 10% | 4 | 4 | 5 | 5 | ||||
| Number of loans to managers and insiders larger | |||||||||
| than 5 percent of capital | 0 | 4 | 4 | 6 | 5 | ||||
| Liquid assets to short–term liabilities | 100%4/ | 7 | 7 | 7 | 7 | ||||
| Open foreign exchange position | 35% | 7 | 7 | 6 | 6 | ||||
Included in the prudential regulation of the BCRG. Presented as average of seven banks.
The minimum regulatory net capital was GNF 2 billion before March 2002.
The ratio was 8 percent before June 2003.
The ratio was 70 percent before June 2003.
Guinea: Financial Soundness Indicators of the Banking Sector, 2002–June 2005
(In percent, unless otherwise indicated)
| Prudential Limits | 2002 | 2003 | 2004 | June | 2005 | ||||
|---|---|---|---|---|---|---|---|---|---|
| Capital adequacy | |||||||||
| Net capital (GNF billion)1/ | GNF 5 billion 2/ | 9.2 | 8.7 | 10.8 | 14.6 | ||||
| Regulatory capital to risk–weighted assets 1/ | 10%3/ | 18.4 | 15.8 | 12.2 | 12.7 | ||||
| Loans larger than 15 percent of capital to regulatory | Eight times | ||||||||
| capital (ratio)1/ | capital | 1.4 | 1.8 | 1.7 | 2.9 | ||||
| Number of loans larger than 25 percent of capital 1/ | 0 | 2.1 | 2.6 | 1.3 | 2.1 | ||||
| Loans to managers and insiders to regulatory capital 1/ | 10% | 11.3 | 9.3 | 7.7 | 6.5 | ||||
| Number of loans to managers and insiders larger | |||||||||
| than 5 percent of capital1/ | 0 | 0.6 | 0.6 | 0.3 | 0.7 | ||||
| Liquidity and foreign exchange position | |||||||||
| Liquid assets to short–term liabilities 1/ | 100%4/ | 363.6 | 172.8 | 214.8 | 175.4 | ||||
| Open foreign exchange position to regulatory capital 1/ | 35% | 7.7 | 11.0 | 17.2 | 19.3 | ||||
| (Number of banks respecting the prudential limits, out of | |||||||||
| a total of seven banks) | |||||||||
| Net capital (GNF billion) | GNF 5 billion 2/ | 5 | 6 | 6 | 7 | ||||
| Regulatory capital to risk–weighted assets | 10%3/ | 7 | 7 | 7 | 5 | ||||
| Loans larger than 15 percent of capital to regulatory | Eight times | ||||||||
| capital (ratio) | capital | 7 | 7 | 7 | 7 | ||||
| Number of loans larger than 25 percent of capital | 0 | 3 | 5 | 2 | 3 | ||||
| Loans to managers and insiders to regulatory capital | 10% | 4 | 4 | 5 | 5 | ||||
| Number of loans to managers and insiders larger | |||||||||
| than 5 percent of capital | 0 | 4 | 4 | 6 | 5 | ||||
| Liquid assets to short–term liabilities | 100%4/ | 7 | 7 | 7 | 7 | ||||
| Open foreign exchange position | 35% | 7 | 7 | 6 | 6 | ||||
Included in the prudential regulation of the BCRG. Presented as average of seven banks.
The minimum regulatory net capital was GNF 2 billion before March 2002.
The ratio was 8 percent before June 2003.
The ratio was 70 percent before June 2003.
37. The primary concerns in the area of banking supervision are compliance with regulations for risk concentration and capital adequacy. Several banks regularly exceed prudential limits for risk concentration and allocate the bulk of credit to their largest customers, in particular to petroleum–importing companies that have access to revolving credit lines. As of mid–2005, four of Guinea’s seven banks have provided loans exceeding 25 percent of their net capital to prominent clients, and two banks have extended five such loans each. Given the economic slowdown, weak judicial system, and high transaction costs, banks need to develop close ties with borrowers to insure their readiness to repay credit. This strategy seems to bear fruit: the share of nonperforming loans (NPLs) in total loans to the private sector declined to 22 percent by mid–2005 from more than 30 percent in 2003, with provisions covering 97.5 percent of NPLs. Although close ties between banks and their largest borrowers help reduce transaction costs, they also raise the risks of systemic failure because banks’ soundness becomes critically dependent on these clients’ solvency. Bank recapitalization can help improve risk concentration ratios, and the recent recapitalization of one of the banks demonstrates that such a solution can be feasible. The issue of capital adequacy had become even more relevant by mid–2005, when the net capital of two banks dropped to less than 10 percent of their risk–weighted assets, the limit set by the banking regulation.
Structure of Credit Portfolio of the Commercial Banks, 2002 – June 2005
Structure of Credit Portfolio of the Commercial Banks, 2002 – June 2005
| 2002 | 2003 | 2004 | June–05 | ||
|---|---|---|---|---|---|
| (In billions of Guinean francs) | |||||
| 1. Total credit outstanding | 310.7 | 368.7 | 381.3 | 468.8 | |
| 2. Performing credits | 225.5 | 259.7 | 276.8 | 365.3 | |
| of which: nonimputed values (NIVs) | 6.3 | 7.0 | 0.2 | 0.2 | |
| 3. Frozen credits | 5.3 | 5.8 | 4.5 | 1.1 | |
| 4. Doubtful and contentious loans net | 9.2 | 16.9 | 2.0 | 2.6 | |
| 5. Provisions | 70.7 | 86.4 | 98.0 | 99.8 | |
| 6. Nonperforming loans (NPLs)(4+5) | 79.9 | 103.2 | 100.0 | 102.4 | |
| 7. Unpaid loans (NIVs+3+4+5) | 91.5 | 116.0 | 104.7 | 103.7 | |
| (In percent) | |||||
| Unpaid loans to total loans | 29.4 | 31.5 | 27.5 | 22.1 | |
| NPLs to total loans | 25.7 | 28.0 | 26.2 | 21.8 | |
| Coverage of NPLs | 88.5 | 83.7 | 98.0 | 97.5 | |
Structure of Credit Portfolio of the Commercial Banks, 2002 – June 2005
| 2002 | 2003 | 2004 | June–05 | ||
|---|---|---|---|---|---|
| (In billions of Guinean francs) | |||||
| 1. Total credit outstanding | 310.7 | 368.7 | 381.3 | 468.8 | |
| 2. Performing credits | 225.5 | 259.7 | 276.8 | 365.3 | |
| of which: nonimputed values (NIVs) | 6.3 | 7.0 | 0.2 | 0.2 | |
| 3. Frozen credits | 5.3 | 5.8 | 4.5 | 1.1 | |
| 4. Doubtful and contentious loans net | 9.2 | 16.9 | 2.0 | 2.6 | |
| 5. Provisions | 70.7 | 86.4 | 98.0 | 99.8 | |
| 6. Nonperforming loans (NPLs)(4+5) | 79.9 | 103.2 | 100.0 | 102.4 | |
| 7. Unpaid loans (NIVs+3+4+5) | 91.5 | 116.0 | 104.7 | 103.7 | |
| (In percent) | |||||
| Unpaid loans to total loans | 29.4 | 31.5 | 27.5 | 22.1 | |
| NPLs to total loans | 25.7 | 28.0 | 26.2 | 21.8 | |
| Coverage of NPLs | 88.5 | 83.7 | 98.0 | 97.5 | |
38. The authorities are taking steps to improve the legal framework for banking business and supervision, but further change in judicial practices is needed. development of the banking sector has been hampered by the weakness of the legal system, which makes it difficult to protect contracts and recover nonperforming loans. The new banking law, adopted in July 2005, is expected to strengthen the legal framework. The draft of the new law on MFIs, which has been submitted to the National Assembly, will extend banking supervision to cover MFIs as well. The authorities are finalizing a draft of a new law to step up measures to combat money laundering and the financing of terrorism.9
Development of domestic financial markets
39. The financial market in Guinea generally lacks depth and would benefit from further development of basic infrastructure and regulations. Only in the foreign exchange and government securities markets are the volumes of operation substantial. There are no domestic markets for corporate bonds or securities. In March 2005, the authorities began taking steps to unify the foreign exchange market and to move from dual exchange rates to a unified market–determined exchange rate.
Preconditions for a Successful Liberalization of Foreign Exchange Market
Monetary authorities should address several key issues for a successful move to a more flexible exchange rate regime in the context of foreign exchange market liberalization (Duttagupta, Fernandez, and Karacadag, 2004):
develop a deep and liquid foreign exchange market
formulate intervention policies consistent with the new exchange rate regime
establish an alternative nominal anchor in the context of a new monetary policy framework
build the capacity of market participants to manage exchange rate risks and of the supervisory authorities to regulate and monitor them
In particular, the following steps can increase the depth and efficiency of the foreign exchange market in the process of moving toward more flexible arrangement:
allowing some exchange rate flexibility within the preexisting arrangement
reducing the central bank’s market–making role, and increasing market information
eliminating (or phasing out) regulations that stifle market activity
unifying and simplifying foreign exchange legislation
facilitating the development of risk–hedging instruments
In Guinea, the need to eliminate macroeconomic imbalances meant that the authorities had to move to a more flexible exchange arrangement before they could adequately address these key issues. As a result, both the monetary authorities and market participants have had to adapt to the changes as they have occurred rather than prepare for them in advance.
40. The authorities have made strong progress in reforming the foreign exchange market. In March 2005, the central bank abandoned the system of rationing foreign exchange for critical imports through official auctions and took the first steps to unify and liberalize the foreign exchange market. Furthermore, the authorities are implementing technical measures to strengthen the functioning of the foreign exchange market, encourage dissemination of market information, and improve the central bank’s capacity to monitor and influence market developments. Following the introduction of the new foreign exchange market setup, the Guinean franc has depreciated rapidly. At the same time, the gap between the central bank’s reference exchange rate and the exchange rate of exchange bureaus shrank to less than 2 percent by October 2005, as compared to the spread between official and free market rates of 25–30 percent in 2004 and early 2005. The central bank has normalized settlements with banks and reduced the backlog in banks’ foreign exchange transfers abroad to US$2.5 million by end–September from about US$18.5 million at the onset of market unification.10 However, the central bank has still not defined a policy to guide its interventions in the foreign exchange market and is upgrading capacities for performing open market operations.11
Guinea: Exchange Rates Before and After the Market Unification Reform
(Guinean francs per U.S. dollar, unless otherwise indicated)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Central Bank of Guinea.Guinea: Exchange Rates Before and After the Market Unification Reform
(Guinean francs per U.S. dollar, unless otherwise indicated)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Central Bank of Guinea.Guinea: Exchange Rates Before and After the Market Unification Reform
(Guinean francs per U.S. dollar, unless otherwise indicated)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Central Bank of Guinea.41. Despite the ongoing market reform, some foreign exchange transactions are still conducted outside the banking system. The banks perform foreign exchange operations mainly with their regular clients, buying foreign exchange from exporters and selling it primarily for critical imports.12 As the interbank market is virtually nonexistent for foreign exchange, the banks have few other sources of it but the supply that comes from their clients.13 Outside the banking sector, there are 86 authorized exchange bureaus and an unknown number of informal traders that can promptly perform conversion operations. There is no official statistics for the foreign exchange turnover, even for the operations performed by the banks.
42. The authorities are gradually improving procedures for placing government securities. The government finances the budget deficit by placing treasury bonds (BDT) with maturities ranging from four weeks to six months. The central bank uses two–week notes (TRM) to sterilize excess liquidity in the banking system and manage reserve money growth. Commercial banks are the principal buyers and holders of government and central bank securities. There are no secondary market or repurchase operations with these securities. The interest rates on the government securities remain sticky: they do not respond promptly to changes in market conditions. As of October 2005, the average TRM interest rate was 19 percent, and the interest rates on BDT were 19–20 percent depending on maturity, resulting in negative real interest as 12–month inflation was running as high as 28 percent. The amount of BDT and TRM outstanding totaled about 4 percent of GDP.14
Government Securities: Volumes and Interest Rates, 2001:Q2–2005:Q2
(In percent of broad money (M2))
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Government Securities: Volumes and Interest Rates, 2001:Q2–2005:Q2
(In percent of broad money (M2))
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Government Securities: Volumes and Interest Rates, 2001:Q2–2005:Q2
(In percent of broad money (M2))
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.C. Banks in the Foreign Exchange Market
Competition with exchange bureaus and informal trader
43. Although price competition dominates the nonbank market for foreign exchange, the banking sector, which centers on building long–term relationships with valuable clients, remains less competitive. Nonbank operators post competitive quotes to attract clients; the clients react quickly to quote changes, and the resulting average exchange rate broadly reflects the interaction of supply and demand. On the contrary, competition among banks is subdued, and foreign exchange conversion operations represent, for them, only a small part of the overall package of services they offer their clients. A client, attracted by the overall package, chooses a bank and stays with it as long as the package remains satisfactory, because the transaction costs of shifting all operations to another bank can be significant.
44. Banks and exchange bureaus specialize in different types of transactions and serve different groups of clients, which results in market segmentation. Commercial banks perform mainly noncash operations related to settlements with foreign countries. For their part, exchange bureaus and informal traders mainly carry out cash transactions related to trade with neighboring African countries and to the demand for foreign exchange for domestic circulation. For many economic agents, the main benefit of using the services of exchange bureaus and informal traders is that the contracts are less formal, which helps reduce transaction costs. The main advantages of using the banking system relate to access to international settlements, which are essential for many international trade operations, and stronger legal protection of the contracts. The market outside the banking system seems to be characterized by a structural surplus of foreign exchange, whereas the banking system normally experiences a structural deficit of “scarce” foreign exchange. The supply of foreign exchange to the banks (for example, from exporters selling a part of their revenues) in the first nine months of 2005 was barely enough to cover the demand related to the banks’ long–term contracts with valuable clients, including the amounts that banks need to mobilize for petroleum importers. It has been difficult for the banks to attract foreign exchange, partly because of the absence of price competition in the banking sector and partly because of institutional problems that provide a competitive advantage to exchange bureaus and informal traders. For example, the sources of currency circulating outside the banking system usually cannot be verified, which can raise money laundering issues for banks operating with this money. Therefore, the banks concentrate on providing traditional banking and settlement services to their clients, while nonbanking institutions mobilize and sell foreign exchange.
Recommendations for foreign exchange market development
45. Further reforms of the foreign exchange market should be centered on promoting transparency and price competition. The authorities should continue dismantling the formal and implicit constraints that prevent banks from bidding competitive exchange rates. In particular, they should not pressure the banking sector to finance critical imports below the market price — a practice that distorts market competition and discourages banks from reporting the actual size of operations. For their part, the banks could be more proactive in expanding their foreign exchange operations. With support from the central bank, they can begin transacting in foreign exchange with each other and with authorized exchange bureaus. Furthermore, the authorities should strive to create equal conditions for all agents operating in the market. Because Guinea’s banks may be subject to stricter prudential controls than the exchange bureaus — not to mention the informal traders, who are largely not subject to control — their transaction costs are higher. In particular, the authorities can reconsider the recent regulation that limits cash withdrawals from banking accounts to the equivalent of about US$5,000, requiring an explanation of purpose for larger withdrawals.15 The leveling of the playing field for all market participants would help promote price competition and reduce market segmentation in the domestic foreign exchange market.
D. Dollarization of the Economy and Interest Rate Structure
Causes of increasing dollarization
46. The dollarization of the economy has occurred in response to macroeconomic instability. Historical evidence for Guinea suggests that dollarization declined in periods of prolonged exchange rate stability, and increased sharply in periods of currency depreciation.16 The recent increase in dollarization can be attributed to both the depreciation of the national currency and to unfavorable macroeconomic developments. When inflation is high and unpredictable and banks are offering low interest rates, converting savings into foreign exchange helps preserve their purchasing power. To reverse dollarization, the authorities need to stabilize the local currency’s exchange rate, bring inflation down, and raise the interest rates on bank deposits in national currency. Although exchange rate stability would play a significant role in any program to reverse dollarization, it would be insufficient without supporting policies in place.
Currency Depreciation and Dollarization of Assets, 1998–2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Currency Depreciation and Dollarization of Assets, 1998–2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Currency Depreciation and Dollarization of Assets, 1998–2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.47. Guinea’s unification and liberalization of the foreign exchange market in 2005 released the pent–up demand for foreign currency assets, which resulted in further dollarization of the economy. Liberalization of the foreign exchange market reduced the transaction costs of buying and selling foreign exchange, as well as the risks of using it as a medium of payment or of holding foreign cash savings. Despite increasing dollarization, the creation of a transparent and competitive market for foreign exchange should have a positive impact on the economy in the medium term. The reduction of excess reserves of commercial banks, elimination of a backlog in banks’ foreign exchange transfers abroad, and the narrowing of spreads between foreign exchange quotes of banks and exchange bureaus to less than 2 percentage points by mid–October indicate that the pent–up demand for foreign exchange has largely been satisfied.
Impact on the banking system’s deposit and lending operations
48. The availability of low–interest deposits is the main pillar of the banking system’s profitability, which dollarization could undermine. Demand and short–term saving deposits account for up to 80 percent of liabilities of commercial banks. Demand deposits bear no interest, while the interest on savings deposits is low and remains well below inflation. The banks can attract cheap deposits mainly because of very limited competition and the lack of alternative investment opportunities in the economy. However, the increasing availability of foreign exchange for savings and transactions has created an alternative to bank deposits for both individuals and businesses. Therefore, to safeguard the deposit base, the banking system may find it necessary to raise interest rates, which would require a fundamental change to the existing system of interest rate setting and credit allocation in the economy.
Guinea: Deposit and Lending Operations of the Banks, Selected Indicators, January 2002 – September 2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Guinea: Deposit and Lending Operations of the Banks, Selected Indicators, January 2002 – September 2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.Guinea: Deposit and Lending Operations of the Banks, Selected Indicators, January 2002 – September 2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Sources: Guinean authorities; and IMF staff estimates.49. The rising dollarization of deposits in 2004–05 prompted banks to increase their foreign asset positions and limit domestic credit. Nearly two–thirds of the funds that banks raise from local currency deposits go to the government as credit, while foreign currency deposits contribute to increases in net foreign assets. In this way, banks limit currency and maturity mismatches in their balance sheets. If the dollarization of economy continues to rise, the dwindling supply of local currency deposits can constrain banks’ potential to extend credit to domestic companies and households.
Implications for the central bank’s interest rate policy
50. Guinea’s interest rate policy helps keeping the costs of financing the budget deficit low while guaranteeing banks’ profitability. The central bank sets the floor for some deposit rates and the ceiling for some lending rates. At the same time, the banks bid for government and central bank securities at the rates that guarantee at least a small margin above the average costs of attracting deposits. This system allows the government to finance the budget deficit at a rate below inflation and still maintain the soundness and profitability of the commercial banks. However, it works only as long as there is a steady supply of deposits remunerated at rates well below inflation n or not remunerated. The increase in the reserve requirement ratio from end–October 2005 will reduce excess liquidity in the banking system. Furthermore, as discussed above, dollarization of the economy can undermine the local deposit base of commercial banks and force them to enter into price competition for deposits, for which the banks may be not fully prepared.
Interest Rate Structure and Inflation, January 2002 – September 2005
(Percent)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Guinean authorities.Interest Rate Structure and Inflation, January 2002 – September 2005
(Percent)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Guinean authorities.Interest Rate Structure and Inflation, January 2002 – September 2005
(Percent)
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Guinean authorities.
Exchange and Interest Rates, January 2004–September 2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Guinean authorities.Exchange and Interest Rates, January 2004–September 2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Guinean authorities.Exchange and Interest Rates, January 2004–September 2005
Citation: IMF Staff Country Reports 2006, 025; 10.5089/9781451815276.002.A002
Source: Guinean authorities.51. Interest rate policy in Guinea effectively limits the use of the interest rate as a signal of the stance of monetary policy. The system is efficient in maintaining low interest rates, which, to some extent, can be viewed as reflecting the conditions of the domestic money market. However, it works only as long as there are factors other than interest rates that motivate economic agents to keep assets denominated in local currency. In particular, the central bank cannot effectively use this system to transmit monetary policy signals, influence the demand for foreign exchange, or reduce inflation pressures. For example, the increase in the interest rate structure by as much as 6 percentage points since July 2005 has had no discernible effect on the exchange rate trend.
52. Interest rate policy should become more flexible as the barriers between domestic monetary and foreign exchange markets erode gradually. Until recently, it has been difficult to convert local currency assets into foreign exchange. To make the conversion, it was necessary for economic agents either to pay a conversion premium over the official exchange rate or to wait in line for an allocation of foreign exchange through official auction procedures. Moreover, banks had to wait many months for the central bank to transfer abroad the foreign exchange that they purchased. As a result, the interest rate for assets denominated in local currency was low, reflecting the limited opportunities for investing them. However, with the obstacles for converting local currency into foreign exchange getting lower, the interest rate might once again become an incentive to hold balances in domestic currency. Market forces should be allowed to move interest rates to levels consistent not only with the equilibrium in the domestic liquidity market, but also with a broader equilibrium in the financial markets in general, encompassing the markets for both local and foreign currency instruments. In particular, domestic short–term interest rates should normally match or exceed both the expected inflation and the expected depreciation rate of the local currency. To facilitate interest rate flexibility, the central bank should consider discontinuing the practice of setting limits on the interest rates of banks’ deposit and lending operations, leaving banks to set the relevant rates. The implementation of recent MFD recommendations to improve central bank monetary operations and liquidity management was a major step in the right direction.
E. Conclusion
53. The authorities have recently introduced a number of measures to enhance the operations of financial markets in Guinea, but much remains to be done. In particular, the central bank should level the playing field for all operators in the foreign exchange market. At the same time, the authorities should take steps to promote a freer and more flexible market for instruments denominated in local currency. These policies would help ensure a healthier foreign exchange market and a stronger framework for the implementation of monetary policy while promoting soundness and good business practices in the banking system.
References
Basu, Anupam; Blavy, Rodolphe; Yulek, Murat, 2004, “Microfinance in Africa: Experience and Lessons from Selected African Countries”, IMF, Working Paper 04/174 (Washington: International Monetary Fond)
Duttagupta, Rupa; Fernandez, Gilda; Karacadag, Cem, 2004, “From Fixed to Float:Operational Aspects of Moving Toward Exchange Rate Flexibility”, IMF, Working Paper 04/126 (Washington: International Monetary Fond)
Hardy, Daniel C.; Holden, Paul; Prokopenko, Vassili, 2002, “Microfinance Institutions and Public Policy”, IMF, Working Paper 02/159 (Washington: International Monetary Fond)
Prepared by Michael Gorbanyov.
The factors explaining MFI development in Guinea and in other African countries are discussed in Basu et al., 2004; for a broader perspective on MFIs, see Hardy et al., 2002.
MFD provided extensive comments on an early draft of the law.
The central bank has a monopoly on performing settlements between the local and international commercial banks and, in particular, on transferring foreign exchange from local banks abroad.
The authorities are implementing the recommendations of MFD technical assistance missions with regard to foreign exchange market development and capacity building in the central bank.
According to an agreement with petroleum –importing companies, the three largest banks mobilize foreign exchange for oil imports. The banks operate in turn, so that each month one bank sells to importers the amount of foreign exchange they need.
This situation implies that a bank cannot quickly mobilize large amounts of foreign exchange if the need arises. Therefore, the banks have to maintain large foreign exchange balances on their operating accounts and control open foreign exchange positions so that an unexpected temporary shortage of foreign exchange would not affect their liquidity and solvency.
The authorities are also implementing MFD technical assistance recommendations with regard to further development of the auctioning system for government and central bank securities.
The regulation was introduced in mid –2005 to encourage noncash settlements in the economy, counter money laundering, and protect the banking system from unexpectedly large deposit outflows. The practical results have been mixed, with many bank clients complaining that the regulation imposed additional transaction costs, which discourage them from operating through the banks.
The measures of asset dollarization are sensitive to changes in the value of foreign exchange deposits resulting from movements in the exchange rate of the Guinean franc.
