by Paul Chow, Leader of the Democratic Party,
Introduction
The official devaluation of the rupee has so far achieved no tangible result in the form of the national currency being convertible. By this I mean the ability of residents to exchange rupees for dollars or any international currency on demand at the counter of a commercial bank. There are rumours of new dose of devaluation to fix the outstanding problems. The devaluation alone, however, will not achieve the desired result without running the risk of the cure being worse than the disease. Whatever policies we adopt must, nevertheless, be sustainable. That is we must not return to the same bad practices that have caused out present problem of lack of foreign exchange in the first place and a new round of devaluation. With this article, I am proposing a new but tried and trusted monetary system which will remove the need for a further devaluation, spur new economic activities while at the same time secure long term monetary stability and convertibility of the currency.
One of the weaknesses of the current economic policies has been the lack of control by the Central Bank of Seychelles (CBS) over the money supply. How much money is created has a significant bearing on prices of services or locally produced goods, or on the quantity of imports (reduction in foreign exchange reserves). That is why in all the economically stable countries the central banks keep tabs on the money supply. However, it is one thing to keep tabs on it but another deciding to do something about it.
If we are to resolve the currency crisis (convertibility) and maintain long term monetary stability, action must be taken on the money supply. We must, therefore, find a way to bring the money supply to an equilibrium level conducive with good economic performances of all the factors affecting economic activities. In many stable, small and open economies, to ensure long-term stability in the money supply, they have established rules for the creation of money in the economy which works virtually on autopilot. My proposal centres around creating and maintaining a rule-based system for the creation of paper money in the Seychelles economy.
Of all the components of the money supply, the one which is most critical in the creation of money or liquidity in the economy is the so-called high powered money (also known as base money). This is a term used to describe the aggregate face value of notes and coins in circulation or in the vaults of banks, as well as cash reserves that banks have to keep with the Central Bank from the deposits their customers make with them. It is the most liquid form of money according to economists. If the Central Bank causes bank reserves to increase, money is removed from circulation and vice versa, but the ultimate effect of the change depends on the “velocity” of circulation or “money multiplier”.
High powered money is one of the indicators tracked by the Central Bank for obvious reasons. The rule established by stable open economies such as Singapore is to ensure that these two components of the money supply are always equivalent to the value of the net foreign reserves for a given exchange rate of the local currency. In other words, the ratio for a given exchange rate of the US dollar (for example) must be one to one at all times.
The ratio of high powered money in US$ to net foreign assets in US$ was 1.8 in September 2007, according to CBS statistics. This shows the extent of the adjustments needed in dollar terms to make the ratio one to one. That adjustment must be in the form of increasing foreign reserves or adjusting the exchange rate of the rupee against the US dollar or a combination of both. In this proposal, I have settled for a combination of both.
Setting up rules to issue notes and coins
However, in order that we do not end up chasing a moving goal post, we must first of all establish rules for the issue of the most important component of money – the paper currency. Between the two indicators (foreign exchange reserves and the face value of the notes & coins in circulation), the one whose supply is under our total control is the local currency. By controlling the amount of notes and coins in circulation, we would also automatically determine the value of foreign exchange reserves abroad.
If we can, somehow, establish a strict rule whereby all the currency notes in circulation has its counterparty in US dollars deposited in an institution overseas, part of our country’s foreign exchange reserves will automatically increase or decrease according to the propensity of residents of Seychelles to hold rupee notes and coins rather than foreign currencies. And that propensity will depend on the confidence we will have in the rupee. At present we have very little confidence in it, and neither does our government (or for that matter our Central Bank) despite the fact that, by law the rupee is the legal tender. But once it is seen that it can be exchanged on demand for an international currency, confidence will be restored.
The first rule, therefore, must be how we issue currency notes and coins. In Singapore, notes and coins are placed in circulation under a law which says that, in order for the local commercial banks to obtain Singapore dollar notes and coins, they must first surrender foreign exchange to the Currency Commissioner who, in turn, is obliged by law to place the proceeds in a currency fund which must be available at all times to buy back the Singapore dollar notes and coins on demand. This simple arrangement ensures automatic convertibility of the notes and coins in circulation. In our case, although the Central Bank Act makes the CBS the sole authority that issues the currency notes and coins, the Act does not establish any rule as to how this is to be done. If we establish a similar rule, as say, in Singapore, Hong Kong, Brunei or Bahrain we could, overnight, restore the convertibility of the rupee notes in circulation.
Which currency should be the reserve currency?
Many small open economies have chosen to keep their foreign exchange reserves in one major international currency such as the US dollar at a fixed rate of exchange with the local currency precisely to smooth out the uncertainties associated with volatile exchange rates. A fixed exchange rate also ensures long term confidence and enhances our country’s credit worthiness when borrowing abroad. It eliminates currency risks, at least with the most important international currency.
The dollar is the preferred choice in this proposal simply because it is still the most used international currency for transactions. But most importantly, a large part of our external debts are dollar denominated and the prices of most of the goods we import are heavily influenced by the international value of the US dollar in the countries where they originate, especially fuel. In this case, using the same currency as our suppliers and creditors reduces currency risks for everyone.
Under this proposal, commercial banks must come up with dollars to maintain their reserve ratios. Since rupee notes can be exchanged with the currency commissioner for dollars, banks would never have a problem to find the dollars they need by simply surrendering rupee notes if necessary. Once this exercise is complete, it is evident that the face value of all the rupee currency notes and coins in circulation would be backed by more than 100% by US dollar deposits in an institution abroad at the fixed exchange rate earning interest.
How to implement a new exchange rate regime?
To give effect to the new exchange rules, sufficient official reserves will have to be acquired to back the existing face value of notes and coins in circulation as well as the commercial bank reserves with the Central Bank (R1643 as at 30 May 2008). The new rules will not allow currency fund reserves to be used as collateral for any debts of the government in order to preserve the integrity of the fixed exchange rate regime. Of course, the CBS would be free to create other reserves.
Commercial banks already keep substantial rupee currency notes in their vaults, estimated at SR35 million at anyone time. Hence, if the fixed exchange rate is set at US$1 to SR10, the banks will have to surrender US$3.5 million to the currency fund to keep those currencies. To obtain more rupees notes and coins in future commercial banks will have to surrender dollar deposits to the Seychelles currency commissioner at the fixed rate of exchange once the new currency regime comes into operation. Once the process is completed, all currency notes and coins in circulation in Seychelles would have the backing of US dollars held in reserves abroad.
Once the new rules come into force, there will be an initial high demand for US dollars in exchange for rupee notes. So as to be able to purchase notes and coins from the public on demand, the currency commissioner would establish a US dollar line of credit with one or all the international banks currently licensed to operate in Seychelles. This would be a simple matter since commercial banks already hold substantial foreign currency deposits already. It would require commercial banks to simply physically import sufficient dollars notes to buy back the rupee notes and coins currently in circulation.
Once it is seen that the authority is committed to defending the exchange rate and is able to satisfy the demand for dollars in exchange for rupee notes at the fixed exchange rate, confidence in the rupee currency will have been established. Henceforth, the supply of rupee notes in the economy will rely on the foreign exchange inflow and vice versa. As part of the normal course of business, foreign currencies should be able to move freely around the country to satisfy the local demands of different establishments. The easiest way to satisfy the demand for dollar currency notes or other foreign currency notes is for the CBS to liberalise the licensing of money changers and remove any impediment in the import and export of foreign currency notes by licensed money changers and banks. Foreign currency notes brought by tourists are but only one small way for the country to earn foreign exchange.
Money changers will charge commissions to exchange currencies of the public with the rupee and vice versa. Regulations controlling the commissions an establishment can charge when changing money must be abolished in order to free the business of money changing. Since the business of money changing is a retail operation, competition will force the commission level down. Competition to attract foreign currency notes or other foreign exchange instruments such as travellers’ cheques will encourage tourists to change their money into local currency. When more tourists arrive than previously, or the same number of tourists spends more money than previously causing the demand for rupee notes to exceed current supply, new notes will come into circulation only in exchange for dollar deposits in the currency fund. In addition, the regulations requiring foreigners to pay their hotels, restaurants and other services in foreign currency must be abolished. This will have the effect of increasing the demand for rupee notes by tourists wanting to exchange their foreign currencies. Thus more foreign exchange will be available in the economy to satisfy the existing demand instead of remaining in dormant bank accounts.
Commercial banks will, however, have to cope with the daily requirement of their customers for cash. They will have to encourage their customers to use cheques and debit cards if they are not to rely on the currency commissioner for new notes and coins, because this will mean surrendering dollar deposits into the currency fund. They could also borrow from other banks which has surplus cash. Banks will start to talk to each other and do business with one another, strengthening the integrity of the banking system in the process. Banks would be able to provide customers with debit cards they can use abroad, based on their rupee deposits. Competition among banks will be good for their customers.
Banks would entice customers to make deposits by offering better interest rates or other incentives. Hence the margin between deposits and lending rates will narrow to the benefit of customers. This will create new dynamics in the banking system as at the moment banks penalise new customers who wish to deposit money with them. Competition for deposits among banks will be good for the customers and the economy as a whole.
One of the immediate effects of a viable currency will be an increase in economic activity in the rupee economy. With a viable currency in their hands tourists will have more ways to spend them than at present, and benefits will spread to a larger number of commercial entities than at present. Economic activities would generally, therefore, be more sensitive to the number of tourists arriving. Special foreign currency shops in SITZ areas will no longer enjoy trade privileges as they would have to compete with rupee based ones.
Shortages of goods would quickly disappear; thus prices in the shops will stabilise as a result of a more stable exchange rate and competition. With more goods available in the shops fewer people will see the need to travel abroad. Imports will be by faxes and emails rather than a trip abroad by either the final consumer or the trader. Letters of credits and other financial instruments would protect importers against fraudulent overseas suppliers. This will serve to reduce the cost of imports and therefore, the domestic price of goods. Suppliers abroad would be more confident in extending credits to importers. More credits or deferred payments translate into foreign exchange reserves for the country as a whole.
However, the exercise would make only part of the money supply fully convertible but all the same a very important component since cash is king. People are ultimately confident with the money they have in their hands. Nevertheless, other transactions would continue to be paid for using cheques or other forms of bank transfers as at present. As banks offer incentives for surplus rupees to be deposited with them and since this will encourage savings, these savings will in turn be available for investments.
To improve this environment, all the existing foreign exchange controls and mechanisms such as retention accounts or control on interest rates should be abolished. In the end only the commercial banks can guarantee customers that their money held with them will buy goods abroad on demand. But banks can create this confidence only if they know the rules governing the currency are there to stay.
A new and dynamic economy?
As the entire available rupee notes in circulation would have their counter party in dollars deposited with and protected by the currency commissioner, supply of dollars to buy back the rupee notes is guaranteed, because holding rupee notes is equivalent to holding dollar notes. Most people will not need to go the currency commissioner’s counter at the CBS unless one has 100,000 rupees or more to exchange, as the commercial banks, money changers and even hotels and restaurant will facilitate a smaller amount for a fee of course.
Under the existing regime, banks rely on the CBS to supply them with rupee notes in return for a bank account deposit in rupees. Under the new regime banks would be able to obtain rupee notes from the currency commissioner only in exchange for US dollar deposits. Indeed, commercial banks would also be able to print their own notes under their own name, so long as the currency commissioner holds their equivalent face value in dollar deposits abroad earning interest.
Initially the most telling effect of the new currency regime will be the transformation of the cash economy which has become very dominant today, hence creating new dynamics because of the confidence in the currency. Thus, the reduction in moral hazard will generate greater confidence in the rupee not only serving as a means of exchange but also as a store of value, enhanced by the guarantee of convertibility as well as the fixed exchange rate.
Under the new currency regime, the exchange rate with the US dollar will be guaranteed. Hence, the rupee will truly become an international paper currency making international trades more effective and smoother than at present. With a viable paper currency, traders will be able to walk out with rupee notes and buy goods abroad or simply buy a monetary instrument from commercial banks to send to their suppliers. When rupee notes go abroad they are taken out of circulation in Seychelles (thus reducing demand for imports) while their counterparty, US dollar deposits in the currency fund overseas earn interest for the economy. Since suppliers abroad will be confident to exchange them for dollars at the counter of the CBS in Seychelles, they will have no hesitation in accepting rupee notes in exchange for goods. Money changers abroad will want to acquire them to sell them to passengers going to Seychelles. Hence our paper currency would “circulate” beyond our territorial boundary. This dynamic means that our economy will start the process of being part of the global economy.
As financial intermediaries, banks will be able to support their customers’ foreign exchange needs better, unlike now where only foreign currency notes that are accounted for under foreign exchange regulations get into the banks. Under the new regime anyone would be able to buy any amount of foreign exchange with rupee currency notes. Because any money changer will be able to facilitate this transaction, any shortage would be localised to the institution concerned resulting only in the entity failing its customers and going out of business rather than the whole economy going out of business as at present. Profits made by money changers in rupees would be as good as the profits they make in dollars. Hence, money changers will want to exchange their surplus foreign currency notes with commercial banks to obtain rupees with which to buy more foreign currencies. Hoarding of foreign currencies would no longer be a worthwhile endeavour. Under the new regime, surplus currency notes with banks will also mean dollars for banks to use and lend or to hold abroad as reserves earning interest for the economy.
More competition between banks is good for consumers. Liberalising of interest rates is an important part of that endeavour. Imagine the entire trade value of the processing of tuna, worth nearly US$200 million a year, going through the local commercial banks because international operators have the confidence that the local banks would be able to service their needs when the time comes and pay them better interest rates than banks abroad on their surplus funds? Imagine a new investor with permission to invest US$100 million or more transferring their entire investment funds to a local bank because they can earn better interest rates? Imagine what this means for the rest of the economy when we can borrow funds from our friendly commercial bank to import new equipment, or spares as and when we need them to keep the machinery working all the time? Imagine what it means to our health when we can import the best drugs to treat our ailments here in Seychelles instead of travelling abroad? Just imagine a new and dynamic economy?
This article is based on a longer paper which appeared in the April issue of the economic journal Conjoncture, published in Mauritius.