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AN ALTERNATIVE CENTRAL BANK ANNIVERSARY LECTURE

After many years have elapsed, the Central Bank decided, out of the blue, to organise a lecture to mark the occasion of the anniversary of the creation of the Seychelles Central Bank. Since the last anniversary lecture, the currency crisis has become more acute while the economy, according to official figures has contracted by 13 percent on a per capita basis. Rather than invite international known expertise to talk about our crisis and suggest ways to resolve it, the Board of the Central Bank preferred to divert the attention of the public from the issue by choosing a topic that is far removed from our real problems.

To mark the occasion of the Bank’s anniversary this newspaper presents an alternative Central Bank Anniversary Lecture on the issue of the currency.

"The soundness of a nation’s currency is essential to the soundness of its economy. And to uphold our currency’s soundness, it must be recognized and honoured as legal tender,"

Alan Greenspan – Chairman of the Federal Reserve System (Central Bank) of America on the occasion of the unveiling of the new US$20 note in Washington DC on May 13, 2003

THE INDEPENDENCE OF THE CENTRAL BANK AND THE SOUNDNESS OF THE CURRENCY

The new Central Bank of Seychelles created by the Central Bank Act, 2004 is supposed to be an independent institution. The independence we are talking about here means from the government. But the new Central Bank Act does not pre-suppose that it is creating an independent Central Bank only because the current government, formed by the SPPF, has misused the previous Central Bank.

The notion of an independent central bank is based on experiences of other countries that have gone through the same economic troubles we are going through for the same reasons. The best example of a country that adopted new rules in an effort to create an independent central bank which changed that country from one wrought with economic crises (basket case) to a stable and more prosperous one is New Zealand. Because of the success of New Zealand’s economy after its central bank was made independent of the policies of the government of the day (as well as many examples like the New Zealand), it is now accepted that an independent central bank is desirable as an end in itself.

But how can our new Central Bank achieve independence from the Government? Article 3 of the Central Bank Act 2004, which establishes the institution says that “the Bank shall, discharging its functions, act independently and no person shall seek to influence the Board or any of the Bank’s officers, its employees, in the discharge of his or her functions or interfere in the activities of the Bank.”

Of course, this caution against interference is not for your average Tom, Dick or Harry on the street holding anyone of these individuals to ransom. It is about politicians, from the President of the Republic down, who has a political as well as perhaps a pecuniary interest in having the Board make decisions in a certain fashion. Note that the Act talks about the Board and its officers that should be responsible. In other words, the Board is the dog whilst the Governor etc., is the tail so to speak. It’s the dog usually that wags the tail.

Credibility crisis

Barely a year into its existence, the Board of the Central Bank is already faced with a serious credibility crisis in respect of its independence. It has kept the official exchange rate the same as it has always been, although all the evidence shows that when it took over the control of monetary instruments, the supply of money (rupees) in the economy had already outstripped what is prudent to maintain the official exchange rate set by the defunct Board. This imbalance has created a parallel market for foreign exchange, which is now very vibrant and is the one that drives the economy exacting a hefty premium to the official exchange rate. It is imperative, therefore, that the Bank adjusts the official exchange rate accordingly to restore exchange in the official market – in other words, the banking system. This measure is in fact an obligation for the Board under the Act.

The President of the Republic has said that his government does not want that adjustment, obviously for his and his party’s personal reasons. The Governor of the Central Bank – the dog’s tail – wags the same tune. What is the Board’s view under the law? When I raised this with a member of the Board recently, I found that not only was he ignorant of the Act but does not believe that he was appointed for that purpose. His role, he seems to say, is simply to be the rubber for the Governor’s stamp.

Whilst the Board is expected to act independently of any individual, it must do so in the pursuit of the objectives the Act has set out for the Bank to achieve. Article 3 (4) articulates a number of things the Bank must and is empowered to do without any fear or favour. These things are not frivolous stuffs, but essential actions necessary to maintain a sound economy which is the desire of the country at large.

Indeed, the most important of these objectives – in so far as the achievement of a sound economy is concerned - are those of Article 3 (4)(a)(b). These two obligations give the Central Bank a unique role in influencing economic policy in a modern context through the supply of money. How the currency is issued has been found to be of great significance especially for a small and open economy like ours.

Article 3 (4)(a) says that one of the Bank’s principal objectives is “to regulate the issue, supply and availability of money and its international exchange”. Since the basic form of money is the currency notes (and coins), the issue of money the Act refers to here means, therefore, how the notes and coins are actually put in circulation. To the uninitiated this may sound banal, but it is signally important in monetary economics terms to a small open economy that imports almost everything.

At the present time, notes and coins are issued by the Central Bank to the commercial banks in return for bank deposits in Seychelles rupees. In return commercial banks issue the notes to their customers when they cash cheques. But commercial banks also sell rupee notes in return for foreign currencies which they can resell to their customers at a profit. Indeed, this activity had been, until the currency crisis, an important profit centre for commercial banks. In principle, the commercial banks can return the rupee notes back to the Central Bank in exchange for bank deposits.

To date the face value of all the notes and coins in circulation amounts to over SR 300 million. So the Central Bank has accumulated liabilities (deposits) of that amount in its books from which it can earn interest for itself but pay no interest to the banks in return. The interest earned by the Central Bank on this sum is called Seigniorage. This arises because while it costs the Bank a fraction of the face value of its notes to create the paper money, it earns interest on their face value on which they have no obligation to pay interest. Seigniorage can reach as much as 2% of GDP according to some IMF studies.

The importance of a currency board arrangement

Rupee notes were in use in Seychelles even before the first commercial bank was established. Until 1978, the rupee notes were issued by the Treasury. To get notes, commercial banks (or anyone) had to deposit pound sterling at the Bank of England, at a fixed rate of exchange. The sterling deposits acted as a form of guarantee that the Treasury in Queen’s Building will be able to return sterling for rupees on demand. As a result of this implicit guarantee given to the rupee, the currency became a sound one. All the face value of the notes and coins in circulation equalled the value of the sterling reserved when calculated at the fixed rate of exchange.

The currency board was responsible for the economic stability during the period of frenetic construction that followed the opening of the international airport in 1971. While in 1971 the value of imports was only SR 100 million, it reached over SR 500 million a year by 1978. Despite this meteoric rise in imports, over the same period foreign exchange reserves reached record levels and the currency could buy foreign exchange on demand from the banks at all times. Economic growth between 1976 and 1977 was estimated at over 10%. Seychelles had no official external debt. Foreign exchange reserves were worth many months of imports. That is why the claim by Mr Rene – faithfully repeated by Mr Michel and Chang Leng – that today’s’ currency crisis is the result of the construction of houses for the people etc. is economic nonsense. We have historical proof that with the right terms that our currency is issued we can achieve all these things at once without our currency losing its soundness.

But the currency board was abolished after independence when the Monetary Authority (later the Central Bank) was created. The way currency notes were issued was also changed. The link between the total face value of the currency notes in circulation and foreign currency reserves were abandoned. The conventional economic wisdom then (as the late John Kenneth Galbraith would say) was that countries, especially emerging ones, needed to keep the sovereignty over monetary policy. Indeed, the objectives of the current Central Bank Act – to a large extent – recognises and to an extent gives credence to this theory.

Yet the currency board system remains the corner stone of some of the most successful small but open economies in the world today. The most celebrated currency board is the Hong Kong currency board which fixed the Hong Kong dollar to the US dollar at HK$ 7.80 to US$1, following a currency crisis in 1983. Since then Hong Kong has developed into the principal financial centre for the Far East with one of the highest per capita incomes in the world. While many currencies collapsed during the currency crisis that hit the Far East in 1998, the Hong Kong dollar remained fully convertible. In all the countries where their currencies collapsed they supposedly had full monetary sovereignty while Hong Kong didn’t. The Hong Kong dollar notes are issued not by the Hong Kong Monetary Authority but by three commercial banks.

Almost all the Caribbean states have continued with the currency board system to issue their local currency at a fixed exchange rate with the US dollar, backed by US dollar reserves equal to the face value of all the notes in circulation. They are all stable economies with high GDP per capita. In the Far East, Brunei, an oil producing state issues its currency under the currency board rules with the Singapore dollar as their reserved currency. Singapore itself issues its currency in return for foreign exchange which must be held in reserve by the currency commissioner. So does Namibia which holds reserves in Rand to back their currency. In the Gulf, Bahrain has adopted the currency board system to issue its currency. Lithuania is considered to have made the most successful transition to a market economy because it adopted a currency board system with the D-Mark and later the Euro as reserve currency. Lithuania is expected to have little difficulty being a fully fledged member of the Euro zone. So if this method of issuing currency is good for these countries, it must surely be good for us too. And we have the historical evidence to prove it.

In the light of our recent and continued experience we too must decide whether we should continue with the current arrangement which allows for a different economic or monetary discipline or lack of it or adopt a currency board system – that is, issue the currency at a fixed exchange rate, in exchange for a reserve currency such as the US dollar or the Euro or both that is held abroad. A currency board system provides an autonomous monetary discipline which engenders confidence in the currency.

Regulating the creation of credit in the economy

In a modern economy money is created not just by printing notes and coins and using them. It is also created by credit. The “supply of money” which the Act refers to is in its wider economic sense, exactly that aspect of money.

When money is deposited in a bank, the deposit is a liability for the bank (it owes you) but an asset for the depositor. But a bank can lend someone else or even yourself the money that has been deposited with it. In this instance your loan or overdraft becomes an asset for the bank as well as a liability for you to the bank. These two actions – depositing money in the bank and the bank lending that money at the same time – can take place simultaneously. Accountants will add up the liabilities and the assets to find that both have increased in total. Hence the money supply has increased!

For the economy as a whole, by the simple action of lending the money of a depositor, the commercial banks create additional buying power in the economy - since the money you have borrowed can be and is spent. For this reason alone, therefore, a Central Bank’s principal role is also to regulate the creation of credit in the economy which, as we have seen, creates buying power.

Central bankers have developed various financial instruments to encourage or discourage credit expansion. The price of credit being the interest a lender charges, it stands to reason that restricting credit causes interest rates to rise. The reverse happens when the Central Bank causes credit to expand. A higher interest rate is a discouragement to borrow; a lower interest is an encouragement to borrow. Getting the balance right at the right moment are the tight ropes central banks walk on everyday in a modern economy. This is what it means by market driven interest rates.

Since expanding credit by the commercial banks is synonymous with increasing buying power in the economy, the same applies when the Central Bank makes an advance (loan) to the government. Usually, the government needs the money when its expected revenue – taxes etc – is late in coming. In this instance, the Central Bank does not create additional spending power. Independent central banks insist that the government repays this money as soon as the revenue returns, in other words in the same financial year it has been lent. That was the cornerstone of the reform of the Central Bank of New Zealand that changed that country’s fortunes. In the last fifteen years, however, our Central Bank has been a long term lender to the government. By this action it abandoned its monetary responsibility of being a regulator of credit in the economy to become a creator of credit.

The impact of an increase in the money supply

As credit expanded as a result of Central Bank advances so did demand for goods and services. To provide these goods or services, importation was necessary. Meanwhile, in the official currency market, that is the commercial banks, the demand for foreign currencies gradually outstripped supply at the official exchange rate. Commercial banks started finding that they could not honour the demands of suppliers to settle their clients’ invoices on demand. Commercial payments arrears therefore started growing. Outside the banks, where there was no regulation on exchange rate, a new market developed at a higher exchange rate to the official one. As Mrs Margaret Thatcher once said, “you cannot buck the market”. Attempts by the government to reign in the parallel market naturally failed. Returning this genie (the surplus money) in the bottle is the difficult task of the new independent Central Bank, its Governor and its Board, even if it wants to abandon the practice of making advances to government.

The third important term used in Article 3(4) of the Act requires the Board to make sure that money is available for use in the local economy in sufficient quantity at all times. This entails deciding the different denominations as well as ensuring that there is enough paper money available when they are needed. This responsibility, although straight forward, can be fraught with problems. It can cause serious problems for the credibility of banks if they cannot cash cheques because they don’t have the cash at hand.

Sometimes banks just run out of money for some innocuous reason. This happens when customers are withdrawing more money than there are customers depositing. In this instance, the Central Bank must be ready to advance money to banks at short notice either in cash or in bank deposits if the banks are not to shut their doors. If a bank were to shut its doors because it has temporarily run out of money, it can cause panic with many customers queuing to withdraw cash. Such a crisis is called a run on banks. The Central Bank must at all times be ready, therefore, to step in as the banker of last resort for commercial banks to prevent runs on banks.

Finally, the objectives of the Central Bank Act 2004 also require the Governor and its Board to regulate the “international exchange” of our currency - the rupee. In other words, this allows the Central Bank to impose exchange controls and to change the exchange rate of the currency. Such a move may not, however, be what the government of the day would like to see, especially if a fundamental disequilibrium develops as a result of deliberate government budget policies such as the current situation. Here lies the challenge for the new Central Bank. So far it has failed dismally to meet this challenge.

Another central element of the objectives of the Central Bank Act 2004 which is contained in Article 3(4) (b) has more to do with economics generally. This objective is “to promote price stability and the maintenance of both domestic and external value of the Seychelles currency.”

This very desirable objective for the Central Bank is based on the theory that by controlling the money supply one can control demand or buying power. It has been said that this must be the single obsession of a central bank, epitomised by the fame made by Alan Greenspan in America, acclaimed for achieving the longest period of low inflation in America’s history, despite the largest budget deficit ever.

But it is doubtful if, in a very open economy such as ours, this can be achieved with much success unless there is in tandem a firm budgetary discipline on the part of the government of the day. That is why another objective in the Central Bank Act 2004 is for the Board of the bank to consult and advise the government.

The concept of convertibility of the rupee

More crucially, the Central Bank is tasked, according to the Act with “maintaining the domestic and external value of the Seychelles currency” as part of its objectives. That task compels the Central Bank to ensure that our currency can at all times be fully converted into foreign exchange on demand. In other words a holder of rupees should be able to settle a foreign debt using that currency. This is concept of convertibility. At the present time it is not possible to use our currency to settle a foreign debt, as the government and SMB know so well.

Achieving the main objectives of the Central Bank Act 2004 - to create and maintain a sound currency is possible with the right mechanism. We did it before, when we had the currency board system to issue the currency. It is irrelevant whether the exchange rate is R5 or R10 to the dollar or the Euro. Only a free market will ensure the buying power of the money in our pockets increases and says high. But without a sound currency a free market economy cannot even start to deliver productivity, the source of the buying power of money.

A sound currency is one, as Alan Greenspan once said, is whether the people are prepared to hold it and has trust in it and uses it as legal tender. When our government in its dealings with its citizens shuns the currency it itself issues, surely there is no better proof that that currency is in practice not useful as legal tender.

If we bring back the currency board system, we will not only have a full proof way to restore soundness to our currency but also set in place a mechanism that will ensure it remains sound. It can be done.

Paul Chow