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Issue 437 -- June 12- 18, 2010
Constructing A Reliable Central Bank For Somaliland
By Abdillahi A. Duhod B.S.c, email@example.com
Regional Manager of PxL Associate
The day is set 26th June 2010, when the critics and cynics boasted would never come. They constantly said “The elections in Somaliland will never happen, because this is Africa” but we as a nation have again triumphant over them, and have silenced the haters. As our people look forward to the election date, I write this article at this crucial time, to remind the Parties of their responsibility to the country. Conducting the elections will no doubt strengthen our case for recognition, but I say “what is recognition if our institutions are not robust and transparent”? The answer to that question is that we will be like any other African nation, which for us is not good enough. We must reform our institutions, firstly in order to utilize every financial opportunity effectively and secondly so that we can successfully defeat corruption at all levels. In this article I wish to highlight the necessary steps, which must be taken by the present or future governments to build our Central Bank. The Central Bank of a nation is like the heart is to the body, and for this is the reason as to why it must be constructed our Central Bank to become a credible institution.
A Central Bank is a banking institution granted the exclusive privilege to lend a government its currency. Like a normal commercial bank, a central bank charges interest on the loans made to borrowers, primarily the government of whichever country the bank exists for, and to other commercial banks, typically as a 'lender of last resort'. However, a central bank is distinguished from a normal commercial bank because it has a monopoly on creating the currency of that nation, which is loaned to the government in the form of legal tender. It is a bank that can lend money to other banks in times of need. Its primary function is to provide the nation's money supply but more active duties include controlling subsidized-loan interest rates and acting as a lender of last resort to the banking sector during times of financial crisis (private banks often being integral to the national financial system). It may also have supervisory powers, to ensure that banks and other financial institutions do not behave recklessly or fraudulently.
Before getting to the substance of what the Central Bank of Somaliland needs to do, and how it will have to do it, there is an important precondition for success. Every successful financial and economic system is predicated on the idea that investors can keep the fruits of their investments. For this to happen, there has to be a government making and enforcing laws to protect property rights. The Babylonia ancestors of modern day Iraqi’s were the first people to figure this out when, around 1750 B.C., King Hammurabi created the first recorded rules governing financial operations. What was true 4000 years ago is still a reality today.
With the legal foundations in place, the Central Bank will need to focus on meeting two principle objectives. First, it must create an environment in which financial institutions can flourish, insuring stability of the entire system. A banking system that is constantly in crisis is worse than useless. Secondly, the Central Bank must operate a monetary policy that keeps domestic Somaliland inflation check. Inflation makes doing business difficult by increasing risk to both borrowers and lenders, and making prices unreliable signals. Low inflation is an indispensable foundation for real growth.
To achieve financial stability, the Somaliland Central Bank needs to encourage the development of a sound banking system based on arms-length relationships and market incentives. This means chartering banks to keep unsavory characters from running them, and setting up a system of supervision that penalizes bad business decisions. Then there are day-to-day services that the central bank will have to provide. These include both the more mundane job of exchanging old, worn currency for new, crisp notes, and the technologically complex task of providing a payments network that allows funds to move among banks. The existence of an electronic payments system is essential to the process of intermediation. It will persuade individuals to deposit funds into banks and, in turn, encourage banks to make loans.
To ensure that the payments system develops, the Central Bank of Somaliland should subsidize the interbank payments system at least initially, making it cheaper and easier for commercial banks to serve their retail customers. Success in policymaking is as much an issue of institutional environment as of the people who are put in charge.
Over the past several decades, we have come to a consensus about the best way to design a central bank so that the people running it can be successful. A central bank must be (1) independent of political pressures, (2) accountable to the public, (3) transparent in its policy actions, and (4) a clear communicator with financial markets and the public. There is also an agreement that it is prudent to have policy decisions made by committee rather than by a single individual.
Of these requirements, independence is by far the most important. In fact, virtually every high inflation episode in the world, including the Somaliland inflation that averaged somewhere between 1000% and 1500% per year since the collapse of the central government, is a direct consequence of the political subjugation of the Central Bank. Without alternative sources of revenue, governments turn to the central bank for financing, forcing them to print more and more money. The result, not surprisingly, is inflation. So the first step in achieving economic stability is to take the printing presses away from the politicians.
As for accountability, transparency and communications, these become crucial once the ban k has been made independent. While the manner in which they are implemented depends critically on local culture and so it differs across countries, a few things are universal. First, the public announcement of targets for the central bank is the only way to generate credibility. And second, the central bank has to publish certain statistics regularly. Many central banks publish their balance sheets weekly, and the Central Bank of Somaliland should do the same thing. But in the end, exactly what they say and how they say it should depend on what works best with the Somaliland people.
All of this is well and good, but what about the transition? How can Somaliland get from where it is today to where it needs to be? Conditions on the ground in Somaliland are surely changing by the hour in ways that only people who are there can appreciate. So my recommendations need to be read in that light. First, the 1990s experience in Somali and Ethiopia leads us to expect that Somaliland will encounter high inflation in the near term. When a previously centrally planned economy abolishes price controls, that’s what happens. The important thing is to expect a bought of high inflation and make certain that it is brought under control as quickly as possible. Looking at the history, there are two paths that the Central Bank of Somaliland might take to stabilize prices. It could set up a currency board, or it could adopt an inflation target.
I favor the inflation targeting approach mainly because of my strong opposition to a currency board. The problem with the currency board is two fold. First, since the central bank can no longer simply print money it cannot operate as a lender to sound banks that come under unjustified attack. The inability to act as a “lender of last resort” severely limits the central bank’s ability to avert financial crises. Second, a currency board creates the false impression of monetary policy austerity. As the Argentineans learned the hard way, a currency board provides no protection from fiscal excesses. Without fiscal discipline, monetary policy is impotent to control inflation. It doesn’t take much imagination to envision a Somaliland regional government following in the footsteps of Argentinean regional governments, and printing up its own currency in defiance of the central bank.
Without fiscal discipline, monetary policy is helpless. Looking at Somaliland today, we see immediately that this creates a serious risk. Rebuilding the country’s physical infrastructure and transforming its economy into a market-based system is going to be very expensive. During the transition, the Central Bank is going to be pressured to print money to finance the widening fiscal deficits. It is absolutely essential to find a way to avoid this. My suggestion is that the government should take charge of fiscal policy during the transition, giving the central bank some breathing room to confront the inflation problems they will inevitably face. The hope is that the Central Bank of Somaliland will be able to control inflation in the short-term, thereby building the credibility that will be essential to a successful long-term inflation-targeting regime.
Cultural legitimacy is the final and most important issue to confront in designing the Central Bank of Somaliland. What any of foreigners write or say is irrelevant unless the people of Somaliland are involved. Most importantly, we cannot go into Somaliland and build a set of institutions that reflect American and Western European values. This will not work. And while I might think that publication of a quarterly report inflation conditions is a good way for central bankers to communicate with the public and ensure accountability, if the people of Somaliland want to do it differently, that’s their business. We can set out framework of principles that appear to be universal, but the details are up to the people who live there.