Keynote Speech:

Simon Gray
Advisor, Markets and Financial Infrastructure
CCBS, Bank of England

"The views expressed in this paper are those of the author and not necessarily those of the Bank of England"

I want to say a few words today about central banking (because I am a central banker), and about the development of financial markets (which I hope will be relevant to this conference). The Governor of the central bank will be speaking after the break, and I am clearly not as familiar with the current state of affairs in Syria as he is. But I hope my remarks will provide a useful backdrop to his talk, and will provoke some discussion.

Globally, central banking legislation gives central banks the task of maintaining the value of the domestic currency - essentially, o achieving and maintaining low inflation (sometimes referred to as monetary stability). In many cases, there is an additional task of achieving and maintaining financial sector stability: this may imply banking supervision, monitoring the financial infrastructure, and also an interest in financial sector development (not least because a developed financial sector makes the implementation of monetary policy more efficient). In a number of cases, legislation also specifies additional goals - perhaps supporting economic growth, the balance of payments etc. Normally these goals are less specific, are not ideally suited to central banks, and tend to detract from effective implementation of the central bank's primary tasks of monetary and financial sector stability.

Division of Labour, à la Wealth of Nations, makes sense.    

  • The central bank should run monetary policy and supervise institutions and infrastructure;      
  • The MoF should manage the budget and its impact on domestic demand, avoiding monetary financing which spills over into the central bank's area of business;
  • The central bank should not engage in commercial banking, nor second guess commercial decisions on who borrows nor at what rate;  
  • State-owned commercial banks should not be used for MoF sectoral purposes (too open to corruption).

The economy will be better off if it is well managed; there is just too much information involved for central planning to do this efficiently in any sizable economy over time.

Syria, as I understand it, has in recent years embarked on a cautious programme of economic reform. This is essential if the economy is to achieve sustainable and healthy long-term economic growth. It would be hard to point to a developed economy in the world today that does not have a market based financial system. A rentier economy may become rich without one; but wealth is not the same as economic development; and rentier economies - and this would, broadly, describe a number of oil exporting nations at present - tend to find that wealth alone does not answer questions of wealth distribution or job creation. Financial sectors cannot develop in isolation - they are essentially service industries. And a soundly structured financial sector does not guarantee economic development. It is probably best viewed as a necessary, but not sufficient, condition for the sort of economic growth to which pretty much all countries in the world aspire.

Central Planning
Before I continue, a brief word on central planning. It is widely recognized now, though perhaps not as widely accepted, that old-style central planning of the economy cannot cope with the complexities of the world today. In most cases, it had at best short-lived success. The countries of central Europe, the former Soviet Union and Former Yugoslavia have nearly all recognized the need to move to market-based economic structures, and this entails their central banks abandoning administrative controls for indirect instruments of policy, particularly in the pursuit of monetary stability and financial sector development. The same is true of the formerly centrally planned economies in the Arab world. The countries of North Africa, each at their own pace, are developing market based economic structures; the same is true of Syria and Iraq.

When, in the late 1980s, Mikhail Gorbachev initiated a reform of the old Soviet system, he found out - gradually - that the interconnectedness of the economy meant that reforms to one sector, in isolation, failed to deliver the hoped-for benefits. I would suggest that the same is true for a central bank - accompanied and supported by its Finance Ministry, of course - in undertaking financial sector reforms. Isolated measures, however sensible and important in themselves, may fail to deliver the hoped-for benefits if the whole chain of financial relationships is not tackled. Let me describe for you a vicious circle of frustrated development, and a virtuous circle.

In both cases, I will assume - as is the case in many countries around the world, and as is the case in Syria, I believe - that the government has some need of borrowing; that the banking sector has a structural surplus of liquidity, evidenced by excess balances at the central bank; the financial sector is dominated by state-owned commercial banks; and that there is a predominantly cash economy. Most people are un- or under-banked. The central bank may have monetary goals, but finds it hard to achieve them. It worries about exchange rate liberalization, imposes some exchange controls, and relies largely on administrative controls of the banking system, not knowing what else would work.

In the vicious circle case, the government agrees to switch its borrowing from the central bank to using the issuance of securities; but it does not know what level market rates might be, and is reluctant to rely on thin or hitherto non-existent markets for its borrowing. So it lets the state-owned commercial banks know that they are to bid for its securities in the newly established auctions at low yields. The banks comply. As they cannot make a profit from taking retail deposits and investing in these securities, they make no effort to attract additional deposits - this would not make sense. Neither do they have an incentive to develop financial services - payment services for instance – since they cannot benefit from attracting more deposits. The central bank tells the commercial banks they are lazy and should lend to the private sector, not the government; but it is ignored. And the population continues to transact in cash, and to hold its savings in cash (often in foreign currency cash) because it has no incentive to do anything else.

Savings lie under mattresses instead of being channeled to productive investment; and entrepreneurs cannot borrow because the large banks have no incentive, while the small banks are cash-constrained. The government continues to use the state-owned banks as extra-budgetary tools, guiding the direction of their lending, and the rates at which they lend to so-called priority sectors.

In the alternative case, the government agrees to finance itself by issuing securities, and is cautious about what market rates might be. So it starts gradually, with short maturities. But it instructs the state-owned banks to operate as if private banks: it no longer wants to subsidize inefficient behaviour by them. Since the government's need to borrow is matched by the population's desire to find a risk-free savings instrument, interest rates are acceptable, and the borrowing programme can be extended. Commercial banks now find that they can make a profit from investing deposits in government securities, and so have an incentive to compete for more deposits. This means offering to pay interest, but also competing in other ways: investing in payment services, making their operations more efficient so that customers do not have to queue for hours or face a mountain of unnecessary bureaucracy when opening accounts or making deposits or withdrawals. The government decides that it will gradually move the payment of civil servant salaries from cash, to crediting bank accounts; and if only by inertia, individuals leave some money in their accounts. Companies find that the payment services offered by banks are far better and safer than the use of cash or informal systems, and begin to use them more and more; and as volume increases, unit costs fall. With more of the population drawn into the financial sector, and banks more sensitive to interest rates, the central bank finds that it can use interest rate levers for demand management; and that these are far more effective than reliance on exchange rate management and administrative controls.

Now imagine, in the second case, that the Ministry of Finance holds down the level of yields artificially. The rest of the chain does not work. Or if payment systems are not developed, and the bulk of the population cannot be drawn into the financial sector - whether because if offers them no services, or because the government cannot use it to credit salaries to accounts. Or the government continues to use the state-owned banks to bypass the central bank's monetary policy, so that the central bank cannot provide the level of monetary stability, which will encourage people to use the currency as a store of value. Or the central bank may choose not to drain all excess liquidity from the market because it is concerned about the impact on its balance sheet of so doing. Again, banks will have little incentive to develop markets and services.

That is not to say that everything has to be tackled at once. Changes can be brought in gradually. But if the chain is incomplete, it will not function fully effectively, or maybe not at all; and if changes are too gradual, the failure to deliver will lead to disappointment and loss of momentum.

In part, the process involves developing a familiarity with financial services. It is of course important to pursue stock exchange development; but it may prove to be a large jump from risk-averse savings in the form of cash to intermediated investments in uncertain equities. If the savings of the wider population are to be harnessed for productive investment, it may be necessary to start with simpler products such as bank deposits.

What might all this mean for Syria?
In many ways, Syria is well placed to engage in the move towards a market-based financial system. Foreign banks have been allowed into the Syrian market for some years now, and have some familiarity with the economy. It is likely to be some time before the market becomes fully competitive: it is commonplace that in such economies the banking sector is dominated by a state-owned bank that has mixed incentives – some economic, some dictated by the Finance Ministry. And there may be legislation or guidelines which tend to preserve such a bank's dominance of the system. Early privatization is not necessarily the answer: a dominant private sector bank is not necessarily any better than a dominant state owned bank. Neither is recapitalization. Developments in Morocco over the past 10 years or so, as far as I understand them, may provide a good example of maintaining the benefits of an existing bank with a widespread branch network while allowing the new private sector banks to grow strongly and thus be able to meet the needs of an expanding economy. It is important that the structure of the central banks operations, and its mode of banking supervision, do not maintain market dominance.
But it is also important that private sector banks do not grow faster than the central bank's ability to supervise them adequately. Some countries in the region have bad experience of a rapidly growing private sector bank running into difficulties - bankruptcy - with a damaging impact on confidence in the banking system. Allowing a number of strong foreign banks into the market may be necessary.

The central bank currently has on its balance sheet substantial lending to the government. I understand that consideration is being given to securitizing this turning it into securities, which the central bank can sell to the commercial banks (and anyone else, for that matter). Here is great potential for liberating the central bank's balance sheet, provided the transformation is handled correctly. If the central bank can sell the assets to the market, it will probably be able to drain much or even all of the structural surplus of liquidity in the market. This cannot be done overnight: dumping a large quantity of securities on a market, which is not familiar with them, would not be helpful. But a programme of selling the assets over the next year or two could do much to strengthen the hand of the central bank in conducting monetary policy, develop a yield curve and support secondary market development. If done badly, it could be a cosmetic change, which changes nothing of substance.

Some governments, when starting the process of selling securities to the private sector, are concerned about the potential cost - if the market asks for higher yields than it currently pays on its borrowing (eg from the central bank). Some are therefore tempted to ask state-owned commercial banks to bid at a low rate. But this is indeed a false economy. If the government is saving money, who is losing it? Is it effectively a tax on savers? And if so, what is the impact of taxing savers as opposed to raising taxes by other means? If the government borrows 'cheaply' from the central bank or a state-owned commercial bank, then its profit remittance each year from those institutions will be lower - it is taxing itself, but at the same time distorting markets.

Of course a government cannot rely on competition and market forces if there is little competition in the financial sector, and the participants are not used to market forces. There will be a learning curve, and it makes sense to try to minimize costs during this period - for instance by issuing shorter-term securities initially, and maximizing their liquidity - and gradually building the market.
Payment system developments are already underway, as I understand. A number of central banks in the region have initiated payment system projects, normally involving real-time gross settlement (RTGS) systems as well as more retail oriented systems. The only note of caution I would sound here is that ambitious projects can take years to implement; and sometimes it makes sense to introduce a simple payment system early on - in part to acclimatize the market to such systems - while at the same time developing the more complex systems.

I will not dwell on the structure of market operations, which a central bank might usefully develop in order to implement its monetary policy. The details are normally too arcane even for most central bankers, let alone 'outsiders'. Perhaps the key issues are to ensure that the central bank's monetary policy is clear to the market - and this means communicating it to the population, as well as to the commercial banks, albeit at different levels - and that its operations implement the policy efficiently, rather than clouding the policy. This may sound obvious: but many central banks do not clearly express their monetary policy goals (including for instance the US Fed, which does not have a specific announced inflation target); and in many cases the banking system is unclear how to interpret the policy and operational signals from the central bank. Being clear is harder work, and may appear riskier (since the goals may more clearly be missed); but is beneficial.

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