Libya’s Liquidity Crisis

Photo Credit Reuters

Restoring confidence in the banking system

In our Long Read policy paper Time is Money, we anticipated the Central Bank of Libya’s most pressing near term issue would be currency stabilization; that is, deciding what foreign exchange mechanism to adopt for the new Libyan dinar. This issue, we argued, would arise as soon as new currency had to be printed to pay for accrued public sector salaries.

In addressing this, our November forecast called for the adoption of a managed float system against a basket of world currencies. This would support an orderly revaluation of the Libyan dinar (whose value had been subject to a systematic devaluation by the Libyan regime, presumably to achieve the Socialist ideal of an autarkic state) and allow for policy flexibility in setting interest rates that reflect economic fundamentals.

Since our publication, the Deputy Governor of the Central Bank, Ali Mohammed Salem, has announced (in a late-December interview to Reuters) that the new Libyan dinar would continue to be linked to the IMF’s Special Drawing Rights (XDR) currency for a period of “up to three years”. We would argue that this is not the ideal long-term policy solution but will recognize that what it does achieve, in an uncertain transition stage, is it instills a sense of continuity and predictability in the marketplace. We welcome the move, with the caveat that in what is likely to be 18-24 months’ time, the Central Bank will have to revaluate this policy that we don’t predict will last for the maximum announced three-year term.

This will be particularly true if an oil-price shock takes place (perhaps due to the escalation of tensions between the US and Iran, further Shi’a unrest in Saudi Arabia’s oil-producing Eastern province or further trade union strikes in Nigeria’s oil sector during 2012). A sustained oil price increase and a US/EU accommodating monetary policy response (in the form of interest rate cuts or stimulus), against the backdrop of a recovering, surplus-producing, Libyan economy (our 2013 forecast), would escalate the need for greater monetary policy flexibility and a quicker revaluation of the Dinar. We maintain at this stage that the managed-float system would be the desirable longer-term policy option.

In the near term, the Central Bank has turned its attention to restoring liquidity in the banking system. Central Bank Governor Sadeq Omar ElKaber has stated that 96% of available money (equivalent to 15 billion Dinars) is held outside the banks.

A plan for withdrawal of the Gaddafi-depicting banknotes is underway with the 50-Dinar denomination first in line to be withdrawn by March. The Central Bank has also announced the printing of 6 billion new Dinars to restore liquidity. While the current policy response is sensible and the phased approach prudent, what will restore confidence in the banking system (and thus promote liquidity, as citizens return their cash holdings to the banks) will be the payment of accrued 2011 public-sector salaries, the timely payment of 2012 salaries and the removal of withdrawal limits on current accounts. The former two must be solved by printing new currency and ensuring accuracy in stipend records are kept by the state; the NTC cannot afford payroll mismanagement, nor street demonstrations by struggling state employees (who make up the majority of the workforce). Either would not restore confidence in the banking system, nor would it encourage disenfranchised militias to join state-paid police and military jobs – an outstanding key security threat. Once salaries can be consistently and credibly paid, this being achieved by removing the limitations on current account withdrawals in a move that should restore broader confidence in the interim cabinet.

Interestingly, the ex-Central Bank Governor Gassem Azzoz, who led a weak short term as Governor for the latter months of the war, had declared the liquidity crisis “solved” in September when a shipment of banknotes arrived from the UK. What is crucial now and will continue to be crucial for the foreseeable future is to avoid this kind of sensationalism. The Central Bank must progress prudently, communicate with a united voice and leverage the technical assistance of international partners like the IMF, while remaining – crucially – free of domestic political interference. The restoration of confidence in Libya’s unsophisticated banking system rests importantly on the credible and independent management of the Central Bank.