TABLE OF CONTENTS

 PREFACE                                                                               

INTRODUCTION                                          

THE EVOLUTION OF THE EXCHANGE RATE PROBLEM IN SOMALIA        

DETERMINANTS AND REGIMES OF EXCHANGE RATES                       

 MONEY SUPPLY, EXCHANGE RATES AND INFLATION       

A CURRENCY BOARD SYSTEM FOR SOMALIA                        

BIBLIOGRAPHY                                                                                          

 APPENDIX:  CHRONOLOGY OF THE CIVIL WAR                                    

Tables

 Developments in Exchange Rates 1977 – 1998

Money Supply 1981 – 1989

Total Credits 1981 – 1989

Money Supply, Parallel Exchange Rates and Inflation rates 1985 – 1989

 ----------------------------------------------------------------------

 PREFACE 

This review of Somalia’s experience with monetary and exchange rate polices over the period 1960 – 1990 was originally written as my Maters Thesis for a graduate program in Administration conducted jointly between the Somali Institute of Development Administration and Management and the State University of New York at Albany.  It has been updated and revised, especially the last chapter, so as to take into account developments since 1991.

 The program was funded by U.S. Agency for International Development and was intended to train top Somali administrators.  Unfortunately, the completion of the program coincided with the outbreak of the civil war.  As a result, of the fifty-five graduates we were, only three returned in Somalia, four remained in U.S.A. and the rest of us headed to Canada where we joined an already large Somali community in Toronto and Ottawa.

 Much has been written about Somalia in the last eight years; about its history, politics, civil war, clans, warlords, famine, the humbling of the United Nations etc, but little was written, as far as I know, about monetary issues.  By publishing this work, I, therefore, intend to provide some insight into the past monetary experience of Somalia in the hope that some lessons will be drawn from it. 

 I would like to thank my instructor David McCaffrey for his advice.  I would also like to thank Mr. Ali Khalif Galayr who encouraged me to publish this book.

   

INTRODUCTION

 During the 1980s the Somali shilling had suffered from large and continuous devaluations.  These devaluations, in turn, added to the inflationary pressure, eroded the purchasing power of money and caused a chaotic financial situation that, according to many observers, was the decisive factor contributing to the downfall of General Mohamed Siad Barre’s government. 

 To underscore the importance of exchange rates, Professor Robert Mundell, a renowned international currencies expert, warned that “if there is a single issue that could lead to the break up of Canada, it’s the exchange rate.”  He argued that Quebec may realize that it could be better off by fixing an independent currency to the U.S. dollar instead of sharing an unstable Canadian dollar¹

 What is the exchange rate?  And why is it so important?  The exchange rate is the price of a currency in terms of other currencies.  It is the most important price, perhaps the single most important price in the economy.  In fact, the exchange rate is regarded as a barometer, which measures the relative strength of an economy over time.  Well-performing and successful economies are judged by the strength and firmness of their currencies; while less successful and crisis-ridden economies are associated with soft and depreciating currencies.  The fact that the Somali shilling had depreciated from So.Sh.  6.23 per US dollar in early 1970s to SoSh. 6,000 at the end of 1990 is held as a proof of the gross economic mismanagement done by the previous government. 

 The exchange rate is also important because it profoundly affects the standard of living of the population.  In a small open economy like Somalia, where almost everything is imported, a depreciating currency raises the domestic prices of imported goods and thus reduces the purchasing power of money, and finally erodes the real income of the population, especially the poor.

 Moreover, the exchange rate heavily affects the cost of external debt servicing which is crucial for Less Developed Countries.  In fact, large devaluations lead to exorbitant debt servicing costs in terms of the local currency, which in turn lead to higher fiscal deficits and further inflationary pressures and exchange rate devaluations. 

 Exchange rates, also, have broad and pervasive effects on the economy.  The are not only an instrument for achieving balance of payments equilibrium, but also a key instrument in the allocation of scarce resources within sectors in the economy, between domestic and external sectors and even between regions of the same country.

 The Central Bank of Somalia was the authority legally responsible for the conduct of exchange rate policy.  One of the bank’s objectives, as written in its statutory law was to safeguard the external value of the Somali shilling² Despite this clear mandate, decisions regarding exchange rate policies were either assumed by the minister of finance, or the president.  In practice, however, exchange rate changes were most of the time dictated by the International Monetary Fund, or the parallel market (black market).

 The purpose of this book is to document the exchange rate policies pursued by the government of Somalia in the last thirty years and look for lessons from past policy mistakes.  One important lesson to be learned is that the process of money creation must be kept outside the control of the politicians not only to achieve exchange rate stability but also to reduce the scope for corruption and abuse of power.  That is why I recommend the introduction of a currency board system in Somalia, a system that constrains the ability of politicians to print money at will.

 The book is organized in four chapters.  The first chapter traces the evolution of the problem of exchange rate instability in Somalia, looking into all different phases through which the Somali shilling had gone over the years.

 The second chapter reviews some of the literature on the exchange rate determination as well as exchange rate regimes.  There are several theories explaining the rationale behind exchange rate movements.  These will be briefly reviewed along with the different exchange regimes that existed in Somalia.

 The third chapter analyzes data on money supply, inflation rates, and exchange movements.  The analysis will concentrate on the relationship between growth in money supply on the one hand, and inflation and exchange rate depreciation on the other.

 The fifth chapter offers recommendations for dealing with exchange rate stabilization.  In particular, it proposes the introduction of the currency board system in Somalia as a way to stabilize the exchange rate.

 Finally, an annex is provided at the end of the book with a chronology of major events that happened since 1991.

 THE EVOLUTION OF THE EXCHANGE RATE

PROBLEM IN SOMALIA

Historical background

 During the Second World War, Britain occupied the Southern part of Somalia, which was until then an Italian colony.  The Northern part of Somalia was, and remained, a British protectorate.  During that period the British Administration introduced the East African shilling to Somalia.  The latter circulated in Kenya, Uganda and Tanganyika.  The East African Shilling (E.A.Sh.) was issued by the East African Currency Board, based in Nairobi, Kenya, and had a gold parity of .0124414 grams, which was equivalent to an exchange rate of E.A.Sh. 7.14 per US dollar or E.A.Sh. 20 per UK pound.

 In 1950 the Southern part of Somalia was transferred to Italian Trusteeship Administration under United Nations supervision.  The Italian Administration followed the example of the British.  They introduced a currency board  “Cassa per la Circolazione Monetaria della Somalia”  and issued a new currency called “Somalo”, which had the same gold parity as the E.A.Sh. and the same denominations, namely 5, 10, 20, and 100 shilling banknotes; and 1.00 Somalo; 50, 10, 5, and 1 cent coins³

 On July 1, 1960, Italian Somalia and British Somaliland, after attaining independence, united to form the Republic of Somalia.  On the same day the Somali National Bank was established and the currency was renamed as the Somali Shilling (So.Sh.), with a gold parity of .0124414 grams or So.Sh. 7.14 per US dollar, the same as the E.A.Sh. and the Somalo, and with full backing of foreign reserves⁴

 In 1968 the requirement of covering the currency in circulation with foreign reserves and gold was abolished.

 In October 1969, General Mohamed Siad Barre seized power in a military coup. One year later, the military regime declared Scientific Socialism and nationalized all major economic activities.  Of particular importance was the nationalization of four foreign owned commercial banks, namely Banco di Roma, Banco di Napoli, National and Grindlays Bank and Banque de Port Said.  Out of the nationalized banks came two new government owned banks, the Somali commercial Bank and the Somali Savings and Credit Bank.

 In 1975 a mini reorganization of the banking system was carried out.  The two banks were amalgamated into one bank, the Commercial and Savings Bank of Somalia (SCSB), which remained the only commercial bank in the country until it collapsed in 1990 and dragged the whole financial system down.  Furthermore, the Somali National Bank’ name was changed to Central Bank of Somalia.

 In January 1991 Siad Barre was ousted from power and forced to flee from the capital.  Since then Somalia had no central government and no monetary authority.  At present, the country is divided into four or five mini zones controlled by clan based factions.

 From 1991, some faction leaders started issuing their own separate banknotes, which circulate only in their mini-zones of influence. The first was Ali Mahdi, the Mogadishu North faction leader who introduced a new currency, the “N” currency, which was planned and ordered by the former regime⁵ Also, M.I. Egal the president of the “Somaliland Republic”, in Northwestern Somalia, issued his own currency called the “Somaliland shilling” and Mogadishu South faction leader Hussein Aideed issued notes similar to the old Somali shillings.  In June 1998, a new regional state “The Puntland State” was established in Northeastern Somalia.  Probably it too will introduce its own currency in due course.

 The years of stability 1960-1970

 During the decade of 1960s the So.Sh. Displayed a remarkable degree of stability.  The official rate remained fixed at its declared gold parity and the country adhered firmly to the fixed exchange rate system.  Under such a system countries could devalue or revalue their currencies only under conditions of “fundamental disequilibrium” and with the consent of the International Monetary Fund (IMF). 6

 The stability of the So.Sh. can be better gauged by the absence of a parallel market rate of any significance and the reduced level of restrictiveness of the exchange control system during the period under review.  Nevertheless, economic conditions were not without strains.  In 1964 a severe balance of payments situation emerged.  An overall deficit of So.Sh. 60 million was recorded in 1964 and the trade deficit reached an all time high of So.Sh.  202 million.  In 1965 net foreign reserves dropped to an uncomfortably low level of So.Sh. 5.8 million.  Several factors were responsible for the strained balance of payments conditions.  In early 1964, there was a border clash with Ethiopia, drought had struck in many parts of the country and the United Kingdom terminated its aid to Somalia following a break up of diplomatic relations between the two countries⁷

 In 1965 the authorities adopted a comprehensive stabilization program under a stand by arrangement from the International Monetary Fund.  The program relied on credit control as an instrument of stabilization, which proved very successful.  So successful was the program that 1971-73 development plan document had to not:  “The economic picture, as the 1971-73 plan gets underway, is reasonably bright, consumer prices are stable, the trade deficit is improving, the government’s budget for this year is in balance.  The national foreign exchange reserves are at a ten-year high⁸

 The pegging of the Somali shilling

 In 1971 the US dollar crisis disturbed the international monetary system.  On August 15, 1971 the US government suspended the convertibility of the US dollar into gold and devalued the dollar establishing a new parity of US$ 38 per ounce of fine gold.  Many countries followed the example of the US government and devalued their currencies.  Somalia, however, did not devalue and the new So.Sh/US$ exchange rate became So.Sh. 6.91 per US dollar.  On June 23, 1972 the British authorities decided to float the pound sterling.  The floating of the pound Sterling and its continued deterioration caused many difficulties to the Somali exporters, because the pound was the major export currency, particularly for the livestock sector.  To cope with this problem, the Central Bank of Somalia introduced a system of differentiated spreads between buying and selling rates ranging from 2.3 to 4.5%.

 In 1973 international foreign exchange markets experienced unrest.  The US dollar was further devalued and finally the Bretton Woods system broke down, and was replaced by a floating exchange rate system⁹ Again, Somalia did not deem it necessary to follow the US dollar devaluation and therefore the So.Sh./US$ rate appreciated to So.Sh. 6.23 per US dollar.

 The advent of the generalized floating system confronted the Somali authorities with a new problem: how to set the value of So.Sh. against other currencies in a regime of floating exchange rates.  After some initial hesitance, the Somali authorities decided to peg the So.Sh. to the US dollar, instructed exporters to switch their earning currencies from the UK pound and Italian lira to the US dollar, and unified the spreads between the buying and selling rates to 2%.  The peg to the US dollar was justified, because many developing countries, some of which Somalia had close trade relations, such as Saudi Arabia and Kenya, had switched to the US dollar.

 The peg at the rate of So.Sh. 6.23 per US dollar remained unchanged for a long time 1973-1981.  That, however, did not mean true stability, as we will see in the following section.

 The emergence of the parallel exchange market.

 The origins of the parallel exchange market lie in the nationalization policies adopted by the Somali government in the 1970s.  Between 1970 and 1975 the government nationalized the importation of foodstuffs, petroleum products, construction materials, medicines and pharmaceuticals, clothes and a wide range of other commodities.  By October 1975 all import trade was practically under state monopoly with twelve government agencies involved in foreign trade.

 State trading proved disastrous in terms of the balance of payments position.  Lack of experience in foreign trade, poor distribution and inventory systems, combined with waste, mismanagement and patronage, caused an upsurge in imports and shifted the balance of payments from a surplus of So.Sh. 124 million in 1972 to deficits of So.Sh. 45 million and So.Sh. 124 million in 1972 to deficits of So.Sh. 45 million and So.Sh. 66 million in 1973 and 1974 respectively¹⁰ As the foreign exchange reserves were depleted, import restrictions were introduced and consequently an acute shortage of goods in the domestic market occurred.  The ensuing inflation considerably overvalued the So.Sh. And paved the way for the emergence and thriving of the parallel market.  Soon traders started to smuggle So.Sh. banknotes abroad.  They sold the notes to Somali workers in the Gulf and used the proceeds for the importation of badly needed commodities into the country.  The initial reaction of the authorities was harsh.  Controls at ports and airports were tightened, and punishment for foreign exchange law offences was raised¹¹ However, the gap between the official and parallel rates grew so large that the Somali workers were reluctant to use the official banking channels, and the prospect for profit was so attractive that the traders were willing to operate in the parallel market despite the risks involved.

 To ease the acute shortage of goods in the market, the government introduced in 1976 a scheme known as “Franco Valuta”¹² Under this scheme an importer, who obtained foreign exchange abroad (from migrant workers) was automatically given permission to import goods into the country.  This, in effect, amounted to a government recognition and legalization of the parallel market (the hitherto illegal black market).  Gradually, the scheme increased its scope both in terms of participants and transactions and developed into a sizeable parallel market that overwhelmed the official one.  For example, from 1986 exporters were allowed to retain 60% of their foreign exchange earnings and sell them at the parallel market.  Later, the scheme was extended to landlords who leased houses to expatriates and foreign diplomats.  In addition, the parallel market was regularly supplied with foreign exchange obtained from official channels at a lower exchange rate.  Under the parallel market, the exchange rate depreciated continuously in response to market conditions and set the pace for the perennial devaluation of the Somali shilling.

 The crisis of the Somali shilling

 In June 1981 the Somali authorities adopted a stabilization program within a framework of a stand-by arrangement with the IMF.  The objectives of the program were to close the growing gap between the official and the parallel exchange rates, attract foreign exchange resources into official channels, and curb the mounting inflationary pressure.  Under this program the Franco Valuta system was abolished, restrictions on foreign trade were eases, and a dual exchange rate system was introduced.  Under the dual exchange rate system, the official exchange rate applied to some essential imports, and 100% devalued rate (So.Sh. 12.5 per dollar) applied to all other foreign transactions.  With that devaluation, the government embarked on a course of continuous and large devaluations chasing the parallel exchange rate (see table 1).  The sequence has been as follows:  

In 1982 the official rate was devalued to So.Sh. 15.01 per U.S. dollar, while the parallel rate stood at So.Sh. 24 per U.S. dollar.

 In September 1983 a managed floating system was introduced under which the official rate devalued to So.Sh. 17.0 per U.S. dollar compared to a parallel rate of So.Sh. 45.0 per U.S. dollar.

 In 1985 the official rate was devalued several times to So.Sh. 42.5 per dollar, while the parallel rate fell to So.Sh. 115.0 per U.S. dollar.

 In 1986 the official rate was devalued by So.Sh. 4 per month until it reached So.Sh. 86.5 per dollar in October 1986.  

In September 1986 a system of foreign exchange auction was introduced.  Under that system, foreign exchange was auctioned to successful bidders on a regular fortnightly basis, who used it for the importation of commodities into the country.  The aim of the foreign exchange auction was to unify the different exchange rates and provide a stable and realistic exchange rate.  However, under the auction system, the official rate depreciated form So.Sh. 94.1 in November 1986 to So.Sh. 159.9 per U.S. dollar in September 1988.  Over the same period the parallel rate, which was supposed to disappear, depreciated from So.Sh. 120.0 to So.Sh. 180.0 per U.S. dollar.

Unhappy about developments in the exchange rate, the Somali authorities suspended the auction system in September 1987 and pegged the exchange rate at an unrealistic rate of So.Sh. 100 per U.S. dollar.  That rate soon proved ineffective and consequently the auction system was reintroduced.

In June 1988 a managed floating system was reintroduced, and the official rate was devalued to So.Sh. 180 per U.S. dollar.  Thereafter, the exchange rate was adjusted on a weekly basis.  By December 1990 the official rate stood at So.Sh. 4,500.0 per U.S. dollar.

 The sharp and continuous depreciation of the Somali shilling was due to the high volume of liquidity injected into the economy through expansive monetary and fiscal policies.  As we will see later, excessive monetary creation fueled the inflationary pressure, which in turn, led to further depreciation, plunging the economy into a vicious circle of inflation-depreciation-inflation.

 Developments since 1991

 With the collapse of the Somali State, many national institutions faded away, but not the foreign exchange market.  On the contrary, it grew bigger; more efficient and more endowed with resources.  Several factors explain this development, namely the absence of any sort of controls, a cheap and good communication system, and the increased inflow of remittances from the large Somali community abroad.

 Moneychangers operate in all parts of Somalia crossing clan lines and have representatives all over the world.  In recent times, many small moneychangers joined forces and formed several large companies with far greater capability and expertise¹³

 

The exchange rate is freely determined by the interplay of market forces.  For example, if the harvest is good, or more livestock is exported to Arabia, or more remittances and international aid are received, the shilling strengthens.  An opposite situation, of course, makes the shilling weak, e.g. the ban on export of Somali livestock to Arabia.  A list of exchange rates is published daily in local newsletters and even posted in the Internet.  The US dollar remains by far the dominant currency in the economy.  Other widely used currencies include the Kenyan shilling, the Ethiopian Birr, The Saudi Arabian riyal and the UAE dirham.  Principal foreign exchange markets include Mogadishu, Bossaso, and Hargeysa.

 

In contrast to the massive devaluations of the Somali shilling in the 1980s, the exchange rate showed a remarkable stability in the period 1991-98, floating between So.Sh. 6,500 and So.Sh. 8,000 per U.S. dollar.  This stability is due to the fact that there has not been any large-scale monetary creation, of the sort experienced in the 1980s.  Most significantly, there were no commercial banks that created money through their lending operations as happened in the past.  Later we will see how the commercial bank created money excessively and thus contributed to the financial crisis in the country.

 

While the notes issued by Mogadishu North leader Hussein Aideed, which are similar to, and passed as the old shilling notes, put some pressure on the exchange rate, yet they did not cause any large depreciation¹⁴.  Apparently, they filled a gap left by the physical depletion of the old Somali shilling notes. However, the “Somaliland shilling (S/L)” fared very badly.  It depreciated dramatically from S/L 50 per dollar in 1996 to S/L 3,920 per dollar in October 1998^15. This happened because M.I. Egal the president of the “Somaliland Republic” inflated the economy by printing and spending planeloads of banknotes exactly as the regime of Siad Barre used to do.  The depreciation was so severe that, at times, merchants refused the “Somaliland shilling” and demanded payments in U.S. dollars¹⁶.

 

Table 1.  Developments in exchange rates 1977 – 1998

(Somali shillings per U.S. dollar)

End of period	Official rate	Parallel rate	Differential
1977	6.295	7.00	1.1 times
1978	6.295	8.50	1.3
1979	6.295	10.00	1.6
1980	6.295	14.00	2.2
1981	6.295*	20.00	3.2
1982	15.206	24.00	1.6
1983	17.556	45.00	2.6
1984	26.000	87.00	3.3
1985	42.500	115.00	2.7
1986	90.500	140.00	1.5
1987	100.000	250.00	2.5
1988	270.000	460.70	1.7
1989	930.000	1742.00	1.8
1990	4500.000	5500.00	1.3
1991 – 98+	---	6000 – 8000.00	---

 Source:  Central Bank of Somalia and interview with moneychangers.

*           From June 1981 there was a second exchange rate of So.Sh. 12.59 per U.S. dollar.

+          Up to July 1998

   

II

 DETERMINANTS AND REGIMES OF EXCHANGE RATES

 In this chapter, I will discuss the various approaches to exchange rate determination.  It should be pointed from the outset that these approaches are not mutually exclusive.  Each one explains the process of exchange rate determination from one perspective, and contributes to our understanding of this process.  I will also examine the different exchange rate regimes, which basically deal with the mechanism of setting the exchange rates.  Finally, I will discuss the rationale behind the movements of exchange rates in Somalia.

Determinants of exchange rates.

 Purchasing Power Parity (PPP)

The PPP theory explains the movements of the exchange rates in terms of inflation differentials.  It states that, in equilibrium conditions, prices of the same goods and services in different countries must be equal when translated at the current exchange rate.  Thus, the PPP exchange rate is the one that equates the price of externally traded goods in one country with the price of the same goods in another country¹⁷. For example, if the price of a pair of shoes in USA is US $50 and the same pair of shoes cost So.Sh. 250,000.00 in Somalia, the PPP rate is SoSh. 5,000 per US dollar.

The Economist magazine provides a good example.  The latter publishes every year what it calls the Big Mac index based on PPP theory.  The Big Mac is McDonald’s hamburger, which is produced in 110 countries.  “The Big Mac PPP is the exchange rate that would leave Mac Donald hamburgers costing exactly the same in America as abroad. Comparing actual rates with PPPs signals whether a currency is under-orovervalued.”18.

The PPP suffers from a number of defects.  First, it is difficult to establish a point at which currencies were in equilibrium.  Second, there are many price indices, which do not only vary between themselves but also suffer from statistical defects and make the calculation of PPP very problematic.  Third, many goods are not traded goods, that is, they are not imported or exported which further complicates comparison between prices in different countries.  Finally, PPP assumes a free flow of international trade.  The reality is, however, different.  In fact, there are innumerable barriers, tariffs, and other impediments that restrict world trade and cause distortions to price changes.

Balance of Payments Approach

The Balance of Payments Approach attributes movements in exchange rates to developments in the balance of payments.  According to this approach, the exchange rate is a price, and as such is determined by the demand for and supply of currencies in the foreign exchange market.  As demand for foreign exchange is derived from imports, and the supply is derived from exports, the balance of payments is, therefore, regarded as a better indicator of exchange rate variations.  Initially, attention was focused on the current account.  As it is known, the current account comprises merchandise, services, and transfers (grants and remittances).  A deficit in the current account means that a country is paying for purchase of goods and services and for transfers than it is obtaining.  Such a deficit, the argument goes, will consequently lead to a depreciation of that country’s currency.  The opposite is true in the case of a surplus.

Nowadays, the role of the current account as a better guide for exchange rate movements is put into question.  This is so because of the increasing importance of the capital account.  In fact, as a result of the generalized floating of exchange rates, the sophistication of international financial mangers, the spread of technology, the globalization of markets, and the increased volatility of interest rates, funds move easily, and quickly from one country to another, causing appreciation or depreciation even though the current account sends opposing signals¹⁹.

The Asset Market Approach

Today’s foreign exchange markets are dominated by a multitude of investors and speculators who are motivated by profit making or risk avoiding.  By transferring funds quickly and massively from one currency to another, these investors/speculators cause sharp swings in exchange rates that are not often justified by balance of payments developments or other economic fundamentals.  The Asset Market Approach attempts to explain why exchange rates fluctuate more than is warranted by economic fundamentals.  According to this approach currencies are considered as assets.  As any other assets, demand for currencies is determined by the investors/speculators.  It follows that expectations of future events, be they political, economic or even trivial, will affect the exchange rate.

The Monetary Approach to Exchange Rates

 The Monetary Approach to exchange rates views the process of exchange determination as a monetary phenomenon.  It focuses on the demand for and supply of monetary assets.  This approach postulates that since the exchange rate is the price of one currency in terms of another currency then it must be determined by the relative supply of and demand for the two currencies.  For example, if money supply grows faster in one country than in the rest of the world, while demand for money remains the same, the exchange rate of the country experiencing higher growth of money supply should depreciate.

The Monetary Approach to exchange rates assumes that the Purchasing Power Parity holds true, that money supply is exogenously determined by the authorities, and that relative interest rates affect the demand for money²⁰.

In its simplest form, the Monetary Approach to Exchange Rates is no more than the quantity theory of money applied to an open economy.  In brief, it states that an excess money supply will eventually lead to an increase in imports and will cause balance of payments deterioration or exchange rate depreciation.

The simple monetary model is said to be an extreme case not very mush close to developments in this real world²¹. It also has been criticized for failing to provide “an adequate explanation of the movements in major currency values during the floating rate period that began in 1973.”²². Furthermore, some economists rejected what they called the strong version of the Monetary Approach, which always identifies balance of payments deficits with an excess money supply.  Instead, they suggested a weak version that reconciles with other approaches, and recognizes that “although shifts in the demand for and supply of money to hold are not necessarily the immediate cause of exchange rate movements, they can be and perhaps usually are.”²³

Exchange rate determination in Somalia

In analyzing the causes of exchange rate depreciation in Somalia, I will argue that the weak version of the monetary approach applies.  At the same time, I acknowledge the importance of other factors.  Indeed, balance of payments developments, inflation differentials, expectations, and political uncertainties have played their part.  But the point is that without monetary accommodation the effects of the other factors would have been absorbed or even reversed.  In my view, the Monetary Approach is relevant in the case of Somalia, because of the following reason:

The massive growth in money supply during the 1980s, and the consequent high inflation rates and perennial exchange rate depreciations, brought about a widespread “dollarization” of the economy as people learned to switch shillings into dollars as a hedge against inflation.  After the 1991, the “dollarization” phenomenon increased to such an extent that the dollar is now used not only as a store of value but also as the most preferred means of payment.  In addition, the parallel market became now the only foreign exchange market where the Somali shilling floats freely with full convertibility.  Under these conditions any access monetary creation affects immediately the exchange rate causing a chain reaction of depreciation-inflation-depreciation as demonstrated by the experience of the shilling in the 1980s and the Somaliland shilling more recently.  A likely scenario will be as follows: excess money is created, cash balances are converted into dollars, the exchange rate of the shilling depreciates, merchants revise the prices of their stocks up-word as they anticipate higher import costs in terms of the local currency, new money is needed to offset the effects of inflation, depreciation follows, and the process goes on.

Exchange Rate Regimes

 Floating exchange rates

Exchange rates are said to be freely floating when they are determined by the forces of demand and supply without government intervention.  Free or “clean” floating is seldom encountered in real world (present stateless Somalia being the exception).  Instead “dirty” or managed floating is the norm.  This is so because exchange rates are so pervasive in their effect that governments feel obliged to intervene, from time to time, in the foreign exchange market to prevent sharp fluctuations of their currencies.

Supporters of floating exchange rates argue that such a system is advantageous because it provides a continuous and smooth adjustment of the exchange rate, relieves the authorities from holding large foreign exchange reserves to support their currencies, and depoliticizes the process of exchange rate setting.  The chief disadvantage of this system is that movements in exchange rates can be large and frequent and cause uncertainty in international trade.

Partial floating

This system is mainly practiced in developing countries.  It is characterized by the existence of two markets: A free market in which the exchange rate is determined by the interplay of market forces; and an official market controlled by the government.  Under this system, exporters and other foreign exchange earners are allowed to retain a portion of their foreign exchange income and sell it in the parallel market at market determined rates.

The advantage of this system is that it reduces the scope for illegal black market, and allows the government time to unify the two markets.  Its chief disadvantage is that it discourages those exports which are channeled through the official market, and may encourage the illegal siphoning off of resources from the official to the free market where exchange rate are high.

Auction

 Under this system foreign exchange is auctioned to successful bidders.  Supply of foreign exchange comes from specified exports, services, and transfers which are surrendered to the central bank, and auctioned on regular basis (fortnightly, weekly or even daily).  All bidders are required to lodge either partial or equivalent of 100% of the foreign exchange they are going to purchase.  Once bids are opened and examined, foreign exchange is allocated to the successful bidders from the highest bidder to the bid which exhausts the available supply, and clears the market.  This rate becomes the market exchange rate and applies until the next auction.  Under a “Dutch auction” system, each bidder pays his bid price, and the weighted average bid price may determine the exchange rate²⁴.

 Interbank

 Under this system the exchange rate is determined in negotiations between the central bank and the commercial banks on the basis of the demand for and supply of foreign exchange.  Individuals and firms bid through the commercial banks.

 Fixed exchange rates

 Under this system rates are determined by the authorities, which accept an obligation to peg the exchange rate at a determined level and prevents the market deviating from that level.

 The advantage of this system is that it provides a high degree of stability.  However, a big problem arises when a government under fixed exchange rates pursues deficit-financing policies.  The expanding money supply associated with the deficit financing leads eventually to balance of payments deterioration, loss of reserves, and build up of speculation.  At the end the government will be forced to devalue in an environment of crisis and political recrimination.

 Exchange rate regimes of Somalia

 As described in chapter one, almost all sorts of exchange rate regimes have been tried in Somalia.  From 1960 to 1971 a fixed exchange rate system reigned.  The “Franco Valuta” system (the parallel market), which was introduced in 1976, was in effect a partial floating.  In late 1980s the official rate used to be adjusted weekly for inflation differential between the Somali shilling and a basket of currencies representing Somalia’s major trading partners, and that was managed floating.  The auction system was in use from 1986.  Finally, the present exchange rate system of Somalia constitutes a classical case of “clean” floating.

 One may wonder why the exchange rate system of Somalia prior to 1990 was so unsuccessful.  The problem, however, is not with the exchange rate regime, but rather with the fiscal and monetary policies.  In fact, “no exchange rate system can do well if fiscal and monetary policies are out of control, while most exchange systems will do reasonably well if fiscal and monetary policies are prudent.”²⁵.

 In recommending a particular exchange rate system for a country, one has to take into account the characteristics of that country’s economy.  For a small, open country like Somalia, with rudimental financial markets, a small number of exchange dealers, and a history of irresponsible monetary policy, the fixed exchange rate system is the most appropriate²⁶. But, as repeated again and again, a fixed exchange rate regime has to be supported by tough monetary and fiscal policies.  If the authorities lack the credibility to enforce these policies, as happened in Somalia, a currency board system can best serve the interests of the country.

   

III

 MONEY SUPPLY, EXCHANGE RATES AND INFLATION

 This chapter will analyze the relationship between money supply, exchange rates and inflation.  It will start by showing developments in monetary aggregates, will identify factors affecting money supply and finally will examine the link between money supply, exchange rates and inflation.  To begin with, the relevant variables will be defined as follows:

Money supply is defined as the stock of total monetary assets (broad money).  These comprise currency in circulation, demand deposits and savings deposits.  They are, in fact, the only monetary instruments that were available in Somalia.  It is worth noting here the composition of demand deposits, which consist of current accounts “xisaabaha socda” (checking accounts) and circular cheques “jeegagga wareega”.  The latter are banker’s drafts that were widely used in Somalia in place of personal cheques.  Originally, the circular cheques were intended for small payments and transfers, but, over time, they became a widespread and convenient means of payments and replaced cash for settlement of big transactions.  As will be discussed below, circular cheques had proven to be an uncontrollable source of monetary creation by the Commercial and Savings Bank of Somalia (CSBS).  

Money supply data have to be examined with caution.  This is so because the banks, especially CSBS, experienced some difficulties in reporting data accurately and on timely basis.  Poor communication between the headquarters and the branches coupled with inadequate and dubious accounting practices (not excluding some element of book-cooking) caused considerable delays in reporting data.  Nevertheless, the figures reveal the trend experienced in those years.

Exchange rate is the nominal rate that measures the relative price of the Somali shilling in terms of U.S. dollar.  The official rate is the one published by the Central Bank of Somalia, while information on the parallel rate is supplied by private dealers.

Inflation rate is measured by the consumer price index of Mogadishu, which is based on a Mogadishu family budget survey in 1985.  It used to be published by the Ministry of Planning.

 Money Supply

 As shown in table 2, money supply increased phenomenally from So.Sh. 4.4 billion in December 1981 to So.Sh. 158.0 billion in December 1989, which represents a spectacular growth of 3,474%.  Among the components of money supply demand deposits showed the highest increase (3,767%) followed closely by currency in circulation with an equally sharp increase of 3,649.5%.  Savings deposits went up 2,331%.  It is worth noting that, only in one year 1989, money supply increased by a staggering amount of So.Sh. 97.9 billion.  However, a word of caution is in order here.  It is highly probable that part of these figures may belong to previous years.  This could happen because of poor and dubious accounting practices.  Still these are huge numbers for one year even discounting for the faulty accounting practices.  When one considers that this explosive trend continued also in 1990, for which data are not available, one understands how far things got out of hand.

 It may be interesting to see monetary developments in Ethiopia; a country that had suffered from civil war, famine and influx of refugees as Somalia did.  Figures show a sharp contrast with Somalia.  In fact, during the period 1981-89 money supply in Ethiopia increased by only 148% compared to 3,474% recorded in Somalia (see above)²⁷.

 

Table 2, Money supply 1981 – 1989

(In millions of So.Sh.)

 

End of Period	Currency in Circulation	Demand Deposits	Savings Deposits	Total
1981	1,890.9	1,783.2	747.1	4,421.2
1982	1,455.7	2,652.7	1,014.2	5,122.6
1983	1,355.5	2,953.8	1,191.5	5,500.8
1984	1,900.0	3,130.0	1,600.0	6,630.0
1985	3,787.4	5,986.7	2,785.2	12,559.3
1986	5,208.5	6,935.1	4,690.8	16,834.4
1987	12,326.9	17,718.9	8,187.4	38,233.2
1988	21,033.3	24,403.0	14,678.7	60,115.0
1989	70,900.0	68,961.8	18,159.4	158,021.2

 Source:  Central Bank of Somalia, Quarterly Bulletin, various issues,

Currency outside banks’ figures for 1989 were taken from International Financial Statistics Year Book.  IMF, Washington, 1992

 The Major factor, which contributed to this enormous increase in money supply was credits by the banking system.  As can be observed from table 3, total credits rose sharply by So.Sh. 94.3 billion or 2,076% between December 1981 and December 1989.  The bulk of these credits represented loans to the private sector which expanded from So.Sh. 0.6 billion in December 1981 to So.Sh. 56.1 billion in December 1989.

   

Table 3: Total credits 1981 – 1989

(In millions of So.Sh.)

End of Period	Credits to government	Credits to public enterp	Credits to Private sector	Total
1981	2,249.6	1,721.4	574.6	4,545.6
1982	2,100.0	1,300.0	1,623.8	5,023.8
1983	1,805.0	1,163.0	2,292.8	5,260.8
1984	4,378.1	1,511.2	3,726.9	9,616.2
1985	5,421.7	2,071.2	4,023.9	11,516.8
1986	6,077.2	3,730.4	4,094.8	13,902.4
1987	14,254.1	6,408.8	13,926.9	34,589.8
1988	20,118.7	11,845.5	19,102.4	51,066.0
1989	14,065.6	28,803.8	56,061.9	98,931.3

 

Source:  Central Bank of Somalia, Bulletin, various issues, Mogadishu.

 Credits to public enterprises rose by So.Sh. 27.1 billion or 1,573% while credits to the central government went up by So.Sh. 11.8 billion or 525%.  Only in 1989 credits to the private sector and the public enterprises rose by an enormous amount of So.Sh. 53.9 billion, and most probably by a bigger one in 1990.

 In addition to credits, there were also two other factors that fueled the increase in money supply.  These were uncontrolled and wasteful expenditure by the banks and government’s misuse of the proceeds from the sale of commodities received as aid.  In fact, both the treasury and the banks went into an incredible spending spree.  They spent huge sums on construction, furniture, luxury cars, foreign trips and on a wide range of other goods and services that should not have been bought except for corruption; looting may be the right term.

 As it is evident from the table above, in the early 1980s government deficit was the major factor behind the excessive monetary expansion.  The war with Ethiopia, the influx of large numbers of refugees, natural calamities and government profligacy necessitated huge expenditures that were financed through recourse to central bank borrowing.  Later, however, the government position improved as a result of inflow of sizeable official grants and loans.

 Unfortunately, while the government position was somehow improving, credits to the private sector grew out of control and stood as the major factor contributing to the monetary expansion.  This happened because the CSBS, the only commercial bank at that time, became more politicized, resisted successfully central bank supervision, and indulged in widespread abuses, irregularities and corruption.

 The Central Bank itself did not provide an example of financial discipline and integrity.  It also succumbed to political pressure, and became too busy rationing scarce foreign exchange than developing policies.  For example, in a typical day the Director General of the Central Bank spent most of his time either signing, promising, refusing, or delaying to sign the “D Form”, or the permit to purchase foreign exchange at the official rate.

 In a sound banking system, a commercial bank must keep a reserve of legal tender to meet any possible demand by its customers.  This, the CSBS did not do.  Not only did the CSBS lend out all of its reserves, but also it issued uncovered circular cheques in large quantities and amounts.  The situation became so critical that in mid 1989 the bank was literally unable to meet the demand of its depositors even for small amounts of cash.  As if that were not enough, the bank continued to issue more circular cheques against new unsecured credits at a massive scale.  This further aggravated the situation, and caused the worst-banking crisis in the history of the country.  The bulk of the circular cheques were cashed at high discount (20-40%) by private traders who used them for the payment of taxes and/or the purchase of foreign exchange in the auction system.  In turn, this contributed to the depletion of reserves from the central bank, which was receiving only circular cheques, and led to an acute shortage of banknotes in the country with devastating consequences.

 Ironically, the authorities blamed the currency crisis on the public who allegedly hoarded cash as a plot to undermine the government’s credibility.  In fact, the President warned, in a broadcast speech, that those hoarding cash were doing so at their own risk as the government could not guarantee their security.

 To ease the severe cash shortage, the central bank printed large quantities of banknotes and supplied a portion of them to CSBS on regular basis, further swelling the volume of money supply.  But, despite the continuous and substantial injection of liquidity, the fortunes of the CSBS could not, however, be reversed.  For circular cheques were still being issued by corrupt and politically protected commercial bank’s branch managers, while the ability of the central bank to print more cash was constrained by lack of foreign exchange resources.  To compound the problem, the President refused to authorize the printing of higher denomination banknotes arguing that these will facilitate the smuggling of currency out of the country.  Because of hyperinflation the cost of printing exceeded the face of value of almost all of the denominations.

By early 1990, the situation was out of control and the CSBS totally lost the confidence of the public, and practically ceased to act as a financial intermediator.  Its role was taken up by a multitude of small private parallel banks that held abundant cash and discounted circular cheques at heavy discount rates.

In July 1990, the government adopted a comprehensive financial sector reform within the framework of an IMF sponsored program.  The most important measures adopted in the program were the following:  

A new commercial bank the “Somali Commercial Bank” was established by the government, and started operations in August 1990.  The initial capital of the bank was So.Sh. one billion paid up by the Ministry of finance (50%) and Central Bank of Somalia (50%).  Private businesses were allowed in principle to buy shares into the new bank and take over the ownership and management of the bank within a year.  The objective of establishing a new bank was to fill the gap left by the CSBS and, in general, to introduce some competition in the banking business.  

            The CSBS was instructed to stop any new issues of circular cheques.  

The central bank was instructed to cease granting any further loans and advances to the CSBS.

 Circular cheques were declared no longer valid for the payment of taxes and/or purchase of foreign exchange in the auction system.

 It was decided that the central bank pay in cash up to 20% of all deposits owed by the CSBS to its customers within August 1990.  The remaining balance of deposits will be paid by CSBS through loan recovery.

 By the time the negotiations of financial sector reform were completed, the situation was out of control politically, economically and militarily.  The rebel movements, which were fighting the government since early 1980s were closing in on Mogadishu, the capital, while inflation, by wiping out the value of wages, turned government soldiers, who were supposed to defend the regime, into street vendors.  For more details about the civil war see appendix.

 

The link between money supply, exchange rates and inflation

 Having discussed developments in monetary assets and identified the major cause behind the excessive monetary expansion, I will now examine the link between money supply, exchange rates, and inflation rates.  Table 4 shows movements in money supply, parallel exchange rates and inflation rates.  Generally, the figures reveal a noticeable relationship between the three variables.  Over the period 1985-1989, on average money supply increased by 88%, parallel exchange rates by 99% and inflation by 59%.  However, one can distinguish between tow periods.  In the first period of 1985 to 1987 money supply increased faster than the depreciation in exchange rates and the rise in prices.  This is explained by the inflow of grants and loans in favor of the government, which partly absorbed monetary expansion and therefore offset its inflationary impact.  In the second period 1987-1989, the exchange rate depreciated more rapidly than the growth in money supply.  It is in this last period that currency substitution (dollarization) has emerged, as people became more sensitive to exchange rate depreciation and the rapid loss of purchasing power.  As a result, any new addition to the money supply triggers a bigger amount of depreciation.

   

Table 4:  Money supply, parallel exchange rates and inflation rates 1985-1989

(changes in percent)

 

End of period	Money supply	Parallel Exchange rate	Consumer price index
1985	81.1	32.2	37.6
1986	34.0	21.7	35.8
1987	127.1	78.5	28.1
1988	57.2	84.3	81.7
1989	138.8	278.1	110.4

 Source:  Central Bank of Somalia, Ministry of Planning and Private traders.

 In sum, the adjustment program failed to close the gap between the official and parallel rates as well as stabilize the exchange rate for the simple reason that there were no supportive monetary and fiscal policies.  This is not to say that the program neglected the monetary and fiscal aspect.  Rather, it prescribed some tight monetary and credit measures as usually stabilization programs do.  But these, for one reason or the other, were not compiled with, and consequently the burden was put on the exchange rate.  The argument is that devaluation is not only appropriate for small open economy like Somalia but it is also dangerous politically as it lowers the standard of living of the population.  That argument is supported by a number of authors who claim that “by allowing countries to adop administered exchange rate system characterized by frequent small devaluations, IMF programs have been excessively inflationary.”²⁸

 

IV

A Currency board system for Somalia

As pointed out in the introduction, the collapse of the financial system of Somalia was one of the major factors that contributed to the fall of the Somali government.  At the root of the financial crisis was the tendency on the part of the government leaders to create money at will to finance their personal, political and clan interests.

 The same factor, e.g., the power to create money, is probably the chief obstacle that stands in the way of the formation of a broad-based national government.  For it is common knowledge that faction leaders have so far failed to form a government, mainly because of the dispute over who would become the President and, therefore, would control the printing presses of the Central Bank.  So far, faction leaders who printed their own currency have shown that, as far as currency management is concerned, they are worse than the previous regime.  Apparently, their motive in issuing currency is not to provide the economy with a medium of exchange but merely to generate funds for themselves, their clans and clients.

 In this chapter I recommend the introduction of the currency board system in Somalia in the place of the Central bank as a way to achieve exchange rate stability as well as stop the politicization of monetary creation.  The currency board system, I believe, is appropriate for Somalia because of its simplicity, transparency and its relative ease of implementation.  Most importantly, it provides an effective way “to stop currency chaos, limit corruption, and establish stability.”²⁹

 In recent years, a number of countries have successfully adopted the currency board system.  The Economist magazine reviewing the countries under the currency board system noted that “Estonia’s currency board helped stabilize the Baltic country’s economy.  Hong Kong’s, created in 1983, has kept the colony’s currency steady despite the massive changes in China.  Argentina’s has put an end to decades of inflation.”³⁰

 Historically, Somalia has had experience with the currency board system as described in the first chapter.  Moreover, the experience of eight years of a free and stable foreign exchange market and the absence of banking crisis make the introduction of a currency board system much easier.

 The beauty of the currency board is that it can be established even without a central government provided the international financial community sponsors it.  Professor I.M. Lewis of London School of Economics suggests that, since a centralized Somali state is impossible to restore, Somalis have the option to co-operate in specific fields without reference to any national authority³¹. The currency board system provides, I believe, an excellent opportunity for cooperation and national reconstruction.

 Operating the Currency Board

 What is a currency board?  A currency board is a monetary authority which issues notes and coins in exchange for a reserve currency at a specified fixed exchange rate.  Unlike the Central Bank, a currency board cannot print money at will since it is required to maintain foreign reserves equal in value to the total amount of notes and coins in circulation.  Thus, the core features of a currency board are the fixed exchange rate, the reserve or anchor currency and full convertibility.

 Anchor currency:  The U.S. dollar should, logically, be the anchor currency as it is the most widely used and accepted currency in Somalia, in addition to being the international currency par excellence.

 Exchange rate: As to the exchange rate, the prevailing market rate at the time of the establishment of the board will be adopted, e.g. So.Sh. 8,000 per dollar.  In the last eight years, the exchange rate of the Somali shilling vis-à-vis the U.S. dollar had exhibited a remarkable stability floating between 6,500-8,000 shilling per dollar.

 Reserves:  At any given time the currency board should maintain dollar reserves equal to 100% of the value of the notes and coins in circulation.  This will ensure the unlimited convertibility of the shilling into U.S. dollars.

 Relation to government: By law the currency board is prohibited form lending money to the government, or public enterprises.  The government should finance its budget through taxes, or borrowing from the capital market, if there is any, or international aid, and not through recourse to printing money and thereby creating inflation.

 Relation to banks: The currency board is prohibited from lending money to the banks.  This means that the currency board has no responsibility to bail out insolvent banks.  It follows that commercial banks must rely on other sources for lending of last resort.  Generally, “a currency board would be much easier to operate if all banks were foreign, supervised by the monetary authorities of other countries, and with access to their lender-of-last resort facilities.”³² Given the past banking history, government owned commercial banks must be vigorously opposed.  Instead joint ventures between Somali private banks and foreign banks should be encouraged.

 As for the supervision and regulation of the banks, a department within the ministry of finance can do the job, or an office specially established for that purpose.

 Outstanding currency: The board cannot redeem the notes currently in circulation unless dollar reserves of equal value are provided.  For example, notes issued by faction leaders cannot be redeemed unless the latter provide the backing dollar reserves.  One option is to let these notes circulate along side with the currency board notes until reserves are provided or they wear out overtime.

 Management:            The board will be governed by a board of directors representing the different regional states of the country and will establish branches in regional capitals.  Each region or state of Somalia will contribute a certain amount in U.S. dollar s and receive the equivalent in Somali Shillings.  To enhance the credibility of the board, representatives from international financial or aid organizations, and Somali businesspersons (moneychangers) could sit in the board as shareholders.

 Profit:   The board realizes profit from the difference between the interest earned from the assets held in US dollars and its operating costs.  A part of these profits could be allocated as reserves and the rest paid to the shareholders in proportion to their contributions (e.g. federal government regional governments, and international financial organizations, moneychangers).

  Advantages of Currency Board

 The biggest advantage of the currency board system is the depoliticization of the process of money creation.  By prohibiting the financing of government budgetary deficits, the currency board system prevents corrupt governments from printing money at will.  This is extremely important in the case of Somalia as the involvement of politicians was behind the financial chaos that inflicted so much damage on the economy and on the people.

 Other strong benefits of the currency board system are price stability, stable exchange rate and currency convertibility, which result from the imposition of strict fiscal discipline.  The resulting stable economic environment promotes trade, investment and economic growth.

 Disadvantages of currency board system

 A currency board system is criticized for being inflexible and not allowing the use of discretionary monetary policies to suit a country’s own economic conditions.  In fact, the monetary base (notes & coins) is automatically determined by changes in the balance of payments.  For example, a deficit in the balance of payments, and the resulting outflow of foreign reserves, causes the monetary base to contract, and hence the interest rate to rise sharply.  However, this may not be the case in Somalia as the incidence of large speculative capital outflows are minimal and there is no market determined interest rate of any kind.

Another weakness of the currency board system is that it precludes use of the exchange rate as an instrument for correcting balance of payments imbalances.  As the local currency is linked to a strong currency, it could become overvalued and make the country’s exports uncompetitive.  But, as experience had shown, devaluations, by adding to the inflationary pressure, do more than good to a small economy like Somalia.

Conclusion

The currency system is preferred because of its simplicity; predictability and rule based nature.  Furthermore, it promotes greater stability of domestic prices and the exchange rate, and as a result, enhances confidence.  And confidence is of crucial importance given the high rates of inflation and pervasive exchange rate instability experienced throughout the 1980s, not to mention the public’s mistrust of government institutions and the feuding of different regional clan based factions.

It should, however, be noted that the currency board system is not a panacea.  Certainly, it cannot provide a magic solution to a country’s economic problems; nor it can operate in an environment where other important supporting institutions are missing.  But it provides a stable and convertible currency, which must be seen as a fundamental right of every citizen.  It also reduces the scope for corruption and at least does not allow corrupt politicians to hide their fiscal abuses.

 

 

 

FOOTNOTES