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Paper: Time is Money

On November 12, 2011

Exploring issues of currency stabilisation in the Libyan post-conflict period.

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The NTC should focus on the Libyan dinar

For many, what has been most revelatory of the February 17th revolution has been perhaps not the sheer violence of the Gaddafi regime – the open and systematic handing out of which managed to silence a population for over 40 years – but a more subtle, though arguably equally-as-grave a subjugation: the broad economic disenfranchisement of the Libyan people.  Behind the thick veil of Gaddafi’s “Third Way”, the Socialist State, have emerged economic realities that do not square with the headline figure many have repeated en route for years: “Libya has the highest GDP per capita in North Africa and the 9th largest oil reserves of the world”, a phrase that speaks of potential though we have discovered, certainly not of reality.  One of the most striking images of the recent weeks perhaps: a group of five orphan boys found, illiterate, clothes in tatters, tending to a flock of sheep; this, in a country with over $160bn in foreign assets and annual government revenues exceeding $45bn. We knew it wasn’t good, but did we know how bad?

Images from inside the villas of the Gaddafi family have exacerbated the sense of injustice so, that much of the “economic talk” on the Libyan street these days has centered on one of three issues: (1) how soon can we resume oil production and start sharing in the wealth of our country? (2) how much of our money did Gaddafi hide outside the country and how do we get it back? (3) how much gold do we have and did Gaddafi sell any to finance his grip on power? While the sentiment behind these questions is well placed – and the resumption in oil production a basic necessity – the immediate economic focus of the new Libyan leadership should be on an issue with little popular appeal beyond economic circles: the stabilization of the Libyan currency.

“Bullets are still flying in places like Bani Walid and Sirt, surely it’s too early to speak of currency stabilization”.  On the contrary, let us take Iraq as an example: the US-led invasion began on March 19th 2003, Baghdad was taken 21 days later on April 9th, George W. Bush gave his too-eager “Mission Accomplished” speech on May 1st and by May 15th, only two months into armed hostilities, the Council on Foreign Relations, arguably the most influential think tank in the US, published a policy analysis co-authored by one of the world’s most-sought after economists, Nouriel Roubini, on what should be done about the Iraqi dinar. The haste with which the US sought to shape the new Iraqi currency (two months into a war that has thus far lasted eight years and an entire seven months before Saddam was even captured) should serve as an indicator to Libya’s leadership. On September 10th 2011, the International Monetary Fund recognized the NTC as the legitimate government of Libya and in her press conference, Christine Lagarde, the Fund’s chief, cited “stabilization of the currency” as the number two priority in Libya, preceded only by oil production.

The Libyan currency: a brief history

Shortly after independence, the Libyan Currency Commission was established and began issuing Libyan pounds on 24 March 1952, named after the British Pound Sterling, to which it was linked at a fixed rate of 1 Libyan pound to 1 British pound (GBP; at the time, still linked to the gold standard). At this stage, the currency was managed by a currency board, i.e. the issuing authority held close to 100% foreign reserves of GBP for every Libyan pound in circulation and had the ability to exchange on demand; monetary policy (intended as the setting of interest rates and control of money supply in response to inflation and economic growth) were left to the market.

In response to the increased sophistication of the Libyan economy, the National Bank of Libya was established in 1956 and the currency board system was thus replaced by the central bank; the currency was no longer fixed to the GBP, but was instead pegged to it (significantly loosening the foreign reserve requirements and allowing for a relatively-more independent monetary policy, though not in the sense by which independence is understood today in a post-Bretton Woods world). The pegging to the GBP was de-facto replaced in 1967 by a determination of value relative to the Deutsch Mark and French franc, as Libya did not follow the GBP’s devaluation in the same year; nonetheless the gold standard prevailed globally. On the US’ abandonment of the gold standard in 1971, the value of the Libyan pound was determined only nominally against gold, floating against the US Dollar (USD) and GBP.

With Gaddafi’s coup in 1969 the Libyan pound was renamed the Libyan dinar to acquire a distinctly pan-Arab character and in response to the nationalization of British Petroleum’s Libyan assets in 1971 by the Gaddafi regime, Libya was expelled from the Sterling area, sealing the demise of the close relationship enjoyed between the Kingdom of Libya and the United Kingdom.

While the GBP no longer served as a reference currency, the nominal relationship with gold and pegged- value to the USD held until the use of gold par values was ended by the IMF globally; at this stage, the Libyan dinar remained pegged to the USD at a value of 1 LYD = 3.3777 USD which lasted until 1986 (a value that is now recalled by Libyans as a source of national pride). With the escalating tensions between the Gaddafi regime and the US, the pegging of the LYD to the dollar was ended in 1986 presumably in symbolic retaliation (symbolic, as it has no economic consequences to the US) and replaced by a pegging to the IMF’s international reserve currency, known as “Special Drawing Rights” (commonly known as SDR, denoted by “XDR”). The XDR is not a tradable currency in itself, rather it is a unit of measure used by the IMF, whose value is calculated weekly as a weighted exchange rate of a basket of the world’s most traded currencies (its associated interest rate values form the basis of IMF loans). Despite Gaddafi’s symbolic retaliation, the USD, as the world’s de-facto reserve currency, forms a significant part of the XDR basket.

Beginning on 1 May 1986, the rigid peg to the XDR was loosened, introducing a managed-float system with an associated band. The published band grew from 7.5% to a peak recorded width of 77.5%, allowing the Gaddafi regime to systematically devalue the LYD at every new widening of the band. As at the latest values available prior to the February 17th revolution, the LYD had been devalued so much so that from a 1986 peak value of 1 LYD = 3.3777 USD, every dollar is now worth 1.30 LYD (meaning, 1 LYD = 0.2960 USD, an over 91% devaluation).

The rationale for currency stabilization

The Central Bank of Libya (established in 1970), headed pre-revolution by Farhat Bengdara, recently replaced by an unknown Gassem Azzoz, has been representative of the Gaddafi regime in its opacity in releasing data; Bengdara and Azzoz themselves have not been questioned publicly about the exchange rate system and systematic devaluation of the LYD in the Gaddafi years (questions towards Bengdara in the international media have thus far focused on an accounting of the assets held by the Central Bank, particularly gold, and whether Gaddafi had taken any to finance his last stand; Bengdara’s answers have been approximate at best).

Presumably though, the weaker LYD supported Gaddafi’s policy of national self-sufficiency, that is, a weaker currency would make imports too expensive, promoting the Green Book imperative for economic autarky and justifying the need for central planning and the Socialist state. In this sense, a systematically devalued Libyan dinar largely contributed to an isolated Libyan economy; a reversal of this policy could therefore lead to a veritable economic transformation of Libya with the demise of uncompetitive industries, increased specialization, an exponential growth in trade and more choices for Libyan consumers.

In the near term however, what is likely to trigger public scrutiny over the currency mechanism, will be one of two issues:

(1) the resistance of the NTC’s Ali Tarhouni (de-facto interim minister of the economy) towards liquidating Libya’s foreign assets – despite dwindling domestic funds – to pay for salaries (which will raise the question of printing currency), or

(2) the potential discovery of false banknotes rumored to have been used by the Gaddafi regime to pay for the alleged use of mercenaries.

While the latter issue remains but a rumor, in an unstable transitional stage, any credence lent to this rumor could lead to a discrediting of the banknotes in circulation and informal use of dollars or euros may emerge (during the 80’s and 90’s economic embargo period, many Libyans will remember dollars smuggled from Tunisia and Egypt, waved in stacks by make-shift brokers to passing cars on highways willing to exchange them for extortionate black market rates). It is our view that this is not likely to happen, particularly if the NTC continues to speak with one voice to the public, as it has through Abdel-Jalil and now with Al-Keeb (previously Jibril) . Notwithstanding the continued roles of Abdel-Jalil and Al-Keeb or a strong replacement, the effects of a banknote discrediting could be easily stemmed by exchanging old banknotes for new ones on a one-to-one basis on demand at all banks (if this is not executed rapidly however, a banknote recall followed by limitations on bank cash withdrawals to “buy time” would not work, as the Gaddafi-imposed limit of 500 dinars/month withdrawal per person in the late 70’s – early 80’s, is a sore memory for Libyans and if repeated, may lead to discrediting of the NTC and political deadlock).

The former issue however is the more likely scenario; that is, as the NTC’s Ali Tarhouni is resisting populist calls to have all foreign Libyan assets liquidated and repatriated to Libya, the alternative that will emerge in public discourse is the currency will have to be printed domestically to pay for salaries. From an economic (as opposed to populist) perspective, this is the sensible decision, as Libya’s foreign assets are invested in a variety of portfolios, the nature of which should be determined before making decisions to liquidate, potentially at a loss. Additionally, foreign assets have been invested as strategic long-term reserves for future generations and while there is a pressing short-term need, this view should not be entirely forfeited. In the interim, loans taken out based on future oil revenues, collateralized by frozen assets, could be an acceptable financing option. Once domestic funds run out however, the “printing money and currency mechanism” conversation will have to be held publicly and it is important for the NTC to send a clear message to the public as to how it expects to pay for upcoming salaries, and to the international community, as to how it expects to print money (and maintain its value) to finance any interim external debt taken on. Overall, the NTC should recognize that any decision made now regarding the currency affects future policy flexibility and it is therefore critical to get it right.

What are the options?

For the new head of the Central Bank, Azzoz, who is said to have launched a competition to “re-design” the Libyan banknotes (it would be embarrassing for the NTC to continue paying the workers of a “free Libya” with banknotes depicting Gaddafi for much longer), there are a number of options regarding the dinar, though a revaluation seems inevitable. There exist a variety of exchange rate mechanisms available to any monetary authority; the analysis here presented will borrow the framework used by Roubini and Setser in their Iraq policy analysis for the Council on Foreign Relations (“Should Iraq dollarize, adopt a currency board or let its currency float? A policy analysis, Roubini, N. and Setser, B., Council on Foreign Relations, 15 May 2003).  Their analysis was chosen as a relevant case study due to the similarities between Iraq and Libya in terms of economic reliance on oil, relative population size and rapid change in governance.

Roubini and Setser focus their analysis on three exchange rate mechanisms:

  1. Dollarization
  2. Currency board
  3. Managed float

The first option, dollarization (or euroization) entails using the USD or EUR as the currency of Libya in an interim stage and usually occurs informally in emerging economies with discredited domestic currencies; this was relevant in Iraq as the US government and the Federal Reserve were shipping millions in small-denomination US dollar banknotes to the ‘new Iraq’ as an interim solution and contractors rebuilding the Iraqi infrastructure were paid in US dollars. This is not relevant – at least at the time of writing – in Libya as a shipment of newly minted Libyan dinars has recently been unfrozen and delivered to the NTC by the UK government where they were being printed. It also appears people in Libya have not made a “run on the banks” to withdraw their deposits and are managing to make basic purchases with the volume of dinars in circulation instead of resorting to an alternate currency. At a policy level, dollarization entails relinquishing monetary policy authority over to the Federal Reserve and the Central Bank would de-facto have little to no power.

The currency board system has much the same effect; while the currency would be a local print and design, it would have to be backed one-to-one with foreign reserves of the anchor currency (for arguments’ sake, the US dollar); that is, for every Libyan dinar, an equivalent value of US dollars would have to be held in reserves by the Central Bank and be exchangeable on demand at the fixed exchange rate. This is in essence, putting a Libyan face on a dollar note and entails the same loss of monetary policy authority as dollarization.

The third option, a managed float exchange rate mechanism – advocated by Roubini and Setser for Iraq and herein advocated for Libya – entails a new Libyan dinar whose value relative to other currencies is allowed to float within an acceptable band (for example, ± 5%). In order to preserve the band (which can itself be readjusted upwards or downwards if need be), the Central Bank would make ad-hoc interventions by buying or selling Libyan dinars in the open market (vice-versa, selling the reference currency, e.g. the US dollar, or buying it) to respectively revalue or devalue the currency. Interventions would be carried out with foreign currency reserves, of which Libya holds in excess of $100 billion. The Central Bank would hold discretion over its growth and inflation targets, interest rate decisions and money supply volumes.

Which system should Libya adopt?

What should be categorically avoided are the first two options: dollarization or a currency board. In particular, any form of informal dollarization should be stemmed at the outset (whether it occur in trade, payment of salaries, or everyday purchases and transactions occurring privately); the key here for the NTC is in the payment of salaries as a significant proportion of Libyans are employed by the state and will make purchases with the currency they are given. In parallel, foreign and domestic companies resuming operations in Libya should be forced to make payments to their employees and settlement of trade contracts in Libyan dinars (perhaps by instating a routing of all payments to domestically-held bank accounts once liquidity has been credibly established).

In a related option, what should also be avoided is a pegging of the value of the dinar to the dollar or euro (as was previously the case with the dollar until 1986, the GBP before that and now to the SDR). In all these cases, the Central Bank of Libya loses all sovereignty over its monetary policy (that is, it cannot set its own interest rates to adjust to the inflationary conditions in Libya). As elucidated by Roubini and Setser in their Iraq paper, the US/EU are net oil importers and Libya is a net oil exporter, which means an increase in the price of oil hurts them (as it is such a significant input-cost), but benefits Libya; if Libya adopts their monetary policy (by pegging the LYD to the USD for instance), it would be setting interest rates too high in a slowdown (exacerbating the crisis) and too low in inflationary times (causing more inflation). This is the trap the GCC (Gulf Cooperation Council) countries, whose currencies are pegged to the dollar, are currently suffering from. The US is in a recession following the global financial crisis, so the Federal Reserve has slashed interest rates to the lowest rates on record (close to 0%; negative in real terms if inflation is taken into account). At the same time, the price of oil has shot up, amassing great wealth for GCC economies. The economic growth in the GCC generates inflation (as too many riyals or dirhams chase too few goods), which should be tamed by raising interest rates. However, because GCC currencies are pegged to the dollar, the GCC central banks have to follow the Federal Reserve in slashing their interest rates – simply creating more inflation. In essence, their currencies fixed exchange rates systems have not allowed monetary policy to provide “counter cyclical output stabilization” (i.e. adjusting to absorb the impact of inflation due to booming oil prices) and the real purchasing power of its citizens is thus eroding.

Additionally, since the 2007 global financial crisis, the reliability of the dollar as the reserve currency of the world has come under severe scrutiny and its value has in real terms been on a steady course of devaluation; pegging the Libyan dinar now could spell instability down the line and not serve to reverse the devaluation carried out by the Gaddafi regime. An alternative pegging to the euro is not desirable either as the very survival of the Eurozone’s single currency is in these days coming under severe test by the economic crises in its peripheral states.

What the Central Bank of Libya should adopt is a managed-float currency system whereby the LYD is allowed to move freely against a basket of world currencies within a band, thus reflecting a truer market value, which is almost certainly higher than that of the Gaddafi-era LYD (the Iraqi dinar continues to shoot up since the free float system was put in place in 2004). While an entirely free-floating currency system is also an option, a managed-float system (i.e. one that has a band) can provide stability and predictability to the economy. A managed-float system would overall provide the Central Bank of Libya with the appropriate discretion in managing interest rates to control inflation as well as the ability to intervene to absorb terms of trade shocks (that is, intervening to devalue the currency to protect nominal domestic wages and employment and to reroute consumption from imports to domestic goods, when there is an oil price shock).

Next steps

The current LYD-XDR pegging (and the XDR’s large weighting towards the USD and the EUR) is an unsustainable and undesirable option for Libya and should be replaced in the near term with a managed float against a basket of currencies. An initial “free float” period can be used to establish a range of reference values for the managed band.

To ensure this can occur, the Central Bank must first of all be an independent and credible institution. Citizens’ first scrutiny in a transition phase should be on Gassem Azzoz’s qualifications as Central Bank chief: he must be, importantly, a technocrat, not a politician, and an economist by background. It is of the essence that political interference with Central Bank functions be refuted. Along with Ali Tarhouni, who heads up the economic affairs ministerial portfolio for the NTC, Azzoz should establish a clear currency agenda (which system will be chosen to determine the value of the LYD?) and step up to the media forefront, rather than be relegated to counting the gold bars in the coffers of the state.

In a related matter, public calls have been made recently through several media outlets by Jamal Abdelmalek, Chairman of the Libyan Bank of Commerce and Development (an until-recently state-owned bank) to “immediately de-peg the LYD from the US dollar”; that such a high-level banker is seemingly not aware of the currency’s peg to the SDR and has not been as yet publically rectified by the NTC or the Central Bank, does not serve to instill confidence in the economic management of the new Libya (irrespective of his role as a private, not Central Bank, banker); a more proactive and public approach from the Central Bank is urgently needed and a cadre of qualified technocrats, supported by technical assistance from the IMF and the EU, should replace the old guard in Libya’s banking sector which is almost-entirely state-owned.

The reality of currency stabilization is that once a system is adopted, it will be difficult to replace and when the NTC begins paying salaries in new oil revenues – a matter of when not if – the decision will have to be made.

Fayruz Abdulhadi
fayruz.abdulhadi@sadeqinstitute.org

November 2011
London, UK

 

One Response to “Paper: Time is Money”

  1. Giacomo de Nardis says:

    Good morning Fayruz!

    Solving the issues addressed in your article in a sustainable manner is key to the future prospects of Libya. Deciding which exchange system to implement should solve 50% of Libya’s problems, as the effects on the economy and wealth will surely help ease other tribal/political based tensions. I lack a deep insight on Libya, it’s demography and economy. Hence, my comments might not always hit the nail on the head.

    I believe Libya’s economic objectives should be the following: reduce unemployment (30%), diversify its economy and improve infrastructure. In order to reach these objectives, a weak, devalued currency should be preferred. The euro-area’s mistake was to allow appreciation versus the dollar ($1.50) which has condemned the euro region to a lost decade. Libya should avoid that.

    Bearing in mind these three objectives, the exchange rate mechanism should be chosen. I do not believe a managed float mechanism is the right way to reach the three objectives stated above as it does not solve some relevant issues: currency overvaluation, currency credibility and attacks on the currency.

    Currency overvaluation: while one might believe the currency should appreciate as the current account is positive, his analysis is biased by a $100/bbl figure. Oil at $100/bbl will surely turn the current account positive, strengthening the currency, but the rest of the economy is and will remain uncompetitive (and forced to shutdown). This is what is happening in Australia and goes against the three primary objectives stated above.

    Currency credibility: there are rumors of fake notes circulating, persistent political tensions and a new government/institutional framework has yet to be established. As a foreign investor, I would consider this environment as unfriendly and I would probably not invest in Libya.

    Attacks on the currency: in this delicate moment for Libya, having a currency on an $100 billion economy might make it very weak in the face of a speculative and/or fundamental attack on the currency. This is an issue also faced by Iceland, which my adopt the euro or another currency in the near future.

    What Libya should do is adopt a currency board exchange rate mechanism, possibly with the dollar and establish a low fixed-rate exchange. The libyan notes and coins will obviously be new and will be backed by a weak currency with low interest rates, yet with a good reputation. In the meantime, the libyan government should foster new industries and sectors (ex: tourism, automobile, agriculture, infrastructure) through well designed policies. Foreign investment should demand a lower risk premium thanks to the currency board. Unemployment should go down.

    Tourism and new industries will only be attracted by steady, credible currencies that are possible devalued. In the medium/long term, Libya, I agree, should establish a managed float system.

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