The Comforting Illusion of Debt Relief Reforms
Why Covid-19 provides an important reality check for Somalia’s economic reforms under the debt relief programme
What do global financial firms, Hawala companies in London and a hawker pushing watermelon on carts in the Xamarweyne market in Somalia all have in common?
They all need to use the United States dollar.
"We should not be caught up in a collective euphoria about debt relief or Decision Point. It is important to remain cautious about any suggestion that reforms in Somalia have turned an important corner. Currency reform is an obvious example of what happens when ends (debt relief) is prioritised over means (locking in credible reforms first)."
Flight to quality
A well-known aspect of financial crises is the concept of “flight to quality”. It simply means that in times of stress, the United States dollar (USD) is generally the one thing every one wants and which most financial and non-financial firms cannot do without. The expectation is that the USD is the ultimate safe haven which will not dry up altogether because the Federal Reserve (“Fed”) will always be ready to intervene to ease any dollar market crunches. This is the belief that the Fed, as the lender of last resort, can bring a sense of stability to the financial markets.
When the need for dollar liquidity increases, companies that are desperate for cash first sell off any assets they hold - corporate bonds and equities for instance. When that fails, they turn into other high-quality liquid assets (such as government securities), hence the sharp falls in stocks and bonds we have seen in recent weeks. If these options are still inadequate, firms start to draw down on their dollar credit lines, thus shifting the crunch to banks which will now have both on and off-balance sheet commitments to honour. Enter the world of Covid-19 liquidity squeeze.
Unlike the 2007/08 financial crisis, the problem caused by Covid-19 is that many firms are stuck in a double-bind: rapidly depleting revenues because of the global lock-downs and continued commitments to meet liabilities (eg. fixed costs, supply chains and debts) falling due often in USD. All of this demand for the dollar pushes the currency to appreciate against a basket of other currencies and the scramble for USD accelerates.
This is why the Fed’s trillion-dollar intervention to open up swap lines is intended to make USD availability easier to help avoid a more damaging seizing up of the global economy. If the economic lock-downs were to drag on for much longer, the Fed’s current intervention may well not be enough.
By now, you might wonder what these financial acrobatics have to do with Somalia and the debt relief reforms. Well, everything if a country’s economy, such as Somalia's, is anchored on the dominant (USD) currency over which it has no control.
The perils of a dollarised economy
A country’s currency is the vital artery that supports its economic well-being and critical to its path to sustainable economic development. Somalia remains unique in the world as having a recognised government but without a viable national currency.
Somalia’s “Shilin” is mostly counterfeit and the Central Bank of Somalia (CBS) has not issued any new currency denominations for 30 years. The Shilin is not used for key goods or services and all economic transactions are in dollars. This over-reliance on the dollar means the country is materially exposed to what happens in global financial markets.
Second, one of the key dollar liquidity inflows into Somalia is the remittance from overseas from which a significant proportion of the population directly or indirectly benefits. However, almost all of these inflows are used to buy imported consumer goods “Bariis, Baasto, Barafuun” and eventually materialise as outflows over time. Without USD liquidity buffer in the country, the effects of dollar scarcity becomes easily amplified in the economy, leaving households and the wider financial system exposed to dollar crunches.
What Covid-19 dollar shortage means for Somalia
When there is a scramble for dollars, two seemingly counter-intuitive things happen in Somalia. Firstly, businesses start to hoard USD and increase prices, injecting inflationary pressures into the economy; and wider economic activities grind to a halt (i.e. most households defer non-essential expenditures, other economic activities – eg. construction, wage payments stop). The dollar market sizes up quickly.
In normal times, the central bank steps in and uses its monetary policy levers to open up dollar liquidity lines by purchasing the local currency through open market operations. The effect of this would be to increase the dollar circulation thereby bringing down the overall demand for dollars. Somalia's problem is that the dollar is the de facto national currency and there is no monetary policy framework in place.
On the financial markets, the impact of Covid-19 on Hawala companies is also immediate: (a) remitters losing their jobs start to cut down on remittances which means low volumes and compressed margins for Hawalas; and (b) Hawala companies’ reliance on cash transportation in bags, in the absence of proper payment clearing systems, creates pockets of trapped liquidity outside of Somalia, stopping dollar inflows into the country.
The result: the liquidity held outside of Somalia is both reduced and trapped whilst outflows from Somalia continue as people transact in dollars for their daily necessities. Unlike other global firms that can tap into either central bank liquidity or bank credit lines, there is not much Somali businesses can do, nor can Somalia’s central bank help ease this dollar pressure. This is the first important lesson on monetary policy, showing why riding on the greenback as a substitute for a national currency is economically perilous indeed.
In the absence of dollar liquidity lines or the banking infrastructure that can shift liquidity into the country quickly, the only option left for Hawala companies would be to preserve USDs held locally in Somalia by reducing dollar pay outs and putting a cap on how much money can be sent to Somalia – something which is starting to happen already. Large investments, sent through the Hawalas, dry up. Overtime, the whole economy starts to seize up as cash runs out and viable businesses become illiquid or insolvent with ruinous economic consequences for the country.
Furthermore, these liquidity issues portend much more serious problems for Somalia's financial system. A prolonged global and local economic lock-downs mean a potential run on the electronic mobile money transfer (E-MMT) operators will become inevitable. Major E-MMT operators in Somalia are also Hawala/bank companies and the customers’ E-MMT funds are not backed up by central bank deposits (and may already be tied up in illiquid assets or used to pay out cash remittances). If, because of dollar scarcity, enough people realise that they would be better off having cash in hand, rather than in an E-MMT wallet (i.e. flight to quality, leading to “II Soo Tuur” becoming “Doolarkayga ii Soo Bixi), the liquidity crunch in Somalia would be much worse indeed in the weeks and months ahead. This is another point that highlights why the failure to regulate E-MMT operators could lead to a much bigger liquidity crisis in the country.
Credible reforms or mere recrudescence?
This is why having USD as the country’s monetary and economic backstop is dangerous. Somalia is exposed to these financial markets acrobatics precisely because it neither has a viable national currency nor anchored in any of the basic key reforms that would have mitigated these risks. The interplay of the risks crystallising here - liquidity risk, clearing system and monetary policy could have been mitigated had the right reforms been embedded.
Reflecting the critical importance of currency reform, the first ever IMF Staff Monitored Programme (SMP I) that was agreed with the then Federal Government of Somalia in May 2016 included the four structural benchmarks. The most important of which was “initiating the first stage of comprehensive currency reform”. Somalia has since “successfully” completed SMPs I, II, III and IV over the years, all of which included several milestones on currency, monetary policy, central bank and other fiscal reforms. If one were to believe the official announcements, Somalia is now at the debt-relief “Decision Point”, having apparently delivered on all of the reform benchmarks successfully. It is an episode that underlines the contradictions of what the SMP says and the reality on the ground.
It has been five years since the currency reform was first mooted and to date it still remains a distant dream; mobile money regulations have yet to be implemented effectively and monetary policy framework, including payment and clearing systems are still far away. We should question why these important reforms continue to be sacrificed for a spot of good news on the debt relief journey. Perhaps, this is a sign of low expectations for Somalia and these reform achievements are convenient milestones. It does not of course mean all of this is in Somalia's national interest.
Credible reforms are difficult and take time. Good reforms are not only launchpads for economic growth but also mitigate economic and financial risks while protecting businesses and people's livelihoods. Countries have their own national currencies and effective central banks because both are important pillars for good, sustained economic well-being.
We should of course celebrate Somalia’ progress and the work of the young men and women who are making a difference on the ground in difficult circumstances. However, we should not be caught up in a collective euphoria about the debt relief or Decision Point. It is important to remain cautious about any suggestion that reforms in Somalia have turned an important corner. Currency reform is an obvious example of what happens when ends (debt relief) is prioritised over means (locking in credible reforms first).
The adverse economic implication of Covid-19 is another important reality check and timely reminder of why "Decision-Point” and the talk about successful reforms in Somalia are merely comforting illusions.
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The personal views, thought and opinions expressed in the text belong sorely to the author, and not necessarily to the author’s employer, organisation or other group or individual.
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