Madagascar - Financial policies for diversified growth : choices for a market economy (Vol. 1 of 2) : Executive summary list of main recommendations

Report No. 981 7-MAG Madagascar Financial Policies for Diversified Growth: Choices for a Market Economy (Inr Two Volumes) Volume l: Executive Summary List of Main Recommendations March 16, 1992 lndustry and Energy Division MICROFICHE COPY South and Central Indian Ocean DepartmentMCOFHE OP Africa Region Report No. 9817-MAG Type: (SEC) FOR OFFICIAL USE ONLY NAIR, GOVI/ X34002 / J-7064/ AF3IE Docum"ent of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disctosed without World Bank authorization.  CURRENCY EOUIVALWNTS Currency Unit Malagasy franc (FMG) US$1 = 1800 FMG (end 1991) WEIGHTS AND MEASURES Metric International Standard System 1 meter (m) = 3.3 feet 1 hectare (ha) 2.47 acres 1 kilometer (km) = 0.62 mile 1 sq kilometer (km2) = 0.39 sq mile (sq mi) 1 kilogram (kg) = 2.2 pounds (lb) I liter () 0.26 US gallon (gal) I metric ton (m ton) = 2,204 lb LIST OF ABBREVIATIONS AON - Appels d'Offres Ndgatives AOP = Appels d'Offres Positives APB = Association Professionnelle des Banques BA = Bankers' Acceptances BCEAO = Banques Centrales des Etats de l'Afrique de l'Ouest BCRM = Banque Centrale de Madagascar BFV = Banky Fampandrosoana ny Varotra BMOI Banque Malgache de l'Ocdan Indien BNI = Bankin'ny Indostria BTA = Bon du Tresor par Adjudication BTC = Bon du Trdsor Classique BTM = Banidn'ny Tantsana Mpamokatra CCBEF = Commission de Controle des Banques et d'Etablissements Financiers CCP = Compte des Cheques Postaux CD = Certificates of deposits CEM = Caisse d'Epargne de Madagascar CNAPS = Caisse Nationale de Prdvoyance Sociale CPI = Consumer Price Index ECGS = Export Credit Guarantee Scheme EPZ = Export Processing Zone FIARO = Financiere ARO FMG = Franc Malgache IOC = Indian Ocean Commission NGO Non-governmental Organization PTA = Preferential Trading Agreement PTT = Postal and Telecommunications Services SA = Socidtds Anonymes SARL = Societes & Responsabilite Limit6e SILI = Systeme d'Importations Lib6ralisdes SME = Small and Medium Enterprises GOVERNMENT OF MADAGASCAR FISCAL YEAR January 1 to December31  FOR OFFICIAL USE ON?LY PEFEACE This study Is the product of close collaboration between the World Bank and the Government of Madagascar to formulate a strategy for the developme3it of the country's financial sector. The analysis in this study is based on two missions to Madagascar led by Govindan Nair (task manager) and comprising: R. Karaoglan and P. Popiel (AFTEF), Bernd Balkenhol ([LO), and Bernard Connen (consultant) in January/February 1991; as well as A. Op de Beke (IMF), P. Berglund and L. Lindroth (consultants) in May 1991. The completed study was discussed with the Government in January 1992. Ihe support of the Government of Madagascar is gratefully acknowledged. The Bank missions express their thanks especially to the many staff members of the Central Bank of Madagascar and the Treasury who collaborated in this study. Notwithstanding the collaborative nature of this study, the conclusions are ultimately the responsibility of the Bank team. In addition to Govindan Nair, principal author of the study, and the members of both missions, the following individuals in the Bank provided substantial advice, comments and input: Michael Sarris, Philippe Le Houerou, Gerard Caprio, Edgardo Barandiaran and Sunil Benimadhu. The conclusions are also the result of close collaboration of the IMF. The study consists of two volumes: Volume One includes an executive summary and a list of main recommendations; Volume Two contains the main report, a series of annexes and a statisdcal appendix. This document has a restricted distrtbution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CHOICES AND PII)SF'OR A M&IZECONOMY VOLUME ONE Executive Sumqmry Fmnandal PoUcies: Diagnosi and PoUcy Agenda ............................................ 1 Increasing Financial Savings ..................................................................... 2 Increasing the Efficiency of Investment ................................................. 6 Reducing the Costs and Risks of Financial Trsasactions ................................. 9 Implementing Polices for Fnancial Sector Development ............................. 11 Lst of Main Reconmendations ........................................................................ 19 Volume Two: Table of Contents ........................................................................ 25 Tables Table 1: Proposed F ncial Sector Strategy ................................................. 3 Table 2: Near-term Financial Polcy Measures ........................................... 14 Table 3: MedIum- and Long-term Financial PoUcy Measures ......................... 16  GLOSSARY OF FINANCIAL TERMS 1/ Averaae Cost of Funds: A weoghted average of the interest cost of a bank's deposits and own funds, based on the composition of its deposits at a point in time. Cagital Markie: The market in which long-term financil instruments, such as equities and bonds, are issued and traded. Clnimn: In the context of the payments system, refers to the transfer and recording of payment instructions made by a payor to a financial institution. Clearing can be done on a gross basis i.e. transaction by transaction or, if channelled through a specialized clearing organization such as a clearinghouse, on a net basis where total receipts of one institution are offset against payments to be made by that institution. Commerdca Bills: Short-term debt instruments that are used mainly to finance trade. Examples are promissory notes, by which debtors commit themselves to pay to creditors or to their order a stated sum at a specified date, and bills of exchange, which are drawn up by creditors and accepted by debtors. Commercial bills that are also accepted by banks are known as bank acceptances. Promissory notes issued by large corporations to meet their general financial needs are known as commercial paper. Contractual Savings Institutions: Occupational pension funds, national provident funds, life insurance plans, and similar institutions that collect financial savings on the basis of long-term financial contracts. Direct instruments: In connection with monetary policy, refers to actions affecting monetary conditions which directiy force banks into portfolio positions they would not voluntarily accept such as aggregate and individual bank credit ceilings, interest rate controls and directed credit policies. Discount: A reduction from the face value of a financial contract. Disintermediation: Usually it refers to the removal of funds from interest-bearing time accounts in savings institutions and commercial banks for the purpose of reinvesting the funds at higher rates in market instruments. In other cases, ordinary sight and saving deposits are removed to increase the demand for durable (e.g., land, gold) or consumption goods, or to be lent directly by surplus agents (households) to enterprises, bypassing financial intermediaries. Equity Finan: The provision of finance in a fcrm that entitles its owner to share in the profits and net worth of the enterprise. Finandial Bph: The extent to which savings in an economy is channelled through the financial system. Usually measured as the ratio of broad money (M2) to GDP. Flnancial Distress: Usually refers to the sharp deterioration of a group of financial indicators resulting in changes in the behavior of the agent before its restructuring or bankruptcy.; When such distress reaches crisis proportions and is widespread, it usually leads to a rush out of real or financial assets into cash. l/Definitions of financial terms as they are specifically used in this Report.  lnndgiInfras trucrture: he framework of laws, regulations and accounting practices governing financial transactions and the logistics and practices of the payments system. Eln, dal sffLr: The structure of arrangements in an economy which facilitates the conduct and growth of real economic transactions through the use of money for payments, savings and investment. This strucure of arrangements include monetary and regulatory policies, Infrastructure, institutions, instruments and markets which are intended to enable the transfer of financial resources with minimal possible risk and cost from payers to recipients of funds and from sav-rs to borrowecs. Flmmdal syten: IlThe institutions, instruments and markets in the financial sector. Flnandial Savings: The portion of total wealth held in the form of financial assets. FilDefidt: Defined on a cash basis as the difference between total Government cash outiays, including interest outiays but excluding amortization payments on the outstanding stock of public debt, and total cash receipts, including tax and nontax revenue and grants but excluding borrowing proceeds. Girobnkan: An institution for handling financial payments and transfers. It receives payments from individual payers which aggregate several payment obligations (eg. utility and tax bills) or from a firm or public entity making payroll transfers. The girobank then re-aggregates all these payments by individual payees who receive a lump sum settlement from the girobank for obuiigations due from a group of a group of clients (eg. the utility company). Hedglng: The acquisition of a financial contract designed to protect the purchaser or the seller against a future change in the price of a commodity or security in which the purchaser or the seller has an interest. Indatin: A mechanism for periodically adjusting the nominal value of contracts in line with movements in a specified price index. Indirect lnstrtments: In connection with monetary policy, refers to policy actions affecting monetary conditions such as interest rates and price levels through use of market forces and financial markets. ULuld labilities: Money plus highly liquid money substitutes, such as savings deposits. Liquidity Manag ement: In connection with monetary policy, refers to actions taken by a central bank to ensure that the banling system can flexibly provide in the short-run for the cash and payment needs of society. Monetary goliia: Refers to actions taken by central banks to affect monetary and other financia conditions in pursuit of the broader objectives of sustainable growth of real output, high employment and price stability. Distinguished from fiscal policy which affects these broader objectives through Govermnent expenditures and taxes (see direct Instruments and Indirect Instruments). Monly: Currency and other liquid assets. Narrow definitions such as MI refer to money used as a medium of exchange. Broader definitions such as M2 or M3 add to Ml money used as a store of value.  Monwu markels: Markets in which financial instruments with a term of one year or less are issued and traded. These instruments usualy include enterprise bills, commercial paper, bankers acceptances, Treasury bills, and negotiable certiflcates of deposits. NoneRforming Loans: A loan on which contracual obligations (for example, interest or amortization payments) are not being met. Open market operations: A tool of monetary policy through which a central bank can affect reserve money through purchase or sale of securities. Eaymenltws system: The system of logistics and practices involved in settling economic obligations and transferring resources through financial payments. Clearing and settement are the two major steps in the payments process. The institutional elements of this process include, for example, the system of checks, clearinghouses, girobanks and automatic deposit and payment orders executed by financial institutions including the postal system. (see deafring, girobank, and settlement) Prudential Regulation: Refers to the set of laws, rules and regulations which are designed to minimize the risks banks assume and to ensure the safety and soundness of both individual institutions and the system as a whole. Examples include lending limits, minimum capital adequacy guidelines, liquidity ratios, etc. OMasi-fiscal Activities: Refers to activities undertaken by the central bank that are outside the strict ambit of monetary policy and which are normally undertaken by the Government; these activities can affect the profit and loss account of the central bank or initially show up only as a change in composition of central bank assets. Ouasi-fiscal Defldt: Refers to the losses of the central bank that arise from activities not specifically related to monetary policy and that would be normally undertaken by the Goveranment (see riscal defidt, quasi-fiscal activities, monetary policy). -Rseserve Money: Currency in circulation plus deposits (of banks and other residents but not the Government) with the monetary authorities. Scrities: Financial instruments which can be readily transferred through sale from one owner to another either directly or through the intermediary of specialized insttutions and markets. The term generally refers to shares and bonds specifically. Suritiztin: The process of conferring the tradeable characteristics of securities to a financial instrument. Seignorag : The net revenue derived from money issue. Settilment: In the context of the payments system, refers to the actual transfer of value based on payments instruction through the use of account balances at a financial institution which can be bank balances or on the books of the central bank. Term Finance: Equity or medium- and long-term debt finance. Write-Offs: The act of removing an asset from the books of a company or bank, acknowledging and charging the loss against loan-loss provisions or capital.  MADAGA,SCAR.ENNIL OIISER FM SFE GROWTH CHQOICES AND PRIORIS FOR A MARKET ECONOMY Elnaia,cial Dolidesf: diagnosis and nolicy affenda 1. Madagascar's financial sector today features several changes and policy measures undertaken during the 1980s. The commercial banking system has emerged from technical insolvency and regained financial stability. The opening of the banking sector to private capital in 1988 has led to establishment of a new private bank in 1989 and parial privatization of two of the three state-owned banks in 1991. These changes have increasingly differentiated the ownership of banks from that of their borrowing enterprises, led to greater competition and are creating an environment conducive to sounder investment. Progressive liberalization of interest rates which began during 1983-85 has led to removal of all official controls on deposit and lending rates since November 1990. Directed credit policies have also been progressively dismantled. Credit can now be allocated more effectively according to market signals. The new regime also helps lead to lending rates and long-term deposit rates which are positive in real terms. Madagascar has been one of the pioneering countries in the Africa and Indian Ocean region to begin shifting from direct to indirect instruments of monetary control. 2. Despite these advances, the challenges confronting the real economy in the 1990s require further financial sector improvements in order to effectively service the needs of a market-oriented economy increasingly based on private sector initiative. Promising potential in agriculture, mining, manufacturing and tourism remains untapped despite considerable endowments in human and physical resources including Madagascar's unique flora and fauna. Underlying this unsatisfactory performance are low domestic investment and savings which remain below the average in Sub-Saharan Africa as well as among low-income countries generally. Available capital in Madagascar must be deployed into its most productive uses ij order to realize the investment opportunities afforded by the new incentive structure. Without improvement in aggregate savings and in the level and quality of investment, economic diversification and trade expansion in an increasingly market-oriented system would probably remain sluggish and significant growth in per capita income would unlikely be sustained throughout the 1990s. 3. The main Report examines how a revitalized financial sector can help meet the above-mentioned challenge by further improvements in three closely related areas: (i) Increasine the level of finandal saying: Channeling available savings through the financial system can help ensure that capital is most productively used. This requires measures to increase confidence of savers in the value and safety of financial assets which can increasingly substitute for the significant share of savings in Madagascar that is unmonetized. Furthermore, there appears to be promising potential in two areas to encourage savings through financial assets: (a) among the vast majority of small-scale economic agents who have not yet accessed the existing financial system; and (b) through long-term financial contracts such as insurance and social security. (ii) increasine the eMdiency of investment: As the key ingredient for increasing efficiency of investment and promoting rapid economic diversification in Madagascar, increased private investment requires that financial savings be  2 effectively channeled to its most productive uses. A well functioning financial system will help promote high-yielding projects by: (a) fostering ccmpetition among lending institutions which disciplines their lending decisions on which their profits and survival depend; and (b) ensuring that risks and returns of investments are appropriately balanced through financial markets which help price the cost of capital and distribute the risks of investment; and (iii) lowering the cos and risks of flnndal _Mnation: Effective intermediation of savings and investment through the financial system in Madagascar depends fundamentally on reducing the costs and risks of transferring resources from savers to borrowers and from payers of financial obligations to recipients of fiuds. Improvements in the legal, accounting and payments system are needed to lower these costs and risks, thereby encouraging use of the financial system to setde economic obligations, to channel savings and to fimance investment. 4. These three objectives are the subject of diagnosis and recommendations of the main Report in Volume Two. Ihese recommendations are referred to in Table 1 and are summarized below. To help attain these objectives, the role of government will remain important, notwithstanding the increasing market-orientation of the Malagasy economy. A common aim of government is to stimulate and to maintain stability in the financial system and confidence in the real economy. By focusing its policies on appropriate monetary and fiscal policies as well as on flexible exchange rate management and prudential regulation, the Government should confirm the shift away from its previous policies of direct intervention and ownership in the financial sector. This focus should be viewed as supporting rather than displacing increased private involvement in both the real and financial sectors of the economy. The proposed financial sector strategy would require several policy ehoices in the near term. These are spelled out in the following sections of this summary. Coupled with sound fiscal policies and timed to follow far-reaching ongoing reforms in the incentive structure and business environment, these financial policies are crucial for rapid expansion of the private sector which is expected to be the engine of future growth in Madagascar. Increasine financial aingfs S. The Report recommends three sets of measures to increase financial savings that are summarized in the rest of this section: -The first of these (paras 6 to 10) concern the confidence of savers in the value and safety of finsmncial isets. There are at least two key ingredients for stinmlating and maintaning such confidence: (a) stability in the overall price level which affects the real return on financial assets; and (b) effective regulation and supervision of depository institutions to ensure that they observe prudent practices in the use of funds entrusted to them by depositors. Price stability which helps achieve real returns on financial assets would encolurage savers to hold wealth in monetized form. Ihis would help recoup the losses in financial depth (measured by the ratio of broad money to GDP) which began in the early 1980s, partly due to high inflation and negative interest rates, among other factors. Depositor confidence would also be enhanced by prudential surveillance of depository institutions that effectively monitors the various and changing risks of banking activities which, until recendy, has been largely neglected in Madagascar. Summarized below are key steps to help the Central Bank in Madagascar (BCRM) improve the key roles it plays in assuring price stability and prudential regulation and supervision.  3 Table 1. Proposed Financial Sector Strategy KEY OBJECTIVE KEY MEASUR RECOMMNDATIONS IN VOLUME TWO INCREASING Increased credibility and Chapter 2 (para 2.48-2.53) FINANCIAL SAVINGS effectiveness of Central Bank monetary policy Operational goals: Strengthened supervislon Chapter 4 (para 4.36-4.42) Increase real returns on and regulation of financial financial assets and institutions confidence of depositors Revamping postal checking Chapter 6 (para 6.26-6.34) Small-scale savings and savings system mobiUzation Improving operating Chapter 5 (para 5.26-5.28) Boosting contractual incentives and regulatory savings framework of insurance and __________ social security ENHANCING Averting crowding out of Chapter 2 (para 2.54-2.56) EFFICIENCY OF private investment from INVESTMENT Central Bank losses Operational goals: Enhancing competition Chapter 7 (para 7.44) within financial sector Increase share and level including divestiture of of private investment remaining government shareholdings Chapter 4 (para 4.284.30) Promoting high-yield Chapter 7 (para 7.29-7.46) investments Building money and capital markets to price and Improving prlcing of distribute financial risk capital LOWERING COSIS Strengtening legal Chapter 3 (para 3.3-3.37) AND RISKS OF framework to protect FINANCIAL financial contracts TRANSACTIONS Improving accounting, Chapter 3 (para 3.28-3.35) Operational goals: auditing and financial disclosure Improving financial Intermediation and Increasing speed, accuracy Chapter 3 (para 3.42-3.54) payment services and reliability of financial Annexes 3.3-3.5 ________________ .payments and transfers  4 -A second set of measures (paras 11 and 12) involves building an effective system to tap the signiflcant resources of small-scale savers who constitute the overwhelming majority of the Malagasy population. Specific recommendations to build such a system, virtually absent in Madagascar unlike several other Sub-Saharan countries, entail revamnping the existing postal savings and checking system and stimulating the creation of professionally and communally-based savings groups. -The third set of recommendations (para 13) complements the improvements sought In depository institutions by aiming at revitalization of contractual savings institutions (insurance plans and social security) which currently mobilize more than three-quarters of term resources in Madagascar. 6. An effective role by BCRM in helping to ensure price stability requires means for conducting a credible monetary policy free of government interference. The negative consequences of the present lack of independence of the Central Bank in conduct of monetary policy are illustrated by the mounting operating losses of BCRM during the 1980s. These losses result principally from foreign exchange losses incurred by BCRM because it services rescheduled external debt obligations of the public sector. Another element contributing to BCRM losses is the fact of central bank advances extended to the Treasury at virtually a zero interest rate until 1991. Although statutorily capped at 15 percent of ordinary government revenues during the previous budget year, central bank advances to the Government have continually exceeded these statutory limits. At the end of 1990, these advances were over nineteen times the statutory limit. Since the Government does not systematically respect its statutory obligations to compensate foreign exchange and operating losses of BCRM, the latter, as a result, has acquired unremunerated claims on government representing three-fifths of its assets. With three-fifths of its assets yielding no income and their corresponding liabilities generating expenses, BCRM has been incurring operating losses equivalent to several percentage points of GDP. During the 1980s, the potentially inflationary outcome of the chronic operating losses of BCRM - and their deleterious consequences for financial savings - has been averted through a specific pattern of government deposits and payments to BCRM. This situation is unlikely to be sustained throughout the 1990s (see Chapter 2 of Volume Two for a full discussion). 7. A key policy decision is for the Government to assume its statutory responsibilities for compensating BCRM for its accumulated losses and stemming future losses. The underlying problem remains fundamentally one of fiscal policy since transfer of these government financing responsibilities back to the Treasury does not itself reduce the financing requirements of the public sector. However, in addition to increasing the transparency of government financing, this policy decision reduces the risks of one of two alternative outcomes which would be unfavorable to the financial system and private finance: (a) generating inflation (thereby discouraging savings) through uncompensated central bank losses; or (b) forcing a crowding out of the private sector (thereby discouraging private investment) to enable the central bank to attain its monetary targets. 8. Eliminating operating losses of BCRM should be part of broadet 1olicy allowing BCRM to conduct monetary policy effectively. The statutory objectives of the Central Bank (BCRM) should be redefined by narrowly focusing them on maintaining price stability. To strengthen its role in this respect, the statutory responsibilities of BCRM should encompass both formulating as well as executing monetary policy. The four-year term of the BCRM Governor provided under current statutes is insufficient to ensure Central Bank autonomy. It should be lengthened as part of a revision of these statutes. Grounds for dismissal of the Governor and  5 members of the BCRM Board should be clearly specifled and essentially be limited to moral turpitude or inf.rmity. Such dismissals should ideally be effected by a procedure which limits arbitrariness by the executive branch such as the necessary consent of a majority of the legislative body. The key policy decision here for the Government is not only to formulate and enact new statutes for BCRM embodying the abovementioned provisions, but to ensure that the statutory obligations of the Government to BCRM are, in practice, strictly respected. 9. Maintaining confidence of savers in the quality of assets of depository institutions Is also essential for increasing financial savings. As part of the supervisory and regulatory role attributed to it by the 1988 Banking Act, BCRM should formulate a framework of appropriate risk-based capital adequacy ratios for Malagasy banks in line with new regulatory practices emerging worldwide. This will help address the new risks of banking associated with an increasingly market-oriented economy. These risks will arise from the expansion by commercial banks of off-balance sheet commitments and the widening range. of new instruments, institutions, and markets, including the eventual use of hedging instruments. 10. Policy decisions to ensure independence of BCRM should be accompanied by systematic efforts to strengthen its capacities in both monetary management and bank supervision. This would lend credibility to a program which is intended inter alia to help foster a positive climate for financial savings. BCRM should accordingly develop a strategic development plan facilitated by external assistance. This plan would comprehensively cover its organizational structure, its systems and methods for gathering and processing economic and monetary data as well as its manpower and logistics. All these aspects should be evaluated and improved according to the existing and future functions and objectives of the Central Bank. Among other things, this development plan should identify a clez program for recruitment and training of personnel with necessary supervisory, economic, mnancial, and other central banking expertise. Such a program would be most effectively implemented once new statutes for BCRM have also been enacted. 11. The second set of measures to mobilize financial savings is aimed at tapping potential financial savings among small traders, ..tisans, farmers, and other small-scale entrepreneurs who represent the majority of Mala, -sy households. This savings potential has been largely untapped by existing banks whose clientele is focused on wage earners and larger enterprises in urban areas. The postal savings system (Caisse d'Epargne de Madagascar or CEM) however already exhibits excellent potential for fiurther monilizing the savings of small-scale economic agents. Benefitting from a widespread network through over two hundred post office windows, CEM has attracted over a quarter of a million accounts with funds equivalent to 35% of all term deposits held by individuals at commercial banks. At the same time, it has managed in recent times to add over one thousand new accounts on average a month in spite of its passive or absent marketing efforts. It has appropriately remained a depository institution although a 1985 decree enables CEM to make loans. Although it has substantial potential to filrther develop deposits, the postal savings system is constrained by the requirement to place its funds with the Treasury which offers a belo. v-market interest rate. 12. The Government needs to make a policy decision enabling CEM to operate as an autonomous entity capable of independently pricing its deposits and placing its resources and engaging in more active marketing policies. A new charter for this institution should be drafted, paving the way for its transformation to a full-fledged banking institution in the long term. At the same time, it is crucial that an institution development program be implemented with external assistance initially emphasizing basic management and marketing skills. Once solidly established  6 as a successful and self-sustaining depository institution, credit skills can also be developed and relationships with emerging commlunally and professionally-based savings associations could then be extended into lending activities. As part of a comprehensive review of postal financial services discussed below (para 27), the Government could also consider merging CEM with the postal checking system (Compte des Cheques Postaux or CCP) alongside a decision to operate CCP as a girobank as part of a revamped payments system. T,is merger could provide considerable economies of scope and help ensure that the new entity is self-sustaning. 13. A third set of measures would be aimed at increasing financial savings through long-term contracts offered by insurance plans and social security. Such contractual savings account for three-quarters of all term savings in Madagascar and about one-quarter of all resources placed in bank and non-bank financial institutions outside of the Central Bank. The Government should immediately undertake a comprehensive review of taxation policies and foreign exchange controls which affect the volume of contractual savings activity. Tflhis should be coordinated with a broader study of taxation of all kinds of financial products. In 1991, the Government initiated a review of the strcture and regulatory framework of the insurance industry with a view to enhancing competition in this segment of the financial system which is dominated by two wholly state-owned insurance companies. This effort should be complemented by an organizational and financial audit of the social security fund (CNAPS) with a view to increasing the internal efficiency of this institution. This audit should include an actuarial evaluation and a revaluation of the assets of CNAPS. At the same time, a dialogue should be initiated between the Government and its social partners on the future of social security and associated contractual savings. An increased private sector role in the management of CNAPS should be envisaged. As soon as the various studies are completed, fiurter policies and institution-building efforts could be considered. These should aim at making contractual savings institutions a more important source of financial savings as well as more dynamic institutional investors within the financial system. Incressins the effldenc of Investment 14. The efficiency of overall investment depends on the quality of individual investments made by governent, enterprises and households. The increasing market-orientation of the economy should lead to an increased level of private investment and an increase in its share of aggregate investment relative to the public sector. With increasing private investment, the financial system will become involved in voluntaritly financing a larger share of investment. The financial sector will aftict the efficiency of investment only to the extent that it is a mechanism for selecting individual investments into which available resources are channeled. Private investment can be financed through the financial system in two main ways. The most important for the foreseeable future is through financial intermediaries such as banks. Financial intermediaries will be the most important channel for a while as savers still have a preference for placing their financial savings in relatively safe and liquid instruments such as bank deposits rather than lending directly to enterprises. At a much later stage, private enterprises can seek to directly finance themselves in domestic financial markets once these become well developed and widely accepted in Madagascar. IS. I Government policies can help ensure that the financial system supports private initiative and promotes high-yielding productive investment. At a fundamental macroeconomic level, government should ensure that resources for investment are not unduly pre-empted from the private sector. This is why the underlying problems of public finance which are manifested  7 by central bank losses need to be addressed as was discussed above (paras 6 to 8). Two other sets of policies are summaized below through which the government can facilitate efficient investment. First, govermnent can foster effective competition among financial institutions which in turn disciplines the judgment they bring to lending decisions on which their profits and survival depend. Second, government can facilitate the emergence of financial markets which help price financial resources and help savers and financial intermediaries better judge and balance risks and returns of investment. 16. A major step towards increasing competition among financial institutions has been the introduction of private capital into the banking sector which previously consisted of three wholly state-owned banks. Private capital has been introduced through the establishment of a new private bank in 1989 and partial privatization of two of three state-owned banks in 1991. This wUi reduce the risks of 'connected lending" which leads to lax credit appraisal and poor enforcement of debt obligations. These risks were manifested prior to recent reforms in Madagascar when banks were wholly state-owned and had clients who were largely enterprises which were also state-owned. While the impact of privatization on the quality of financial Intermediation cannot yet be fully evaluated, it can be expected that the costs of intermediation will decrease and the quality of investments financed by banks will improve. There remains scope for further privatization of the banking system, notably BTM, the largest bank in Madagascar. The Government also has the possibility of using divestiture of its remaining shareholdings in the financial system as a means of catalyzing capital markets development as is further discussed below (para 22). 17. Encouraging the emergence of well functioning financial markets will involve policy challenges for the government. The government's consciousness of the importance of financial market development is reflected in its decision to gradually shift from direct to indirect instuments of monetary control. Since November 1990, a number of important changes were made in this direction. Banks are now permitted to engage in interbank transactions on freely otiated terms. The BCRM has replaced its former refinance system with a system of auctions hat gives it more immediate control of reserve money. Instead of rediscounting eligible paper from banks as under the former system, BCRM injects or withdraws liquidity from the banklng system based on its liquidity projections and monetary stance during its refinance auctions. The weighted average yield of accepted bids during the auction provides a reference rate within the money market. To stabilize market interest rates, the BCRM establishes minimum and maximum rates for the bids from banks for either injections or withdrawals of liquidity. 18. Interest rate flexibility is crucial to the move from direct to indirect monetary control. It is important for BCRM to now allow a widening of the interest rate spread between the minimum and maximum rates it uses in its refinance auctions. As a complement to indirect means of monetary control, BCRM has also adopted a new system of required bank reserves which had formerly bee used as a tool of selective credit. While changes in the required reserves ratio should be used sparingly as a monetary tool, BCRM can further modify the present system to improve its ability to predict the behavior of banks in management of their central bank reserves. BCRM should begin collecting balance sheet data from banks on a bimonthly or weeldy basis. This will set the stage later for calculating required reserves on a bimonty or weekly end- of-period deposit base rather than end-of-period monthly base as is currently done. Furthermore, BCRM should aim to use a new kind of collateral from banls for its refinance auctions which could promote financial market development. Currently, BCRM accepts promissory notes or bills drawn on enterprises. Alternative collateral mechanisms to be encouraged are government securides or bankers' acceptances. This move would also allow BCRM to cease appraising the  notes issued by individual enterprises. This activity is strictly a commercial banking rather than a central bank function. 19. Promoting the use of government securities to stimulate financial market development requires the government to shift away from its captive sources of finance within the financial system. The major s3ource of domestic financing is borrowing from the central bank as discussed above (para 6). A strict limit on the volume of government borrowing from the central bank should be observed. These advances should only be used to finance cyclical cash flow fluctuations of the Treasury. By limiting the flexible access the Treasury currently has to central bank advances, the Treasury will have a stronger incentive to develop accurate forecasts of its cash flows. This in turn would help BCRM improve the liquidity forecasts on which it bases its refinance auctions. The government should increasingly meet its domestic financing requirements through issuance of securities whose volume is presently equivalent to less than one per cent that of central bank advances to the Treasury. Government financing needs in turn should be carefully managed as the outcome of efficient and well executed public revenue mobilization and expenditure programs. 20. Once a fundamental policy decision is made to restrict government borrowing from BCRM and to rely more on issuance of securities, a more active approach to government debt management can be envisaged. This would entail closer coordination between Treasury and BCRM which can both develop teams of professionals to manage issuance of government securities. A key goal should be the development of an active secondary market in government securities. The government should make its securities negotiable, investigate how to make them more attractive to individual and institutional investors and review the agency arrangements of the Treasury with commercial banks to ensure that they contain adequate incentives. To save on administrative costs, Treasury bills could be issued at a straight discount with no coupon. Centralization and computerization of the present manual book-entry system could also be envisaged. A simple but important measure is to ensure that the results of each auction of government securities are announced immediately after every auction. 21. The development of financial markets in Madagascar should focus in the immediate term on the money market where instruments with a maturity of less than one year are issued and traded. Nonetheless, the groundwork for future capital markets can begin to be planned now and laid in coming years. As a basis for a decision to plan a future stock market, the Government could commission a feasibility study which would review the potential demand and supply of corporate securities and examine the motivations for individual and institutional investors to hold and trade such instruments in Madagascar. If such a study confirms the existence of reasonable prospects for building capital markets in the medium term, the initial target could be establishing an embryonic stock market. Trading in this market might occur on a weekly or monthly basis until trading volume increases sufficiently to warrant a more developed market. This undertaking should be seen from the start as a collaborative venture between the government and private sector. As a first step, a joint committee including representatives from banks, insurance companies, venture capital firms, and various employers, business and professional associations, should be created to help plan the development of such a market. With the support of appropriate technical assistance, this committee should recommend measures for the purchase and sale of securities; outline an appropriate legal, regulatory and supervisory framework for these activities; and promote the concept of securities among savers, investors and businesses.  9 22. To support this effort, the government could make a policy decision to use a program of public offerings of its shareholdings in enterprises as a means of catalyzing the development of capital markets. Similar programs have worked well in many developing countries to broaden the base of shareholders and create or deepen domestic capital markets. Further divestiture of state shareholding in the financial system itself would constitute an appropriate part of such a program of public offerings together with some degree of divestiture in other activities - examples could include utilities, manufacturing and petroleum distribution. These enterprises could be prepared for broad-based share offering in conjunction with an appropriate nationwide campaign explaining the program and its advantages. inudng the costs and risks of financial transactions 23. Confidence in the financial system among savers and investors depends on the ability to protect financial contracts, to obtain reliable information on financial institutions and their borrowers, and to receive and transfer funds quickly and safely through the financial system. Holders of financial assets need confidence that they will get their money back with a reasonable probability according to the terms of the financial contract. Depositors and creditors need regular and reliable financial information on financial institutions and on borrowers respectively. To settle economic obligations and to transfer resources, payers and recipients of funds need to be assured that financial payments can be effected in a manner which is swift, reliable, accurate and widely accepted. In all these respects, the Government plays a special role in ensuring that the basic elements of financial infrastructure, namely the legal, accounting and payments systems in Madagascar, enable the financial system to transfer resources with minimal risk and cost from savers to borrowers and from debtors to creditors. Three sets of measures are recommended in the Report and summarized below which are aimed at reducing the costs and risks of financial transactions. The first is a detailed series of recommendations to improve both the framework of legal texts and their application to ensure that financial contracts can be reasonably protected. The second set of measures applies to improvements in the framework of accounting practices, auditing requirements and financial disclosure. The third is a strategy to help increase the speed, accuracy and reliability of domestic and international payments and transfers. 24. Although it is beyond the scope of financial sector development alone to envisage reforms in the framework and in the application of legal texts, no strategy of financial sector development in Madagascar will be meaningfil without such reforms. Immediate steps relevant to financial transactions could be taken in a number of areas including but not limited to the foilowing examples: fixing the legal rate of penalty interest with reference to market rates; expediting court decision for debt recovery by raising the minimum limit for court competence on claims without right to appeal; and easing of various procedures for enforcement and court seizure of goods in dispute. Recognition of property rights and improvements in land law are important areas for action over the medium term. Although the development of a complete national land registry is an expensive and long-term venture, a program to develop such a registry in key economic centers should be formulated. Other medium term measures crucial to financial sector development are the modernization of company law, improvements of procedures concerning bankruptcy and liquidation and creation of alternative procedures for prevention and setdement of financW disputes through arbitration and conciliation (see Chapter 3 of Volume Two for detailed suggestions). 25. Madagascar's new accounting plan introduced in 1987 has most of the elements necessary to enable its accounting practices and auditing standards to become harmonized with international norms. However, an urgent policy step is for the Government to issue the text  10 regulating entrance into the accountancy profession. Further delays of this measure, already under discussion for five years, would only reinforce the oligopolistic position of existing accounting firms who will be unable to meet the demand for auditors if the new accounting plan is to be fully implemented. It is also important for an entity to be established to act as a Registrar of Companies to register companies, keep records of financial md other returns and monitor compliance with a revamped company law. The sectoral code of accounts for banks, insurance, public works an d other activities have yet to be drawn up. The new accounting plan needs to be adapted for microenterprises and small and medium enterprises who need a simplified chart of accounts in which training should be facilitated through approved management centers. Just as all registered nonfinancial enterprises, all financial institutions including the new postal savings and checking entity (para 12), CNAPS and BCRM - should be required to publish audited annual accounts which should foster accountability to shareholders, depositors and borrowers as well as confidence in among the general public in financial institutions. 26. The development of a more efficient domestic payments system requires collaboration between the Government and the financial institutions which are the essential operators of the payments system. Within the new economic envirooment characterized by the advent of private banking for the first time in fifteen years, government should envisage collaboration with an independent professional banking association in which government is not directly involved. To facilitate this, government should therefore sever all its organizational ties to the Association Professionelle des Banques (APB) which are vestiges of the former wholly state-owned banking system. This would ensure that the new professional banking association henceforth becomes responsible for its own rules in areas of common interest to all banks including the payments system. Government could then play a catalytic role in developing a new payments system by ensuring that a study is undertaken to formulate a new domestic payments system. Among other issues, this study could more fully explore a proposal discussed in the main Report for an information-based system to replace eventually the present document-based system. Ihe proposed new system envisages inidally a network of clearinghouse operations that is decentralized regionally and which would use a new system of personal and corporate check with nhanced features to reduce fraud. Government should initiate any legal changes required in the payments system and payments instuments that become apparent from the study. BCRM could facilitate the new payments system by introducing any necessary changes in clearinghouse practices. Govermnent should also ensure cooperadon from other government departments, notably the telecommunications authority which could be consulted on alternative modes of data transmission to facilitate clearance and setdement of payment obligations. 27. Another improvement within the domestic payments system which government could promote is the upgrading of the existing postal checking system (CCP) into a full-fledged girobank as has occurred in several countries. The girobank could be merged with the existing postal savings institution if this is deemed appropriate following a comprehensive study of the future role of these institutions (para 12). This new entity could reduce the costs and burdens of effecting transfers and payments solely through the check-based system oparating through clearinghouses described above. It would do so by receiving and transferring payments of a regular periodic nature through a standardized process. A government decision to channel, for example, payments of civil service salaries, taxes, and utility bills through this entity would catalyze its use by private individuals and enterprises for their own regular payments. The new entity could thereby be self-sustaining, financing itself through the float between its receipt of funds and their transfer to the final recipients. Once it decides in principle to support such an instittion, the Government could commission an in-depth study to specify the operational details which would make such an institution feasible in Madagascar and to outline an implementation  11 strategy for its establishment. Tbis should be coordinate with the proposed study on the reorganization of the postal savings institution in order to identify whether a merger of these two entities is appropriate and what future relationship they should have with the Post Office. Inglenenting policies for financdal sector develoment 28. Implementing the three-pronged financial strategy outlined above entails a multifaceted and complex process. A variety of near-term policy decisions would be necessary which would also lead to institution building efforts extending over the medium term. Ihe strategy would also entail interaction of many policies and would require close ongoing collaboration between Government and a broad range of private insdtutions. There are two basic prerequisites to enable such a strategy to be effectively implemented. R should first be thoroughly discussed and well understood at various levels of government. Second, a coherent and coordinated approach to this strategy should be led by an economic management team at the highest level of the executive arm of the Government. This team should have the authority to ensure that all necessary public policy actions for financial sector development can be authorized and appropriately coordinated. A basic framework for structuring the phasing of various elements of this strategy is indicated below. It contains all of the policy decisions and institudon building measures discussed above. The actual phasing r-,d speed of implementation of this strategy would depend, among other things, on how quicldy the private sector responds to various initiatives within the overall strategy. 29. Taking into account various macroeconomic and sectoral reforms that have already been realized and other ongoing actions, it appears that a number of important public policies or actions could be finalized immediately or should be completed in the near future (ndicatively, within six to twelve months), including the following: - specification of a new code of accounts for banks for purposes of prudential supervision; - creation of a new and independent professional banking association; - privatization of BTM, the only remaining wholly sta-owned bank; - defining and adopting entrance reqwrements to the accountancy profession; - elimination of all prior authorization requirements of commercial bank credit; - identification of modalities for Government to compensate BCRM accumulated losses and to avert future losses; implementation of these measures; - monitoring by BCRM of commercial bank balance sheets on a bimonthly or weekly basis to enable the stage to be set later for enforcing required reserves on a bimonthly or weeldy end-of- period deposit base;  12 adoption of a number of previously mentioned expedients and improvements to legal procedures and texts; making government securities negotiable; initiation of a market study to determine the potential scope and depth of a market for corporate equities; and creation of a joint committee with financial institutions to help prepare development of a future capital market. 30. At the same time, a second set of policy actions will require further study but could be completed in the near term (within twelve to twenty four months, depending on the complexity of each action): - completion of a strategic development plan for BCRM; - formulation of a framework of risk-weighted capital adequacy ratios for banks; - elimination of bills drawn on enterprises as collateral for BCRM refinancing except first-class private paper for short-term interventions ("pensions'); - regular publication of BCRM annual accounts; - formulation of a domestic payments system strategy; - completion of a diagnostic study of the Social Security Fund (CNAPS) including a financial and organizational audit; - drafting of new statutes and a corporate strategy for the postal savings and checking system; - selection of appropriate government shareholdings to be divested through public offering; - drafting of proposals for the legal and regulatory framework for issuance and trading of securities; and - preparation of prospectuses and other measures for public offering of the relevant targeted public enterprises. 31. Resulting from the above mentioned first two phases, a number of actions could be completed over the medium term (two to five years depending on specific objectives). They include: - operation of an active government securities market as the primary vehicle for Treasury financing;  13 broadening of money market to include an enlarged group of actors including new commercial banks and insdtutional investors; public offerings of a selected number of public enterprises with adequate incentives to encourage secondary market trading; and - autonomous operation of the Social Security Fund with private sector participation and as an active and accountable insdtutional investor in the financial system with regularly published and audited accounts. 32. At the same time, the medium term horizon would cover progress of various institution building measures of the program which should include the following: - overall strengthening of BCRM to include creation and operation of a number of full-fledged specialized units or departments including for bank supervision; policy and research; and international operations such as external asset-liability management; - regular on-site inspections by BCRM of all commercial banks; - beginnings of open-market operations for monetary management; - operation of a financially autonomous postal savings and checking institution which could also function as a credit institution; - establishment of a revamped legal and judiciary apparatus for financial transactions including the beginnings of a modern land registry in key economic centers; - functioning of a partially or wholly information-based domestic payments and transfer system, possibly including a girobank; and - operation of an embryonic capital market. 33. The phasing of this proposed public policy program is indicative since the actual time horizon of each phase would vary depending on the time frames of individual actions or policies involved. The sequencing of these measures is summarized in the attached Table 2 (near- term measures) and Table 3 (medium and long-term measures) reproduced from Chapter 8 of the main Report. As a whole, the program is ambitious in many respects. Yet, it is not an unrealistic one given the potential of Madagascar's economy. The experience of other developing countries suggests that Madagascar's unique set of physical and human resources afford it excellent prospects for developing over time among the most dynamic financial systems in the Africa and Indian Ocean region. This would be concomitant with the emergence of a well diversified and export-oriented economy. For this potential to begin to materialize during the 1990s, a combination of strong government commitment and adequate technical and material support wil be needed to execute a program of financial policies in a thoughtful, consistent and systematic way.  14 Table 2: Near-term finandal nolIc Measur. POLICY AREAS KEY ACTIONS PREREQUISITE OR l _______________ _________________ PARALLEL ACrIONS 1. Rqgulation & Adaptation of PC 1987 to Identification of manpower supervision baning sector and logistics plan to strengthen bank supervision as part of Development of risk-bused BCRM rategic development capital adeuy ratio0 ps Update of pruential liquidity Finalization of motrance guidelines equirem ts to accountancy profeaion 2. Central Bank statutes Development of new BCRM Coordination with statutes including lengthened development of BCRM tenure for Board members and strategic plan BCRM mandate in formulation as well as execution of monetary policy. 3. Central Bank-Treury Identification of steps for Implementation of new market financial redations complete remval of BCRM rates for BCRM lending to claims on Tresry on and deposits from Treasury; revaluation and ccumulated coordination with review of losses accounts government securities market 4. Central Bank Strtegic Comprehnsive review of Coordination with review of Development Plan BCRM organiational BCRM statutes and structure, systems, methods, articulation of existing and manpower and logistics futre goals of BCRM S. Monetary Pbolicy Collection of key commercial Strengthened information bank data on a bimonthly or systems for monitoring bank weekdy basis and managing public debts Elimination of all prior audthoriation for bank credits Discontinue use of private Flexibility in interest rate collateal in refinance spread (-fourchette) in opeations money market auctions 6. Government securities Maret uvey for government Formulation of pln for scurities; review of agency institutional stegteing of arangements of Treasury with debt management capacity of banks; negotiability of Treaury and coordination Treasury securities with BCRM  15 Table 2 (onxtinued Near-term nol_ messurm POLICY AREAS KEY ACTIONS PREREQUISTE OR I _______________ ________________ PARALLEL ACTIONS 7. Banking system Encourge banks to edablish Disolve existing Asociation now and indqep ent Profeoionlle des Banques profossionl banking (APB) association Examine fesibility of Measres to privltize BTM including remaining Govenment deholdings in bak in future program of capital muaket public offerin 8. Payments system Develop new system of check Establihmt of new design and verificaion; begin professional baning identification of new association; coordinaton with clearinghouse opertion naional teomcations system; begin feability study development plan for a giro-based payments i _ _ _ _ _ _ _ _ _ _ _ _ _ _ .system 9. Postal savings Begm study of new corporate Promotion of small-scale charter and plan for savings goups and autonomous posta savings associations istitution 10.Capital markets Establish joint commission to Egement of a development study capital maets technical assistanc to assist development including all key commission in identification of financial and professional regulatory and operating institutions framework and traiing programs for capitd market Preliminary study to assess development nature and scope of investor domand for securities U. Privatization of public Identification of a selected Formation of capitd markets enterprises number of public enteris as development commission candidates for future public offerings to catalyze capital maWket development  16 Table 3: Medigm- and long-tem fnancial measui POLICY AREAS KEY ACTIONS FPREREQUISiTE OR PARALLEL ACTIONS 1. Establishment of Adoption of new chae for Enforcomt of staltitory independent and BCRM limits on Treaury borowing accountable monetary ftom BCRM authority Setlement of all previous BCRM claims on Government Adequate functioning of on revaluaton and accumulated govx.mn ent securities market losses accounts incl;;kjg secondary market trading Regular publication of BCRM annual report including annual accounts 2. Institutional To include strengthened or new Completion of diagnosis and stengtheing of BCRM research, supervision and implementation of new |intenational operations units or systems and methods for departments within BCRM accounting, foreasting, and statistical reporing within BCRM Ongoing technical assistance for manpower development in all. key aresn of monetary ___________ __________ __________m anagem ent 3. Monetuay Policy Begings of open madret Creation of active pnmary and operations seonday govermment debt market Required reserves on a weeldy Improvement in domestic or bimonthly end-of-period payments system base 4. Government debt Regular issues of negotiable Reinforcement of agency management Treasury securities for private arrangements with all and institutional subscription goverment security agents Improved coordination of Active ongoing a _ t of government cash flow forecast investment portfolio needs of with liquidity management of major institutional investors BCRM (contractual savings, postal savings, girobank, commercial Maintenance of computerizd bans) govenmuent debt records and publication of al necessary Creation of a professional market information on government debt management Treasury issues team in Treasury  17 Table 3 (continued) Mediun- and long-tern finandal nolidi. POLICY AREAS KEY ACTIONS PREREQUSTE OR PARALLEL ACTIONS S. Revitdized postal savings Operation of postal savings as Autonomy of both existing and chedWdg systm an indpedt and posibly CEM and CCP from credit entity Treasy; revision of sta and transformation of both Financial extension services to entties into autonomous small scale and mutualist bodies savings gups Coordination with overal Paralll operation of postal rstcuring of PlT chocidng as a girobank to complement system of Conclusion of new awency and payments through bank checks coopetion agrements with and clearnghouse operations Post Office Operation of an appropriate techmcal assistance program for posal savins training, murketing and finacia extension sevices For girobmnk, existence of an adequately liquid govemment scurity madcet for placement ________________________ of funds 6. Sodal Secrity Fund Opeation of an autonomous Completion of finacial and and accountable Social Security organizationd audit of entity CNAPS. Completion of review of all regulatory statutes of contractual savings institutions and appropriate changes as necessary Review of taxation and exchange control regimes affecting contal savings institutions  18 Table 3 (continued) Medhn- and log-LteM fian alildas POLICY AREAS KEY ACTIONS PREREQUISITE OR PARl .I ACTIONS 7. Payments systun Movemet toward an Ooeho of W check informaon-basd cleaing and systm with enhanced desip sottlemet system to replace and safety ftuo document-based syaem Pilot tetng of a dcenalizd regional cleaing sytem Coordinaton of information- based clearing with developmet of tlecommimicatios network ad alterative modes of data ________tras_son 8. Capital markets Public offerings of seected Ptparation and devdopment public enterpises implemtation of reutory framwork for seurities Functioning of embryonic tranctions capital markets (less than daily tading) Completion of evaluation and prospets of public ..entepdrss for saia to public Media campaign to explain and promote capital MAt offeris Campletion of initial taining progam for securities .______________________________ ___________________________ _ nprofessionals  19 LS O LM RCMMENDAION 1. Listed below are some of the main recommendations discussed in the main repert (Volume Two) which can be regarded as near or medium term priorities for financial sector development in Madagascar. This list i8, however, not complete. A number of other recommendations as well as all supporting analysis are found in the individual chapters of the main report. BCRM lossg 2. The stock of accumulated BCRM losses which are represented by claims on the Government should be remunerated. One way of achieving this is for the government to issue to BCRM bonds bearing an adequate interest which would s'ibstitute for these claims. These bonds could also be perpetual bonds (without a maturity date). Alternatively, in the context of a comprehensive resolution to the problem of BCRM losses, the Government could consult and persuade Madagascar's donors to give up their lien on the sizeable counterpart funds held by the Treasury in the BCRM in order that these be used to write off accumulated BCRM operating losses. 3. The flow of new operating losses of BCRM should be stemmed. All BCRM operations, arrangements and accounting practices that can be identified as contributing to these losses should be amended. The accounting system should enable cash and accrued losses to be clearly distinguished. Valuation losses on account of the foreign liabilities the BCRM has assumed from the Government should be covered by debiting the government's advance account. .klnSb policy 4. To develop greater flexibility in interest rates, the BCRM should now consider widening the interest rate spread ("fourchette") used in its refinancing auctions (mappel d'offres"). 5. To encourage banks to use refinancing auctions more than short-term BCRM facilities ('pensions"), uniformly defined utilization limits per bank should be considered. Such limits could be defined as a percentage of capital plus reserves, which would have the side benefit of stimulating banks to build a proper capital base. 6. In the case of dealing with a bank that becomes chronically illiquid, the BCRM should adopt a policy of meeting the problems of such a bank outside the system of refinancing auctions. A special medium-term credit line for the bank concerned could be developed while terminating the bank's access to ordinary facilities. By the time the necessary restructuring is completed, the refinancing should be repaid and any remainder written off. 7. The BCRM should aim to replace as commercial bank collateral for refinancing the promissory notes or bills drawn on enterprises that are presenty used. The alternatives to this collateral could be either government secudties or bankers' acceptances. First-class private papers could continue to be used for some time if limited to short-term interventions ("pensions"). 8. To set the stage for eventually implementing a required reserves policy calculated on an averaging of bimonthly or weeldy end-of-period deposit base, BCRM should begin  20 monitoring certain key elements of the balance sheets of commercial banks on a bimonthly or weeldy basis. 9. To encourage the Treasury to produce more accurate cash flow projections, thereby facilitating liquidity forecasts by BCRM, a statutory limit on BCRM advances to the Treasury should be strictly enforced and respected. Once a well-functioning government securities market is developed, such BCRM financing to the Treasury should only be used for covering cyclical variations in government cash flows. 10. To ensure that commercial banks are well aware of the link between bank-specific credit ceilings and deposit motiiization, BCRM should consider issuing a specific circular describing the procedure for computing these ceilings. 11. Given that information on the banking system and monetary aggregates is subject to serious delays, the BCRM should consider selecting an operating variable for monetary policy from its own balance sheet, for instance, net domestic assets of the central bank or reserve money. BCRM statutes and management 12. The commission currently reviewing the 1973 statutes of the Central Bank (as amended in 1983) should consider amending Article 30 by assigning to BCRM not only the responsibility for implementation but also for formulation of monetary policy. Consultation with government could be prescribed. Where there is clear disagreement with the Government, arbitration procedures could be prescribed allowing for the Government and Central bank to present their case to the National Assembly. 13. To ensure adequate independence of the BCRM, the relevant provisions of the statutes (Sections I, 1I, and IIl) should be reviewed to lengthen the term of the Governor and specification of groundr for dismissal and to allow the Executive Board to nominate new members who would be appointed by the Government. Grounds for dismissal of the Governor and members of the BCRM Board should be clearly specified and essentially be limited to moral turpitude or infirmity. Such dismissals should ideally be effected by a procedure which limits arbitrariness by the executih branch such as the necessary consent of a majority of the legislative body. Moreover, to avoid any conflict of interest, all BCRM Board members and staff should be strictly forbidden from any role in the board or management of any financial institution or enterprise. BCRM itself should not be a shareholder in any financial institution or enterprise. 14. The BCRM should begin to develop a strategic development plan which would establish the main objectives of the BCRM, its organizational plan and its manpower and logistics development strategy. The plan should be based on a comprehensive review of existing organizational structure, systems, methods and main operating problems and issues observed as well as a forecast of future development needs. Such a plan could be formulated with external support through technical assistance. 15. In the interest of transparency and accountability, the BCRM should aim to resume publication of annual report including its balance sheet and profit and loss accounts.  21 Prudential sugrision and regulation 16. The adaptation of the 1987 general accounting plan to conunercial banks should be completed as soon as possible for the purposes of prudential regulation. 17. The BCRM should begin to develop a system of risk-weighted capital adequacy ratios in keeping with emerging worldwide practices. Lal framework for finandal transactions 18. To expedite court decisions and enhance the quality of justice dispensed for small claims, the Government should consider rasing limit on claims without right to appeal from FMG 125,000 to FMG 1 million with the same limits for actions to obtain injunctions for payments. 19. The legal rate for penalty interest against debtors where a specific rate is set should be adjusted with reference, for example, to one of the rates established by the new money market. 20. The requirement on an order authorizing attachment when the prosecuting party is acting based on an enforceable tide is superfluous and should be removed. 21. Another superfluous requirement to be removed is for the creditor to hold an enforceable tile to submit a petition for authorization of attachment when the creditor's tide of interest is manifest and when it would be sufficient to allow the debtor to challenge the attachment if he has a plea or other grounds to challenge the debtor. 22. A department should be set up to act as Registrar Of Companies which would register companies, keep records of financial and other returns and also monitor compliance with a revamped company law. 23. In tandem with a review of land law, the Government should attempt over the medium term to develop a land registry, beginning with major economic centers, to authenticate titles to property. Framework for accounting, audit and finandal disdosure 24. The Government should issue the next text regulating entrance into the accountancy profession as soon as possible. 25. A simplified chart of accounts should be developed for small traders and artisans who cannot afford to employ professional accountants. Approved management centers should also be set up to facilitate bookkeeping for small and medium enterprises and training in accounting for their managers. Paments system 26. The first step in improving the domestic payments should be an improved system of personal and corporate undertaken primarily by a revitalized professional banking association with the collaboration of BCRM (see para 30 below). A new system of printing, verification,  22 honoring and monitoring of checks by bank should be adopted to enhance the safety and ease of use of checks (see Annex 3.2 in Volume Two for detailed sugestions). 27. A second s-ep which should be Jointly undertaken by BCRM and commercial banks is the identification, testing and eventual full-scale implementation of a information based clearance and setdement system for payments to replace the existing document-based system. Detailed suggestions for a decentralized regional clearing system are found in Annex 3.3 of Volume Two. 28. A third step towards improving the domestic payments system is to study the feasibility of a girobank facility being operated by a revamped postal savings institution (see para 37 below) which would revitalize and enhance the existing postal checking system. Detailed suggestions are presented in Annex 3.5 of Volume Two. 29. As a first measure to speed up external payments transactions and as a step towards an eventually deregulated currency market, the BCRM should consider giving banks the possibility to only buy or sell the net amount they need in foreign currency instead of having to buy and sell foreig curencies to and from the BCRM on a gross ansactions basis. Commrdal banking sym 30. A new professional banking association should be set up independent of the Government to replace the existing Association Professionelle des Banques. The new association should be free to set its own rules and should work in areas of common interest to all banks including banking ethics, education and training issues, promotion of standardization of checks and education campaigns to inculcate appropriate financial habits. 31. In pursuing the process of privatization of the banking system which began in the late 1980s, the Government should consider divestiture of its remaining shareholdings in banks as a possible part of a broader program of public offerings and capital market development. Contractul savings: Insurance and sodal security 32. To help develop contractual savings, the Government should review the taxation of life insurance premiums. Reducing the tax burdens of these financial products should be considered especially where these funds are held with the fiduciary agent for a given period of time or until the policyholder reaches retirement age, failing which a penalty could be assessed. 33. As part of a broad review of the investment guidelines for insurance companies, the Government should consider the scope for allowing insurance companies to invest in foreign currency assets to promote overall financial savings and to help reduce the costs of reinsurance. 34. A comprehensive organizational and financial audit of the Social Security Fund (CNAPS) should be undertaken to ensure the financial and managerial autonomy of CNAPS in the future, by eliminating legal ambiguities and clarifying the roles of the social partners in the organization. The audit should include an actuaial evaluation and a revaluation of the assets of CNAPS.  23 35. The legal character of mutual savings groups and associations should be clearly established and universally understood and recognized. 36. Monetary authorities should become closely involved in the regulatory and supervisory aspects of small-scale finance institutions. All existing and new grassroots-level savings associations should in principle be subject to the same prudential regulatory and supervisory criteria as other deposit-taking and lending institutions in the country. At the same time, in their initial stages and especially while their operations are solely limited to their members, these institutions could at least partially, if not wholly be exempt, by decree from the monetary authorities, from the full reporting and disclosure requirements of established institutions until they develop their capacity for producing regular and complete accounts. However, once these institutions mature to the point of becoming fWIl-fledged deposit-taking and credit institutions, and especially when these operations are opened to outside the membership of the group, these institutions should be subject to similar regulatory and prudential supervision standards applied to other financial institutions. Postal savings and checking system 37. Caisse d'Epargne de Madagascar should be given financial autonomy from the Treasury to enable it to play a major role in linking small-scale, informal and formal financial institutions and markets. As part of this exercise, a new corporate strategy should be drafted which should aim at making CEM a filly fledged banking institution in the long term. This should occur in the context of a broader transformation of the postal and telecommunications services (PFT) in the country which is being envisaged by the Government. 38. The cooperation arrangements with the Post Office should be reviewed and an adequate agreement signed between the parties stipulatng charges, fees and other services to be performed by the Post Office as an agency of CEM. In this respect, the close relation with the Post Office should be re-examined with a view of developing new and more efficient routines for handling of CEM transactions by the post offices. Furthermore, the possibility of CEM operating its own offices in areas where business volumes could warrant the costs should not be ruled out. The aim should be however for CEM transactions to be transacted in any post office throughout the country. Where feasible, CEM could construct offices of its own; alternatively, some existiAg or new post offices could be designed in such a way as to allow the two disdnct operations to work in the building. Arrangements such as separate entrances which have been undertaken, for example, by the Postal Savings Bank of Zimbabwe, could also be considered. 39. The Government should also consider the possibility of allowing the new postal savings system to operate the postal checking system as a girobank. nandal maket devloment 40. Immediate steps should be taken to revamp the Treasury biUl market. The Ministry of Finance should consult with financial institutions to investigate why there h such a pfor response among investors. The Government could also begin undertakig various measures which could help increase confidence and interest in Treasury biUs among investors. Pirst of all, all references to obligations to invest in Treasury bills should be removed from existing  24 legislation. To save on administrative costs and for transparency, these bills should be sold at a straight discount with no coupon. Ihese bills should become freely negotiable. The Treasury should attempt to sell large volumes of bills in maturities which suit investors liquidity preferences. The agency arrangement of the Treasury with commercial banks should be reviewed to ensure that they contain adequate incentives. Centralization and computerization of the present manual book-entry system should also be considered. 41. As a first step towards development of an embryonic capital market, a committee (an embryonic COBOTA- Commission Boursiere de Antananarivo) should be set up with the following main terms of reference: (i) to recommend measures to be taken to establish a mechanism for the purchase and sale of securities; (i) to promote the concept of securities trading among savers and investors (in Madagascar); (iii) to be responsible for the development of the legal, regulatory and supervisory framework and (iv) to oversee the development of a stock exchange over time. The main players in the capital market should be involved in the process from the beginning: (i) the Ministry of Finance; (ii) the Central Bank; (iii) the commercial banks; (iv) the insurance companies; venture capital firms; and (vii) various employers', business and professional associations. External technical assistance should be sought at an early stage to help guide the committee in its technical work. The committee should be responsible for elaborating the rules and regulations under which trading will take place. It should also have to ensure that enough Malagasy are trained abroad in both the institutional aspects of a stock exchange and in stockbroking activities so that by the time a stock exchange is officially launched there will be adequate trained personnel. 42. The above-menioned program should be coordinated with government attempts to develop the supply side of the capital market. The Government should adopt a program of public offerings of selected viable public enterprises to catalyze capital market development. Once a list of such enterprises is identified, the enterprises should be prepared for public offering within two to three years. During the preparation period, completion of valuation work for the enterprises, prospectus preparation and a public media campaign explaining the objectives of the program should be undertaken.  25 MADAGASCAR: FINANCIAL POLICIES FOR DIVERSIFIED GROWTH CHOICES AND PRIORITIES FOR A MARKET ECONOMY VOLUME TWO Table of Contents CHAPTER 1: FlINANCE IN THE CANGING MALAGASY ECONOMY - Objectives and Organization of the Report 1 - Eknomic Growth and Recnt Policy Developmets 2 - Extal t Developments, 19704990 S - Fubuwes Challenges in Resource Mobilizaon and Alocation 10 - Oveview of the Maagasy iancial S16 CHlAFFER 2: STRENGTHENING MONEWARY MANAGEMENT OF THE CBSTRAL - Goverment Financw Fiscal Deficit and Quasi-Fiscal Operations 25 - Monetary Developments and Sources of Money Creation 32 - Recwt Trends n M ary Magent 39 - The Future Role of BCRM 45 CHAPTER 3: REINFORCING THE INFRASTRUCTURE FOR FINANCIAL SYSTEM DEVELOPMENT - IAl Framework for Financial Transactions 49 - Accounting, Auditing and Fnancial Disdlsure 57 - The Domesic Paymets System 60 - he External Paymts System 65 CHAFFER 4: PROMOTING THE EFFICIENCY OF BANKING INSTITUTONS - Banking Developments Sin 1975 67 - Main Opating Features of the Banking Systen Since 1987 73 - Overall Banking Perfonmance Since 19 77 - Future Chalenges of the Banking System 80 CHAPTER 5: ISSUES IN TERM FINANCE: CONTRACTUAL SAVINGS AND HOUSING FINANIC13 87 - rx Malagasy Insurance Market 92 - Tbe Malagasy Social Security System 97 - Future of Contractual Savings in Madagasr 102 - Problems of Housing Finance 103  26 Table of Contents (Cont.) fgg CHAPTER 6: PROVIDING FINANCIAL SERVICES FR SMALL-SCALE ECQNMIC AGENTS - Nature of Small-Scale Finance 105 - Key Areas of Government Policy 108 - Revitalizing the Postal Saving System 112 - The Role of Venture Capital 117 CHAPTER 7: FINANCIAL INNOVATION F_OR TRADE EXPANSION. NVESTMENT PROMOTION AND EINANCIAL MARKU3 D - Developing International and Domestic Trade Finance 111 - Enhancing Regional Trade and Cross-Border Trade In Financdal Services 116 - Accelerating Domestic Investment Through Leasing 119 - Promoting Finandal Market Development 120 CHAPTER 8: TOWARDS A FINANCIAL SECTOR STRATEGY - Strengths and Weaknesses of the Malagasy Financial Sector 127 - The Agenda for Financial Sector Development 128 - Sequencing Policies for Financial Sector Development 131 - Complementary Policies for Financial Sector Development 141 Annexes 1.1 Survey of Financial Needs of Malagasy Enterprises 2.1 Direct versus Indirect Monetary Controls 2.2 Aspects of Central Bank Independence 3.1 Overview of the Domestic Payments System in Madagascar 3.2 Costs of Existing Delays in Payments and Transfer System 3.3 A Decentralized Regional Clearing System 3.4 Towards an Improved System of Checks in Madagascar 3.5 Concept and Functions of a Girobank System and Applicability to Madagascar 3.6 Overview of the External Payment System in Madagascar 4.1 The Cost of Intermediation 5.1 Contractual Savings in a Worldwide Perspective: Applications to Madagascar 6.1 Postal Savings Banks in Africa: Lessons for Madagascar 7.1 The Foreign Exchange Retention Scheme in Mauritius 7.2 Capital Market Development in Mauritius: Lessons and Pitfalls  27 List of Tables In the Text 1.1 Summary International accounts, 1981-1990 1.2 Financial Depth and Fincial Price Indicators, 1985-1988 Average 2.1 Ceoral Governent Budget Deficit and flnancing,1981-1990 2.2 Sources of Expansion of the Monetary Base, 198S1990 2.3 Quasi Fiscal deficit and Its financing, 1984-1988 2.4 Seignorage and lnflation Tax, 1981-1990 3.1 Solvency Ratio of the Malagasy Bankig System 4.1 Deterioration in the Quality of Commercial Bank Loan Portfolios, 1984-1986 4.2 Revaluations of Fixed Assets of Commercial Bank 4.3 Cleaning-Up of the Commercial Bank Loan portfolios 4.4 Effects of th Cleang-Up of the Loan Portfolios 4.5 Branch Network, Staff and Market shares of Malagasy Banks In 1990 4.6 Government Net Creditor Position with Banks, 1987-1990 4.7 Commercial banks: Ratio of Loans to deposits, 1987-1990 4.8 Commercial banks: Relative Increase in term Loans and Tim Deposits, 1987-1990 4.9 Commercial Banks: Sectoral Breakdown of Loans,1987-1990 4.10 Commercial banks: Aggregate Profit and Loss accounts, 1988-1989 4.11 Elements of the Costs of Intermediation 5.1 Comparative Share of Term Deposits in Total Bank Deposits 1987-1989 5.2 Life Insurance Premiums in Developing Countries, 1983 5.3 Life Insurance funds in industrial countries, 1986-1988 5.4 Malagasy insurance Sector: Financial Results, 1987-1989 5.5 Malagasy insurance Company Investments, 1987-1989 5:6 Social Pension Insurance Systems Contribution Rates S.7 CNAPS: Evoludon of Reserves, 1985-1988 5.8 Assets of Life Insurance Companies and Pension Funds, 1987 8.1 Near-term financial policies 8.2 Medium- and long-term financial policies fist ot F i in the Text 1.1 Madagascar: Inflation Rate 1980-1990 1.2 Madagascar: Merchandise Terms of Trade and Price Indices of Traditional Exports, 1985-1990 1.3 External debt by Type of Creditors, 1986,1989 1.4 Comparative Gross Domestic Investment Rates, 1984-1989 1.5 Comparative Gross Domestic Savings Rates, 1984-1989 1.6 Madagascar: Savings-Investment Gap, 1984-1989 1.7 Entrepreneurs' Ranking of the Main Constraints to growth 2.1 Fiscal Expenditure, Revenue and Deficit, 1984-1990 2.2 BCRM Advances to Treasurv and Statutorv Limits 2.3 Evolution of BCRM Balance Sheet 2.4 BCRM Annual Operating Losses, 198-1990 2.S Madagascar: Major Sources of Changes in Monetary Base, 1988-1990 2.6 Evoludon of Government Counterpart Fund Deposits with the Central Bank 4.1 Effects of Portfolio Clean-Up, 1986,1989 4.2 Sectoral Breakdown of Gross Loans, 1987-1990 4.3 Elements of the Costs of Intermediation, 1988-1989 5.1 Share of Term Deposits in Total Bank deposits, 1987-1989 S.2 Comparative share of Term Deposits in Total Bank deposits 5.3 Comparative Share of Term Lending in Total Bank Lending, 1987-1989 S.4 Relative Shares of Commercial Bank and Contacal Savings Insttons In Total Financial Resources S.S Contractal Savings Contribution to Commercial Bank Term Deposit 5.6 Breakdown of Insurance Premiums, 1987-1989 5.7 Iavestment of Insurance Industry Resources, 1987-1989  28 ltaIsticaI Apndlx A. 1 Comparison of the Level of Commercial Bank Assets Per Employee in Sub-Saharan African Countries in 1989 A.2 Aggregate Balance Sheets of Banks in Madagascar for the Years 1987-1990 A.3 Sectoral Breakdown of Gross Loans of Banks in Madagascar, 1989-1990 A.4 Aggregate Balance Sheets of Three Commercial Banks in Madagascar for the Years 1988-1990 A.5 Aggregate Profit and !oss Accounts of Three Commercial Banks in Madagascar for the Years 1988 and 1989 A.6 Costs of Intermediadon of Tree Commercial Banks in Madagascar, 1988-1989 A.7 Comparison of Operating Ratios of Commercial Banks in Selected Countries A.8 Madagascar: Selected Macroeconomic Data, 1985-1990 A.9 Madagascar: Selectend Public Finance Data, 1985-1990 A.10 Madagascar: Selected Monetary Data, 1985-1990