ALGERIA'S FINANCIAL SECTOR EMERGING FROM THE DARK AGES

UNCLAS SECTION 01 OF 04 ALGIERS 001123

SIPDIS

SIPDIS
SENSITIVE

STATE PLEASE PASS USTR

E.O. 12958: N/A
TAGS: ECON EINV EFIN PGOV AG
SUBJECT: ALGERIA'S FINANCIAL SECTOR EMERGING FROM THE DARK AGES

REF: A. ALGIERS 00129


B. 06 ALGIERS 01519


1. (SBU) SUMMARY: Algeria has billions of dollars in excess
liquidity from hydrocarbon sales that its archaic banking system is
incapable of absorbing and using to fuel economic growth and reduce
unemployment. Unproductive state-run banks dominate the financial
landscape despite the arrival on the scene in recent years of some
foreign retail banks that, at least so far, have brought
conveniences to some customers but contributed little to long-term
growth. Other financial services, from insurance to capital
markets, are weak or non-existent. The Algerian government's
extreme risk aversion has so far prevented more dynamic reforms,
such as a floating exchange rate or the development of a robust
domestic debt market. Nonetheless, there have been important first
steps in reforming Algeria's financial sector, including legal
changes, the early stages of bank privatization, and technological
advances geared at improving the speed of financial transactions.
END SUMMARY.

STATE-OWNED BANKS DOMINATE
--------------


2. (SBU) Algeria maintains its roughly USD 90 billion of foreign
exchange reserves in U.S. Treasury bills and fixed income securities
rather than reinvesting its resources in its own growth. The
banking sector is dominated by seven state-run banks, which hold
over 90 percent of deposits in the system. A Financial Services
Volunteer Corps (FSVC) evaluation estimated that while many of these
banks have substantial holdings in high-yield government bonds, a
large number of their loans and assets are of doubtful
collectability, leaving the banks with little equity. Moreover, the
state-owned banks are characterized by a lack of oversight of the
corporate governance structure at all levels. In terms of retail
services, state banks have few checking accounts, even fewer credit
cards, and no debit cards. State-run banks are universally lacking
in technology; most transactions are done by paper. The Algerian
postal service also provides accounts to an estimated 9 million
people, making it the most diffuse banking network in the country,
although its services are limited essentially to passbook accounts.

PRIVATE BANKS WALLED OFF
--------------


3. (SBU) Private banks, which Algeria allowed into the market in the
1980s in the face of tumbling oil prices, now number nineteen but
remain walled off from much of the economy. They include one
American (Citibank),one Algerian, one British, seven French, and
nine Arab banks. Six Algerian banks and one private foreign bank
(Qatar's Al Rayan) closed in the last four years after Algeria
tightened bank capitalization requirements following the collapse of
the Khalifa Bank empire in 2003 (ref A). That scandal also prompted
the passing of a 2004 law under Prime Minister Ouyahia requiring all
state-run industries to domicile their deposits in state-owned
financial institutions. As a result, private banks are largely
confined to serving high-end commercial entities in the energy
sector and other high net worth clients.


4. (SBU) Foreign retail banks, primarily French subsidiaries of
giants such as Societe Generale and BNP Paribas, have rapidly
expanded their outlets in Algeria in the last two years. While this
recent influx of private foreign banks increased the number of
personal banking services such as ATMs to middle and high-income
households, the bulk of their financing goes to trade-based lending
rather than long-term, value-added investments. The network of
state-run banks also remains much broader than this new influx of
private commercial banks, whose branches still number under one
hundred and exist in only a handful of large cities. This lack of
outlets underscores the size of Algeria's cash-based informal
economy (estimated by the OECD in a 2007 report at 35 percent of
GDP),which largely circumvents the Algerian banking system.

LIMITED LENDING
--------------


5. (SBU) The overpowering role of state-run industries, as well as
the extreme risk aversion of public and private Algerian financial
institutions, limits lending in Algeria to three broad categories.
The first is high-end corporate finance for energy and
infrastructure projects or large-scale import-export services. Such
transactions are limited to trusted and established corporate

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clients. Second, state-run banks continue to provide large amounts
of credit to other state-owned enterprises, many of which are
running at a loss. The government-imposed monopoly granted to
government banks to service state-run industries, coupled with
antiquated risk-analysis methodologies, largely precludes unsecured
lending to individuals or small and medium enterprises that lack
government guarantees. Given the strong liquidity of state-run
lenders (thanks to Algeria's oil-driven forex reserves),these
institutions are often more inclined to earn income by sitting on
government bonds than to take the risk of lending. Finally but to a
lesser degree, some consumer credit is available to individuals for
automobile and, to a limited extent, mortgage lending. FSVC told us
that risk management and credit analysis techniques compliant with
Basel II methods are completely lacking in the state-run banks and
predominantly lacking in the Middle Eastern private banks. The
Western banks, by comparison, have better methodologies in place.

CENTRAL BANK: STRICTER ON MONETARY
POLICY THAN BANK SUPERVISION
--------------


6. (SBU) The Bank of Algeria (BoA),as central bank, retains a
tremendous amount of operational control over Algeria's extremely
rigid monetary policy. Algeria maintains a non-convertible dinar
fixed to the U.S. dollar. All inter-bank payments and foreign
exchange transactions must go through the BoA. The Monetary and
Credit Board, chaired by the BoA Governor, determines monetary
policy and has kept inflation the last several years below target,
around two percent. While the BoA's approach has been successful so
far in keeping down inflation, Department of Treasury advisors have
told us that the BoA's "irrational risk aversion" to capital flight
and fear of returning to the IMF-imposed structural adjustment days
of the 1980s have made policymakers resistant to adopting a more
flexible exchange rate policy that would better insulate Algeria
from future inflation and lower the country's import tab. (Since
fifty percent of Algerian consumer goods come from the Euro zone,
the dollar-pegged dinar has recently witnessed a severe decline in
purchasing power.)


7. (SBU) The BoA's monetary policy instruments are limited to
deposit auctions and changes in reserve requirements. According to
FSVC, the current money market (i.e. the inter-bank market and the
market for short-term government debt) is too underdeveloped to be
used in open market operations. Moreover, volumes, prices and
maturities of primary T-bill markets are largely decoupled from
actual budget figures and larger financial market realities. As a
result, one Treasury advisor assessed, Algeria has no effective
system for monitoring budget activity on a real-time basis, let
alone forecasting.


8. (SBU) The BoA's supervisory abilities of Algerian financial
institutions remain lacking. Treasury advisors assess that the
bank's legal and regulatory framework is hobbled by outdated
implementing regulations and a complicated supporting legal
infrastructure. The BoA lacks aggressiveness in providing
regulatory oversight and enforcement. Across the Algerian financial
community, including at the central bank, there is an absence of a
clear and internationally accepted accounting and auditing
standards. FSVC estimates that poor enforcement of regulatory
requirements by the BoA contributed in part to the magnitude of the
failure of two of Algeria's largest private banks, Khalifa and BCIA.


MODEST BANKING REFORMS TO DATE
--------------


9. (SBU) Banking reforms to date have been modest but noteworthy.
In 2003 Algeria passed the Law on Money and Credit, which Treasury
advisors assess is a solid foundation for strengthening the BoA's
regulatory framework. In 2006, Algeria instituted a real-time gross
settlement system (RTGS) that enabled banks to issue domestic
financial transfers for large amounts in real time. It also enabled
an e-clearing system for checks, reducing the amount of time for
checks to clear from weeks or months to just 48 hours. Algeria
introduced credit guarantee funds that as of July 2007 had earmarked
USD 75 million to over 200 small and medium-sized enterprises. In
October 2005 The GoA selected the French investment bank Rothschild
to help privatize the first of Algeria's public retail banks, Credit
Populaire d'Algerie (CPA). A Department of Treasury advisor told us
that such privatizations normally take 9-12 months to complete in
central and eastern Europe, but the GoA had not yet completed the

ALGIERS 00001123 003 OF 004


process because of certain transactions that the government did not
want potential bidders to review. However, one private banker with
knowledge of the CPA privatization process told us that although the
process was moving slowly, it was going forward in what he assessed
to be a fair and reasonable manner.

OTHER FINANCIAL SERVICES UNDERDEVELOPED
--------------


10. (SBU) Algeria's capital markets remain among the weakest link in
Algeria's financial sector. The Algiers stock exchange opened in
1999 with three stocks and since then has grown to five. The
exchange trades only one hour per week and its market capitalization
is about USD 140 million. Although government securities have been
dematerialized since 1995, delivery and settlement is still handled
manually. Thus far, both state-run and family-owned enterprises
have seen few advantages to the cost and fiscal openness required
for listing. Algerian law prohibits venture capital. Boutique
investment banking firms such as Strategica, which was acquired
earlier this year by Deutsche Bank, have made some headway in
brokering bond issues for large corporate clients such as Sonatrach
and Air Algerie. Nonetheless, the pool of liquid debt and equity
securities in Algeria remains very small. According to a 2007 OECD
report, Algeria's financial depth (the ratio of private-sector
credit to GDP) is just 12 percent, compared to 140 percent in China
and 100 percent in Korea and Thailand.


11. (SBU) Algeria's insurance market has been liberalized since 1995
but is similarly underdeveloped, with limited offerings for property
and life and no provision of medical or deposit insurance. The
insurance markets plays an insignificant role in the economy,
accounting for 0.5 percent of GDP, compared to 7.7 percent of the
U.S. market. Legislation passed by the Algerian parliament in 2006
aimed to increase the independence of insurance regulators and
tighten capital controls, but so far Algerian consumers have not yet
seen new insurance products or services.

CHALLENGES AND OPPORTUNITIES AHEAD
--------------


12. (SBU) Technical assistance implementers from FSVC and the
Department of Treasury have told us that while political will exists
in Algeria to conduct financial reforms, the challenge remains to
translate this resolve into action. Algerian intermediaries,
notably at the Bank of Algeria, have repeatedly voiced eagerness for
reform but incertitude about how to go about it. Such eagerness is
frequently tempered, however, by socialist-legacy bureaucracies and
an instinctive risk aversion to moving too quickly or relinquishing
control. As many officials at the central bank and elsewhere in the
Algerian community still view credit losses as a form of fraud
rather than a commercial reality, it is clear that many
international financial norms are still foreign concepts in
Algeria.


13. (SBU) USG technical assistance will remain an important tool in
transforming Algeria's financial sector into a needed engine of
growth for the country's fledgling non-hydrocarbon economy. To do
so, these implementers have recommended that Algeria maintain its
focus on the following areas:

-- Promotion of a Domestic Debt Market: Having paid off its
international debts for largely political reasons (ref B),Algeria
should resist the temptation to treat its oil reserves as a giant
nest egg and instead develop a domestic debt market to finance
public works projects. This would give an important boost to
Algeria's fledgling capital markets and give the government greater
control over monetary policy. In addition, establishing a link
between the issuance of government securities and the budget process
would encourage more responsible stewardship over government
resources.

-- Minimizing the Role of State-run Institutions: State-run
industries, many of which remain in the hands of Algeria's "pouvoir"
military elite and thus remain insulated from privatization,
continue to crowd out private investment. A first step would be
voiding the 2004 law requiring state-run businesses to domicile
their deposits in state-owned banks. As another important first, a
smooth privatization of CPA bank should lead the way for other bank
privatizations. This would in turn expand the range of financial
products to average consumers and contribute to the taming of
Algeria's informal economy.

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-- More Effective Monetary Policy: Algeria has more than ample
foreign exchange to float its currency but maintains the dollar peg
out of fear of capital flight and a return to the indebtedness of
the 1980s. To avoid inflation and crowding out of private
investment, Algeria should switch to a managed-float exchange rate.
The introduction of instruments such as Repo would facilitate the
use of open market operations by providing a powerful marketable
alternative to the non-marketable deposit auctions. Algeria should
also cease its monopoly control of inter-bank markets and foreign
exchange.

-- Enhanced Supervision and Efficiency: To encourage greater
confidence in the banking sector, continued technical assistance
should focus on improving the BoA's supervision capabilities and
automating bank processes. Algerian financial institutions beyond
the private Western banks, starting with the central bank, should
develop internationally recognized advanced risk management skills
and credit analysis techniques.

-- Continued Legal Reforms and Implementation: Treasury advisors
assess that the 2003 Law on Money and Credit was an important first
step but that a number of additional amendments are needed,
particularly to clarify the BoA's sometimes competing roles to
manage monetary policy and supervise Algerian financial
institutions. The Algerian parliament made important headway in
passing an insurance law in 2006. It now must be implemented as
part of a broader initiative to encourage a private insurance
market.

-- Developing New Institutions and Services: The establishment of
an effective re-mortgage agency would provide greater access to
Algerians in obtaining residential real estate loans.
Mortgage-backed securities would help ease Algeria's housing crisis
and create a pool of long-term productive investment instruments. A
more harmonized tax regime would enable Algeria to combat its
massive informal economy. As the Algerian financial sector evolves,
it should look to creating institutions such as an insurance
commission and a credit bureau.

-- Human Resource Development: This is perhaps the most critically
important effort of all. Efforts should continue towards making the
Algerian judiciary more familiar with commercial transactions to
help resolve commercial disputes efficiently. Developing human
resources at all levels of the financial community -- from central
bank examiners to retail bank employees and insurance actuaries --
would have resounding and multiplying effects.

DAUGHTON