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 ALGIERS 00001123 002 OF 004 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. ALGIERS 00001123 004 OF 004 -- 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