“No minister or prime minister can cause the DPP to prosecute or discontinue a prosecution… No minister or prime minister can instruct the Commissioner of Police to arrest anyone. These offices, which are part of the Executive arm, have their independence explicitly protected in the Constitution as is the Judiciary and the Parliament…
“But that is not so with our Central Bank!”
The following is the text of a presentation made by Dr Terrence W Farrell to the Seminar for Professionals put on by the Lloyd Best Institute of the West Indies on 27 January 2016:
I suppose I should not have been surprised that many people would not understand the foreign exchange market and how it worked. But I was surprised!
On reflection and having spoken with a number of professional persons, I realised that some aspects of the matter are indeed complex and difficult to understand if you are not a professional economist, or a banker dealing in the foreign exchange market.
So my objective is to explain as best as I can what we had before April 1993—and what we have operated since April 1993—with a view to correcting what I think are erroneous views. Along the way I will also try to explain what the foreign exchange reserves are, what the balance of payments represents and the roles performed by a country’s exchange rate.
The Foreign Exchange Market
Most countries in the world have their own currencies—TT dollar, Pound Sterling, Europe’s Euro, Norwegian Krone, etc. For almost all countries, their local currencies are worthless outside their own borders, that is, people from other countries will not hold those currencies.
There are a few countries, however, whose currencies are quite willingly held by citizens of other countries around the world—notably the US dollar and, to a lesser extent, the Pound Sterling and the Euro.
The TT dollar is our local currency issued by the Central Bank of Trinidad and Tobago on behalf of the Government of Trinidad and Tobago. All other currencies are, therefore, foreign currencies. When we talk about ‘foreign exchange,’ though, we do NOT mean all foreign currencies. We mean only those foreign currencies that are useful to us to buy goods and services overseas or to buy assets or discharge liabilities overseas.
The Barbados dollar is a foreign currency for Trinis but it can’t be used to pay for goods and services in the USA or Canada. So foreign exchange really means those foreign currencies like the US dollar and the Euro or any other currency which can easily and quickly be converted into US dollars which everyone in the world is willing to accept.
If we buy goods from South Africa, we don’t have to get Rand; all we have to do is get the US dollar equivalent of the amount of Rand and the South African supplier will happily accept the US dollars.
One other important matter of terminology needs to be understood. When most people think of foreign or local currency, they seem to think about physical notes and coins—actual US dollar notes, quarters, dimes and nickels. But the vast majority of money, whether our local money or foreign money, is NOT in the form of notes and coins (cash) but in the form of a deposit in a bank or other financial institution.
Deposits have no physical existence. They are merely accounting entries in the accounts of depositors. It is a failure to appreciate this that led to some persons who have foreign currency deposits in local banks being upset when they were told they could not withdraw any part of their deposit in cash.
It is simply because the banks hold the deposit in foreign currency in a US bank but does not have US cash available in its tills. This is also true of local currency. If everyone went to a local bank and attempted to withdraw all his/her deposits in cash, the bank simply would not have enough cash available to meet the demand.
So how do we get US dollars to use to buy goods and services from anywhere in the world? We have to earn them—usually by exporting goods and services from Trinidad and Tobago, or from loans and grants from foreign agencies, or from remittances from Trinis living abroad.
Balance of Payments
So how do we know how much foreign exchange is earned, or borrowed or remitted and how much is spent on imported goods and services, or sent or invested abroad? To answer that, economists look at the balance of payments.
The Balance of Payments is a statement which seeks to account for a country’s transactions with the rest of the world. It has two sides—debits or outflows, and credits or inflows. It is further divided into a current account which shows transactions such as exports and imports of goods, exports and imports of services, and transfers.
Economists pay a lot of attention to the current account balance, because if the current account is in deficit (we are importing more than we are exporting), then that deficit has to be financed somehow.
The Balance of Payments always balances. So if the current account is in deficit, the Capital or Financial Account must be in surplus. The Capital or Financial Account records transactions such as foreign direct investment, inflows and outflows of short-term capital, as well as the change in the country’s Foreign Exchange Reserves.
Now in our economy, it is vitally important to understand that some elements of the Balance of Payments do NOT constitute cash flows, and some elements are recorded but the cash NEVER flows through the local banking system.
For example, if a foreign oil company sells oil to its parent company, no cash is passed between the entities. Similarly, if a foreign owned company makes profits and increases its retained earnings, the increase in retained earnings is recorded as foreign direct investment but there is no actual inflow of cash. In fact, the FDI of oil and gas companies is expended mostly on imports abroad, and little FDI actually flows as cash into the local banking system.
Other transactions must also be properly understood. Petrotrin imports crude oil, refines it and then exports much of it. The imports show up as a debit and the exports as a credit. But the real impact for the foreign exchange market is the net exports by Petrotrin.
Now there is another statement that records inflows and outflows of foreign exchange. It is published by the Central Bank and shows purchases of foreign exchange by the commercial banks from the public and sales of foreign exchange to the public by commercial banks, as well as sales of foreign exchange by the Central Bank to the commercial banks.
Graph in US$: Year; Foreign Currency Sales to Public; Foreign Currency Purchases from Public; Foreign Currency Purchases from Central Bank; Total Purchases
2011. (6,177,877) (4,781,951) (1,478,245) (6,260,196)
2012. (6,713,674) (4,859,051) (1,785,000) (6,644,051)
2013. (7,076,414) (5,802,227) (1,315,009) (7,117,236)
2014. (6,955,963) (5,525,195) (1,715,000) (7,240,195)
2015. (7,382,223) (4,941,243) (2,594,900) (7,536,143)
2016. (5,779,647) (4,288,993) (1,811,600) (6,100,593)
2017. (2,578,534) (1,721,734) (950,000) (2,671,734) [From Jan-June]
If we look at the Balance of Payments data and the Sales and Purchases of Foreign Exchange data, we see a big difference! The differences are due to: (1) non-cash flow transactions; (2) government transactions done directly through the Central Bank (debt service); and (3) cash flow transactions which actually take place offshore.
Before April 1993
The Exchange Control Act was passed in 1970. It superseded the Defence (Finance) Regulations which had been instituted during the Second World War. There was a fixed exchange rate regime; that is, the exchange rate was fixed and the Central Bank undertook to supply foreign exchange at that fixed rate and could do so by its control over demand.
Up to 1976, we were pegged to the pound sterling. After 1976, we pegged to the US dollar.
Prior to 1993, under the Exchange Control Act, we operated what was termed the ‘surrender requirement’. Unless you were an authorised dealer, owning and holding foreign exchange in any form (currency or bank deposits) was illegal. Citizens and residents were obligated under criminal penalty to surrender any foreign exchange they acquired to an authorised dealer designated by the Central Bank.
Acquisition of foreign exchange to purchase merchandise imports i.e. goods, was regulated by the Ministry responsible for trade through a licensing regime and the Negative List. Acquisition of foreign exchange for ‘invisibles’—dividend remittances, education, health care, insurance and reinsurance and so on—were controlled by the Central Bank through the EC-1 system.
You had to take an approved EC-1 form to the commercial bank which would then remit the funds abroad.
It is therefore important to understand that: (1) commercial banks could not sell foreign exchange without Central Bank approval via the EC system; and (2) the Central Bank necessarily had to have access to data and information on the names and the business of persons and companies wishing to buy foreign exchange.
Since Easter weekend in 1993, exchange controls have been completely abolished. There is no surrender requirement. Local firms earning foreign exchange may keep it here in local banks in foreign currency deposits or abroad if they wish, and convert as much of it to TT dollars as they need to.
Citizens who acquire foreign exchange by other means can do likewise, except that the remnant of the Exchange Control Act prohibits citizens and residents from selling forex directly to each other; they must sell to an authorised dealer.
Now the foreign companies which earn the foreign exchange from selling ‘our oil and gas’ are under no obligation to bring all their revenues back. They do not now and they never have. They bring back only what is required to pay local wages and salaries, local suppliers and, most importantly, to pay taxes to Government.
These companies and other exporters sell their foreign exchange to the commercial banks (authorised dealers), get the TT dollars and effect their local payments. Except that by an arrangement devised since the 1970s, the oil companies, instead of converting foreign exchange with the commercial banks and then paying taxes in TT dollars, pay their tax obligations in US dollars directly to the Central Bank, which then credits Government with TT dollars in its account at the Central Bank.
Apart from foreign loans and interest income, this is how the Central Bank gets most of its US dollars and what constitutes the majority of our foreign exchange reserves. To the best of my knowledge, this arrangement is not a legal obligation.
Legally, the companies are required to pay taxes in TT dollars. It is this crucial arrangement which makes our foreign exchange market different from those in, say, Barbados or Jamaica, and which allows our Central Bank to manage the market effectively.
In the post-1993 dispensation, the commercial banks do not require any approval from the Central Bank to sell foreign exchange and the Central Bank does not need to know the names and the amounts requested by persons and companies from their bankers. All it needs to manage the exchange rate is some indication of the excess demand for foreign exchange.
Change in Central Bank Reserves (USD Million)
It is the foreign exchange available to the Central Bank that allows it to control the foreign exchange market and dictate the exchange rate. Over the years, it has used allocations of foreign exchange combined with auctions of foreign exchange.
The queues for foreign exchange and the auctions are important in that they provide important information to the Central Bank on the excess demand pressures in the market and, therefore, how it should move the exchange rate.
Its principal objective is to maintain confidence in the system and avoid disruptive changes.
But the Central Bank also has to manage the exchange rate with an eye to the competitiveness of the economy. To do this, it has to monitor a variety of indicators of competitiveness, including the inflation differential between Trinidad and Tobago and its trading partners, the changes in the effective exchange rate, labour productivity (unit labour costs), and other measures where available; and make a judgment as to how the exchange rate should evolve over time.
Failure to do this effectively will tend to result in real exchange rate appreciation with consequences for economic growth and development over the medium and long run.
Independence of the Central Bank
Another issue which seems to have been misunderstood—even by the former governor himself—was the independence of the Central Bank. I had written on this 25 years ago in my book on Central Banking in Trinidad and Tobago as well as in several other articles.
The first point to appreciate is that, in our English tradition of central banking, the Central Bank is part of the executive arm of the State.
Now there are institutions that are part of the Executive that are indeed independent of the political directorate. The Office of the Director of Public Prosecutions is part of the Executive but the Constitution as well as case law spells out the independence of the DPP from the political directorate.
No minister or prime minister can cause the DPP to prosecute or discontinue a prosecution. The DPP is a judicial officer, is an officer of the court since he or she is an attorney, and is appointed by the Judicial and Legal Services Commission.
Similarly, the Commissioner of Police is independent of the political directorate. No minister or prime minister can instruct the Commissioner of Police to arrest anyone.
These offices, which are part of the Executive arm, have their independence explicitly protected in the Constitution as is the Judiciary and the Parliament. The Central Bank is nowhere in the Constitution!
In some countries, the Central Bank does not take guidance or instructions from the minister of finance. This is so in the United States of America and was indeed so with the German Bundesbank or its successor the European Central Bank. Article 130 of the EU Treaty states that:
“…neither the European Central Bank, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a Member State or from any other body. The Union institutions, bodies, offices or agencies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-making bodies of the European Central Bank or of the national central banks in the performance of their tasks.”
But that is not so with our Central Bank! Sections 49 and 50 of the Central Bank Act have been there from the outset. They read:
- 49. The Bank shall keep the Minister informed of the monetary and banking policy pursued or intended to be pursued by the Bank.
- 50. The Minister may, after consultation with the Governor, issue to the Bank such written directives of a general nature as may be necessary to give effect to the monetary and fiscal policies of the Government.
The words are clear and the meaning is pellucidly clear.
So what does ‘independence’ of the central bank in our context entail?
What it means firstly is that the Bank is functionally independent. It manages its own resources, hires its staff without reference to the Government or Service Commissions.
Like the Governor and Deputy Governors, the board is appointed by the Government. The Act actually says appointed by the President. That led some persons to believe that the Governor, Deputy Governors and directors are appointed by the President in his own discretion. But this is not so.
Section 80(1) of the Constitution states:
80. (1) In the exercise of his functions under this Constitution or any other law, the President shall act in accordance with the advice of the Cabinet or a Minister acting under the general authority of the Cabinet, except in cases where other provision is made by this Constitution or such other law, and, without prejudice to the generality of this exception, in cases where by this Constitution or such other law he is required to act: (a) in his discretion; (b) after consultation with any person or authority other than the Cabinet; or (c) in accordance with the advice of any person or authority other than the Cabinet.
It is the Cabinet which appoints the Governor, Deputy Governors and directors, usually on the advice of the Finance Minister.
Secondly, the Bank has a great deal of latitude in formulating and implementing monetary policy. It makes its own assessment of market conditions, forms a view as to what is required to maintain or restore monetary stability, and can take action on the instruments of monetary policy which are under its control—namely the reserve requirement and interest rates.
Some economists also describe this as ‘operational independence’ meaning the freedom of the Central Bank to select the instruments it uses to achieve its objectives. But Section 50 is there in the background.
It should be noted that the Section 50 directive is not implemented until the Minister has consulted the Governor. It clearly anticipates a difference of view which, after discussion, cannot be reconciled, prompting the Minister to issue the directive.
Thirdly, the Central Bank Act places limits on the ability of the Government to access financing from the Central Bank.
The Central Bank of Trinidad and Tobago is best described as being independent within the Executive, not independent of the Executive.
Should the Central Bank have a greater degree of independence along the lines of say the Federal Reserve or the European Central Bank?
That is a topic for another seminar.