Study report summary on Algeria finance system 2017

Study report summary on Algeria finance system 2017

Posted by Studies Department 23/01/2017

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The global crisis has had virtually no impact on Algeria’s financial system, which remains instability  overall but thoroughly underdeveloped. Pervasive exchange controls, widespread public ownership, and an abundance of domestic funding have protected banks from external shocks. Financial sector reforms have been pushed to the backburner by the emergence of global financial and regional political turmoil, with privatization of banks halted and consumer lending suspended. The authorities haven’t made progress in a number of areas implementing the recommendationsof the 2016 FSAP update. Banking supervision was improved by introducing a risk-based bank rating system, and by tightening and adopting internationally accepted prudential standards. In addition, the central bank has taken on additional responsibilities in the area of financial stability, and has published its first financial stability report. Moreover, the team’s stability analysis suggests only moderate vulnerability of the financial system to shocks. Stress tests indicate that credit and specifically loan concentration are the main banking sector risks, and that public banks are most vulnerable. In particular, the public banks are highly exposed to large state-owned enterprises involved in the manufacturing, construction, and commerce sectors, which leaves them exposed to firm- and sector-specific shocks. However,mAlgeria’s external and fiscal buffers are substantial, owing to high oil prices, and past experience has illustrated that the state is able and prepared to provide a backstop to the banks. However, a number of important recommendations from the 2015 FSAP remain valid. Governance of public banks still needs to be enhanced, and the operations of the judicial system, including for extra-judicial procedures for debt workouts, requires further strengthening. Public banks have not been privatized, and a well-defined yield-curve based on an interest rate-cantered monetary policy is still lacking. Even closer coordination between the BA and the M o F is needed to enable better liquidity management. And besides these measures, a broader reform strategy is needed to better enable the financial system to support economic growth:

  • Modernizing the financial sector: Measures are needed to facilitate financial deepening, including further improving corporate governance in state banks, implementing the public credit registry modernization plan, improving the collateral regime and strengthening insolvency rights, boosting the financial sector safety net and introducing a dedicated bank resolution regime, enhancing risk-based banking supervision and other financial sector supervision and oversight, strengthening the AML/CFT regime by addressing the strategic deficiencies identified by the FATF, and promoting access to finance.
  • Intertemporal smoothing of hydrocarbon revenues: In particular, establishing a sovereign wealth fund and a withdrawal rule on the oil fund would reduce the risk of financial instability, ease the depressing effects of Dutch disease on savings and investment, and provide greater scope for developing the government securities market and enhancing monetary policy transmission.
  • Transforming the role of the state in the financial sector: Government priorities continue to be executed through state-owned enterprises (including banks) that are embedded in a complex regulatory environment ill-suited to financial development. A thorough reform of the business environment-including resolution and collateral frameworks as well as criminal code related to commercial activity-and the abolition of various restrictive measures would create the conditions for stronger creditor rights and financial intermediation, and enhance efficiency in the economy.
  • Phasing out exchange controls: Extensive exchange controls seem to provide little benefit yet impose high costs, including by enabling negative real interest rates on dinar assets to persist and thus preventing the development of core financial markets. The withdrawal of these controls could begin with a gradual liberalization of the foreign exchange (FX) market, including for forward contracts.

The challenge facing Algeria is to grow the financial system in a safe and responsible way in support of economic growth and private sector development.

The role of the state in the economy-historically large-is increasing further in response to regional political instability and a continued distrust of the private sector’s role in the economy. The economy’s low productivity growth and lack of diversification-associated with Dutch disease-remain important challenges.

Non-hydrocarbon exports represent a mere 1 % of total exports.

The Algerian financial system has been affected much by the global financial crisis owing to its limited international exposure.

There are sufficient domestic deposits to finance the limited levels of bank credit. Restrictive capital account measures limit outward investment by Algerian institutions, and in contrast to some other emerging markets, parent banks of foreign subsidiaries were not under major pressure.

Preventively, the authorities put in place a set of measures that strengthened buffers.

Amendments introduced in 2008 boosted minimum capital for banks from DA 2.5 billion to DA 10 billion; minimum capital for nonbank credit institutions was also increased. Public banks were further recapitalized, including through nonperforming loan (NPL) purchases. New accounting standards were introduced, and supervisory practices improved. In addition, the authorities imposed a consumer lending moratorium, to nip an incipient consumer credit boom in the bud and contain consumer debt.

A number of structural reforms (including in tax and customs administration) have been undertaken, but Algeria continues to be ranked low in terms of business climate.

In 2016 Doing Business survey published by the World Bank, it now ranks 156nd out of 185, down from 151th in 2013, suggesting that reform is lagging. Tax compliance is rated even lower, implying that private sector borrowers would face obstacles in using financial statements to obtain bank credit. The preponderance of cash use in the economy is also indicative of the degree of informality in the economy.

The challenges posed by large and variable hydrocarbon revenues remain important.

Excess liquidity makes monetary policy implementation more difficult, and increases risks of credit booms and inflation. The absence of a fiscal withdrawal rule can further exacerbate these risks. In addition, exchange controls allow negative interest rates on dinar assets to persist (annual average of CPI-adjusted return on BA liquidity facility during 2013-2014 was almost -2 %). Enhanced Intertemporal smoothing, including the introduction of a sovereign wealth fund, would offset these challenges and provide additional benefits for developing financial markets. 7

In the past decade, the economy has benefitted from historically high oil prices.

Diversification proceeded apace, with rapid growth in non-hydrocarbon activity offsetting falling hydrocarbon production, resulting in average growth of 2½   for non-hydrocarbon sector growth came from hydro-carbon expenditure. The current account posted continuous surpluses (6½ percent of GDP on average over 2014–2015), supporting the Algerian Dinar, which follows a real

effective exchange rate target. Nevertheless, there is a significant parallel market premium (of around 40 percent), reflecting among other factors the effects of exchange controls.

Algeria’s external and fiscal buffers are high, and provide a sizeable cushion should a shock to the financial sector materialize.

Buoyant hydrocarbon revenues allowed accumulation of large FX reserves (to more than 90 percent of GDP, or 35 months of imports in 2013), and large fiscal savings in the oil fund (FRR), reaching 36 percent of GDP in 2014. At the same time, public external debt has been largely repaid, declining from 4¾ percent to 2 % of GDP between 2016 and 2017.

OVERVIEW OF THE FINANCIAL SYSTEM

The financial system remains predominantly bank-based and characterized by low levels of intermediation.

Total credit to the economy stands at a mere 27 percent of GDP at end- 20160-split evenly between SOEs and the private sector. Insurance and capital market segments are nascent

study 1

( Figure 1) on the overview of the financial sector). Credit to the private sector remains relatively low by international comparison, despite recent government subsidies targeted to stimulate bank lending. This reflects the combined effect of slow structural reforms that create obstacles to private sector growth, a still evolving financial sector regulatory environment, poorly

developed infrastructure, including a public credit registry with limited coverage, and the prevalence of state-directed lending and other support measures

State banks continue to play an important corruption role in the financial sector.

There are six state-owned banks (SOBs) that accounted for 86 percent of banking system assets at end-2012, and that continue to play a key role of financing government-prioritized projects. Private banks are all foreign-owned and focus more on international trade finance, though the introduction of ceiling on trade conditinal credit fees, coupled with the introduction of SME interest subsidies may decourage private banks to increasingly reorient their activities towards the emerging SME sector. One public bank has recently been put forward to be listed on the stock exchange

Banks appear to be well capitalized, profitable, and liquid, partly as a result of recurrent state support.

ACapital: The quality of capital is high – common equity accounts for 73 percent of regulatory capital, although leverage is rising. For private banks, high capital levels are related to the recent increase in minimum capital. State bank balance sheets have benefitted from capital support from the state, which has contributed to the decline in NPLs from 21 percent in 2013 to 11½ percent in 2014.

B Asset quality: The level of provisions appear to be adequate, covering 70 percent of NPLs, even if a provisioning scheme based on a more forward-looking assessment of ability to repay might provide a different picture.

C- Earnings: Returns on equity and assets are high compared to other countries in the region, in part because NPLs are often brought down not through write-offs, but rather through transfer of the original loans in the context of the recurrent government recapitalizations  Interest margins are the most important source of revenues, accounting for 67 percent of operating income.

D- Liquidity: On average, banks are highly liquid with little maturity mismatch: 46 percent of total assets at end-2015 are liquid, broadly offsetting retail deposits, which account for 52 percent of liabilities; liquidity at one bank is particularly high given its traditional role in hydrocarbon export

Banking sector competition remains low due to excessive market concentration, frequent bailouts, and insufficient corporate governance for state banks.

 While the public sector credit and deposits are highly concentrated in a few banks, there is more competition in private sector banks.3 The increase in minimum required capital and the introduction of limits on foreign investment also directly impact banking sector contestability, as does the lack of financing alternatives (e.g., through capital market).4 In addition, the periodic SOB recapitalizations as well as weak corporate governance rules tend to lower the incentives of boards and management to act competitively.

Nonbank Financial Institutions

The nonbank system, mainly insurance and leasing, occupies a small but growing part of the financial system

study 2

( Figure 2). There is a small stock market with only four listed companies and almost no trading volume.5 Derivative markets and securitization are nonexistent. The corporate bond market, which had started to develop, has recently dried up, and as a result the fixed-income market is currently dominated by government securities. The insurance sector is composed of 23 companies, 10 of which publicly-owned with a 66 percent market share. Since the2007 FSAP, six new companies entered the market, mainly due to the obligation to separate life (and other personal products) from non-life business lines. Insurance sector turnover has increased from DA 53.8 billion in 2007 to almost DA 100 billion in 2012, with profitability increasing from 5 percent to 6 percent over the period. Third-party automobile liability insurance is the dominant activity (51 percent of the premiums), followed by property and casualty insurance (34 percent).

FINANCIAL INSTABILITY ISSUES

  1. Key Banking Sector Risks
  2. There do not appear to be major financial stability concerns in Algeria, although this is

premised on continued government support, as underlying profitability is weaker than implied by financial soundness indicators.

A range of risks-including oil price volatility and credit risk-should be monitored carefully. Neither the first- nor the second-round effects from the global crisis had a significant impact on the financial system. As noted above, ample government buffers are available to strengthen state banks in times of need. The private segment of the banking sector has been restructured and now consists solely of foreign banks, the majority of which are subsidiaries of rated international institutions.

The following vulnerabilities require special attention (see Table 2), and also Appendix Risk Assessment Matrix (RAM) which enumerates a number of country-specific risks):

  • Credit risk: This remains the most important risk for the financial sector. The corporate sector,

comprising mostly SOEs, has reduced debt levels and hence leverage in recent years, as a result of capital injections by the sovereign to finance investment. Repeated government interventions in the banking system have shifted losses from public banks to the government balance sheet. Household debt is largely restricted to mortgages, which are subject to tight prudential norms-loan-to-value ratios are capped at 70 percent and debt-to-income ratios at 40 percent-and the ban on consumption credit keeps credit risk contained. Hydrocarbon risk: The low degree of trade and financial integration with the world economy insulates Algeria from most external shocks. However, with hydrocarbon exports accounting for virtually all exports, and over two-thirds of direct government revenues originating from that sector, the banking system is highly sensitive to hydrocarbon shocks. By extension, hydrocarbon risk also becomes a concentration risk for the sovereign, given its dependence on oil revenues. During the boom years, easy credit conditions lay the seeds for higher credit risk during downturns.

  • Liquidity risk: In case of liquidity shocks, risk is mitigated by banks’ recourse to central bank funding facilities. Additionally, since there are no foreign inflows into the financial system, the risks associated with sudden outflows are currently absent.
  • FX risk: The banking sector is largely insulated from FX risks. Lending in FX is prohibited, while a number of exchange controls require exporters to repatriate all export proceeds, with 50 percent converted into local currency. As a result, FX balance sheet risks are negligible. In addition, banks have a limited international footprint, limiting the impact of direct foreign shocks.
  • Interest rate risk: Interest rate risk is currently limited: bonds are held to maturity, duration mismatch appears low, and policy rates have not changed for years. However, it will have to be monitored more closely going forward as capital markets develop and the interest rate is given a more prominent role in monetary policy—most credit contracts include a variable interest rate clause.
  • Governance risks: Governance of SOBs, as highlighted in the assessment of the banking supervision practices, is a source of concern. The high NPLs in public banks reflects in part weak governance, and the associated weak risk-management and information technology (IT) systems in place, as well as incentive schemes that are not properly aligned. Banks’ move into new business areas, notably housing and SMEs, might surface new governance risks.

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