Scott Brown and Lorenzo Pérez<1> Introduction In recent years, the Cuban government has introduced a number of economic reforms, intended to improve economic performance and increase the scope for small-scale private sector activity. These appear to have been motivated in by the low rate of national investment, limited productivity growth, and poor performance of public enterprises, as well as the risks stemming from Cuba’s dependence on assistance from foreign governments. Cuba previously experienced a wrenching crisis in the early 1990’s, when it lost access to support from the former Union of Soviet Socialist Republics,Recent developments in global commodity markets and the political and economic outlook have led to doubts about the sustainability of current levels of external assistance from Venezuela. The resumption of diplomatic relations with the United States in July 2015 has raised the stakes, by holding out the possibility of reintegration of Cuba into the global financial system, along with potential access to wider trade relations and new, more market-based sources of external financing. This paper examines challenges that the Central Bank of Cuba is likely to face during the process of reintegration and reform. It begins with a brief overview of lessons from the reform process in former centrally-planned economies, and then summarizes the history of central banking in Cuba and the current structure of the financial system, including changes already introduced that will help in coping with the transition. It concludes by considering issues that the Central Bank of Cuba will need to address as the process unfolds, focusing in particular on the pace and sequencing of reforms, and some implications for exchange rate and monetary policy and development of the banking system. Experiences with Reintegration and Reform Cuba is in a position to benefit from over 25 years of experience with economic reform and reintegration by centrally-planned economies. Approaches to the transition can differ widely, depending for instance on national choices regarding the role of government in economic decision-making and the scope for private sector activity. The countries of Central and Eastern Europe were mostly rapid reformers, and many have embraced membership in the European Union and the European Monetary System. In contrast, both China and Vietnam have achieved major improvements in economic performance and standards of living while retaining greater central control and one-party political systems. However, there have been certain common elements in the transition process. In particular:
It has been crucial to establish incentives for efficient use of resources, by ensuring that relative prices respond to the forces of supply and demand. Thus, the elimination of multiple exchange rates and widespread price controls has typically been an early step in successful economic transition.
The restructuring of inefficient public enterprises is an indispensable part of this process, to ensure that they respond to price signals and improve performance. However, where there is significant risk of capture by elites, it may be better to begin restructuring large enterprises while they are under public control, rather than resorting immediately to privatization. Successful privatization is more likely when it is preceded by development of the legal and institutional foundations of a market economy.
Banking sector and financial market development has a critical role to play in mobilizing domestic resources and putting them to good use, to support higher investment, productivity, and employment. But to minimize risks of instability and fraud, sharp increases in financial intermediation, entry of new institutions, and the development of new financial instruments should take place hand-in-hand with the creation of an appropriate legal framework, financial disclosure, and supervisory capacity. For central banks, the transition has posed a number of specific technical and policy challenges. Under central planning they typically acted as “monobanks,” focused on the allocation of liquidity and foreign exchange to banks and public enterprises, under guidelines dictated by the central government and its economic plan, and the operation of the payments system. Most also operated as fiscal agents of the government. Financial reintegration has obliged central banks to deal with a wide range of additional issues, including:
internal governance and potential conflicts of interest;
the degree of independence from the central government;
the choice of monetary policy objectives;
development of the capacity for indirect instrument s of monetary control;
the scope for and financing of any quasi-fiscal operations;
their role in the supervision and regulation of commercial banks, including mechanisms for cooperating with foreign supervisory authorities;
the mechanisms for providing liquidity support and lender of last resort facilities; and
the implications for all of these potential operations on the solvency of the central bank. This in turn has required the adoption of new or revised central bank laws and regulations, new analytical techniques and data sources, and specialized human resources, as well as ongoing decisions about the degree to which interest rates and the exchange rate will be influenced by market forces. Central Banking in Cuba Cuba lacked a traditional central bank during most of its history as an independent country. From the achievement of independence at the beginning of the Twentieth Century until 1950, Cuba’s financial system consisted mostly of private commercial banks and branches or subsidiaries of foreign banks, regulated under the Commercial Code. In 1950 the Banco Nacional (National Bank) was established as the government’s fiscal agent, bank regulatory agency, and sole bank of issue. However, the National Bank functioned as a traditional central bank only until the assumption of power by the 26th of July Movement in 1959. In 1960 the new government nationalized all private and foreign-owned commercial banks, eliminated most financial intermediation and lending to the private sector, and effectively converted the National Bank into a monobank to support central planning (acting in concert with other nationalized institutions). In the wake of the crisis of the early 1990’s, precipitated by the collapse of the Soviet Union and the loss of its financial support to Cuba, the government decided to recreate a more normal central bank. In 1997 the new Banco Central de Cuba (Central Bank of Cuba or CBC) was established under Law 172, as part of a two-tier banking system, and the National Bank was converted into a commercial bank concentrating on foreign trade activities. Over time, other new financial institutions were created, including additional state-owned banks and a network of foreign exchange bureaus. Some foreign financial institutions were also given licenses to open representative offices in Cuba.<2> Law 172 calls for the CBC to act as the government’s fiscal agent, but to cover its expenses with its own resources and income and not be responsible for the obligations of the state and its agencies, unless it explicitly assumes them. The main functions prescribed for the CBC are:
To issue the national currency and seek its stability;
To contribute to the macroeconomic balance and orderly development of the economy;
To keep custody of the country’s international reserves;
To propose and implement a monetary policy which permits the attainment of the economic goals established by the country;
To ensure normal domestic and external payment operations;
To impose mandatory regulations; and
To discipline and supervise financial institutions and authorized representative offices of foreign banks, as well as any other institutions entrusted to it by law. A provision of the law allows the CBC to give credits to development or investment funds that pursue “socially useful objectives.” The CBC is also allowed to open lines of credit for banks and provide banks with refinancing and discounting facilities (no information is available to the authors on the extent that this has been done in recent years), and to promote credit management by Cuban banks and enterprises through contacts with other central banks, export credit insurance agencies, and other official and private financial institutions. The CBC is authorized to regulate interest rates and has used this power to fix deposit and lending rates (with some flexibility on the latter to permit banks take into account the creditworthiness of borrowers). It is permitted to issue debt instruments in domestic or foreign currency, but has not done so. The government maintains its current account at the CBC, and the central bank law calls for the CBC to manages the issuance of government bonds and bills in domestic and international markets (however, domestic bonds apparently do not exist in Cuba and few international bonds have been issued). The CBC is not supposed to purchase government bonds directly or issue currency to finance government deficits, but the law leaves open the possibility of central bank financing of the government if the Council of Ministers determines that this is necessary. As the government’s fiscal agent, the CBC can act on the government’s behalf to contract credit for the government internally or externally and to represent the government in debt restructuring operations. The president of the CBC is appointed either by the National Assembly or by the Council of Ministers, at the request of the President of the Republic. The appointment is open-ended and the president serves at the pleasure of the government. This is also true of the appointment of other CBC officials. CBC’s board of directors takes decisions regarding monetary, financial, and exchange rate policies but these are subject to government approval, which limits significantly the operating autonomy of the CBC. Law 172 does not appear to have established mechanisms for the accountability of the CBC to the general public; financial data published by the CBC are generally seen as opaque and little information is available its balance sheet and operations. Central Bank Operating Modalities Within the CBC, a Monetary Policy Committee is responsible for analyzing monetary data that have an impact on inflation, including foreign exchange transactions. The work of the Committee is complicated by the existence of two domestic currencies circulating in parallel, the Cuban Peso (CUP) and the Convertible Peso (CUC), as well as by the characteristics of Cuba’s centrally planned economy. State enterprises are not completely autonomous in their investment and production decisions, and must take into account not only prices and other commercial conditions, but also political decisions taken in the national plan. Furthermore, state enterprises are assigned foreign exchange allocations at preferential exchange rates (discussed further below). For these reasons, CBC operations to regulate the growth of broad monetary aggregates are focused largely on the household sector. However, transactions between state enterprises and households also have monetary implications, and decisions on the use of resources by state enterprises also have an impact on aggregate demand and prices. The CBC does not conduct open market operations because there is no public debt market in Cuba, and it has not issued its own securities that could be used for open market operations. Available information through 2010 indicates that very little use has been made of the CBC discount window or changes in reserve requirements. Thus, regarding the household sector, the primary instruments of monetary policy are the official exchange rate of the CUP, interest rates on term deposits, and central bank sales of foreign exchange to the Ministry of Internal Commerce (MINCIN), which oversees sales of goods and services to the population in CUP. <3> Since 2002 the official exchange rate of the CUP, which serves as an anchor to a wide range of prices, has been fixed at a 1:1 parity with the US dollar, except for a small appreciation in March 2005 and a subsequent depreciation in 2011 that restored the current parity. The CUC is made available through foreign exchange houses, and is used in transactions in the tourist sector, including the conversion of foreign exchange by foreign visitors, as well as sales by certain state stores. The CUP currently trades at an exchange rate of 24:1 with the CUC, a level which has prevailed since 2011. Foreign visitors pay a 10 percent tax on the converted amounts. The CBC fixes the rate of interest on term deposits in CUP, CUC, and US dollars. It regards the interest rate on term deposits is an important monetary instrument because about half of the monetary liquidity of the population is maintained in savings accounts, and because savings decisions could have a significant impact on the exchange rate and prices. The Sixth Congress of the Communist Party in April, 2011, approved wide-ranging Guidelines for economic policy that widened the scope for small-scale private activity and signaled the need for retrenchment, restructuring, and greater efficiency in public enterprises. The guidelines relating to the CBC confirmed the policies of directly setting interest rates and the exchange rate, advocated the elimination of the dual currency system, and made recommendations to facilitate the granting of credits and their collection. Immediate Challenges for the Central Bank of Cuba Exchange rate and monetary policy. Unification of the exchange rate is widely seen in Cuba as a major objective of the current government. While some official institutions and public enterprises have access to foreign exchange at preferential exchange rates, foreign exchange earnings and remittances are subject to surrender requirements and taxation and high levels, both explicitly through the 10 percent conversion tax and implicitly through the mandatory conversion of overseas earnings (including remittances by Cuban doctors and other professionals working abroad) at the official 1:1 CUP exchange rate. This tends to obscure both the magnitude of enterprises’ operating losses and the ways in which they are financed, while reducing the profitability of private sector activity and sharply undermining incentives to export. To the extent that exchange rate unification is accompanied by the elimination of preferential exchange rates, it will contribute both to greater transparency about enterprises’ performance and the magnitude of their financing requirements. There was no indication in the 2011 Guidelines of the timetable for currency unification or the likely future exchange rate of the remaining national currency against convertible foreign currencies, but President Raul Castro spoke of a process lasting 3-5 years. Public discussions in Cuba now focus on possible unification before the next Party Congress in April 2016, at an intermediate exchange rate between the official rate of one CUP per US dollar and the 24:1 exchange rate between the CUP and the CUC. Preparatory measures already taken include the introduction of new, higher-denomination banknotes of 200, 500, and 1000 CUP in February 2015, and exploration of ways to increase the accessibility of electronic transactions, point-of-sale terminals, and other non-cash means of payment in CUP. Recently the CBC has used different exchange rates for some public enterprises—for instance, moving transactions from the official CUP rate of 1:1 to an intermediate rate of 10:1—apparently in an attempt to gain additional information on the appropriate future exchange rate. In view of the widespread distortions in the Cuban economy and the lack of well-developed financial markets, exchange rate unification is unlikely to be accompanied by an immediate shift to a floating, market-determined exchange rate. But even while maintaining a fixed or heavily managed exchange rate system, the Cuban authorities could take important steps to pave the way toward a more flexible arrangement that could promote external stability and sustainable economic growth. For instance, in order to reinforce the incentives for improved efficiency, exchange rate unification and the elimination of preferential rates for public enterprises would ideally be accompanied by a restructuring of the accounts of the government and central bank, to reflect the implications of enterprise subsidies for the fiscal deficit, quasi-fiscal operations of the central bank, and monetary expansion. This would contribute both to more open decision-making on support of the enterprise sector, and to the development of stronger technical capacity for the conduct of monetary and exchange rate policy—including the eventual adoption of indirect instruments of monetary policy as financial markets mature. Financial sector development. Both the US embargo against Cuba and court judgments relating to the nationalization of US-owned assets impose constraints on the development and global integration of the Cuban banking sector. Until recently, banks active in the United States—including those based in other countries—were liable to criminal penalties if they did business with Cuba, as a result of its inclusion on the list of countries considered state sponsors of international terrorism. Cuba’s removal from this list in May 2015 paved the way for the opening of accounts in US banks by the Cuban Embassy to the United States, but more generally banks still appear reluctant to risk penalties for potential violations of the embargo. In addition, non-diplomatic accounts could be liable to seizure to enforce judgments against the Cuban government. As these constraints are addressed, the Central Bank will need to prepare to meet its responsibilities for prudential regulation and supervision in a world of market-based lending. In principle, the entry of foreign banks should catalyze substantial improvements in the efficiency of the banking system and set the stage for more effective domestic financial intermediation, but the Central Bank will first need to ensure that it has the capacity for supervision of foreign banks and the cooperation of their home authorities in this process. And even before this, the Central Bank must prepare the domestic banking system for a transition to lending based on creditworthiness and other economic criteria, as part of ongoing, gradual increase in lending to private entrepreneurs and the likely future restructuring of public enterprises. This will require putting in place the necessary laws, accounting standards, and disclosure requirements, along with development of the technical capacity of both the commercial banks and the Central Bank itself. Cuba has reportedly begun adapting domestic accounting practices to the IFRS. As a result of this process, it may be necessary to consolidate or close some of the weaker state bank. In this context, it would be helpful to eliminate regulatory constraints on greater financial intermediation that serve no prudential purpose, and for Central Bank to promote the creation of public credit registries. Over the past 25 years, central banks in other transition countries have benefitted greatly from the assistance of international financial institutions, such as the International Monetary Fund, the World Bank, and the Inter-American Development Bank in meeting these challenges. Hopefully, Cuba will soon be in a position to access these sources of technical assistance and expertise—either through special arrangements, or as part of a process aimed at eventual membership. <4> <1> <1> The authors are retired senior staff members of the International Monetary Fund, with wide experience in Latin America and transition economies, and both provide consulting services to bilateral and international organizations. A previous version of this paper was published in the Quarterly Journal Central Banking in November 2015. <2> <2> According to the latest information available on the website of the CBC, the financial system consists of 8 commercial banks, 18 non-bank financial institutions, 13 representative offices of foreign banks, and 4 representative offices of foreign non-bank financial institutions. See www.bc.gob.cu/English/home.asp. <3> <3> For a discussion of the results of monetary policy regarding prices, international reserves, and creditworthiness see Pavel Vidal Alejandro’s chapter on monetary policy in Miradas a la Economia Cubana II (Editorial Caminos, La Habana, 2010) and Lorenzo Pérez’s article Cuba: Banking Reforms, the Monetary Guidelines of the Sixth Party Congress, and What Needs To Be Done (Association for the Study of the Cuban Economy, Annual Conference Volume, 2011). <4> <4> This issue is discussed further in a paper by Pavel Vidal and Scott Brown, Cuba’s Economic Reintegration: Begin with the International Financial Institutions (Atlantic Council, Adrienne Arsht Latin America Center, July 2015).