Are Currency Boards a
Cure for All Monetary Problems?
By: Charles Enoch and Anne-Marie Gulde Currency board arrangements may be coming
back into fashion. What recent successes have countries had with currency boards and in
what circumstances are they most likely to be effective?
Currency board arrangements, under which domestic currency can be issued only to the
extent that it is fully covered by the central bank's holdings of foreign exchange, were
long generally dismissed as throwbacks to the colonial era. (See box for an explanation of
what currency boards are and how they work.) It was argued that such a rigid, rule-based
arrangement was not well suited to diversified economies in many of which the authorities
had developed sophisticated skills in monetary management. Instead, currency boards were
seen as desirable and, indeed, workable only in very special circumstances, such as the
small, open economies of city-states and small islands. In 1960, 38 countries or
territories were operating under a currency board. By 1970, there were 20 and, by the late
1980s, only 9.
What is a currency board? |
A currency
board combines three elements: an exchange rate that is fixed to an "anchor
currency," automatic convertibility (that is, the right to exchange domestic currency
at this fixed rate whenever desired), and a long-term commitment to the system, which is
often set out directly in the central bank law. The main reason for countries to
contemplate a currency board is to pursue a visible anti-inflationary policy. A
currency board system can be credible only if the central bank holds sufficient official
foreign exchange reserves to at least cover the entire narrow money supply. In this way,
financial markets and the public at large can be assured that every domestic currency bill
is backed by an equivalent amount of foreign currency in the official coffers. Demand for
a "currency board currency" will therefore be higher than for currencies without
a guarantee, because holders know that "rain or shine" their liquid money can be
easily converted into a major foreign currency. In the event of a "testing of the
system," a currency board's architects contend, automatic stabilizers will prevent
any major outflows of foreign currency. The mechanism works through changes in money
supply within the currency board countrya contraction in the case of a flight into
the anchor currencywhich will lead to interest rate changes that, in turn, will
induce investors to move funds. While this is essentially the same mechanism that also
operates under a fixed exchange rate, the exchange rate guarantee implied in the currency
board rules ensures that the necessary interest rate changes and the attendant costs for
the economy will be lower.
Economic credibility, low inflation, and lower interest rates are the immediately
obvious advantages of a currency board. But currency boards may prove limiting, especially
for countries that have weak banking systems or are prone to economic shocks. With a
currency board in place, the central bank can no longer be an unlimited lender of last
resort to banks in financial trouble. At most, it may make loans from an emergency fund
that is either set aside at the time the currency board is designed or, over time, funded
from central bank profits. Another cost could be the national authorities' inability to
use financial policies, such as adjustments of domestic interest or exchange rates, to
stimulate the economy; instead, under a currency board, economic adjustment will have to
come by way of wage and price adjustments, which can be both slower and more painful. |
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The renewed interest in currency boards has come in several waves, raising the number
of countries currently using them to 14 (see table). Following the successful use of a
currency board to stabilize the economy in the aftermath of Argentina's hyperinflation in
1991, additional attributes of currency boards became evident as a result of the
successful efforts made by two transition economiesEstonia and Lithuaniato
achieve credibility quickly for their newly established currencies. In 1997, a currency
board was introduced to end the economic chaos in Bulgaria. In view of the favorable
outcome, and given that to date no currency board has had to be abandoned as a result of a
crisis, the discussion about potential candidates has recently been broadened further. In
early 1998, there was serious discussion of whether a currency board would be an
appropriate anchor to use in efforts to halt the Indonesian currency crisis. Most
recently, there have been calls to study the possibility of stabilizing the Russian ruble
under a currency board.
Currency boards in operation
|
Country/region |
Years
in
operation |
Peg
currency |
Special
features |
|
Antigua and
Barbuda |
32 |
U.S. dollar |
Member of
East Caribbean Central Bank (ECCB) |
Argentina |
6 |
U.S. dollar |
One-third
of coverage can be in U.S. dollar-denominated government bonds |
Bosnia and
Herzegovina |
1 |
deutsche
mark |
|
Brunei
Darussalam |
30 |
Singapore
dollar |
|
Bulgaria |
1 |
deutsche
mark |
Excess
coverage in banking department to deal with banking sector weaknesses |
Djibouti |
48 |
U.S. dollar |
Switched
peg currency from French franc to U.S. dollar |
Dominica |
32 |
U.S. dollar |
Member of
ECCB |
Estonia |
6 |
deutsche
mark |
Excess
coverage for domestic monetary interventions |
Grenada |
32 |
U.S. dollar |
Member of
ECCB |
Hong Kong
SAR |
14 |
U.S. dollar |
|
Lithuania |
4 |
U.S. dollar |
Central
bank has the right to appreciate the exchange rate |
St. Kitts
and Nevis |
32 |
U.S. dollar |
Member of
ECCB |
St. Lucia |
32 |
U.S. dollar |
Member of
ECCB |
St. Vincent
and the Grenadines |
32 |
U.S. dollar |
Member of
ECCB |
|
Sources: Baliño and
others (1997); and Ghosh, Gulde, and Wolf (1998).
|
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Currency boards and inflation
Ultimately, the relative merits of currency board arrangements and other forms of
exchange rate pegs cannot be resolved by theory alone. Ghosh, Gulde, and Wolf (1998) have
undertaken an empirical investigation, extending the existing literature on inflation
performance under fixed exchange rates. Given the empirically verified anti-inflationary
capability of fixed exchange rate systems, it can be argued that instituting a currency
board arrangement makes sense only if the regime delivers even better inflation
performance. By using a data set containing all IMF member countries over more than
twenty-five years, the study attempted to isolate the inherent effects of a currency board
arrangement regardless of the many country-specific challenges facing countries where such
arrangements are in operationfor example, hyperinflation (Argentina and Bulgaria),
transition to a market economy (Bulgaria, Estonia, and Lithuania), volatile terms of trade
(Eastern Caribbean Currency Board), post-conflict situations (Bosnia), or the presence of
an international financial center (Hong Kong SAR).
Comparative statistics and more formal econometric analysis confirm that, historically,
currency board arrangements have done better than even other fixed exchange rate regimes.
For example, the presence of a currency board arrangement is found to lower annual
inflation by about 3.5 percentage pointsthe result of a "confidence
effect" that essentially arises from the faster growth of money demand made possible
by the greater institutional certainty associated with a currency board. In contrast to
fears often raised by opponents of currency boards, Ghosh, Gulde, and Wolf (1998) did not
find that existing currency boards had any negative effects on growth.
Creating an operating environment
Even if economic arguments favor a currency board arrangement, its operational
feasibility will depend on whether the attendant legal and institutional issues are
effectively addressed. Their importance should not be underestimated: although a currency
board is a simple monetary arrangement, a range of important decisions must be made about
its specific nature, including changes needed in the institutional framework for financial
management in the economy and, especially, in the legal environment in which central
banking is carried out. Unless these adjustmentswhich tend to be more time-consuming
than those involved in carrying out other exchange regime shifts and in many countries
will have to be resolved in full public view (for instance, in parliamentary
debates)are completed satisfactorily, a currency board cannot be established in a
way that will enable a country to achieve the necessary improvement in the credibility of
its monetary policy.
The basic decisions that need to be made when a country establishes a currency board
arrangement include choosing the peg or anchor currency, setting the level of the peg, and
determining whether or not to include a "safety margin" for the financial
sector. Changes are also required to the legal system and the government's relations with
the central bank.
| Obvious criteria to use in choosing an anchor include the strength and international
usability of a currency, which generally rule out all but a handful of moneys. In fact,
the 14 currency board arrangements currently in operation involve pegs to only three
currencies: the U.S. dollar (10 countries), the deutsche mark (3 countries), and the
Singapore dollar (1 country). In choosing from among this much narrower field, a country
should carefully consider its current and prospective trade flows, as well as other
economic links, with the country issuing the currency to which a country's currency is
pegged. A country's choice can get more complicated if its economy is characterized by
widespread "currency substitution," where the currency used is not that of its
major trading partner. In this case, or where the values of a country's trade with two
dominant currency blocs are roughly equal, a currency basket is a theoretical option. In
practice, however, all countries that have introduced currency board arrangements so far
have opted for the simplicity of a single currency. |
| Setting the exchange rate would appear straightforward, given that a currency board
arrangement by definition has to cover a monetary aggregate, usually the full amount of
reserve money but sometimes narrower definitions of money. Yet the rate at which the
central bank's available international reserves cover the monetary aggregate in question
varies depending on the exact definition of reserves used. Choosing the appropriate
definition most likely involves a trade-off: although a narrow definition of foreign
reserves, such as "net reserves," might signal strong discipline and possibly
improve the credibility of the system, it might also require an up-front devaluation that
would prove politically and economically infeasible. |
| In a "pure" currency board arrangement, the currency board has no margin to
intervene as lender of last resort on behalf of a bank in difficulties or to engage in
open market operations. A country weighing the option of establishing a currency board
may, however, seek a "safety margin" of some excess coverage, holding reserves
of 100+x percent of the monetary base. In this case, interventions of up to x
percent of base money would be possible without violating the currency board rules. While
most operating arrangements do allow for some form of limited intervention, the decision
to include this feature should not be taken lightly. Room for maneuver in case of
unexpected difficulties is possible only at a more depreciated exchange rate than would
have been necessary under other exchange arrangements. Intervention may also limit the
transparencyand, thereby, the credibilityof the system. |
| A sound legal basis is essential, because a currency board arrangement derives much of
its credibility from the changes required in the central bank law concerning exchange rate
adjustments. Countries seriously considering establishing a currency board may therefore
wish to incorporate some, or all, of the above-mentioned principles into the central bank
law. The law must define both the exchange rate and reserves, as well as specify the
limited powers of the managing institution under the system. It is sometimes argued that
the rules governing a currency board could be asymmetrical, permitting the central bank to
appreciate the exchange rate but requiring legal action before depreciation can be
undertaken. For example, the rules governing Lithuania's currency board contain such
provisions. The period needed to set up the necessary legal process will obviously differ
across countries, depending on the availability of technically skilled lawyers who can
draw up a draft bill and the minimum parliamentary requirements for its enactment into
law. In most countries, the process will take time owing to parliamentary discussion about
the merits of the proposed arrangement, which may itself require the relevant authorities
to carry out an intensive information campaign. |
| Finally, establishment of a currency board arrangement will require the redefinition of
the financial relationships within the country's government. More often than not, the
initial inflationary impetus that is to be eliminated by moving to a currency board has
been created through extensive central bank financing of the government. Rules for a
currency board arrangement therefore need to prohibit new central bank loans to the
government. What financial links there are to be between the central bank and the
government, and how these are to functionmost important, how the central bank will
handle government depositswill also need to be worked out. Although the central bank
continues to handle government accounts under some currency board arrangements, doing so
may decrease the arrangement's transparency. Further difficulties may arise from the fact
that government deposits are callable at short notice, and consistency with currency board
arrangement rules can be achieved only if such accounts are fully covered by foreign
reserve holdings. For these reasons, some economies with currency boardsmost notably
Hong Kong SARhave moved all government accounts to commercial banks. Other economies
with currency board arrangements, including some transition economies, have felt that the
commercial banking sector was not yet able to handle the government's accounts and, hence,
have opted to keep them with the monetary authority. In this case, however, interest on
these accounts can be paid only to the extent that the currency board has a flow income
from its foreign reserve holdings that exceeds its operating costs. In addition,
transparency is likely to be enhanced if the public debt management function, an auxiliary
service provided by many central banks, is clearly placed outside the domain of the
currency board, possibly by creating an independent agency under the ministry of finance. |
Transition to a currency board
The rules laid down in the new central bank law will serve as guideposts for
reorganizing the central bank into a currency board. In a number of countries that have
recently adopted currency board arrangements, this has involved setting up separate
banking and issue departments, each with distinct functions and coming under the authority
of different deputy governors. Other countries with currency board arrangements, such as
Argentina, have retained a unified structure for the monetary authority. In either case, a
reorganization has to take place to allow easy identification of the central bank's key
activities and to ensure that maintenance of the relevant currency cover ratios will be
clearly visible. To that end, the currency board arrangement will have to publish a
well-defined set of statistics (including, for instance, the balance sheet of the issue
department or statistics on selected assets and liabilities included in that balance
sheet) in a form, and according to a calendar, that are consistent with the currency board
arrangement law.
Establishing a currency board arrangement will also generally involve reviewing how the
central bank will carry out its new core functions, the most important of which is reserve
management. The added importance of reserve management under a currency board arrangement
is obvious, given that the board's earnings from foreign exchange holdings will probably
be its major source of income and because even a small violation of the cover requirement,
which could arise from technical problems in reserve management, might cause serious
trouble for the arrangement.
Finally, conducting a review of the banking sector and prudential standards and
deciding on the location of banking supervision will generally also be necessary during
the transition to a currency board arrangement. The review and, if required, a
streamlining of the banking sector are important because of the elimination of, or
reduction in, the central bank's ability to function as a lender of last resort under such
an arrangement. During this period, the authorities may decide to transfer banking
supervision, which has often been carried out by the central bank, to an independent
agency to avoid possible circumvention of currency board arrangement rules in case of
banking sector difficulties. If, for reasons of timing or organization, banking
supervision functions cannot be performed outside the central bank, it has to demonstrate
clearly that any support it provides to banks in difficulty will not breach the currency
board arrangement rules.
Conclusion
Currency boards in many countries have achieved impressive economic results, both in
achieving lower inflation than other exchange rate regimes and in stabilizing expectations
after prolonged hyperinflation. There have thus been calls for such arrangements to be
established in a rather diverse group of other countries, many of which are in crisis.
Such calls should be viewed warily by national governments, for at least three reasons.
First, the success stories largely reflect the experiences smaller countries have had with
currency boards, whose applicability to larger countries has yet to be fully demonstrated.
Second, and equally important, the successful establishment of a currency board
arrangement requires time for building consensus, as well as for careful planning and
implementation of important legal and institutional changes. Third, countries with one or
several weak banks may have to rehabilitate them before changing their monetary regimes.
These prerequisites to establishing a currency board may, in many cases, be too involved
and take too much time to make it advisable for a country to attempt to do so during a
macroeconomic crisis.
Suggestions for further reading:
Tomás Baliño, Charles Enoch, Alain Ize, Veerathi Santiprabhob, and Peter Stella,
1997, Currency Board Arrangements: Issues and Experiences, IMF Occasional Paper 151
(Washington: International Monetary Fund).
Charles Enoch and Anne-Marie Gulde, 1997, "Making a Currency Board
Operational," IMF Paper on Policy Analysis and Assessment 97/10 (Washington:
International Monetary Fund).
Atish R. Ghosh, Anne-Marie Gulde, and Holger C. Wolf, 1998, "Currency Boards: The
Ultimate Fix?" IMF Working Paper 98/8 (Washington: International Monetary Fund).
Charles Enoch is an Assistant
Director and Chief of the Banking Supervision and Regulation Division of the IMF's
Monetary and Exchange Affairs Department. Anne-Marie Gulde
is a Senior Economist in the Monetary and Exchange Policy Review Division of the IMF's
Monetary and Exchange Affairs Department. |
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