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Richard W. Judy is director of the Center for Central European and Eurasian Studies at the Hudson Institute. The views expressed in this article are his alone and not necessarily those of the Hudson Institute.
Is the currency board system about to make a comeback as a preferred monetary regime among the nations of the world? Even before the Mexican peso's recent near-meltdown, the currency board idea had moved out from its long-held redoubts in Hong Kong and Singapore and won new converts in Argentina, Estonia, and Lithuania. Currency board zealots were proselytizing in various former Soviet republics, including Kazakhstan and Ukraine, as well as in Jamaica and El Salvador. Now, in the wake of the peso's plunge, the idea is attracting new interest as Mexico itself considers replacing its existing central bank and fiduciary money with a currency board system.
But before enthusiasm turns to faddism and unrealistic expectations breed future disillusionment, it is prudent to examine the real strengths and limitations of the currency board system. Start with the most basic question about it: what is a currency board? For the answer we can do no better than turn to Sir Alan Walters, the architect of Hong Kong's currency board:
"The main characteristic of the currency board system is that the board stands ready to exchange domestic currency for the foreign reserve currency at a specified and fixed rate. To perform this function the board is required to hold realizable financial assets in the reserve currency at least equal to the value of the domestic currency outstanding. Hence in the currency board system there can be no fiduciary issue. The backing of the currency must be at least 100%."
Another characteristic of all genuine currency boards is that they should be prohibited from buying or holding domestic treasury or commercial securities. Since a currency board is constrained to issue currency only in exchange for "realizable financial assets" that are freely convertible into the reserve currency, it is powerless to create domestic money by extending credit as conventional central banks can do. That means that a currency board (unlike a central bank) cannot function as "lender of last resort" either to the state treasury or to commercial banks.
Strict limits on a currency board's power to issue money constrain its operations in two important respects: the board cannot finance (i.e., monetize) the government's budgetary deficits, and it cannot regulate the nation's money supply by engaging in open market operations or discounting domestic bank-held paper. It is these two constraints that attract the most determined opposition to the currency board idea and, at the same time, inspire its greatest admiration.
Populists and free-spending politicians, devotees of monetary dirigisme, and many finance ministry officials vociferously oppose currency boards. Even the International Monetary Fund used to dismiss the currency board idea and only recently has come to offer it tepid and tentative support. How, these critics ask, can the state finance its budgetary deficits if the treasury cannot count on the monetary authority to buy its bonds and notes? How can a monetary authority bound by such an iron rule of currency emissions have sufficient flexibility to "fine tune" the money supply or otherwise conduct an active monetary policy?
These particular criticisms of the currency board idea lack force. In fact, the depoliticization of monetary emissions is the currency board system's chief virtue. The political pressures to overspend are strong in all democracies but they tend to be overwhelming in nascent democracies undergoing difficult economic and political transitions. Institutions, such as currency boards, that make it difficult for governments to spend more than they can tax or borrow in free capital markets actually provide a great service to a country. By impeding monetization of budgetary deficits, a currency board goes far to promote fiscal discipline that otherwise would be impossible to achieve.
Nor does the "inflexibility" criticism withstand close scrutiny. Most of the world's central banks have, in fact, done an exceptionally poor job of managing their nations' monetary affairs over the past few decades. Pervasive inflation and exchange rate instability cast grave doubts on the feasibility of active monetary policy as it is actually conducted in most countries. The record indicates that most central banks' attempts to manage the money supply or to manipulate interest rates cause more harm than good. That is because the conduct of sound monetary policy demands independence from political pressures, solid economic information, as well as considerable competence and courage that are rarely found within the world's central banks. As the Mexican case has demonstrated so convincingly, recent developments in global capital markets, including worldwide integration and greater volumes of money, make monetary dirigisme even more problematic than before. Most developing nations, as well as industrial ones, would be better off if their monetary authorities had neither the power nor hubris to attempt it.
A different and novel argument in favor of currency boards is being heard these days. It is that a currency board, by maintaining a fixed exchange rate with respect to its reserve currency, can insulate its country from the destabilizing effects of international capital movements. That argument also has merit, but it requires careful examination lest more be expected of a currency board than it reasonably can deliver.
The issue here is not whether a nation's currency board (or its central bank, for that matter) can peg its monetary unit to a foreign reserve currency. Obviously, that is possible because it has been done hundreds if not thousands of times in the past. The question is, can such a fixed peg be maintained, and does the institution of a currency board make that more likely?
The most vital contribution a currency board can make to exchange rate stability is indirect, by imposing discipline on the process of money creation. It precludes public deficit spending except to the extent that lenders are willing to put their money at risk by buying government securities. The upper limit of the domestic money stock is defined by the size of the monetary base which, in turn, cannot expand beyond what reserve currency holdings will permit. These constraints on both deficit spending and monetary expansion mean that the classical mechanisms of currency debasement and, therefore, of price inflation are disabled.
If currency boards do, indeed, disable the classical inflationary mechanisms, then nations with currency board systems should be seen to enjoy greater stability of domestic prices and exchange rates than comparable nations with central banks and fiduciary currencies. Few nations have yet embraced the currency board system, but two that have are Estonia and Argentina. It is instructive to examine their experiences.
Estonia regained its national independence from the collapsing Soviet Union in late 1991. For several months thereafter, however, it remained inside the old ruble currency zone and suffered the same hyperinflationary tortures as all other former Soviet republics. Consumer prices increased nearly 220% during the first half of 1992. Then, in June of that year Estonia introduced its own national currency, the kroon, and pegged its value at eight kroons to the D-mark. A currency board was instituted and the kroon was declared convertible on current account.
Positive results came almost immediately. From 17% in the third quarter of 1992, consumer prices rose only 7% in the fourth quarter of that year, and steadily decreased thereafter. By the last quarter of 1994, the monthly CPI rise amounted to only 1.4%. In the meantime, the Bank of Estonia's holdings of gold and convertible currency reserves tripled by mid-1994, exceeding by more than 15% the amount required to back the kroons in circulation.
The nation's current account also became strongly positive as the direction of trade shifted sharply from Russia and other CIS countries to Western Europe and beyond. GDP growth resumed in 1993 and continued in 1994. Citizens converted their hard currency hoards into local currency, enterprises repatriated deposits squirreled away in foreign banks, and foreign private investment began to flow into Estonia.
But not everything has proceeded so smoothly in Estonia. The capital influx since installation of the currency board system has caused the kroon monetary base to grow, thereby fueling domestic inflation. In the face of a nominally fixed exchange rate, there has been a real appreciation of the kroon against the D-mark as well as other western convertible currencies. The trade and current accounts turned negative in the last quarter of 1993 and remained that way throughout 1994. Exporters are now complaining, and calls for devaluation are heard in the land.
Will Estonia tread the Mexican path by abrogating its promise to maintain a fixed exchange rate? Or will it remain steadfast to its currency board principles? Mr. Simm Kallas, the tough Governor of Eesti Pank (Estonia's currency board), vows to maintain the 8-to-1 peg to the D-mark and is even executing forward contracts at that rate up to the year 2000. But much will depend on the disposition of the new parliament elected in this year's March elections. Estonia's currency board system is not chiseled indelibly in tablets of stone; it was created by three parliamentary acts and parliament could change it. Fortunately, all major Estonian political parties have voiced their commitment to maintaining the kroon as a strong and internationally convertible currency. Even more important, the Estonian people appear to take extraordinary pride in the strength of the kroon. That, in all probability, is the very best guarantee this currency will not be debased.
During the 1980s, Argentina appeared the very model of macroeconomic instability. The public sector deficit was huge, the nation was in default on its foreign debt, hyperinflation reigned, and there was massive capital flight. In 1989, however, the Menem government began a series of economic reforms that continue to the present day. One of the most significant was the April 1991 Law on Convertibility which established a new fixed exchange rate regime whereby the Argentine peso was to be backed 100% by foreign currency reserves and made freely convertible with the US dollar at a one-to-one basis. In short, that law implemented the currency board system in Argentina.
The Argentine economic reforms have been aimed at liberalizing and privatizing the economy, reducing the public sector deficit, and lowering inflation. Together, they have brought very positive results. From a 39% monthly rate in 1989, inflation has declined steadily and was less than 4% for all of 1994. Argentina's growth rate has climbed, posting a GDP gain of 6% last year. Meanwhile, foreign investment has flowed into the country in ever increasing amounts. Foreign currency reserves have tripled since 1991.
As in Estonia, the economic picture in Argentina is not all rosy. The peso has appreciated in real terms by more than 100% since 1991. Meanwhile, the current account deficit has mushroomed for reasons both good (heavy foreign direct investment) and not so good (rapidly growing consumer good imports and decreasing export competitiveness). Public sector deficits remain stubbornly high. The national savings rate remains stuck at around 15% of GDP, which helps keep investment lower than it needs to be. Low domestic savings also make Argentina too dependent on foreign money to finance the capital investments that are being made. Until 1993, most foreign investment was in the form of foreign direct investment (FDI), but portfolio investment has boomed in the last two years and may actually have exceeded FDI in 1994. That shift is undesirable because it increases Argentina's vulnerability to capital flight at a time when servicing of the foreign debt already absorbs roughly a fourth of total export earnings.
What do the cases of Estonia and Argentina tell us about the relative merits of currency boards versus conventional central banks? Several conclusions emerge. Major benefits of the currency board system are:
 | making a nation's currency and exchange rate regimes more transparent, rule-bound, and
predictable; |
| placing an upper bound on the nation's base money supply, a bound that is determined by
net capital inflows; |
| forcing the government to restrict its borrowings to what "arms-length"
foreign and domestic lenders are willing to lend it at market interest rates; and |
| engendering confidence in the soundness of the nation's money in direct proportion to the length of time it is maintained in harmony with other supporting policies. |
Despite evident advantages, however, there is a danger the currency board idea could be oversold. It is not a panacea, and it should not be expected to solve all macroeconomic problems single-handedly. In particular, both the Argentine and Estonian experiences illustrate that a currency board is no guarantee against potentially destabilizing capital inflows which can bring monetary expansion, inflation, real appreciation of the domestic currency, reduced international competitiveness, and large current account deficits, all of which can generate pressures to devalue and make nervous money managers even more skittish.
If private capital inflows are large and if significant portions of them come in the form of short-term loans or speculative portfolio investments, then the potential for destabilizing capital flight can arise irrespective of the receiving nation's monetary regime. It is worth noting that a currency board's fixed exchange rate is very unlikely to be credible if it is perceived to be overvalued vis-a-vis the reserve currency either because it was set that way initially or subsequently became overvalued as a result of an inflation-induced real appreciation.
It is possible for a nation's monetary regime to be orderly and disciplined under either a currency board or a central banking system. But neither system, by itself, creates either necessary or sufficient conditions for that order and discipline. That is because the effectiveness of both systems depends on other conditions such as fiscal discipline, the "proper" composition of capital inflows (including a high proportion of long-term foreign direct investment), a sound commercial banking system, etc. In other words, it is a whole cast of responsible and mutually supporting policies and institutions that makes for sound money and stable exchange rates. No monetary regime, however well conceived, can bear the entire burden alone.
The issue here is whether a country with a currency board system is, by virtue of having that system, less vulnerable to destabilizing international capital flows than one operating a more conventional central bank with fiduciary currency. On that point, the emerging evidence from Estonia and Argentina, together with that of countries such as Hong Kong where currency boards have prevailed for many years, is very positive if not yet totally conclusive. It indicates that a country with a currency board is indeed more likely to be resilient to the destabilizing forces operating in today's integrated global currency markets. By encouraging more transparent and disciplined fiscal and monetary management, a currency board makes it more likely that the supporting cast of other policies and institutions will also be in place.
Most important of all, a nation's replacement of its central bank with a currency board should symbolize that nation's seriously enhanced commitment to maintaining a sound currency and a stable exchange rate. Such credibility in the eyes of domestic and foreign investors is the greatest asset of a currency board. The critical importance of safeguarding that credibility is what makes understanding of the currency board's true capabilities and limitations so essential to any nation contemplating its introduction.
In many nations the time for introducing currency boards has surely arrived, but it is vital they be introduced correctly and in the company of a proper cast of supporting policies.
