The Stability of Currency Boards

Front matter

CEGE-SCHRIFTEN

The Stability of Currency Boards

CEGE-SCHRIFTEN

Contents

List of Figures

List of Tables

List of Abbreviations List of Variables

Introduction

In 1991 Argentina introduced a currency board to stabilize its troubled economy, plagued by hyperinflation reaching up to 20,000%. This represented the revival of an old monetary arrangement that had gone out of fashion a long time ago. For the first time for almost 20 years—not considering Hong Kong’s 1983 return to the currency board system abandoned in 1974—a country had decided to adopt a currency board as its exchange rate arrangement.

The Argentinean currency board proved to be very effective in achieving monetary stabilization. Inflation was brought down to single digit rates within two years—a level of monetary stability that had not been achieved in Argentina for fifty years—and economic growth quickly rebounded.

The outstanding stabilization success of the Argentinean currency board, coupled with the administrative simplicity of setting up and operating a currency board, made it a very attractive monetary arrangement for transition and post-chaos countries. Four countries have eventually followed the Argentinean example and set up their own currency boards; all of them located in eastern Europe. Estonia was the first transition country to adopt a currency board briefly after gaining independence from the Soviet Union. In 1992 it introduced a sovereign currency, the kroon, which was pegged to the Deutsche mark by means of a currency board, and replaced the ruble as legal tender. Lithuania followed the successful example of its Baltic neighbor in 1994, and introduced a currency board with the US dollar as the anchor currency. In 1997 Bulgaria and Bosnia and Herzegovina also introduced currency boards, both pegging the value of their domestic currencies to the Deutsche mark.

The successful revival of the currency board system, which had been spread throughout the whole world during its heyday in the first half of the twentieth century, prompted increased interest of economists in the topic.

Some currency board advocates even propagated the allegedly beneficiary Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access

26 1. INTRODUCTION adherence to early twentieth century currency board design." The sudden popularity of currency boards, and repeated proposals to introduce them in a variety of countries facing monetary destabilization, even led some authors to ask, whether currency boards offered a “cure for all monetary problems” (Enoch and Gulde 1998, part of paper title), and were the “ultimate fix” (Gosh, Gulde, and Wolf 1998, part of paper title).

They were not. In the late 1990s it became apparent that currency boards, while unquestionably successful in monetary stabilization, were not a tool to overcome all economic problems, and exposed countries to the risk of real economy imbalances. This risk was dramatically highlighted by the Argentinean debt default and subsequent currency board exit in early 2002, which had a devastating effect on the domestic economy.

Most of the literature concerned with the potential benefits and risks of currency boards draws on the arguments of the standard fix versus float discussion, or the theory of optimum currency areas. Yet, only few models exist that consider some of the essential design features of currency boards, most specifically the strong legal commitment, by which the currency board rules are set forth in law.

This thesis examines in great detail the potential benefits, but also the risks of introducing a currency board, by employing a modified second generation currency crises model. The model underlines the important role of legal and political commitment to the currency for the stabilization process, but also highlights the adverse role such commitment may play, once the currency board economy faces real imbalances, such as high unemployment. Furthermore, the thesis studies the potential effects that the presence of foreign-currency denominated debt—often a byproduct of currency board introduction, particularly when following monetary destabilization and hyperinflation—may have on the stability of the currency board and the performance of the economy.

The thesis is structured as follows: Chapter 2 presents a general currency board definition by emphasizing the essential design features of currency boards, and by showing how a currency board differs from a central bank. Further, a short overview over the literature on currency board is given, highlighting the characteristics, pros, and cons of currency boards, such as the ability to lend policy credibility and achieve monetary stabilization, or the importance of fiscal austerity.

Chapter 3 outlines the history of currency boards and introduces to a selection of present-day currency boards. Studying the history of currency boards illustrates how the currency board system has evolved over time.

1See the discussion of currency board design in subsection 2.1.3. Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access

1. INTRODUCTION 27

The primary rationale for introducing a currency board has changed over time, from having a simple monetary regime that easily provides a domestic currency, to achieving monetary stabilization and gaining policy credibility. The introduction to modern present-day currency boards, exemplified by the cases of Hong Kong, Argentina, Estonia, Lithuania, and Bulgaria, serves to provide an overview over the different currency board designs countries have opted for, and to show how the respective economies performed under the currency board. For each country, separate subsections are devoted to the lead-up to the currency board, to the currency board design, to economic performance under the currency board, and, in the case of Argentina, to the exit from the currency board.

Chapter 4 examines the benefits and risks of having a currency board by applying a modified second generation currency crises model. First, an overview over the basic features and properties of second generation currency crises models is given, and the differences to first generation models are illustrated. Following the introduction of the modified model, exchange rate decisions, stability of the currency board, and the loss from a currency board exit are examined. The following section then extends the model to include the effects from foreign-currency denominated debt, after briefly surveying the literature regarding that topic. That section serves to demonstrate how the model results differ from the previous results, due to the presence of foreign-currency denominated debt.

Finally, chapter 5 presents the policy implications that can be derived from the model examination, taking into account also the results from chapters 3 and 4, and concludes.

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Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access

Chapter 2

This chapter is intended to give a very brief overview over currency board design and characteristics. Section 2.1 explains the basic design features of currency boards and what distinguishes them from central banks. Section 2.2 then shortly examines the pros and cons as well as prerequisites for successfully operating a currency board.

2.1 Basic Features of a Currency Board

2.1.1 Definition of a Currency Board

A currency board (CB) is a very simple, strictly rule-bound institution for supplying an economy with a domestic currency. In the past, currency boards have usually been operating in place of a central bank, although more recent currency boards, starting with Argentina 1991, have usually been set up within previously existing central banks.

A typical currency board is defined by the four following central features:

Fixed exchange rate The value of the domestic currency is strictly tied to the value of an anchor currency at a fixed rate of exchange. Until the second half of the 20th century, the predominant anchor currency was the British pound sterling, although there have been pegs to other currencies and even gold, as well. Recent currency boards have either chosen the US dollar or the Deutsche mark, respectively the euro since the introduction of the common European currency, as an anchor.

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Backing requirement A typical currency board is required to fully back the monetary base with foreign exchange reserves. Foreign exchange reserves held by the board must at all times be sufficient to, at least theoretically, convert all notes and coins in circulation, as well as all domestic currency deposits held with the currency board, into the anchor currency at the fixed exchange rate. Domestic currency can only be issued in exchange for the respective amount of foreign exchange. The reserves of the currency board are to be held in foreign cash, and in foreign, liquid, interest-bearing assets denominated in the anchor currency. In practice, most currency boards hold reserves exceeding 100% of base money in order to guard against the risk that the market value of their assets will diminish.

Unrestricted convertibility A typical currency board is a passive monetary institution. It exchanges the anchor currency into domestic currency and vice versa on demand and unlimited, so that the supply of base money always matches the demand for it.

Legal commitment The rules of the currency board, i.e. the choice of an anchor currency and the exchange rate, the backing requirement, and the convertibility undertaking are usually set down in law. This practice serves to prevent the currency board from becoming subject to short-term changes and to signal stability and reliability to economic agents. The currency board rules might be included in the constitution or in basic law, to achieve highest legal rigidity, or be set down in the law governing the central bank, or a special currency credibility law, as is the case with most current currency boards.!

A currency board with all these features implemented is a very simple, yet stable, strictly rule-bound institution for supplying an economy with a domestic currency. It is one step short of officially dollarizing? the economy, but the local currency is retained, yet only as a token for the anchor currency.

The various motives for introduction of a currency board, which will be discussed in further detail in section 3.1, highlight some characteristics of currency boards. The earliest currency boards were introduced in British colonies in the second half of the 19th century as a simple, yet reliable source

1Hong Kong, while not having any special statutory provisions that require the Hong Kong Monetary Authority (HKMA) to adhere to currency board rules, has codified a backing requirement into its basic law, that obliges the HKMA to maintain sufficient reserves to fully back all bank notes in circulation. 2In this context the term ”dollarization” refers to replacing the domestic currency with any other foreign currency. The chosen currency could be the US dollar, but could as well be the euro or any other currency deemed appropriate. Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access

2.1. BASIC FEATURES OF A CURRENCY BOARD 31 of domestic money. Prior methods of supplying money had failed, proven unreliable, or led to abuse, such as the free issue of notes through private banks or the issue of unbacked money by colonial governments. Currency boards, in turn, offered a stable and easily administrable way of supplying domestic money that did neither require many nor highly skilled staff.

Later currency boards, such as the West African Currency Board established in 1913, added another motive for currency board introduction. Rather than using British notes and coins as money, colonial governments wanted to use their own currencies that would earn them income from seigniorage. Introducing a currency board, therefore, proved a suitable solution. On the one hand, the domestic currency, backed by the British pound sterling, was merely a token for the anchor currency, on the other hand, the currency boards earned interest on the reserves they held, which would be transferred to the colonial government.

Current currency boards, starting with Hong Kong’s re-introduction of its currency board in 1983, and, most notably, the Argentinean currency board established in 1991, introduced yet another motive for currency board selection. These countries sought to achieve economic stabilization by introducing a credible nominal anchor. As a currency board is the most rigid form of fixing the exchange rate vis a vis an anchor currency, short of dollarizing the economy, these countries opted for a currency board to reconstitute trust in their domestic currencies. In the case of Hong Kong, the exchange rate had gotten under pressure and the Hong Kong dollar was rapidly losing value prior to the introduction of the currency board. Argentina introduced the currency board to put a stop to rampant hyperinflation.

2.1.2 Currency Boards vs Central Banks

A currency board is not only an exchange rate system, but a different monetary system. It differs essentially from any other exchange rate system under a central bank in the most important aspect that almost no discretionary monetary policy is possible under a currency board. In the most extreme case, the currency board is not only subject to a total backing rule, but also to a marginal backing rule. While the total backing rule specifies that at all times the foreign exchange reserves have to fully cover the monetary base, the marginal backing rule goes one step further and requires that every change in the monetary base has to be accompanied by a corresponding change in foreign exchange reserves. With a marginal backing rule in place there is no way for the monetary authority to actively change the money supply, except through changes in reserve requirements for commercial banks. With only a total backing requirement in place some scope for monetary policy exists, Kai Stukenbrock - 978-3-631-75699-7 yet limited to the extent of foreign exchange reserves exceeding the monetary base.

Currency Board

Assets Liabilities

Liquid reserve-currency assets Notes & coins in circulation (Deposits of commercial banks)

Net worth

Central Bank

Assets Liabilities

Liquid reserve-currency assets Notes & coins in circulation

Domestic assets Deposits of commercial banks (government debt)

Net worth

Source: Williamson (1995, p. 3)

Figure 2.1: Stylized T-accounts of a currency board and a central bank.

Consider figure 2.1, where the stylized T-accounts of a currency board and a central bank are shown. The assets of a currency board consist only of its foreign exchange reserves. The liabilities of the currency board are the monetary base, consisting of notes and coins in circulation and, if applicable, deposits of commercial banks, containing for example the required reserves of the banking sector.” Unlike in a central bank system, many currency boards allow or even require commercial banks to hold their reserves in the anchor currency (Williamson 1995, p. 2). The net worth of the currency board, representing its excess reserves, has to be either zero or positive in order not to violate the backing requirement.

3Note that many historical currency boards, as well as orthodox currency boards advocated by Hanke and Schuler (which will be discussed in more detail in the following subsection), were not allowed to keep deposits.

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2.1. BASIC FEATURES OF A CURRENCY BOARD 33

The key difference between a currency board and a central bank is the fact that a central bank is allowed to also hold domestic assets, including loans, of which the most important part normally is government debt. This enables the central bank to pursue a discretionary monetary policy, systematically influencing the supply of domestic money. The central bank can increase the money supply by buying domestic assets. It may, in turn, reduce the supply by selling such assets. If the central bank is required to sell foreign exchange to defend the exchange rate, it may offset, or sterilize, the ensuing reduction of the monetary base by buying domestic assets. Also, the central bank may act as a lender of last resort (LoLR) during a liquidity crisis affecting the banking system, by granting loans to banks or by buying assets from them through a discount operation (Williamson 1995, pp. 3-4).

These options are not available under a pure currency board. The monetary base is solely determined by demand. If the public sells foreign exchange to the currency board, the monetary base increases, and if the public sells domestic currency in exchange for foreign exchange, the monetary base decreases.

2.1.3 Flexibility in Design

While the key currency board features described in subsection 2.1.1 represent a definition of an ideal type of currency board most economist could agree on*, such a definition still fails to capture every aspect and nuance of a monetary arrangement that has existed and evolved for more than 150 years.

As a pure currency board characterized by the four key features described in subsection 2.1.1 enforces extreme rigidity concerning monetary policy, most present-day currency boards have decided to introduce some flexibility in their currency board design to retain at least some scope for discretionary monetary policy. Of the five modern currency boards discussed in chapter 3, none adheres to the marginal backing rule, which would preclude any discretionary change in the monetary base without a corresponding change in foreign exchange reserves. These currency board countries have opted for such flexibility, primarily to gain the ability to engage in LoLR operations. While LoLR support is in all cases restricted to the extent of excess reserves of the monetary authority, the ability to extend at least such limited support in the case of a liquidity crisis in the banking system was deemed necessary. Yet, the scope for discretionary monetary policy is not only restricted to LoLR support. While Bulgaria’s currency board has the least scope for dis-

4See for example Balifio and Enoch (1997, pp. 1-4), Bennett (1994, pp. 2-6), Gulde (1999, p. 5), Schwartz (1993, pp. 147-148), and Williamson (1995, pp. 2-5). Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access cretion and may only change reserve requirements to affect the money supply, the Lithuanian currency board has almost all monetary policy instruments of a full-fledged central bank at its disposal, among them issuing Treasury-bills or engaging in open market operations.

Some of the five currency boards do not even adhere fully to the total backing requirement. While all currency boards are obliged to fully back the monetary base, not all of them are obliged to do so by exclusively holding foreign cash and foreign assets. The Argentinean and the Lithuanian currency board are? both allowed to hold domestic anchor-currency denominated government bonds as reserves. While this does not violate the 100% backing requirement—the monetary base is still fully covered by anchor-currency denominated assets—it introduces some scope for discretionary monetary policy, as the monetary base can be expanded without a reduction of the domestically available foreign exchange.

Further deviations from typical currency board design may be observed concerning unrestricted convertibility. While all five currency boards are obliged to sell foreign exchange against the domestic currency at, or very close to the official exchange rate, some of them, specifically Argentina, Hong Kong, and Lithuania, are not required to sell domestic currency against foreign exchange on demand at the official exchange rate, even though in practice they usually do.° Also, the extent of legal commitment varies greatly among the five currency board countries. While both Argentina and Bulgaria have set down in respective laws all three central elements, backing requirement and composition of reserves, anchor currency and exchange rate, and convertibility, Estonia does not specify the exchange rate, and Lithuania specifies neither the exchange rate nor the anchor currency. Yet, regarding low legal commitment, Hong Kong is in a class of its own. While the HKMA has shown great commitment towards the currency board, there are barely any statutory provisions that oblige the HKMA to operate a currency board. Only Hong Kong basic law requires the HKMA to keep bank notes in circulation fully backed, but otherwise no provisions are made concerning the exchange rate, the anchor currency, or convertibility.

©The Argentinean currency board was abandoned in early 2002. Nevertheless, it still represents an example of a modern present-day currency board. If referred to in presenttense throughout this thesis, this will be for the sake of uniformity. 6This one-way convertibility poses no threat to the credibility of the currency board, though. It guarantees to agents the exchange of their domestic cash holdings into foreign exchange anytime, which is an important pillar of currency board credibility. The failure to exchange foreign exchange into domestic money may only pose a problem if agents feared the domestic currency might be revalued. Consequently, a lack of two-way convertibility may hinder arbitrage mechanisms to function properly in situations of upward pressures to the currency, but does not lessen the credibility of the currency board. Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access

2.1. BASIC FEATURES OF A CURRENCY BOARD 35

Despite all these deviations from the four key features, these currency boards are generally—and in the context of this thesis—considered to be currency boards. They are still, by and large, rule-bound monetary institutions, fully backing the monetary base, and pledging to convert on demand domestic currency into foreign exchange at a fixed exchange rate.

Yet, some economist disagree. According to one of the strictest and most voiced definitions of a currency board, strongly advocated by Steve Hanke and Kurt Schuler, these five present-day currency boards are merely “currency board-like systems” (Hanke and Schuler 2000, chapter 3, section 5).’ The authors base their definition of what they call an orthodox currency board on the design of historical currency boards, most notably the West African Currency Board, established in 1913 (Schuler 1992, chapter 4, paragraph 1).° According to their definition, which includes but exceeds the key features described in subsection 2.1.1, a currency board’s sole purpose must be to be a passive device for conversion of the anchor into the domestic currency and vice versa. The currency board must not pursue any other ends in monetary policy nor should any other state-owned or state-controlled institution do so. Consequently, any scope for discretionary monetary policy, lending to the government, LoLR support, or financial regulation and supervision by the currency board are explicitly ruled out. The currency board must not accept deposits from commercial banks (which consequently rules out reserve requirements for banks) or the government. Complementary, to ensure the functioning of the monetary arrangement and the adjustment process of the whole economy, regulation of goods, factors, and financial markets should be liberal, markets should be open and integrated with world markets (Schuler 1999, pp. 5-6).

While this definition has been voiced often, it is not generally agreed upon. The insistence on orthodoxy, based on a design almost a century ago, seems to suggest that properly mimicking today the features and peculiarities of the currency board systems existing during the first half of the twentieth century will also lead to the indisputable stability and growth that the economies hosting these systems enjoyed. Yet, this would obviously be an oversimplification, as “the notion that [currency boards] can be revived to function as they did in the past idealizes them and neglects the change in economic fundamentals in current circumstances as well as the need for pre-

"For Hanke and Schuler’s definition of currency boards see for example Hanke and Schuler (1992, 1993, 2000), Hanke, Jonung, and Schuler (1993), Hanke (1999, 2000), and Schuler (1992, 1999). Kurt Schuler also maintains a site on the internet dedicated to currency boards and dollarization at http: //www.dollarization. org.

8The West African Currency Board will be discussed in great detail in subsection 3.1.4.

Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access commitment by governments and their constituencies to the discipline these institutions exact” (Schwartz 1993, p. 183).

Section 2.1 has shown that a currency board is a very simple monetary arrangement that is rather easily set up and operated. Little skills in monetary policy are required. ‘The main tasks of a pure currency board are the exchange of domestic currency into foreign exchange and vice versa, which requires few and not overly skilled staff, and the investment and management of reserves, which requires few but expert staff. The operation of the currency board is easily carried out and easily understood by the public. This makes currency boards particulary attractive for post-chaos countries—such as Bosnia—or for small countries that have recently attained independence—such as Estonia and Lithuania—and wish to create their own currency for motives of seigniorage as well as national identity (Hanke, Jonung, and Schuler 1993, p. 106; Balino and Enoch 1997, p. 6).

Besides such simplicity of administration and operation, the main reason why currency boards have been set up in recent years was their effectiveness in stabilizing economies, in which the credibility and value of the domestic currency have been threatened or destroyed and where high inflation and marked devaluations of the domestic currency have disrupted the functioning of the economy. This essential benefit of stabilization, and how it can be explained will be discussed in subsection 2.2.1.

Yet, the introduction of a currency board is no magic cure for a destabilized economy, which offers benefits without drawbacks. For the currency board to function properly and to be sustainable a number of prerequisites have to be met and potential disadvantages have to be considered before introducing it. One essential prerequisite are flexible factor and goods markets, as will be shown in subsection 2.2.2. Without the exchange rate providing for external adjustment, domestic prices need to adjust instead. If prices are inflexible, though, adjustment will have to come by potentially costly adjustments of the real economy, through consumption and incomes. The choice of an adequate anchor currency is equally important as the introduction of a currency board effectively implies importing the monetary policy of the anchor currency country, as will be shown in subsection 2.2.3. Yet, if e.g. business cycles in the anchor country are completely unrelated to cycles in the host country economy, monetary policy in the anchor country may exert unnecessary stress on the host country. Further, the introduction of a currency board presupposes a robust banking sector. As lender of last Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access resort (LoLR) support is limited or even non-existent under the currency board, banks have to be able to cope with higher levels of financial system stress than they might have been used to before. This point will be explored in subsection 2.2.4. Finally, subsection 2.2.5 stresses that the policymaker needs to be aware of the implications the currency board has on fiscal policy. Under a currency board fiscal deficits cannot be monetized any longer, but have to be financed by financial markets. Therefore, fiscal policy needs to be austere, closely watching government deficit and debt levels.

2.2.1 Credibility and Macroeconomic Stability

The main reason why recent modern currency boards have been introduced, has been the aim to institute a credible exchange rate mechanism and credible monetary policy, and thereby to import the low inflation and interest rates of the anchor currency country. For example, countries as Argentina, Bulgaria, and Lithuania were all experiencing high to hyperinflation combined with, or driven by large government budget deficits prior to introduction of their currency boards. The introduction of a currency board was seen as an extreme emergency measure to regain trust in their currencies and to achieve stabilization of their respective economies.

By choosing a currency board, policymakers signal their willingness and determination to subject themselves to the strict discipline imposed by the currency board. The scope for discretionary monetary policy is removed, and with it the ability of the central bank to monetize the government budget deficit, one main source of inflationary pressures. Government expenses become subject to a hard budget constraint, forcing the government to increase fiscal discipline and to reduce or eliminate the budget deficit.

Yet, the introduction of a fixed exchange rate and the announcement of tight fiscal and monetary policy alone are not sufficient for economic stabilization, as long as they lack credibility. This point, which distinguishes currency boards from regular pegs, has been made by Kydland and Prescott (1977) in their seminal paper on the time-inconsistency of optimal plans, and will also become very clear from the model in chapter 4.2 Under a regular fixed exchange rate, if the public trust in the policymaker’s announcement of low inflation and therefore adjust their inflation expectations accordingly, the policymaker is presented with an incentive to cheat on his commitment and to generate surprise inflation, thereby lowering unemployment. But, if the public form their expectations rationally, they are aware of this incentive to

°The problem of time-inconsistency and how a currency board may help overcome it, will be discussed in more detail in subsection 4.2.3. Kai Stukenbrock - 978-3-631-75699-7 Downloaded from PubFactory at 01/11/2019 02:47:34AM via free access cheat and will consequently form high inflation expectations. Consequently, the lack of credibility will leave the policymaker with two undesirable options: Either stick to the low-inflation policy and accept higher unemployment, or keep unemployment constant by generating inflation.

Such lack of credibility can be overcome by a currency board. Its operating principle is simple and transparent, making it easily understandable for the public. Second, the choice of a currency board signals the policymaker’s willingness to subject his policy actions to the strict requirements of the currency board. Third, the legal commitment, by which the currency board rules are normally set down in law, assures economic agents that no short-term changes to the arrangement are possible.

In theory, a fully credible currency board operating in an economy with flexible markets should then lead to inflation and interest rates similar to those in the anchor currency country (Baliño and Enoch 1997, pp.8-9). In practice, though, as chapter 3 will show, rates are often, but not necessarily, close to those in the anchor currency country. Inflation may, for example, be higher due to higher productivity growth in the currency board country—the Balassa-Samuelson effect, to which some economist attribute relatively high levels of inflation in Estonia and Lithuania!®. It may be lower due to inflexible labor and goods market, leading to a protracted period of adjustment after a shock, possibly entailing deflation, as has been the case in Argentina in the late 1990s. Interest rates also tend to remain above those in the anchor currency country, as the exchange rate risk is greatly but not completely reduced. For example, in Argentina domestic interest rates on dollar transactions have constantly been below interest rates on peso transactions throughout the currency board period (see figure 3.20).