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Lecture #355 on Europe

December 6, 1991

Currency Boards for Eastern Europe

By


(Archived document, may contain errors)

CURRENCY BOARDS FOR EASTERN EUROPE

by

Steve H. Hanke and Kurt Schuler

S teveH.HankeisProfessorof Applied Economics atTheJohnsHopkins University in Baltimore and Chief Economist at Friedb erg Commodity Management, Inc. in Toronto. He also serves as the Advisor to the President of Deloitte Ross Tohmatsu InternationalVEastern Europe in Brussels. He has advised'senior government officials in Albania and Yugoslavia.

Kurt Schuler is a graduate student in economics and holds the George Edward Durell Assistantship at George Mason University in Fairfax, Virginia. He has been a Summer Fellow at G.T. Management in Hong Kong, where he worked with John Greenwood, who designed Hong Kong's currency boar d system.

This is an expanded version of a presentation by Steve Hanke to a delegation of legislators frorn the Russian Republic, sponsored by The Heritage Foundation, on June 20, 199 1, at The Johns Hopkins University, Baltimore, Mmyland. ISSN 0272-1155. 0 1991 by The Heritage Foundation.

TABLE OF CONTENTS

Chapter 1. Monetary Reform and the Development of a Market Economy . . . . 1

Chapter 2. What Is a Currency Board? . . . . . . . . . . . . . . . . . . . . . . . 5

Chapter 3. How a Currency Board Works . . . . . . . . . . . . . . . . . . . . . 7

Chapter 4. Central Banking . . . . . . . . . . . . . . . . ... . . . . . . . . . . . 16

Chapter 5. Advantages of a Currency Board Over a Central Bank . . . . . . . . . 19

Chapter 6. How to Establish a Currency Board . . . . . . . . . . . . . . . . . . . 22

Chapter 7. How to Operate a Currency Board . . . . . . . . . . . . . . . . . . . 27

Chapter 8. How to.Protect the Currency Board . . . . . . . . . . . . . . . . . . . 30

Chapter 9. Summary and Conclusion . . . . . . . . . . . . . . . . . . . . . . . . 32

Annex I: A Model Currency Board Law . . . . . . . . . . . . . . . . . . . . . . 33

Annex II: Alleged Disadvantages of Currency Boards . . . . . . . . . . . . . . . 35

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37

CHAPTER I

MONETARY REFORM AND THE DEVELOPMENT OF A MARKET ECONOMY

Eastern Europe and the former Soviet Union (which we shall simply call the USSR) are struggling to throw off the shackles of socialism and to embrace capitalism. To do so successfully, they must rid them- selves of their unsound currencies and establish s t able, convertible currencies. The "new" currencies should be convertible into one of the major international hard currencies. A sound currency, which is vital for a well-functioning market economy, serves as a satisfactory store of value, medium of exchan g e, and unit of account. An unsound currency does not fulfill any of those functions. An unsound currency is not a reliable store of value because inflation makes its value highly unpredictable. As a result, people save by hoarding bricks, timbers, food, a n d other commodities, which retain value better than money and other financial assets. Although commodity hoarding slows eco- nomic growth, it is rational for people in nations with unstable currencies. U.S. dollars and other stable currencies also serve a s substitute stores of value in nations with unstable currencies. For example, indi- viduals and enterprises in the USSR probably hold over $10 billion of foreign currency, which is more than the real value of the ruble money supply. "Dollarization" is cos t ly. It requires Soviet citizens to give up real goods and services to obtain bits of paper that Western central banks print at almost no cost, generating a perverse form of foreign aid that flows from the USSR to Western central banks. An unsound currency is not a good medium of exchange. The outside world refuses to accept it. That impedes foreign investment and trade, and hence competition and economic growth. Nor is an unsound currency a good unit of account. Inflation distorts prices and makes business calculation more difficult. Without a good unit of account, it is impossible to make meaningful accounting calculations or to write contracts. In sum, then, an unsound currency prevents important elements of a market economy from working. Eastern Europe a n d the USSR have primitive financial systems that cannot intermediate efficiently be- tween savers and investors because their currencies are unstable and inconvertible. The status of their currencies also explains why they have limited trade with the outs i de world. As long as Eastern Europe and the USSR have unsound currencies, they will be unable to transform themselves into market econo- mies. A sound, convertible currency allows people to carry out decentralized planning, which is more effi- cient than c entral planning. In nations with so-called internally convertible currencies, all that is usually required to buy goods domestically is to have currency to pay a domestic seller. Internal convertibility implies that it is not necessary to obtain authoriza t ion from any central planner to buy or sell goods that are available inside the country. The exchange of goods is much more extensive, rapid, and efficient where internal convertibility exists, as in the United States, Germany, and Poland, than where it d o es not, as in Albania and the USSR. The foreign trade counterpart of internal convertibility is external convertibility-the ability to convert as much domestic currency into foreign currency as one wishes, as market rates rather than at much higher or low e r official rates. External convertibility can be unlimited, as in the major Western countries, or it can be limited, as in Czechoslovakia and Poland at present. Czechoslovakia and Poland allow most current account purchases, in which people buy foreign go ods for import, but they prohibit many capital

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account transactions, in which people buy foreign financial asset s. Current account convertibility ex- poses domestic producers to foreign competition and helps introduce the structure of prices that pr evails in world markets. That induces a nation to specialize in making the goods it is best at producing and then trade abroad for other goods, which increases wealth all around. Capital account convertibility helps at- tract foreign investment, because u n less foreigners can repatriate profits they will be reluctant to invest. Foreign capital investment can offset a large current account deficit and speed the introduction of ur- gently needed foreign goods to modernize the economy. The ability to purchase b oth domestic and foreign goods readily is what makes Western currencies fully convertible "hard" currencies, and what makes them so highly prized in Eastern Europe and the USSR. To reap the full benefits of participating in world markets, Eastern Europe a n d the USSR them- selves need to establish fully convertible currencies. Their present monetary systems are obstacles to a market economy. Inflation is in mid double digits or higher throughout the region. In the USSR, infla- tion is projected to surpass 2 0 0 percent this year. Even in Poland, which has allowed most formerly sub- sidized prices to rise to market levels and has linked the zloty to the U.S. dollar, inflation remains above 40 percent per year. Inflation will remain high, even in nations that fo l low Poland's course, because central banks in the re- gion have no credibility. They have long histories of bowing to political pressures for inflation. For in- stance, the USSR has had government currency issue since 1768, and a central bank since 1860. I n all that time it has had a fully convertible currency for only 35 years, the last year being 1914. All East Eu- ropean central banks, except in the Baltic nations and Albania, caused hyperinflations in the 1920s, and some caused hyperinflations again in the late 1940s. The new central banks established in various former Soviet republics do not have the handicap of bad past performance to undermine their credibility, but they face other problems. So far, none has announced any definite plan for keeping it s currency stable. Also, the general experience of central banks in developing nations suggests that both the established central banks and the new central banks will face ferocious political pressures for inflation. For the 99 nations that the World Bank c lassifies as low-and middle-income, average annual inflation was 16.7 per- cent f3rom 1965 to 1980 and 53.7 percent from 1980 to 1989. This poor performance explains why Paul Volcker, the former chairman of the U.S. Federal Reserve System, has indicated t h at he has little faith that central banks in Eastern Europe and the USSR can achieve full convertibility. Addressing central bankers in Jackson Hole, Wyoming last year, Mr. Volcker notes that markets developed long before central banks, and stressed that E astern Europe and the USSR might actually retard their transition to markets by relying on central banks. 1 Central banks are essen- tially not market institutions, which is why Marx and Engels said in the Communist Manifesto that one of the steps for ach i eving communism was "Centralization of credit in the hands of the state, by means of a national bank with state capital and an exclusive monopoly."" To gain credibility, central banks in Eastern Europe and the USSR must painstakingly establish good track r ecords. The lack of credibility of official promises has already led people throughout the region to conduct their own unofficial monetary reform. They have dollarized local economies. To the extent that dollars and other hard currencies are unavailable, s ome transactions are even taking place in barter, be- cause barter is the only way for people to prevent domestic currency inflation from robbing them of their savings. The shift to barter is particularly disruptive in the USSR, where it is choking trade among

I Volker 1990. 2 Marx and Engels (1848) 1948, p. 30.

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republics. Making national currencies stable and convertible would revive trade among republics and among East European nations. The problem of credibility has locked central banks and the publ ic into a game that has no winners. Central bank promises to maintain currency stability, even by means of fixed exchange rates, are not credible. Prices will continue to rise quickly because workers will base their wage demands on estab- lished central b a nks' dismal past performance, or on well-founded skepticism of new central banks' promises of good behavior. State-owned enterprises and government ministries will likewise continue their free-spending ways, because they will correctly expect that the gov e rnment will rescue them by forcing the central bank to print money, as has so often happened before. Workers and enterprises will anticipate that this "soft budget constraine' will continue, and they will behave accordingly. If central banks in Eastern Eu r ope and the USSR miraculously do maintain currency stability, the con- sequences could almost be worse than under continued inflation. Because the central banks lack credibil- ity, people will remain skeptical of them for years. To gain credibility, the c e ntral banks will have to keep their currencies overvalued and keep real (inflation-adjusted) interest rates high. That may plunge national economies even deeper into depression. In such depressions, the export sector will suffer more than other sectors. T h at is what has happened in Yugoslavia, whose December 1989 currency reform was not completely credible. People correctly anticipated that the National Bank of Yugoslavia would not maintain the original fixed exchange rate, so real interest rates have exce e ded 30 percent per year be- cause the rates contained a large devaluation risk premium. A credible monetary reform that has no de- valuation risk can keep real interest rates in single digits (for the least risky loans), as it is in the Western industrial nations, and hence can save Eastern Europe and the USSR much pain. Eastern Europe and the USSR could make their currencies convertible by maintaining floating ex- change rates rather than fixed rates. But though floating exchange rates balance supply and d emand for domestic currency against foreign currency, they do not restrain central banks' powers to create credit. Instead, they are likely to lead to South American-style hyperinflations. Domestic political pressure groups representing the old order favo r renewed inflation rather than stable money and prices. As infla- tion mounts, prices become increasingly unreliable indicators for guiding economic activity and the tran- sition to a market economy becomes even more difficult because a market economy nee d s fairly stable prices to work well. To have stable currencies, Eastern Europe and the USSR need to remove monetary policy from politi- cal influence. They need to give their monetary reforms instant credibility, to avoid the dangers of con- tinuing infla t ion on the one hand and depression on the other hand. The best way to do so is to strip their central banks of currency issuing functions, and to establish currency boards, whose only job will be to issue convertible currencies according to strictly defin e d rules. Currency boards are explicitly designed to maintain a fixed exchange rate. Currency boards are easy to establish and operate, and they have al- ways been able to maintain fixed-rate currency convertibility, even during the most trying times. Curr e ncy boards would quickly establish hard domestic currencies and instill monetary confidence. As a result, economic agents would alter their expectations. If the U.S. dollar or the German mark were used as a currency board's reserve currency, workers could not raise wages and enterprises could not in- crease prices much beyond their rates of increase in the United States or Germany unless they achieved corresponding gains in productivity or quality. If governments in Eastern Europe and the USSR estab- lishe d secure property rights and removed barriers to foreign investment, interest rates would also be close to American or German levels. Under the currency board system, East European governments would have to finance themselves exclusively by taxation and bo rrowing, not by inflation, because a currency board cannot be an agent of government finance.

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Linking domestic currencies to foreign currencies in Eastern Europe and the USSR would not subject the region to foreign political domination, as some people think. Rather, it would restore an element of national dignity by giving the region the sound currencies it now lacks. By establishing domestic curren- cies that are as sound as the foreign currencies to which they are linked, currency boards offer a way f or domestic currency to become attractive as a store of value and to displace foreign currency from circula- tion. That would stop the perverse form of foreign aid that now flows from the region to Western central banks. The cost of establishing 100 perce n t reserves against domestic currency and sufficient fractional re- serves against deposits is surprisingly low in Eastern Europe and the USSR. At present market exchange rates, the real value of domestic currency and deposits throughout the region is smal l . The hard-currency reserves necessary to establish currency boards range from about $70 million for Albania to perhaps $6 billion for Poland and the USSR. Alternative estimates that claim currency boards would cost many times more are based on flawed ass u mptions, as we shall explain in Chapter 6. Currency boards are essential to wider fiscal and economic reforms. With a stable monetary environ- ment, Eastern Europe and the USSR would be able to successfully take the next steps towards a market economy. Th i s essay explains what a currency board is. It describes the difference between how money is sup- plied in a currency board system and in a central banking system. It demonstrates why the currency board system is superior to a central banking system. It al so details'how to establish and operate a cur- rency board-including how to obtain the foreign currency for the board's reserves-and how to insu- late the board from political pressure.

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CHAPTER 2

WHAT IS A CURRENCY BOARD?

Ac 17 ncy board is an institution that issues notes and coins convertible into a foreign "reserve" cur- rency at a fixed rate and on demand. It does not accept deposits. As reserves, a currency board holds high-quality, interest-bearing securities denomin a ted in the reserve currency. A currency board's re- serves are equal to 100 percent or slightly more of its notes and coins in circulation, as set by law. (Com- mercial banks in a currency board system need not hold 100 percent reserves in reserve-currenc y assets, however.) The board generates profits (seigniorage) from the difference between the interest earned on the securities4 that it holds and the expense of maintaining its note and coin circulation. It remits to its owner (historically, the governmen t ) all profits beyond what it needs to cover its expenses and to main- tain its reserves at the level set by law. The currency board has no discretion in monetary policy; market forces alone determine the money supply. As an introduction, let us briefly ex a mine the main characteristics of a currency board. We shall dis- cuss them in more detail later. Convertibility: The currency board system assures that the currency will be convertible at a fixed rate. No currency board has ever had problems maintaining f i xed-rate convertibility. The currency boards of Burma and North Russia even maintained fixed-rate convertibility in the midst of civil war. The cur- rency boards of British colonies maintained convertibility during the Great Depression and (where not over r un by enemy armies) during World War II. Reserves: A currency board's reserves are adequate to ensure that, even if all holders of notes and coins want to convert them into the reserve currency, the board will be. able to do so. Currency boards have usual l y held reserves of 105 or 110 percent of liabilities, so that they would have a margin of pro- tection in case the interest-earning securities that they held lost value. If a nation used the U.S. dollar or the German mark as its reserve currency, for inst a nce, its own currency would remain as good as the dol- lar or the mark. Chapter 6 will discuss how to acquire the necessary reserves. Seigniorage: Unlike securities or most bank deposits, notes and coins do not pay interest. Hence, notes and coins are lik e an interest-free loan from the people who hold them to the issuer. The issuer's profit equals the interest earned on reserves minus the expense of putting the notes and coins into circulation. In addition, if the notes and coins are destroyed, the issuer ' s net worth increases because his liabilities fall but his assets do not. Under a currency board system, the domestic currency is as sound as the foreign reserve currency. The only economic difference between using a domestic currency issued by a board as legal tender, instead of a foreign currency, is that the seigniorage generated by a currency board issue is captured domesti- cally; whereas, if a foreign currency is used as legal tender, the foreign issuer captures the seigniorage. The domestic seignior age generated by a currency board can be significant. Expenses incurred by cur- rency boards are usually about I percent of assets per annum. Profit rates are equal, therefore, to the in-

3 it is also possible to use a basket of currencies or gold as the r eserve asset, as a few boards have done. 4 Or, for a currency board whose reserve asset is gold, interest on loans of physical gold. A well-organized market for such loans exists in London.

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terest rate earned on assets minus I percent. Conservatively, that rate should be at least 4 percent per annum. In addition to seigniorage, the use of a domestic currency board issue as legal tender, rather than a for- eign currency, generates another domestic advantage: national pride is enhanced. Monetary policy: By design, a currency board has no discretionary powers. Its monetary policy is completely automatic, consisting only in exchanging its notes and coins for the foreign reserve currency at a fixed rate. Since a currency board's role is strictly circumscrib e d, it is less likely than other mone- tary systems to suffer political pressures to engage in economically unsound policies. Over sixty countries have had currency boards during this century. Most of them have been British col- onies or former colonies. H o wever, there have also been currency boards elsewhere, including two cases in Eastern Europe. A Russian currency board existed in the northern region occupied by the British and other Allies in 1918 and 1919. It issued a ruble currency having a fixed exch a nge rate with the British pound sterling. The free city of Danzig had a currency board from 1922 to 1923. The Danzig board too maintained a fixed exchange rate with sterling. Both East European currency boards were extremely suc- cessful during their brie f lives. The North Russian board maintained convertibility in the midst of a civil war, and the Danzig board maintained convertibility despite a deep economic depression caused by the slump in Germany, its chief trading partner.5 Despite the success of cur r ency boards, only a few currency board-style monetary systems exist today, most notably in Hong Kong and (in greatly modified form) in Singapore. Most other countries that once had currency boards replaced them with central banks. These changes were made f or political, not eco- nomic, reasons. Politicians saw central banking as a way of manipulating the money supply to their own advantage. Since abandoning the currency board system, many of those countries have experienced infla- tion and economic stagnati on. Hong Kong and Singapore, on the other hand, have been two of the world's most rapidly growing economies, despite their lack of natural resources. Moreover, they have re- alized relatively low rates of inflation.

5 Hanke and Schuler, 1990,199 1.

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CHAPTER 3

HOW A CURRENCY BOARD WORKS

The currency board system relies entirely on market forces to determine the amount of notes and coins that the board supplies, and also to determine the amount of deposits and other components of the broader money suppl y that banks and other financial institutions supply. The central bank of the reserve- currency country determines the supply of reserves in the whole currency area, including the currency board country. Competition among commercial banks determines the d i stribution of the reserves, includ- ing the proportion of the total that becomes the foreign-currency reserve of the currency board country. The currency board has no role in determining the supply of reserves, because its 100 percent reserve re- quiremen t makes it merely a sort of warehouse for reserves. Since a board cannot influence the amount of reserves, it cannot influence the total supply of credit. This stands in contrast to central banks, which ftequently expand or contract the amount of reserves a vailable to commercial banks in efforts to influ- ence the supply of bank credit. However, the supply of notes and coins is elastic, because, as we shall ex- plain, the currency board country can acquire reserves from the reserve-currency country. As unde r a gold standard, or gold exchange standard, in a currency board system the amount of credit that banks can create (and hence the total money supply) is limited by their ability to acquire and keep reserves sufficient to support that amount of credit. Thi s does not mean that credit is scarcer or carries higher real interest rates than in a central banking system; indeed, Hong Kong and Singapore are major centers of ample and efficient finance. It merely prevents a currency board system from experiencing in - flation as high as is possible under the average floating exchange rate central banking system in a devel- oping country. Under a currency board system, the currency board country stands in a similar relation to the reserve-currency country as, say, Cali f ornia does to the rest of the United States. Commercial banks are middlemen between BALANCE-OF-PAYMENTS lenders (depositors) and borrowers (people who ASSUMPTIONS spend bank loans). A bank cannot for long 1) Bank deposits are convertible into currency boa r d grant more credit to borrowers than depositors notes at a fixed rate. wish to grant to it. If a bank grants excessive 2) The ratio of notes and coins to the broader monsy sup- credit, the borrowers will spend it (for instance, ply (the currency-deposit r atio) is constant. by writing checks), and more funds will flow 3) Income and money holdings move in the same direc- out of the bank than flow into the bank from tion. checks written on other banks. To prevent this 4) There is no international branch bank i ng between the sort of mistake from resulting in bankruptcy, a currency board country and the reserve-currency coun- bank needs to hold reserves. The reserves pro- try. tect it from the consequences of its occasional 5) All balance-of-payments occur in th e current account; mistakes. the capital account did not change. 6) No binding minimum reserve ratios or other special The ultimate reserves in a currency board sys- bank regularions exist. tem are holdings of the foreign reserve cur- 7) People do not hold stocks of foreign reserve currency rency. The only way to acquire new reserves, nor do they use it in domestic transactions. obviously, is to obtain currency from the re- serve-currency country, which in its simplest Note:As we shall explain later, only A s sumption 1 is neces- form requires running a balance-of-payments sary for the analysis of currency boards. The other assump- surplus. Under certain simplifying assumptions tions can be dropped. However, the analysis becomes more that we make for the sake of clarity (see box), complicated then. See Ow 1985 and Walters 1987. changes in the balance of payments change the

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total domestic money supply in the same direction. A balance-of-payments surplus increases the total do- mestic money supply. A balanc e-of-payments deficit, on the other hand, decreases the total domestic money supply. Later we shall explain how under less simple, more realistic assumptions, investment in- flows can enable the domestic money supply even if there is a balance-of-payments deficit. (Recall that the balance of payments is the value of exports minus the value of imports. Recall also that the domestic money supply is made up of the currency board's notes and coins in the public's hands plus commercial bank deposits.) The easie s t way to illustrate the linkage between changes in the balance of payments and the domestic money supply under a currency board system is with a combination of flow and "r-accoune'diagrams. The flow diagrams depict a chain of events, whereas the T account s depict simplified balance sheets for the relevant agents under a currency board system (see Figures 1, 2, and 3).6 A typical currency board's T account looks like this: Figure I

CURRENCY BOARD

Assets Liabilities Foreign-currency securities Notes and coins Net worth

A typical commercial bank's T account in a currency board system looks like this:

Figure 2 COMNERCIAL BANKS

Assets Liabilities Currency board notes & coins (reserves) Public's deposits Loans and investments I Stockholders' equity

The T account of the public as a whole (meaning all of the financial sector except the currency board and the commercial banks) looks like this:

Figure 3

PUBLIC

Assets Liabilities Deposits at banks Loans from banks Currency board notes & coins Net worth

The total money supply is the left-hand (asset) side of the public's T account.

6 The account that follows draws heavily on Greenwood 1981 and 1983a.

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We begin our analysis with a flow diagram (Figu re 4). To start, the balance of payments is in balance and exports equal imports. We then put the system in motion by generating a balance-of-payments sur- plus. That surplus works its way through a currency board system in the sequence depicted in Figure 4. Notice that the currency board plays an explicit role in the chain of events depicted in Figure 4 only at the stage labeled "rise in demand for goods in general, including currency board notes and coins." To look at this stage in more detail, and to cl a rify the relationship between commercial banks and the currency board in the chain of events, we use T accounts. We use some hypothetical numbers to illustr- ate what happens. Let stage I (the starting point) be a situation where the balance of payments i s zero- an equilibrium. For the sake of simplicity, we ignore net worth in the currency board's T account, stockholders' equity in commercial banks' T accounts, and loans from banks and net worth in the public's T account, assuming that they are zero. We a s sume that the banks have a desired deposit-to-re- serve ratio of 50: 1, which maximizes their risk-adjusted profits, and that the public has a desired deposit- to-currency (notes and coins) ratio of 10: 1 (see Figure 5) which maximizes their convenience. For the sake of illustration, let us call the currency of the currency board country the ruble. Figure 4

Balance of Payments is Zero (Stage I In T Account Diagrams)-Equilibrium

Fall in Domestic Demand for Imported Goods and/or Rise in Foreign Demand for Currency Board Country's Goods

Balance-of-Payments Surplus (Exports Exceed Imports)

Rise in Bank Reserves

Rise in Bank Credit (Money Supply)

Fall in Interest Rates

Rise in Income

Rise in Demand for Goods in General, Including Currency Board Notes and Coins (Stage 2 1In T Account Diagrams) Prices of Domestic Goods Rise I Rise in Domestic Demand for Foreign Goods or Fall in Foreign Demand For Currency Board Country's Goods I Balance of Payments Returns to Zero (Stage 3 In T Account Diagrams)-New Equilibrium

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Figure 5 CURRENCY BOARD-STAGE 1

Assets Liabilities Foreign-currency securities 600 Notes and coins 600

COMNERCIAL BANKS-STAGE 1

Assets Liabilities Currency board notes & coins (reserves) 100 Public's deposits 5000 Loans and investments 4900

P UBLIC-STAGE 1

Assets Liabilities Deposits at banks 5000 Currency board notes & coins 500

TOTAL MONEY SUPPLY = 5000+500 = 5500 BANKS'DEPOSIT-TO-RESERVE RATIO = 5000:100 = 50:1 (Equilibrium) PUBLIC'S DEPOSIT-TO-CURRENCY RATIO = 5000:500 = 10: 1 (Equilibrium)

Now let there be a balance-of-payments surplus of 12 rubles, in the form of foreign currency that the public.deposits in local banks (see Figure 6). Since we assume, for the sake of simplicity, that banks hold all reserves in the form of currency board notes and coins, the banks exchange the foreign currency at the currency board for domestic currency. (They exchange the reserve currency a t the fixed exchange rate, and other currencies at prevailing market rates.) The board's assets and liabilities become 12 rubles more than in Stage 1. The banks' reserves become 12 rubles more than in Stage 1, and the public's de- posit holdings become 12 rubles more than in Stage 1. In addition,.the money supply is 12 rubles more than in Stage 1. This is Stage 2.

Figure 6 CURRENCY BOARD-STAGE 2

Assets Liabilities Foreign-currency securities 612 Notes and coins 612

COMNERCIAL BANKS-STAGE 2

Assets Liabilities Currency board notes & coins (reserves) 112 Public's deposits 5012 Loans and investments 4900

10

PUBLIC-STAGE 2

Assets Liabilities Deposits at banks 5012 Currency board notes & coins 500

TOTAL MONEY SUPPLY = 5012+500 = 5512 (expansion = 12) BANKS'DEPOSIT-TO-RESERVE RATIO = 5012:112 = 44.75:1 (Disequilibrium) PUBLIC'S DEPOSIT-TO-CURRENCY RATIO = 5012:500 = 10.024:1 (Disequilibrium)

Notice that banks' deposit-to-reserve ratio is 44.75:1 (S tage 2), which is less than their desired (Stage 1) ratio of 50: 1. Notice also that the public's deposit-to-currency ratio is 10.024:1 (Stage 2), which is more than their desired (Stage 1) ratio of 10: 1. That means that banks will expand their loans, an d the public will expand its holdings of currency, to restore the original Stage I ratios. In Stage 3, they do so, achieving a new equilibrium, with the money supply 110 rubles more than in Stage 1 (see Figure 7). Figure 7 CURRENCY BOARD-STAGE 3

Assets Liabilities Foreign-currency securities 612 Notes and coins 612

COMNERCL4L BANKS-STAGE 3

Assets Liabilities Currency board notes & coins (reserves) 102 Public's deposits 5 100 Loans and investments 4998

P UBLIC-STAGE 3

Assets Liabilities Deposits at banks 5100 Currency board notes & coins 510

TOTAL MONEY SUPPLY = 5100 + 5 10 = 5610 (expansion = 110) BANKS'DEPOSIT-TO-RESERVE RATIO = 5100:102 = 50:1 (Equilibrium) PUBLIC'S DEPOSIT-TO-CURRENCY RATIO = 5100:510 = 10:1 (Equilibrium)

As the T accounts illustrat e, banks' efforts to reattain their desired deposit-to-reserve ratio, and the public's efforts to reattain its desired deposit-to-currency ratio, move the currency board system back to equilibrium when a balance-of-payments surplus occurs. The currency bo ard responds to their actions

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"automatically" by virtue of its 100 percent reserve ratio and its fixed exchange rate with the foreign re- serve currency. When there is a balance-of-payments deficit, the money supply process works as follows:

Figure 8

Balance of Payments is Zero (Stage 1 in T Account Diagrams)-Equilibrium I I Rise in Domestic Demand for Imported Goods and/or Fall in Foreign Demand for Currency Board Country's Goods

Balance-of-payments Deficit (Exports Are Less Than Imports)

Fall in Bi k Reserves

F all in Bank Cre it (Money Supply)

Rise in Ii erest Rates

F all in Income

Fall in Demand for Goods ir al, Including Currency Board Notes And Coins (Stage 2 in T Account Diagrams)

P rices o @stic Goods Fall

Fall in Domestic Demand for Foi Agn Goods and/or Rise in Foreign Demand for Currency Board Country's Goods

Balance of Payments Returns to Zero (Stage 3 In T Account Diagrams)-New Equilibrium

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Starting from an equilibrium in Stage 1 again, the T accounts are (see Figure 9): Figure 9 CURRENCY BOARD-STAGE 1 Assets Liabilities Foreign-currency securities 600 Notes and coins 600

COMMERCIAL BANKS-STAGE 1 Assets Liabilities Currency board notes & coins (reserves) 100 Public's deposits 5000 Loans and investments 4900

PUBLIC-STAGE 1

Assets Liabilities Deposits at banks 5000 Currency board notes & coins 500

TOTAL MONEY SUPPLY = 5000+500 = 5500 BANKS'DEPOSIT-TO-RESERVE RATIO = 5000:100 = 50:1 (Equilibrium) PUBLIC'S DEPOSIT-TO-CURRENCY RATIO = 5000:500 = 10: 1 (Equilibrium)

Now let t here be a balance-of-payments deficit of 12 rubles. The public pays foreigners 12 rubles more for goods than foreigners pay the public. Foreigners will only accept payment in foreign currency, and the currency board has all the foreign currency in the fin a ncial system, so people convert 12 rubles of its notes and coins into foreign currency. They do so by withdrawing 12 rubles from their bank deposit ac- counts as currency board notes. Consequently, the banks' reserves become 12 rubles less than in Stage 1 . People exchange the notes for foreign currency at the currency board's fixed rate, so the board's as- sets and liabilities become 12 rubles less than in Stage 1. This is Stage 2 (see Figure 10): Figure 10 CURRENCY BOARD-STAGE 2

Assets Liabilities Foreign-cuffency securities 588 Notes and coins 588

CON11VIERCIAL BANKS-STAGE 2

Assets Liabilities Currency board notes & coins (reserves) 88 Public's deposits 4988 Loans and investments 4900

13

PUBLIC-STAGE 2

Assets Liabilities Deposits at banks 4988 Currency board notes & coins 500

TOTAL MONEY SUPPLY = 4988+500 = 5488 (contraction = 12) BANKS'DEPOSIT-TO-RESERVE RATIO = 4988:88 = 56.68:1 (Disequilibrium) PUBLIC'S DEPOSIT-TO-CURRENCY RATIO = 5988:500 = 9.976:1 (Disequilibriurn)

Notice that banks' deposit-to-reserve ratio is 56.68:1 (Stage 2), which is mare than their desired (Stage 1) ratio of 50:1. Notice also that the public's deposit-to-currency ratio is 9.976:1 (Stage 2), which is less than its desired (Stage 1) ratio of 10: 1. That means that banks will contract their loans, and the public will contract its holdings of currency, to restore the original Stage I ratios. In Stage 3, they do so, achiev- ing a new equilibrium, with the money supply 110 rubles less than in Stage 1 (see Figure 11): Figure 11 CURRENCY BOARD-STAGE 3

Assets Liabilities Foreign-currency securities 588 Notes and coins 588

COMNIERCIAL BANKS-STAGE 3

Assets Liabilities Currency board notes & coins (reserves) 98 Public's deposits 4900 Loans and investments 4802

PUBLIC-STAGE 3

Assets Liabilities Deposits at banks 4900 Currency board notes & coins 490

TOTAL MONEY SUPPLY = 4900+490 = 5390 (contraction = 110) BANKS'DEPOSIT-TO-RESERVE RATIO = 4900:98 = 50:1 (Equilibrium) PUBLIC'S DEPOSIT-TO-CURRENCY RATIO = 4900:490 = 10: 1 (Equilibrium)

As in the case of a balance-of-payments surplus, banks' attempts to reattain their desired deposit-to-re- serve ratio, and the public's efforts to reattain its desired deposit-to-currency ratio, move the currency board syste m back to equilibrium when a balance-of-payments deficit occurs. There are two important points to notice about the adjustment process in a currency board system. The first is that market forces rather than central bank action set it in motion; it is comp letely "automatic," as far as the currency board is concerned. The second point is that, because the exchange rate is fixed, arbi-

14

trage occurs entirely through changes in the quantity of money, interest rates, and the balance of pay- ments, rather than through the exchange rate. In that respect, the currency board system is like the gold standard or the gold exchange standard. The fixed exchange rate between the currency board currency and the reserve currency should make goods arbitrage between th e two countries very tight, ff the im- pediments to trade between them are small. The overall rate of price changes, as reflected in wholesale price indexes, should not differ greatly between the two countries. Interest rates also should be roughly the sam e in both countries, unless there are real factors such as taxes or perceived risks7 that make lend- ing costlier in one country. The experience of currency board countries bears this out. In Hong Kong, for instance, interest rates and the prices of Hong K o ng goods made for export have closely tracked those of the United States since Hong Kong linked its currency to the U.S. dollar in 1983. The foregoing treatment of the mechanics of currency board money supply was simplified by some as- sumptions that we m a de (see box, page 7). If we drop all assumptions except that currency board notes and coins exchange against bank deposits at a fixed rate, the connection between the balance of pay- ments and the money supply becomes less direct. It is even possible for t he changes in money supply under a currency board system to move opposite from balance-of-payment changes. However, that is perfectly acceptable. There is no reason why the money supply in a modem fractional-reserve banking system should have a rigid rela t ion with the balance of payments, if other factors simultaneously move the money supply in the other direction. Hong Kong and Singapore experienced balance-of-payments deficits for decades at a time, yet their domestic money supplies steadily increased be c ause they were at- tracting large inflows of foreign investment. The many additional factors that can complicate analysis should not obscure the important point: mar- ket forces of profit and loss determine and limit money supply expansion in the currency board country. As long as it is more profitable to invest funds in the currency board country than elsewhere (after tak- ing into account inflation, exchange-rate risk, and transactions fees), banks in the currency board coun- try will expand their loans. They will be able to do so because foreign investment is flowing in, bringing additional reserves to the banking system. When banks have expanded their loans to such an extent that additional loans would be less profitable than investing the funds abroad, they will not make such loans, and so the money supply will cease expanding. If it becomes more profitable to invest funds abroad than in the currency board country, the currency board country will lose reserves, banks will have to contract their loans to preserve their solvency, and so the money supply will contract. The currency board's role in all this is entirely passive: all it does is to convert notes and coins into and out of the reserve currency as the public and banks demand.

7 These include the risk that a balance of payments surplus or deficit will tempt the currency board country to set the exchange rate with the reserve currency at at different level. For example, after returning to the currency board system in 1983, Hong K ong's balance-of-payments surpluses with the U.S. prompted speculation that the Hong Kong government would revalue the Hong Kong dollar against the reserve currency, the U.S. dollar. When it became clear the Hong Kong government would not revalue, specula tive pressure ceased and Hong Kong interest rates, which had fallen to low levels relative to U.S. rates, moved closer to U.S. dollar rates.

1 5

CHAPMR 4

CENTRAL BANKING

The essential difference between a currency board and a central bank is that a cen tral bank does not work automatically. A central bank has discretionary power to influence the supply of money, and it not necessarily guided by considerations of monetary profit and loss. A currency board system is by nature a fixed exchange rate monetar y system, while central banking is not. As we shall explain in the next chap- ter, the nature of central banking tends to drive central banking systems off of fixed exchange rates to floating exchange rates. Consequently, in this chapter, we compare a curr e ncy board to a floating-rate central bank, not to a central bank that maintains a fixed rate. Central banks typically perform many other functions besides influencing the supply of money. They regulate commercial banks, serve as lenders of last resort to t he banking system, give economic advice to the government, and clear checks. However, all these are secondary to their role in influencing the money supply. Only central banks control the supply of reserves in the banking system, whereas other government b odies can and do often perform the remaining central banking functions. For instance, in the United States, the Federal Reserve System shares regulatory powers with the Treasury Department, lender-of-last-resort powers with government deposit insurance ag e ncies, economic advising powers with several other government bodies, and check clearing with commercial banks. We shall focus only on how central banks influence the money supply, so that we can contrast it with currency boards' role in the money supply p rocess. In a currency board system, the starting point in the chain of events in our example of a Figure 12 money supply expansion was a fall in the de- mand for imported goods in the currency board Equilibrium (Say, 50 Rubles = US$ 1) country. Changes in demand for imported goods originate in the market, as a result of changes in people's wants. In a central banking Surprise Central Bank Decision system, the starting point is a decision by the To Increase Supply of Reserves central bank to expand the supp l y of bank re- (Say, By Buying Bonds from Bond Dealers) serves. That is a not a decision that originates in the market. Indeed, the central bank can decide to act oppositely to what would happen under a Rise in Bank Reserves currency board system. Diagramm a tically, the chain of events in the . 8 Rise in Bank Credit (Money Supply) case of a surprise money supply expansion under central banking looks like Figure 12. To bring out more clearly the contrast with a Exchange Rate of Domestic Currency currency boar d system, the diagram omits con- In Terms of Foreign Currency Falls sideration of the effects of various lags. It as- (Say, From 50 Rubles = $1 to 60 Rubles = $1) sumes that nominal prices adjust very quickly, New Equilibrium leaving real prices unchanged. Ile only effect

8 We consider only the case of surprise to avoid complications concerning expectations.

16

of the central bank's decision is a fall in the exchange rate. Under the more realistic assumption that some nominal prices do not change quickly , the central bank's action has real effects on the economy. Indeed, that is the purpose of discretionary central bank policy under floating exchange rates. In the se- quence above, the likely effect of the central bank's action would be to lower the pric e s of domestic goods compared to foreign goods, causing a temporary export boom. The public's T account looks the same in a central banking system as it does in a currency board sys- tem. However, the T account of the currency board (see Figure 13) looks d ifferent than the central bank"s T account (Figure 14).

Figure 13

CURRENCY BOARD

Assets Liabilities Foreign-currency securities Notes and coins Net worth

Figure 14

CENTRAL BANK

Assets Liabilities Foreign-currency securities Notes and coins Domestic securities Deposits of commercial banks Net worth

In addition to holding foreign-currency-denominated securities as assets, as a currency board does, a central bank can also hold dom estic-currency-denominated securities. In fact, many central banks, in- cluding those of the United States, Japan, and Germany, hold far more domestic securities than foreign securities. It is hypothetically possible for a central bank that does not inter v ene in foreign exchange markets to hold no foreign securities at all. Besides notes and coins and net worth, a central bank's liabil- ities also include deposits that commercial banks hold with it. Unlike currency boards, central banks ac- cept deposits. Those deposits count as reserves for the commercial banks. Commercial banks' T accounts in a currency board system are this:

Figure 15 COMMERCIAL BANKS-CURRENCY BOARD SYSTEM

Assets Liabilities Currency board notes & coins (reserves) Public's deposits Loans and investments Stockholders' equity

17

In a central banking system, the commercial banks' T accounts are this: Figure 16 COMMERCIAL BANKS-CENTRAL BANKING SYSTEM Assets Liabilities Central bank notes & coins (reserves) Public's deposits Deposits at ce ntral bank (reserves) Stockholders' equity Loans and investments Compared to the currency board system, there is the additional element of deposits at the central bank. However, in terms of T accounts, there is no important difference between (1) a balanc e -of-payments surplus for a fixed exchange rate, currency board system and (2) an increase in the supply of central bank credit for a floating exchange rate. (To understand why there is no important difference, imagine that the central bank does not have a n y commercial bank deposits, and that commercial banks hold all their reserves in the form of central bank notes and coins.) The wider implications for the economy, how- ever, are extremely significant, as the next section will show. The chain of events in the case of a money supply contraction under central banking looks like this: Figure 17 Equilibrium (Say, 50 Rubles = $1)

Surprise Central Bank Decision to Decrease Supply of Reserves (Say, By Selling Some of Its Bond Holdings)

F all in Bar c Reserves I I Fall in Bank Credit (Money Supply) I Exchange Rate of Domestic Currt icy in Terms of Foreign Currency Rises (Say, from 50 Rubles = $1 to 40 Rubles = $1)-New Equilibrium

Again, the diagram omits consideration of lags, and assumes that nominal prices adjus t very quickly, leaving real prices unchanged. The only effect of the central bank's decision is a rise in the exchange rate. If some nominal prices do not change quickly, though, the likely effect of the central bank's actions will be a rise in the price s of domestic goods compared to foreign goods, causing a drop in exports.

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CHAPTER 5

ADVANTAGES OF A CURRENCY BOARD OVER A CENTRAL BANK

The key difference between a currency board system and a central banking system is that a currency board has no power to carry out a discretionary monetary policy. Two forces "pin down!' the board's ac- tion: a fixed exchange rate with a foreign reserve c u rrency and a fixed (100 percent or more) reserve ratio. The board does not vary the exchange rate, nor does it alter the supply of bank reserves indepen- dently of changes in the balance of payments or in other market forces. Diagrammatically, the range o f values that the supply of reserves (and hence the broader money sup- ply) can have in a currency board system is as in Figure 18. Note that a board's supply function for its domestic currency issue is totally elastic at the fixed exchange rate. Hence, th e quantity of the domestic currency in circulation will depend strictly on the demand for that currency. Figure 18 Exchange Rate Currency Board's with Reserve Fixed Rate for Currency Reserve Currency

M oney Supply

The money supply picture also is as in Figu re 18 when a central bank adheres to a fixed exchange rate. However, as we shall explain below, the nature of central banking tends to make central banks abandon fixed exchange rates in favor of floating exchange rates. In a floating exchange rate central banking sys- tem, any combination of the nominal exchange rate and the nominal quantity of money is potentially possible. That is so because, as the T accounts in the previous section illustrated, the central bank's liabil- ities count as reserves for com m ercial banks. Commercial bank deposit credit expands or contracts as re- serves expand or contract. In the examples in the previous section, which assumed that commercial banks desired a 50:1 ratio of deposits to reserves, their deposits changed by 50 rub l es for each ruble that their reserves changed in the same direction. In a floating exchange rate system, the central bank does not pledge itself to maintain any particular exchange rate between a foreign currency (or gold) and its own currency. Potentiall y , the central bank can make the supply of commercial bank reserves whatever it wishes. Therefore, if the public wishes to hold a constant amount of bank deposits and central bank notes and coins, when adjusted for inflation or deflation, the exchange rate must adjust to keep the real supply of money constant. In a currency board system, in contrast, the exchange rate is fixed. In our judgment and in the judgment of many other economists who have studied the question, a fixed exchange rate is better than a floating exchange rate for a developing country. A fixed exchange rate costlessly eliminates exchange rate risk with the reserve currency. Trade between the currency board

19

country and the reserve-currency country becomes easier than under floating r ates because there is no need to allow for a risk premium in goods prices. People can make more exact price calculations for in- ternationally traded goods. That enhances economic efficiency by making the lowest-cost producers within the common currency a r ea those with the greatest natural advantages, not those temporarily bene- fiting from the distortions to the international price structure that large, sudden exchange rate fluctua- tions cause. A fixed exchange rate also enables entrepreneurs to apply to other problems talent that, in a floating rate system, they would apply to currency speculation. Eliminating exchange rate risk also encourages foreign investment, particularly from the reserve-cur- rency country. Investors know with certainty what exchan g e rate they will receive in terms of the re- serve currency if they should want to repatriate profits in the future. By making it easy for them to exit the market, a fixed exchange rate is more likely than a floating rate to encourage them to enter the ma r - ket. Under the currency board system, British colonies were very successful at attracting British capital to foster their economic development. Fixed exchange rates with the pound sterling and laws resembling those of Britain made investments in Kenya a s secure as investments in the English county of Kent. Brit- ish colonial banks aided the transfer of capital by linking LDndon financial markets to their branch bank- ing networks in the colonies. The colonial banks also helped speed -economic growth by t r ansferring the sophisticated banking techniques developed in Britain to areas where it otherwise would have taken gen- erations to develop local banking expertise to such a pitch without outside help. Today many former Brit- ish colonies, having discarded the currency board system, nationalized British banks, and reduced property rights, find themselves shut out of international capital markets. Another advantage of a fixed exchange rate is that it enables the country that sets the fixed rate to "pig- gyba c k" on the reserve country's financial markets. The currency of the country that sets the fixed rate is essentially a denomination of the reserve country's currency. Accordingly, entrepreneurs in the country that sets the fixed rate can take their cues fro m the highly liquid, well-established markets in the reserve- currency country. Entering the reserve currency country's markets directly becomes extremely easy. Fi- nancial markets in the United States orWestem Europe offer facilities for interest-rate hed g ing, foreign exchange swaps, and many other transactions that will not be available on a similar scale in Eastern Eu- rope for many years. Ready access to large foreign financial markets, with no foreign-exchange risk, speeds economic growth. Hong Kong, f o r instance, attracted enormous investment first from Britain and then from the United States because the Hong Kong dollar was linked to the pound sterling (and, under the BrettonWoods system, to the U.S. dollar indirectly), and since 1983 to the U.S. doll a r. Finally, a fixed exchange rate, if credible, becomes a feature of the economic landscape and ceases to be a subject of political contention. In particular, it enables the economy to avoid the vicious cycle of in- flationary wage and price increases cau s ing pressure on the central bank to depreciate the currency as a way of keeping wages internationally competitive. The cycle leads to a new round of wage increases as workers demand more money to keep pace with the price increases for imported goods, whic h deprecia- tion was to blame for in the first place. In many developing nations today, the knowledge that the central bank will bow to pressure to depreciate the currency induces the vicious cycle of hyperinflation. A fixed exchange rate enforced by a cur r ency board, on the other hand, is supremely credible. No currency board has ever abandoned its fixed exchange rate unless actually overrun by an enemy army. Even then, since currency boards held their assets abroad, they were able to shelter their assets; the problem was with their notes and coins, which invading armies usually tded to replace with inflationary occupation currency. A currency board stops hyperinflation cold because workers and employers know that if they want to stay in business, wages and prices must be competitive from the start. Since a currency board al- ways has reserves of at least 100 percent in assets that it can readily liquidate, it is always able to defend the fixed exchange rate.

20

It is, of course, possible to have a central bank that offers a fixed exchange rate with a foreign cur- rency. However, historical experience shows that it is not easy to maintain a fixed exchange rate in a central banking system. Central banks have a strong tendency to break their promises to main t ain fixed exchange rates. Central bank incentives are such that, at least in the short run, central banks benefit more by breaking promises than by keeping them. There is an inherent conflict between a central be's power to create or withdraw commercial b a nk reserves at will and a fixed exchange rate rule. There is no such thing as a completely rule-bound central bank. 10 In the end, discretionary power has almost al- ways overcome attempts to confine central bank policies with monetary rules. The only cen t ral bank we are aware of that did not abandon the gold standard or impose capital con- trols during the Great Depression was that of Albania. More recently, the Bretton Woods system col- lapsed because the U.S. Federal Reserve and other central banks foll o wed excessively expansionary monetary policies. The history of the two central banks for former French colonies in central and west- ern Africa also illustrates the difficulty that central banks have in maintaining fixed exchange rates. The reason that th e two multinational central banks exist, rather than each country having its own central bank, is to maintain a fixed exchange rate between the CFA franc and the French franc. These central banks have several times gone below their minimum statutory reserv e ratio, which requires them to have French franc reserves of at least 25 percent of total liabilities. They have been able to maintain the fixed exchange rate with the French franc only because the French treasury has replenished their reserves at French t axpayer expense. The history of former currency board countries also offers evidence of the natural tendency of central banks to break fixed exchange rates. For instance, the countries that formerly belonged to the East Afri- can and West African currency boards-Kenya, Uganda, Tanzania, Somalia, Yemen, Nigeria, Ghana, Gambia, and Sierra Leone-have all broken their fixed exchange rates, imposed capital controls, and had higher average rates of inflation than Britain (their former reserve-currency country) s i nce they left the currency board system. From 1974 to 1983, Hong Kong abandoned the currency board system and - experimented with a "fire issue" system, an unusual arrangement that had neither a fixed exchange rate nor a monetary authority. Hong Kong retu r ned to the currency board system in 1983 and since has expe- rienced much more stable monetary growth rates and lower inflation than during the free issue period. In short, then, a currency board is an almost foolproof institution because it cannot act as an indepen- dent disturbing element in the economy. Market forces call the currency board's tune. In contrast, a cen- tral bank has the power to destabilize the economy, and the history of central banks shows that they have often used that power, sometime s intentionally, but other times by mistake. A central bank run by saints, as long as they were not all-knowing saints, would still not work as well as a currency board system.

9 Economists have dubbed this problem "time consistency." See Kydland and Presco tt 1977. 10 A central bank that maintains a fixed exchange rate with gold or a fbreign currency and that keeps 100 percent gold or foreign-exchange reserve requirement for its note issue is not like a currency board, because it retains discretionary contr o l of its deposit liabilities Nor is a central bank like Argentina's at present a currency board. Argentina's central bank maintains a pegged exchange rate between its currency and the U.S. dollar, and it holds close to 100 percent reserves in dollar-denom inated assets, but its commitment to the pegged rate is doubtful. Its history does not inspire confidence, which is why interest rates in local currency are about twice as high as rates in dollars.

2 1

CHAPTER 6

HOW TO ESTABLISH A CURRENCY BOARD

As pas t experience with currency boards in places as diverse as North Russia, Palestine, Danzig, and the Philippines indicates, it is fairly simple to replace a central bank with a currency board. Central bank functions that do not directly concern influencing t he supply of money can be delegated to other govern- ment departments or to commercial banks. The central bank's deposit-creating powers can be abolished, its deposit liabilities can be separated from its note and coin liabilities, and then it can be conv e rted into a currency board, issuing only notes and coins. We now present two step-by-step plans for establishing a currency board. The first assumes that a nation is replacing its central bank with a currency board. The second assumes that the central ban k will continue to exist, and that the currency board will issue a paral- lel currency that has equivalent legal tender status with the central bank currency. The two currencies will not have a fixed exchange rate, though, unless the central bank also deci d es to peg its currency to the same reserve currency that the currency board uses. If a nation replaces its central bank with a currency board, the steps are: (1) Delepte to other bodies all central banking functions that do not directly concern influencin g the supply of money. For instance, the finance ministry can take over the job of regulating bank prac- tices and giving advice on monetary affairs. Commercial banks themselves can take over the cheque clearing system, as they do in Canada, where clearing is more efficient than in the largely government- run American clearing system. Commercial banks can also provide mutual deposit insurance protection, as they do in Germany and Switzerland. (2) Abolish the central bank's power to create credit. This invol v es freezing the central bank's over- all deposit credits (although not necessarily each individual credit) -at existing levels. It is possible for a government to run a budget deficit under a currency board system; the North Russian government did so, for instance. However, in a currency board system, the government cannot finance itself by inflation. If it runs a deficit, it must cut spending, borrow from the public, or raise taxes to close the gap. Govern- ment-owned banks or other enterprises that make l osses must be sold, declared bankrupt, or subsidized out of tax revenue. Hence, a currency board system imposes a "hard budget constraint" on government finances. (3) Separate the central bank's commercial banking functions, if any, from its currency issu e functions. In Western banking systems, there is a sharp distinction between central banking and com- mercial banking. Central banks do not generally take deposits from or lend directly to the public. Corre- sponding to the distinction between central ban k ing and commercial banking is a distinction between central bank-issued currency (which count as reserve assets for banks) and loans (which are assets, but are not reserves). In some East European nations, for instance Albania, there is no real distinctio n be- tween reserves and other assets, because a single bank both issues currency and handles most commer- cial banking functions. The commercial banking functions should be spun off into one or more, commercial banks independent of the central bank's curr e ncy issue department. (4) Make sure that commercial banks' existing reserves are adequate. For nations whose banking systems lack the distinction between currency and other commercial bank assets, it will be necessary to give adequate reserves to the comm ercial banks created out of the central bank. Banks hold these re- serves to guard against deficits in clearing with other banks, a need that exists whether or not legal re-

22

serve requirements exist. Once this step is completed, the commercial banks created out of the central bank should no longer be allowed to borrow from the central bank. None of the British colonies and few of the other currency board systems of the past r e quired banks to hold any particular minimum legal reserve. They left it up to banks to decide what reserve level was best. A currency board system does not need legal reserve requirements to work, and it would be unwise to impose such requirements. After s ubtracting for legally required reserves, average reserves in Western banking systems rarely ex- ceed 5 percent of deposit liabilities. In Eastern Europe and the USSR, higher reserves will probably be necessary because the condition of banking technology i s primitive. We suggest 10 percent reserves as a rough guideline. Many banking systems in the region are in effect bankrupt because of years of misman- agement, and it will be necessary to restructure them. In the meantime, it is vital to commerce that th e government not completely freeze bank deposits, because that would deprive firms of the most ready means for paying each other. Giving banks 10 percent reserves would allow them to allow deposit hold- ers partial use of deposits. An opposite type of prob l em can arise where the commercial banks are solvent. If legal reserve require- ments are abolished in connection with instituting a currency board system, and all central bank notes and deposits are converted into currency board notes, them will be a one- t ime jump in bank credit. The jump may be quite large and may cause a big rise in prices. For instance, if the legal reserve requirement is 10 percent of liabilities, and commercial banks hold 20 percent reserves, their usable reserves are only 10 percent o f liabilities. Assuming that 10 percent is their desired level of reserves, abolishing the re- serve requirements would allow banks to grant twice as much credit as before (20%/10% = 2), other things being equal. To avoid such problems, the government can neutralize C'sterilize") the legal re- serves or some of the central bank notes; in other words, convert them into something other than re- serves. They could be converted into government bonds, or even extinguished altogether. (5) Convert all remaining c o mmercial bank reserves into currency board notes and coins or into foreign assets, as the commercial banks prefer. With this step, the central bank's deposit liabilities will cease to exist. (6) Fix an exchanp rate. After the central bank's deposit liabil i ties cease to exist, all that remain of the central bank will be its note and coins issue and net worth (as liabilities), and its foreign exchange holdings (as its main assets). Its other assets and liabilities will have been given to commercial banks or t he government, or will have been extinguished. The central bank should be given all government- owned foreign exchange that is not distributed to the commercial banks in step (4). To convert what remains of the central bank into a currency board, the gove r nment must now fix an ex- change rate with a reserve currency and, simultaneously, make sure that the foreign currency reserves for the note and coins issue equal 100 percent. The exchange rate between the foreign reserve currency and the domestic currenc y must be appropri- ate. A rate that is too high will price exports out of world markets. A rate that is too low will make im- ports very expensive, inhibiting the ability of domestic industry to buy foreign capital goods for modernization. The best indica t ion of an appropriate exchange rate is the free-market rate, which reflects unconstrained forces of supply and demand. Accordingly, if the economic situation permits some breath- ing room, the first step infIxing an exchange rate for economies in developi n g countries is to lot ex- change ratesfloat for a time. At present, it is impossible to determine the equilibrium level of exchange rates because there are laws constraining supply and (especially) demand. To reveal the true supply and demand, foreign exc hange rates should be unified and all foreign-exchange restrictions, including capi-

23

tal controls, should be removed. East European nations are already moving in that direction, but none has completely removed all foreign-exchange restrictions, and so me, including the Soviet Union, have multiple exchange rates. Market forces will most accurately reveal themselves if foreign trade is also lib- eralized when exchange restrictions are removed. Interest-rate ceilings should also be abolished by this point . At the time that exchange rates are allowed to float, the government should announce which foreign currency it intends to establish as the reserve currency and on what date it will fix the exchange rate. The logical choices for a reserve currency are the U.S. dollar or the German mark, the most widely used un- official currencies and the most widely used currencies in international trade. The European Currency Unit (ECU) may also be worthy of consideration. During the period of floating, the government ca n continue to deal in the foreign-exchange market, but it should not try to influence the market, which would defeat the float's purpose of revealing the free- market exchange rate. It could deal in foreign exchange passively at some suitable spread around the market rate. When the date to flx the exchange rate arrives, the government should fix the rate some- where within the range of recent trading rates. Rate fixing is an art rather than a science, and it is best to err by making the rate too low (too ch e ap in terms of the reserve currency) rather than too high. It is bet- ter to start with a rate that produces a high balance-of-payments surplus than one that produces a bal- ance-of-payments deficit crisis. (Of course, there is nothing wrong with running a balance-of-payments deficit if it is the result of a surge in foreign investment. What a nation wants to avoid is a situation where it not obtaining enough foreign exchange to pay its foreign-currency debts.) There is some lati- tude in setting an exchan g e rate, though, as other countries' experience with exchange-rate fixing shows. As long as the rate is approximately correct and people are confident that the government is committed to it, the economy will make minor adjustments towards equilibrium quick l y. Where drastic currency reform is necessary today rather than a few days or weeks from now, the ex- change rate can be set at the existing black-market rate, or an average of commodity exchange rates, if the commodity rates are even less favorable to th e domestic currency. (7) Ensure that foreign currency reserves equal 100 percent of note and coin circulation. The cur- rency board should begin with foreign currency reserves equal to 100 percent of its note and coin circula- tion. Allowing the board to o p erate with fractional reserves opens the way to discretionary monetary policy, like a central bank. The purpose of a currency board is to make monetary policy completely rule- bound. Having 100 percent reserves from the start is vital to ensuring the curr e ncy board's credibility as a politically independent body with no discretionary monetary policy. The first source of foreign currency reserves are the existing reserves of the central bank and the gov- ernment. If they are less than 100 percent of notes a n d coin circulation, the government could increase the reserve ratio by selling seized Communist Party property for domestic currency and not reissuing the currency or, equivalently, selling the property for foreign currency. If reserves are still less tha n 100 per- cent, it w e necessary to orrow asy to borrow from international agen- cies, foreign central banks, or foreign commercial banks, because the board win be able to repay loans as long as it can either lend at higher interest rates than it borrows o r has large enough unborrowed re- serves. Even if the currency board has to pay a higher interest rate than it receives on its reserve assets, its unborrowed reserves will yield interest that it can use to pay the interest on its borrowed reserves. For in s tance, if the board has to borrow 50 percent of its reserves, has to pay interest of 8 percent, receives interest of only 7 percent, and has expenses of I percent of total reserves (borrowed plus unborrowed), its profits will be 7%-(50% x 8%)- 1 % = 2%, w hich leaves funds to pay the principal on the borrowed re- serves.

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Using present black-market exchange rates as the basis for calculation, the amount of reserve currency necessary for a currency board system ranges from about $70 million in Albania to perhaps $6 billion for Poland and the USSR. We assume 100 percent reserves for a currency board plus 10 percent reserves for commercial bank deposits. The real value of the domestic money supply is so small in Eastern Eu- rope and the USSR because of inf l ation-driven currency depreciation. Some economists have claimed that currency boards in Eastern Europe and the USSR would need re- serves many times greater than our estimates. They wish to base exchange rates on their estimates of pur- chasing power par i ty rather than on actual market rates. For instance, one current (December 1991) estimate places the ruble's purchasing power parity at 8 rubles=$l, versus a market rate of 100 ru- bles=$l. However, if Eastern Europe and the USSR are serious about establi s hing market economies, it is absurd to second-guess market exchange rates as a basis for setting a fixed rate, and it is especially absurd to second-guess market exchange rates by a factor of 10 or more. Purchasing power parity is a no- toriously slippery , difficult to measure theoretical construct; market exchange rates are readily observ- able, actually existing magnitudes. (8) Transfer the commercial bank's remaining assets and liabilities to the new currency board and open the board for business. At th e moment that the government fixes the exchange rate w 'ith the reserve currency, the central bank should officially become a currency board. By then the central bank will have none of its other former functions, so all that remains is to bring into force a statute detailing its functions and responsibilities. Annex I below is a model statute based on typical features of past cur- rency boards in Hong Kong, British West Africa, Burma, Libya, and elsewhere. The alternative to replacing the central bank with a currency board is to establish a currency board as the issuer of a parallel currency. It may be more politically feasible to establish a parallel currency than to directly threaten the entrenched interests that favor keeping the central bank. In a parall e l-currency system, the central bank can continue to function with its existing staff and its existing assets; nothing need be taken away from it to give to the currency board. The two currencies will not have a fixed ex- change rate, though, unless the ce n tral bank also decides to peg its currency to the same reserve cur- rency that the currency board uses. The currency board's notes and coins should be given equivalent legal tender status with those of the central bank. A parallel currency will give the c e ntral bank the choice of ceasing to depreciate its currency or withering away as people switch to using the currency board's currency. Contrary to what one might expect, government revenue from seigniorage under a par- allel currency system might well inc r ease. A currency board would give East European nations the chance to capture some seigniorage that it is now losing to foreign central banks that issue hard curren- cies. How can the currency board get started in such circumstances, though? There must be an incentive for people to exchange their foreign currency for the board's currency. The solution is to offer a small pre- mium on foreign currency for a short period during which the board exchanges its currency for foreign currency, but not the reverse. For instance, after announcing a choice of reserve currency and an ex- change rate with that currency, during a one-week period the board can offer to pay a premium of 2 per- cent on all hard currency offered to it by citizens of that country. (It could a c cept other hard currencies besides the reserve currency, then exchange them for reserve-currency assets.) To prevent arbitrageurs from using its offer for pure speculative gain, the board could announce that it retains the right to revoke the premium at i ts discretion. After the offer expires, the board would cease paying a premium and

11 The Wall StreetJournal, December 6,1991, p. A9; cL Williamson 1991, p. 428.

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would also be open to make exchanges from its currency into the reserve currency. As lo ng as there is some confidence in the board, it will easily be able to recoup the expense of the premium within a short time, from the interest it earns on reserve-currency assets. The board should secure a loan starts to make sure that its reserves are 1 0 0 percent of liabilities from the start, but soon its interest income will enable it to repay the loan. Because the board is a separate body from the central bank, and because it keeps 100 percent reserve-currency assets, it should enjoy greater public co n fidence than typical past parallel- currency reforms, where the central bank has issued both currencies. The next two sections offer sugges- tions for further measures to ensure that the board remains worthy of public confidence. A special type of paralle l issue may occur in former Soviet republics that chose to establish currency boards. To smooth the transition from the ruble to a new currency, and to preserve trade links with other former Soviet republics, they may wish to introduce their currency along s ide the ruble, which is a for- eign currency for them. They could proceed according to the plan we just sketched for a parallel cur- rency, which assumes that the currency board has no hard-currency reserves at the start. Alternatively, if they do have ha r d currency reserves (as the Baltic states now do), they could establish a fixed rate with a reserve currency and bring the new currency into circulation by distributing it free to the population. Each person or household could receive new currency accordi n g to some formula. The currency board should not distribute more currency than the value of its hard-currency reserves. The new currency will have a floating exchange rate against the ruble. People should be permitted to exchange one currency for the othe r without restrictions. Allowing unhindered exchange will enable peo- ple who want the new currency to acquire it, if they are willing to pay the market exchange rate. The two currencies will circulate side by side for awhile. Prices will be quoted and pay m ents will be made in either currency depending on the parties involved. People will keep bank accounts in the new currency and in rubles. (There should be a legal separation between deposits and loans made after the monetary reform and those made before i t , so that the ruble liabilities that banks acquired under socialism do not become claims against new local-currency assets in bankruptcy settlements.) If the ruble continues to de- preciate, the voluntary activity of market participants will probably driv e it out of circulation because it will be inferior to the new currency. There is no need for the government to speed or slow the transition artificially. However, it would be prudent for the government not to accept rubles in payment of taxes should the r uble continue to be an unstable, inconvertible currency.

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CHAPTER 7

HOW TO OPERATE A CURRENCY BOARD

A currency board is simple to operate. Past currency boards have usually had staffs of 10 or fewer peo- ple. They have been able to achieve economies of staff by contracting some clerical and investment func- tions to outside parties. We now describe how to run a currency board. Exchange policy: The currency board's business is to stand ready to exchange its notes and coins on demand at a fixed rate i n to or from the reserve currency. It need not actually accept or pay reserve cur- rency notes and coins. Indeed, to hold a large stock of reserve currency notes and coins would reduce its profits, because the board would not be able to invest those funds i n interest-bearing securities. Hence, the currency board should not serve as a supplier of reserve currency notes to the public. It should leave that to the commercial banks. It should accept and pay in the reserve currency only by check or by elec- tronic funds transfer. Clientele: The public as well as banks should be able to deal directly with the currency board. Some British colonial currency boards dealt only with banks, as a way of reducing their need for staff. How- ever, it seems unnecessary and unj u st to discriminate against the public in that way. Most people win ex- change currency through banks in any case. That was the experience of the West Affican Currency Board when it switched from dealing with banks only to dealing with the public also. Acc e pting transac- tions from the public introduces a form of competition with banks, and ensures that their fees for ex- changing into the reserve currency will be low, thus making the link between the two currencies tighter. Lower and upper limits to exchan g es: To reduce their handling costs, many currency boards did not exchange sums below a certain minimum. For British colonial currency boards, the limit was usually ;E1,000 for small boards such as those of Jamaica and Barbados or;E10,000 for larger ones s u ch as the West African Currency Board. The minimums prevented most members of the public from doing busi- ness with the currency board individually, which reduced the boards' need for clerks to handle transac- tions. However, the minimums were low enough n ot to be a significant barrier to banks that wanted to do business with the currency board, or to private foreign-exchange dealers. The public was still able to exchange small sums of currency board notes and coins for foreign currency through the banks. T here should be no upper limit to the amount of the reserve currency or of its own notes and coins in circulation that the currency board accepts for exchange. No past currency board has ever had an upper limit to exchanges, because that would defeat the f u ll convertibility into and out of the reserve currency that is the purpose of the currency board system. Conindssions: Some currency boards have charged commissions of 1/8 percent to I percent for every transaction. (The North Russian board, for instance, charged a fee of I percent.) Other boards had a scale of commissions, and charged lower commissions or even zero commissions for large transactions. If, as we suggested, the board has a minimum for transactions, it should not charge any commission. Commis s ions would bring little income to the board. Furthermore, commissions loosen the link to the re- serve currency, especially for swaps with short maturities, and they introduce the effects of floating rates, though only within a narrow range. A few boards, most notably the East African Currency Board towards the end of its existence, deliberately manipulated commission rates to influence exchange flows. Since the purpose of a currency board is to maintain a fixed exchange rate, thereby costlessly eliminat- ing exchange-rate risk, there is no point in erecting barriers to switching between its currency and the re-

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serve currency. The social benefits of not having commissions far outweigh the benefits to the board of having commissions. Offices: The cu rrency board should have a main office in the capital city (which is also the chief finan- cial center in all East European countries), and perhaps branch offices or agents in other large cities. The main office will do most of the business, because it wi l l be located where banks do the greatest volume of clearing. The role of the branch offices or agents will be mainly to serve as places for safekeeping cur- rency. It is not necessary to have actual branches. Instead, a commercial bank could act as the cu r rency board's agent, as the Bank of British West Africa did for the West African Currency Board. Management: The currency board should have a small board of directors-a typical size for past cur- rency boards was five directors-to oversee the board's mana g ers. The powers of the board of directors and of the managers will be quite limited; they will have no influence over monetary policy like that of central bankers. To make the board of directors as independent from political pressures as it can be, di- re c tors should have staggered terms. Furthermore, a majority of directors should be foreign nationals, ap- pointed by foreign private fimancial institutions. We will return to this proposal later. Staff: The board's staff will perform two functions: exchangi n g notes and coins for the reserve cur- rency, and investing its assets in high-grade securities denominated in the reserve currency. The ex- change work will require only a small staff of bank tellers. The investment work will require some expert financia l traders, but since the board will follow rather routine, conservative investment practices, its expenses should be smaller than those of commercial banks with portfolios of similar size. Where local expertise to manage the portfolio is lacking, the board could entrust the investment work to one or more suitable foreign banks, for instance, a major Swiss bank. Reserves----composition: The board should hold its reserves in high-quality assets denominated in the reserve currency only. 12 It should not hold a s sets denominated in local currency, because that would open the way to central banking-type operations. Specifically, bank reserves could be changed by chang- ing the proportion of local currency assets to foreign currency assets held by the board. Allowi n g the board to hold assets denominated in local currency was one of the steps that pushed the East African and Southern Rhodesia currency boards, among others, along the road to becoming full-fledged central banks. Besides opening the way for central bank i ng, holding local-currency assets can also be dangerous, as the experience of the North Russian currency board shows. The North Russian board had a policy of holding 25 percent of its reserves in local government bonds. When Bolshevik armies routed the No r th Russian government, it of course defaulted on its bonds. The British government, the main holder of notes, lost about 15.5 million rubles as a result. That all the board's assets should be denominated in the. reserve currency does not mean that the boa r d can only buy securities issued in the reserve-currency country. The huge growth in Eurocurrency markets in recent years has led many governments and com- panies to issue securities denominated in foreign currencies. To prevent the currency board from be c om- ing entangled in the politics of domestic government finance, though, a board should not be allowed to hold domestic government securities. Reserve&--inaturities: It may be desirable to specify in the currency board's charter or by-laws what types of assets it may invest in and what the maximum maturity may be. Likely candidates are the re- serve country's government bonds, high-quality corporate commercial paper, and Eurocurrency loans.

12 We discuss a possible exception to this rule in the next chapter.

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The average maturity of the board's investment portfolio should be short. Long-term fixed-rate bonds swing widely in value as interest rates change. Some of the British colonial currency boards that in- vested heavily in long-term bonds suffered large losses when pound sterling interest rates rose sharply during times of high inflation or speculation that Britain would devalue the pound sterling. British colonial currency boards often divided their investments into a "liquid reserve" and an "inv e st- ment reserve." The liquid reserve, consisting of securities that had maturities of less than two years, was typically about 30 percent of total reserves. The investment reserve, consisting of securities with longer maturities, was the rest of the tota l reserves, equivalent to an estimate of the public's minimum, "hard- core" demand for a board's notes and coins. Because interest rates and hence security values are more volatile today than they were during the heyday of currency boards in the first half of the century, the liq7 uid reserves should probably be at least 30 percent today. Past currency boards had to hold securities with long maturities to obtain high interest rates. But since the collapse of the Bretton Woods monetary system, short-term sec u rities also have paid high rates. Expenses: Judging from the experience of past currency boards, expenses, excluding any loan repay- ments the board may have to make, should average no more than 1 percent of total assets, and may be as low on average as 0 . 5 percent of total assets. The main expense will be printing notes and minting coins. Salaries will be the next greatest expense, and rent, utilities, and remaining costs will be small. Profits: The board's profits will be the difference between the inter e st it earns on its foreign currency reserve assets and its expenses, including repaying any loans it initially received. After the board repays any initial loans, it should accumulate a reserve of 10 percent to protect it against capital losses on secu- r i ties holdings, as most British colonial boards did. It should pay all profits into the reserve until the re- serve is full, and in the future do likewise should the reserve ever fall below 10 percent. All profits beyond that should revert to the board's o wner.

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CHAPTER 8

HOW TO PROTECT THE CURRENCY BOARD

Although the currency board system was a great economic success earlier in this century, currency boards exist today only in a few of the more than sixty places that once had them. The most notable e x- amples of currency board systems today am Hong Kong and Singapore. The reason that boards else- where disappeared was that they lacked the political independence to prevent them from being changed into central banks. Suspicion that a new currency board might be reconverted into a central bank would undermine foreign willingness to invest in the country, defeating one of the main advantages of convert- ibility. Therefore, in this section we propose ways of preventing new currency boards from suffering th e fate that befell most old boards. Our proposals can be summarized as commitment, credibility, and com- petition. They are complementary; any one could be implemented separately or along with the others. The board can commit itself to buy and sell forward exchange at the fixed rate. Macau's central bank makes forward markets in the Macanese pataca against Macau's reserve currency, the Hong Kong dol- lar. Offering forward exchange increase the pataca's attractiveness relative to the Hong Kong dollar, which h as much larger and more liquid private markets than the pataca in forward exchange against third currencies. A currency board could increase the attractiveness of its currency relative to the reserve currency by similar practices. (The board should limit i ts forward exchange transactions if inflation in the reserve currency country becomes high and a switch of reserve currencies becomes desirable, as we discuss below.) The government can improve the board's credibility by insulating it from any possible at t empts at gov- ernment manipulation. One way to do so would be to have some of the currency board's board of direc- tors be foreign nationals, chosen by institutions in their home countries, as we suggested above. For example, only three of the eight direc t ors of the Libyan Currency Board were Libyan nationals; the rest were British, French, Italian, and Egyptian nationals chosen by their respective governments. A majority of directors for an East European currency board could be, for instance, top managers from large West European, American, or Japanese banks. Another way of improving the board's credibility would be to incorporate it in a safe-haven country such as Switzerland, and to make clear that the board's assets belong to the board itself. The East A fri- can and West African boards actually had their headquarters in London for much of their existence. ! 13 Competition will improve the currency board's incentive to maintain the fixed exchange rate. Forced- tender laws, which compel people to accept pa y ment in local currency, should be abolished. People should be able to make contracts in and to use any currency that they find mutually agreeable. In particu- lar, reserve currency notes and coins should be allowed to circulate alongside the currency boar d 's notes and coins. The board's currency could be made interchangeable with the reserve currency by redenominating (not revaluing) the local currency so that the exchange rate is 1 -to- 1. To subject the currency board itself to direct competition, banks could be allowed to issue circulating notes to compete with the board's notes. Like the board's notes, bank notes would be convertible into the reserve currency at the fixed exchange rate. Hence, the board's notes and bank notes would be like

13 The curren cy board could even be auctioned to the private sector, either for a fixed term or permanently. As Harold Demsetz (1968) has argued with respect to utilities, private sector bidders should be willing to pay just enough to exhaust any monopoly profits the board might accumulate.

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different brands of traveller's checks circulating alongside one another. What brands were most widely used would depend on what brands best satisfied consumers' needs, as is now the case with traveller's checks. 14 There are m any historical precedents for such an arrangement. In the British Caribbean colo- nies, banks issued notes not subject to any special reserve requirements. Bank notes competed with cur- rency board notes until the 1950s, when local governments outlawed ba n k note issue to gain mare seig- niorage revenue for themselves. In Hong Kong today, the currency board itself issues no notes. Rather, it holds the 105 percent U.S. dollar reserves that the two note-issuing banks must deposit against their Hong Kong dolla r note issues. In Scotland, three local banks issue notes against 100 percent reserves that they hold at the Bank of England. Going further back in time, over sixty countries had competitive note issue in the 19th early 20th centuries, with generally good r esults (Dowd [forthcoming]). Besides their lack of complete political independence, past currency boards also had one other wide- spread flaw, which however did not first become apparent until the late 1940s. The flaw was that they had no systematic proce d ure for untying their own currency from the foreign reserve currency when the foreign reserve currency became unsatisfactory. British colonies devalued their currencies with the Brit- ish pound sterling in 1949, 1967, and 197 1, because their currency boa r d systems were dedicated to maintaining fixed exchange rates with the pound. Devaluation hurt them by raising the cost of the for- eign goods that they needed for their economic development, such as the food that Hong Kong imported from China. The British pound's chronic weakness led Hong Kong, Singapore, Brunei, and the East Car- ibbean Currency Board to switch from the pound to the U.S. dollar as their reserve currency in the 1970s. There is nothing objectionable in itself about switching reserve currenc i es. In fact, it is a necessity if the reserve currency becomes too unstable, because otherwise the currency board country will suffer the reserve-currency country's monetary problems. If the board has the power to switch reserve currencies, though, the pr o cedure should be carefully specified, rather than being a somewhat arbitrary government decision as was the case with the Hong Kong and other currency boards. We suggest that, for example, the board not be allowed to change the reserve currency unless ann u al- ized inflation in the reserve-currency country, as measured by the wholesale price index, falls outside the range of -5 percent to 25 percent for more than two years, or - 10 percent to 50 percent for more than six months. If inflation exceeds that ra n ge, the board must either devalue or revalue its currency in terms of the reserve currency by no more than the amount of the reserve country inflation rate for the period just specified (two years or six months), or choose a new, less volatile reserve cur r ency and fix the ex- change rate at the rate then prevailing between that currency and the original reserve currency. The board's profits and the 10 percent reserve that we have proposed it hold in addition to its 100 percent re- serves will help cushion a ny losses from switching reserve currencies. It may also be advisable to write a similar provision into the currency board's constitution allowing it to reset the exchange rate with the reserve currency if the reserve currency appreciates or depreciates t o o rapidly against a basket of foreign currencies representing other countries important in the currency board country's foreign trade, even if inflation rates in the reserve-currency country stay within accept- able limits. The general point we wish to st ress here it is best to have predetermined procedures, known to the public, for handling such difficulties, rather than to respond to them in the rather capricious way that some past currency boards have done.

1 4 For an explanation of economic forces that govern competitive note issue, see Selgin 1988b.

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CHAPTER 9

SUMMARY AND CONCLUSION

Currency boards are a tried and true method of ensuring convertibility into a foreign currency at a fixed rate. They have worked well in a wide range of countries, sometimes under conditions even more difficult than those that developing countries face today. They are simple to establish and to operate. They offer a shortcut through the problems that face a central bank trying to establish convertibility. Currency boards exist today in Hong Kong and Singapore, two of the highest-growth economies in the world since World War 11. Developing nations would do well to introduce currency boards as part of their own strategy fo r achieving rapid economic growth. To summarize our earlier discussion of the steps for replacing a central bank with a currency board, they are: (1) Delegate to other bodies all central banking functions that do not directly concern influencing the supply of money. (2) Abolish the central bank's power to create credit. (3) Sepamte the central bank's commercial banking functions, if any, from its currency issue functions. (4) Make sure that commercial banks' existing reserves are adequate. (5) Convert all r e maining commercial bank reserves into currency board notes and coins or into foreign assets, as the commercial banks prefer. (6) Fix an exchange rate. (7) Ensure that foreign currency reserves equal 100 percent of note and coin circulation. (8) Transfer t h e central bank's remaining assets and liabilities to the new currency board and open the board for business. If instead the currency board comes into existence as a parallel issuer alongside the central bank, the steps are even simpler, to wit: (1) Announ c e a choice of reserve currency and exchange rate. (2a) Offer a small premium for all foreign hard currency for a short period, during which the board only makes exchanges from foreign currency into its currency. Alternatively, (2b) If the board has hard-c u rrency reserves, distribute to the population currency board notes and coins equal in value to the reserves. (3) Cease offering the premium and begin two-way exchange with the reserve currency only, at the fixed rate. The currency board currency will have a floating rate against the central bank currency. In addition to those procedures that are detailed in the model currency board law in Annex I, some im- portant rules of thumb for operating a currency board are: (1) Expenses should average no more than I percent of total assets. (2) Liquid reserves (securities with maturities of two years or less) should be 30 percent or more of the total. (3) It may be necessary for the board to have branch offices or agents.

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ANNEXI

A MODEL CURRENCY BOARD LAW

The following model currency board law has many features that existed in the laws of boards in West Africa, Hong Kong, the British Caribbean, Libya, Burma, and elsewhere.

CURRENCY BOARD LAW

1. The [name of country] Currency Board is hereby created. The Cur rency Board's pur- pose is to issue notes and coins, and to maintain them at a fixed exchange rate as speci- fied in paragraph 6. 2. The Currency Board shall have its legal seat in Switzerland. 3. a. The Currency Board shall be governed by a board of -fiv e directors. Two directors, including the chairman, shall be persons chosen by the government of [name of country]. One director shall be a German national chosen by the Deutsche Bank, one director shall be an American national chosen by the Morgan Guarant y Trust, and one director shall be a Japanese national chosen by the Dai-Ichi Kangyo Bank. b. A quorum shall consist of four members of the board of directors, including the two chosen by the government of [name of country]. The board of directors may meet at the board's legal seat and such other locations as it designates. Decisions shall be by majority vote, except as specified in paragraph 15. c. The first chairman and the first other member of the board of directors chosen by the government of [name of c ountry] shall serve terms of five years and one year, respec- tively. The first German national shall serve a term of two years. The first American na- tional shall serve a term of three years. The first Japanese national shall serve a term of four years. Later members of the board of directors shall serve terms of five years. They may not be re-elected. Should a director resign or die, the appropriate organization as specified in paragraph 1 (a) shall choose a successor to fill the remainder of the term. 4 . The board of directors shall have the power to hire and dismiss the Currency Board's staff, and to fix salaries for itself and for the staff. 5. The CurrencyBoard shall assume responsibility for the notes and coins formerly is- sued by the central bank o f [name of country]. 6. The currency with which the fixed exchange rate is maintained is hereafter called the reserve currency. 1nitially, the reserve currency shall be the [U.S. dollar, for instance] and the fixed exchange rate shall be [$1 = 50 rubles, f or instance]. 7. The Currency Board may set a minimum size for transactions, not to exceed 100,000 units of the reserve currency. It may adjust this size upwards in the same proportion as in- creases in the wholesale price index of the reserve-currency co untry. The Currency Board may not charge any commission for transactions of the minimum size or larger.

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8. The Currency Board shall begin business with assets equal to at least 100 percent of its notes and coins in circulation. It shall hold these ass ets in investment-grade securities payable only in the reserve currency. The Currency Board shall not hold any securities is- sued by the national or local governments of [name of country], or in enterprises owned by those governments. 9. The Currency Boa r d shall pay all net profits into a reserve fund until its unborrowed reserves equal 110 percent of its notes and coins in circulation. It shall remit all net prof- its beyond those necessary to maintain 110 percent reserves to the government of [name of c o untry]. The distribution of profits shall occur annually. 10. The Currency Board's head office shall be at [name of country's capitan. The Cur- rency Board may establish branches or appoint agents in such other cities as it sees fit. 11. The Currency Boar d shall publish a financial statement, attested by the directors, quarterly or more often. The statement shall appraise the Currency Board's securities holdings at their market value. 12. The Currency Board may issue notes and coins in such denominations a s it sees fit. 13. Should the change in the wholesale price index in the reserve-currency country fall outside the range of -5 percent to 25 percent for more than two years, or -10 percent to 50 percent for more than six months, within 60 days the Currency Board must either: a. Devalue (if the index's change is negative) or revalue (if the index's change is posi- tive) its currency in terms of the reserve currency by no more than the amount of index's change over the period specified above, or b. choose a n e w reserve currency and fix the exchange rate at the rate then prevailing between that currency and the original reserve currency. 14. If the Currency Board chooses to do 13(b), within one year it must convert all its re- serve assets into securities payab le in the new reserve currency. 15. The Currency Board may not be dissolved or its assets transferred to a successor or- ganization except by unanimous vote of the board of directors.

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ANNEX II

ALLEGED DISADVANTAGES- OF CURRENCY BOARDS

In the 1950s and 1960s, certain economists claimed that currency boards had disadvantages compared to central banking. More recent theories have refuted or diminished the significance of their criticisms, but since no recent published refutation exists, w e briefly consider the criticisms here. 1 Critics claimed that the currency board system leaves no room for discretionary monetary policy, that it makes the money supply operate in a deflationary manner in a growing economy, and that the 100 per- cent fore i gn-currency reserve requirement deprives a currency board economy of real resources that are available in a system with a fractional-reserve central bank. The short reply to the claim a currency board allows no room for discretionary monetary policy is th a t it is true. The purpose of a currency board is to have an automatic monetary policy rather than a discre- tionary one. Economists are far more skeptical than they were in the 1950s and 1960s about the ability of discretionary monetary policy to influenc e economic growth favorably. The "rational expectations" school has alerted economists to the insight that whatever systematic policy central bankers can carry out, other people can anticipate and, by their profit-seeking activity, try to offset. A related criticism of discretionary monetary policy, associated mainly with the "Austrian" school of economic thought, is that it is a form of central planning, subject to the same difficulties as, say, central planning of agricultural output. Central planning sup p resses certain price signals that, in an unhampered market, would reveal information to those who know how to interpret them correctly. In the monetary system, the most important of such signals are changes to banks' reserves. Changes in the balance of pa y ments or in the public's holdings of notes and coins set in motion the changes to bank reserves and, through them, to the money supply, interest rates, and income that we explained in the previous section. Discretionary policy, to be worthy of the name, m u st try to fight the economy's adjustment towaT a _ I new equilibrium. By doing so, however, it merely makes adjustment more prolonged and costly.1 The claim that the money supply operate in a deflationary manner in a growing currency board econ- omy is co r rect under certain stringent assumptions, but has little practical significance. Under the as- sumptions about a currency board system that we discussed in Chapter 3 (see box, page 7), a rise in the demand to hold notes and coins requires a balance-of-pay m ents surplus to produce the additional re- serves to exchange with the currency board. As an economy grows, then, it must generate continual bal- ance-of-payments surpluses for the supply of notes and coin to expand as quickly as the demand. Continual sur p luses are unlikely, implying that in periods of balance or deficit, the supply of notes and coins grows more slowly than the demand, resulting in a fall in prices. The fall would not occur if the notes and coins were liabilities of a central bank committe d to a fixed exchange rate, because it holds only fractional reserves. (The converse, which critics of currency boards never stated, is that in a declin- ing currency board economy, money supply is inflationary.) The simplifying assumptions rarely, if ever , hold. A growing economy in a poor country, such as most currency board countries have been, generally has large capital inflows that balance its current account

15 The best statements of criticisms are Analyst 1953, Hazelwood 1954, Nevin 1961 and Basu 1971. For refutations, see Greaves 1953 and especially Ow 1985. 16 Selgin 1988b makes this argument.

3 5

deficits. Furthermore, with international branch banking, banks are able to pool their reserves between the reserve-currency country and the currency board country, so that they may be able to offset much of the effect of balance-of-payments changes between the two countries (and, by extension, among all the countries where they have branches). An international bank's overall reserves are the same whet h er a given deposit is held by a customer in the reserve-currency country or by a customer in the currency board country. Currency board economies seem to have had little experience of deflation caused by increases in the demand for notes and coins. The on l y example that we are aware of occurred in Hong Kong in early 1984. A few months before, Hong Kong had reintroduced the currency board system. During the Chi- nese New Year, the demand for notes increases because it is customary to give gifts of money. Th e in- creased demand for notes affected bank reserves and interest rates for about two weeks, after which they settled back to their previous levels. The banks learned their lesson: during subsequent Chinese New 17 Years, they have kept higher than usual r e serves on hand, and interest rates have been little affected. The final major criticism of the currency board system is that the 100 percent foreign-currency reserve requirement deprives a currency board economy of real resources that are available in a f i -actional-re- serve system. Economists who investigated the matter in the 1950s claimed that 30 percent to 50 percent of currency boards' reserves were surplus, since there was an irreducible minimum of notes and coins that people held, which would never r eturn to the boards for redemption. Surplus reserves, then, are a cost of the currency board system, since they could be used to buy imports, increasing the real goods available in the economy. There is, first, a question whether these estimates are accur a te.18 Leaving that aside, though, let us con- sider the nature of the alleged cost. Once spent, surplus reserves are gone, and they yield no interest. Currency board reserves, on the other hand, pay interest because the board invests them in foreign-cur- r ency assets. The stream of future interest payments has a present-value equivalent. It is the difference between the surplus reserves and the present-value equivalent of the interest payments on them that is the true cost of a currency board system as com p ared to a fractional-reserve system. Alternatively, it is possible to calculate the interest on the surplus reserves that would be paid if they were lent domesti- cally, and to compare that with the currency board's interest from foreign-currency assets. O nly if the present value of the goods that could be imported is markedly greater than the present value of the cur- rency board's interest income (that is, domestic interest rates are markedly higher than foreign interest rates for comparable loans) is th e currency board system costlier than a fractional-reserve system. Even so, the currency board system may well be less costly than fractional-reserve central banking if we take a broader view. The currency board system offers a degree of credibility and pr edictability that central banking has difficulty matching. Consequently, the currency board system is more likely than central banking to encourage investment, especially foreign investinent, and to result in sustained eco- nomic growth.

1 7 Selgin 1988a. 18 See Bimbaum 1957.

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