DOCSLIB.ORG

The Quest for Sound Money: Currency Boards to the Rescue?

Total Page：16

File Type：pdf, Size：1020Kb

Download full-text PDF Read full-text
The Quest for Sound Money: Currency Boards to the Rescue? n many countries the residents do not give a second thought to what they should use for money. One currency is widely accepted as a I satisfactory medium of exchange, store of value, and unit of ac- count-the traditional roles performed by money. In many other coun- tries, however, the native currency has been a very poor store of value, destroying confidence in it and undermining its usefulness as a unit of account and medium of exchange. This problem has long plagued various less developed countries and has also arisen in the former Soviet Union and in Eastern Europe. One proposal, which has gained much attention recently, is to establish a sound currency in such countries through a device known as a currency board. This article examines this proposal and briefly compares it with alternative basic currency sys- tems. One of these alternative systems is simply to use the currency of another country, and consideration of this alternative will provide a foundation for further analysis. Why Not Use Another Country’s Currency? Rather than nurture their own native sound currencies, some countries have adopted the sound currency of another country, relying on foreign instead of domestic monetary management. In Panama this system is formally enshrined in law. In other countries the system has developed informally and incompletely, as the residents have come to Norman S. Fieleke use growing amounts of foreign currency in place of their increasingly worthless or suspect domestic currencies. Panama adopted the U.S. dollar as its paper currency through Vice President and Econo~nist, Federal legislation enacted in 1904 (Johnson 1973, p. 223). In so doing, it secured Reserve Bank of Boston. Kenneth S. for its residents the same general degree of price stability (at least in Neuhauser provided research assis- terms of tradable goods) that has been enjoyed by residents of the tance. United States, and it averted the severe inflation that has afflicted many other Latin American countries where native monies 1989; Guidotti and Rodriguez 1991). In Bolivia, Peru, have been issued to excess. Another advantage for and Uruguay, dollar and other foreign-currency de- Panama from its use of the dollar has been to facilitate posits grew to account for more than half of the commerce with the United States, its leading trading deposits included in the money supply (that is, in partner by a wide margin. And in view of the M2) during some years of the 1980s (Guidotti and importance of the United States and the dollar in the Rodriguez 1991, pp. 4-6). world economy, Panama’s use of the currency has no In such cases the underlying expectation that the doubt encouraged inward foreign investment and native currency will be substantially devalued has tourism, as well as the country’s development into an usually been stoked by marked rises in inflation international banking center. within the country relative to inflation abroad. In Panamanians are not alone in using a foreign consequence, the "good" foreign money drives out currency as their domestic currency. On the African the "bad" domestic money. Typically, foreign money continent, Botswana, Lesotho, and Swaziland all replaces the domestic first as a store of value and unit employed the South African rand as their legal tender of account, and subsequently as a medium of ex- for a number of years after gaining their indepen- change as well (Calvo and V~gh 1992, pp. 1-2). dence in the late 1960s. These countries’ economies If a foreign currency performs well as a unit of were closely linked to that of South Africa, just as account, store of value, and medium of exchange Panama’s is to that of the United States. And as in the within a country, why should not the country for- case of Panama, they were freed from the need to mally adopt that currency as its own, as Panama has decide and carry out monetary policy. Their mone- done? Not only would the country secure for itself a tary dependence on South Africa did not lead to sound currency, but it would do so without the shortages of liquidity. On the contrary, they tended expense of printing a native currency and operating on balance to be net lenders rather than borrowers of its own monetary authority. banking funds, although their banks were able to But the axiom, "There is no free lunch," applies borrow readily from affiliated South African banking to this scheme. By using a currency issued by a offices when experiencing a demand for loans that foreign government, a country grants an interest-free exceeded locally available funds at the going interest loan to that government. To acquire the foreign rates (Collings and others 1978). currency, the country must give up goods and ser- In other countries a foreign currency has been vices, or securities that pay a return; until the country adopted informally rather than by law, as a partial returns the foreign currency in exchange for goods, replacement for a native currency in which the resi- services, or securities, it obtains nothing in return dents have lost confidence. In recent times this "cur- from the foreign government. And foreign currency that gets lost or destroyed becomes an outright grant. In the case of Panama, U.S. currency within the country may be on the order of $400 million to $500 By using a currency issued by a million.2 If this money were invested in medium-term U.S. Treasury securities, currently yielding about 53/4 foreign government, a country percent, Panama would be earning $23 million to $29 grants an interest-free loan to that million this year from the investment. This forgone government. income or "seignorage loss," from using the U.S. currency instead of its own-issue currency, amounted to about one-half of I percent of Panama’s 1991 gross domestic product. Using a different approach, an- rency substitution" has been prominent in some other analysis for various regions of the world has Latin American countries, although not limited to estimated that their use of the U.S. dollar as their them. For example, Mexicans have exchanged sub- currency from roughly 1960 to 1978 would have stantial holdings of pesos for U.S. dollars, in the form of both currency and deposits, at times when expec- tations of peso devaluation against the dollar have 1 See Gruben and Lawler (1983) and the references cited 1 therein. become strong. This "dollarization" has also been 2 This estimate is based on conversation with Eudoro Jo~n observed in Argentina, Bolivia, Peru, and Uruguay Escavel, Executive Director, National Banking Commission, Re- (Ramirez-Rojas 1985; Melvin and Afcha de la Parra public of Panama, and on Fernandez (1986, pp. 50-51). November/December 1992 New England Economic Review 15 resulted in their giving up to the United States below what would be incurred if the exchange rate seignorage of between 0.3 and 1.8 percent of their were allowed to vary significantly with market forces GNP per year (Fischer 1982). over short periods, because such variation obliges This cost of using another country’s currency has transactors to spend more time in monitoring rate not escaped the notice of officials in the using coun- movements, in hedging against adverse movements, tries. In at least one case, the users were compen- and perhaps in speculating about the best timing for sated. The Rand Monetary Agreement of 1974 speci- executing future foreign exchange transactions. fied that South Africa would pay to Lesotho and to In addition to economizing on transactions costs, Swaziland a sum equivalent to the interest that each a country with a high percentage of its economic would have earned if the volume of South African activity in the form of international trade has another rand circulating within their borders had instead incentive to establish a fixed foreign exchange rate. been invested in an appropriate mix of interest- Other things equal, a change in the price of the earning securities. Botswana, which also had been country’s goods will be more effective in correcting using the rand as its currency, did not enter into the any disequilibrium in the country’s international Agreement but established its own central bank and trade balance than would be the case if the country currency (Collings and others 1978, pp. 103-109). had little involvement in international commerce. Thus, the country would typically have less need to rely on changes in the exchange rate for its currency Currency Independence: The Preferred to help remedy such a disequilibrium. Alternative Much attention has also been given to a situation in which labor market considerations suggest that a The great majority of countries, like Botswana, country should opt for currency independence, have for many years issued their own currencies. rather than join another nation in a currency area. Moreover, they have sometimes altered, or allowed Suppose that labor is highly mobile within each of market forces to alter, the rates at which their curren- two countries, readily shifting in response to internal cies have exchanged for other currencies, including differentials in wages and employment opportuni- the currencies of key trading partners. Thus, not only ties, but is much less mobile between the two coun- have they avoided making interest-free loans of the tries. Also suppose that labor is generally unwilling sort just discussed, but they have also avoided forg- to accept reductions in wage rates, one means of ing rigid links with, and dependence on, the currency maintaining full employment. In this case different or monetary policies of other countries. monetary policies would sometimes be appropriate in Whether a country should opt for such "currency the two countries to promote full employment with- independence" depends on the circumstances.
Load more

Recommended publications
  • A Survey of the Institutional and Operational Aspects of Modern-Day Currency Boards by Corrinne Ho
    BIS Working Papers No 110 A survey of the institutional and operational aspects of modern-day currency boards by Corrinne Ho Monetary and Economic Department March 2002 Abstract This paper surveys the institutional and operational features of the six modern currency boards. The survey is developed around three key aspects: organisation, operations and legal foundation. By laying out the facts, this survey seeks to shed light on how and why modern currency boards in practice are different from the classic definition, and to distil from their features an updated definition and the revised “rules of the game”. JEL Classification Numbers: E42, E52, E58 Keywords: currency boards, convertibility, rules, discretion, liquidity management BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS. Copies of publications are available from: Bank for International Settlements Information, Press & Library Services CH-4002 Basel, Switzerland E-mail: [email protected] Fax: +41 61 280 9100 and +41 61 280 8100 This publication is available on the BIS website (www.bis.org). © Bank for International Settlements 2002. All rights reserved. Brief excerpts may be reproduced or translated provided the source is cited. ISSN 1020-0959 Table of contents
    [Show full text]
  • Currency Board and Dollarization
    Currency Board and Dollarization 1 Currency Board Only a few countries, mainly in Europe, had central banks before the twentieth century. Central banking did not became widespread in the Americas until the period between the First and Second World Wars, and did not become widespread in Africa and Asia until after the Second World War. There were certain arrangements of monetary authorities alternative to central banks. Among the other monetary systems that once were widespread were currency boards. After decades of decline, currency boards have enjoyed a revival of interest in the 1990s. 1.1 What Is a Currency Board? The main characteristics of a currency board are as follows. (1) Anchor Currency The domestic currency maintains a fixed exchange rate to an anchor currency (British pound sterling, U.S. dollar, Euro etc.), and the note-issuing is 100% backed by a foreign assets. A currency board is a variant of fixed exchange rate targeting in which the com- mitment to the fixed exchange rate is by design permanent and is particularly strong. A currency board maintains full, unlimited convertibility between its notes and coins and the anchor currency at a fixed rate of exchange. (2) Reserves A currency board’s reserves are equal to 100 percent or slightly more of its notes and coins in circulation, as set by law. As reserves, a currency board holds low-risk, interest-bearing bonds and other assets denominated in the anchor currency. (3) Monetary Policy By design, a currency board has no discretionary power in monetary policy; market forces alone determine the money supply.
    [Show full text]
  • Sudden Stops and Currency Drops: a Historical Look
    View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics This PDF is a selection from a published volume from the National Bureau of Economic Research Volume Title: The Decline of Latin American Economies: Growth, Institutions, and Crises Volume Author/Editor: Sebastian Edwards, Gerardo Esquivel and Graciela Márquez, editors Volume Publisher: University of Chicago Press Volume ISBN: 0-226-18500-1 Volume URL: http://www.nber.org/books/edwa04-1 Conference Date: December 2-4, 2004 Publication Date: July 2007 Title: Sudden Stops and Currency Drops: A Historical Look Author: Luis A. V. Catão URL: http://www.nber.org/chapters/c10658 7 Sudden Stops and Currency Drops A Historical Look Luis A. V. Catão 7.1 Introduction A prominent strand of international macroeconomics literature has re- cently devoted considerable attention to what has been dubbed “sudden stops”; that is, sharp reversals in aggregate foreign capital inflows. While there seems to be insufficient consensus on what triggers such reversals, two consequences have been amply documented—namely, exchange rate drops and downturns in economic activity, effectively constricting domes- tic consumption smoothing. This literature also notes, however, that not all countries respond similarly to sudden stops: whereas ensuing devaluations and output contractions are often dramatic among emerging markets, fi- nancially advanced countries tend to be far more impervious to those dis- ruptive effects.1 These stylized facts about sudden stops have been based entirely on post-1970 evidence. Yet, periodical sharp reversals in international capital flows are not new phenomena. Leaving aside the period between the 1930s Depression and the breakdown of the Bretton-Woods system in 1971 (when stringent controls on cross-border capital flows prevailed around Luis A.
    [Show full text]
  • A Currency Board for European Monetary Union Outsiders
    A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Sutter, Matthias Article — Digitized Version A currency board for European Monetary Union outsiders Intereconomics Suggested Citation: Sutter, Matthias (1996) : A currency board for European Monetary Union outsiders, Intereconomics, ISSN 0020-5346, Nomos Verlagsgesellschaft, Baden-Baden, Vol. 31, Iss. 3, pp. 131-138, http://dx.doi.org/10.1007/BF02930440 This Version is available at: http://hdl.handle.net/10419/140544 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu EUROPEAN MONETARY UNION distribution system would need to be chosen which, sovereignty individual countries gained ought to be above all, would encourage countries to impose the regarded as a risk rather than an opportunity.
    [Show full text]
  • Wiiw Research Report 265: Fiscal Policy Under a Currency Board Arrangement
    WIIW Research Reports No. 265 March 2000 Rumen Dobrinsky Fiscal Policy Under a Currency Board Arrangement: Bulgaria's Post-crisis Policy Dilemmas Rumen Dobrinsky Fiscal Policy Under a Rumen Dobrinsky is Economic Affairs Currency Board Officer, United Nations Economic Arrangement: Commission for Europe/Economic Analysis Division. The author has longstanding Bulgaria's Post-crisis research relations with WIIW. Policy Dilemmas Contents Abstract...............................................................................................................................i Executive Summary........................................................................................................... iii 1 Introduction ...................................................................................................................1 2 Fiscal policy in a currency board system .......................................................................2 3 Some issues in transitional fiscal accounting.................................................................6 4 Bulgaria’s recent economic performance.....................................................................11 4.1 Post-crisis adjustment..........................................................................................11 4.2 Competitiveness ..................................................................................................13 4.3 The state of the enterprise sector.........................................................................17 5 Current fiscal policy dilemmas
    [Show full text]
  • Currency Substitution: the Use of Hong Kong Dollars in Southern China
    Journal of Economic Integration 17(3), September 2002; 596-607 Currency Substitution: The Use of Hong Kong Dollars in Southern China Kui Yin Cheung and Chengze Simon Fan Lingnan University Abstract This paper studies the circulation of Hong Kong dollars in the Chinese Mainland. It first estimates the amount of Hong Kong dollars circulating in southern China in the last fifteen years. The regression analysis indicates that the growth rate of Hong Kongs foreign direct investment in China and the growth rate of trade volume between Hong Kong and China are some of the main determinants that contribute to the widespread use of Hong Kong dollars in southern China. The difference of real returns between Hong Kong dollar denominated assets and Chinese Renminbi denominated assets, however, has no effect on the amount of Hong Kong dollars circulating in China. • JEL Classifications: E41, F36 • Key Words: Currency Substitution, Hong Kong Dollars, Hong Kong I. Introduction Currency substitution is an important issue in international macroeconomics because it is often regarded as a major contributing factor in the economic interdependence of countries. For instance, currency substitution has important impact on the exchange rate (McKinnon, 1982). In the face of exogenous changes in the expected rate of depreciation, Girton and Roper (1981) show that the exchange rate volatility increases with the degree of currency substitution. Furthermore, currency substitution may transmit the effect of monetary disturbances from one country to another (Miles, 1978). This paper attempts to *Corresponding address: Kui Yin Cheung, Department of Economics, Lingnan University, Tuen Mun, N.T., Hong Kong, Tel: +852-2616 7187, Fax: +852-2891-7940, E-mail: [email protected] 2002-Center for International Economics, Sejong Institution, All Rights Reserved.
    [Show full text]
  • Design and Operation of Existing Currency Board Arrangements
    2 0 3 Ma³gorzata Jakubiak Design and Operation of Existing Currency Board Arrangements W a r s a w , 2 0 0 0 Materials published here have a working paper character. They can be subject to further publication. The views and opinions expressed here reflect Authors’ point of view and not necessarily those of CASE. This paper was prepared for the research project "Ukraine Macroeconomic Policy Program" financed by the United States Agency for International Development (USAID). © CASE – Center for Social and Economic Research, Warsaw 2000 Graphic Design: Agnieszka Natalia Bury DTP: CeDeWu – Centrum Doradztwa i Wydawnictw “Multi-Press” sp. z o.o. ISSN 1506-1701, ISBN 83-7178-208-X Publisher: CASE – Center for Social and Economic Research ul. Sienkiewicza 12, 00-944 Warsaw, Poland tel.: (4822) 622 66 27, 828 61 33, fax (4822) 828 60 69 e-mail: [email protected] Contents Abstract 5 1. Definition 6 2. How are Currency Boards Related to Other Monetary and Exchange Rate Regimes? 6 3. Experience from Existing Currency Boards 8 3.1. Design of Existing Currency Board 8 3.2. Implementation Experience and Long-Term Effects 11 4. Advantages and Disadvantages of the Currency Board Arrangement 17 5.What Conditions Must Be Satisfied in Order to Be Able to Implement a Currency Board Regime? 20 References 22 Studies & Analyses CASE No. 203 – Ma³gorzata Jakubiak Ma³gorzata Jakubiak Junior Researcher, CASE Foundation The author holds an MA in International Economics from the University of Sussex and an MA in Economics from the University of Warsaw. Since 1997 junior researcher at the Center for Social and Economic Research – CASE.
    [Show full text]
  • A Model of Currency Substitution in Exchange Rate Determination, 1973-78
    A Model of Currency Substitution in Exchange Rate Determination, 1973-78 ARTURO BRILLEMBOURG and SUSAN M. SCHADLER * д т THE OUTSET of the current floating exchange rate regime, jfTi expectations were widespread that the new system would allow countries a high degree of policy independence yet reduce strains on the free international movement of goods, services, and capital. Even long-standing critics of exchange rate flexibility seemed unable to oppose meaningfully the advent of flexible exchange rates in the face of the severe strains of reserve changes and international payments imbalances. Domestic financial pol- icies and economic performance in the major industrial countries had diverged to such an extent that fixed relationships among currencies were obviously unfeasible. After several years' experience with floating exchange rates, however, it is far from clear that exchange rate flexibility enhances the ability of coun- tries to pursue their own chosen policies without contributing to severe disruptions in the international monetary system. In fact, as experience with the regime grows, a number of the fun- damental tenets of flexible exchange rate advocates are being called into question. The long-standing case for floating exchange rates has centered principally around the argument that exchange rate flexibility allows individual countries to choose financial policies indepen- dently while removing the burden of intervention on those coun- * Mr. Brillembourg, economist in the Special Studies Division of the Research Department, is a graduate of Harvard University and of the University of Chicago. Ms. Schadler, economist in the Special Studies Division of the Research Department, holds degrees from Mount Holyoke College and the London School of Economics and Political Science.
    [Show full text]
  • The Implications of Currency Substitution Experiencesin Latin America and in Eastern Europe for Cuba
    The Implications of Currency Substitution Experiencesin Latin America and in Eastern Europe for Cuba Lorenzo L. Pérez. International Monetary Fund [1] I. Introduction This paper assesses the experience of dollarization and currency substitution in Latin America and in Eastern Europe and analyzes the implications of this phenomena for Cuba. Under conditions of high inflation, the ability of national currencies to function adequately as a store of value, a unit of account, and a means of exchange is hindered. In these circumstances, the domestic currency tends first to be displaced as a store of value by a stableand convertible currency (usually in the form of interest-bearing foreign currency deposits); this phenomenon is known in the literature as dollarization.[2] Long periods of high inflation induce the public also to conduct transactions in foreign currency, a process which is usually referred in the literature as currency substitution. Both types of experiences are occurring in Cuba. SectionII summarizes the measures taken by the Castro Government to allow the circulation of freely convertible currencies (mostly U.S. dollars) in Cuba. SectionIII discusses the reasons of why dollarization and currency substitution take place, and the form and extent that it has taken place in Latin America and European countries. SectionIV discusses the advantages and disadvantages of allowing a foreign currency as legal tender. SectionV draws conclusions from the experience of other countries for Cuba's recent dollarization and currency substitution developments and the implications for the future. II. Cuba's Experience with Dollarization and Currency Substitution Prior to the summer of 1993, U.S.
    [Show full text]
  • Currency Boards
    85 Currency Boards Ulrik Bie, Secretariat and Niels Peter Hahnemann, International Relations WHAT IS A CURRENCY BOARD? In countries with currency boards a fundamental element of monetary policy is that domestic base money1 must be fully covered by foreign- exchange reserves and gold. Strict interpretation of the rule entails that the responsible authority cannot acquire domestic financial assets, so that the base money is matched to the foreign-exchange reserve. At the same time, it must be possible to exchange currency freely without limi- tations to and from an anchor currency at a fixed exchange rate. This principle is laid down by law and can therefore only be changed by amendment of legislation. This also applies to the fixed exchange rate. Currency boards originated in the British colonies2, where they were established primarily with a view to creating stable monetary conditions while retaining seignorage in the local area. The sole function of the colonial currency boards was to issue banknotes and coins against ster- ling deposits in London and vice versa: to exchange local currency for sterling. Most currency boards were based in the local area, but some had their headquarters in London. In the period after World War II until the colonies gained independence in the 1950s and 1960s by far the majority of the British colonies had currency boards. The former colonies usually established normal central banks upon independence. The currency board countries were required to observe a number of rules, as was the case under the gold standard system.3 Firstly, the ex- change rate against the anchor currency had to be fixed.
    [Show full text]
  • Internationalisation of the Renminbi
    Internationalisation of the renminbi Haihong Gao and Yongding Yu1 Introduction Over the past three decades, China’s fast economic growth and its increasing economic integration with the world have led to a significant increase in its influence in the world economy. During the Asian financial crisis of 1997–98, China was praised as a responsible country, because of its efforts in maintaining the stability of the renminbi while many other countries in the region had devaluated their currencies. It was the first time that China itself, as well its Asian neighbours, started realising China’s emerging influence. Like it or not, China is no longer an outsider in global financial events. This is not only because China is now the world’s third largest economy and second largest trading nation, but also because it holds the largest amount of foreign reserves in the world. Since the Asian financial crisis, China has been faced with three major tasks with regard to its international financial policies. The first is the reform of the global financial architecture. The second is the promotion of regional financial cooperation, which consists of two components: the creation of a regional financial architecture and the coordination of regional exchange rate arrangements. The last is internationalisation of the renminbi. It is fair to say that, over the past 10 years or so, the most discussed issue in China has been regional financial cooperation. Although the result is still highly unsatisfactory, together with its East Asian neighbours China has achieved some tangible results, built on the basis of the Chiang Mai Initiative (CMI).
    [Show full text]
  • A Study of the Internationalization of the Chinese Renminbi ——To Access Its Risks
    A Study of the Internationalization of the Chinese Renminbi ——to access its risks Number of keystrokes:96896 ! Master Thesis by: Supervised by: Youran Wang Bill Liu Jesper Willaing Zeuthen May 2018 Aalborg University, China and International Relations Abstract Since 2009, the People's Bank of China has focused on the liberalization of trade and investment, establishing a policy framework to facilitate international use of renminbi. On October 1, 2016, the RMB was formally included in the SDR currency basket of the International Monetary Fund. This is an important milestone in the process of RMB internationalization. However, over the past two years, the global use of renminbi as a payment currency has declined. Fitch Ratings suggests that China’s policy of restricting capital outflows and global concerns about the devaluation of renminbi impede the internationalization of the currency in the short term. From the end of last year 2017, things have changed. The cross-border use of renminbi has been expanded, and new progress has been made in the internationalization of renminbi. There are several factors that promote renminbi internationalization in the long term. The “One Belt and One Road” initiative suggests global participants also cooperates in the increased international use of RMB. The Renminbi Cross-Border Payment System (CIPS) promoted the opening of China's capital market and brought more opportunities for RMB product innovation in the global markets. Hong Kong RMB offshore financial center continues to develop and serve as an intermediary for RMB to go to globe. According to SWIFT, 49.4% of renminbi payment transfers through Hong Kong.
    [Show full text]