Abstract

While large foreign reserve holdings can strengthen a CBA, using them actively for LOLR or monetary operations might be seen as conflicting with its basic principles of limited discretion. It seems more likely, however, that as long as sufficient resources are available and that the authorities’ actions follow clearly specified rules, some flexibility can add to the sustainability of a currency board and thus enhance its credibility. Institutional arrangements, operational procedures, and monetary and prudential instruments can be designed to reduce risks of a systemic liquidity crisis while limiting discretionary interference from the monetary authorities. In addition, public debt policies can be reformed to limit the risk of a debt crisis. Nevertheless, some LOLR support may well be needed—preferably under central bank control—to contain financial sector problems at an early stage and avert contagion risks. This should be arranged in a manner that addresses systemic problems in the banking system, while seeking to avoid bailouts of insolvent banks. Indeed, the existence of such support facilities can enhance confidence in the domestic financial system, and hence lower intermediation spreads. To build up reserves to provide such support, CBAs may wish to set higher reserve requirements or to introduce liquidity requirements in foreign currency. CBAs can also assume traditional monetary functions, within clearly specified bounds, provided they have sufficient credibility and hold adequate excess reserves.

While large foreign reserve holdings can strengthen a CBA, using them actively for LOLR or monetary operations might be seen as conflicting with its basic principles of limited discretion. It seems more likely, however, that as long as sufficient resources are available and that the authorities’ actions follow clearly specified rules, some flexibility can add to the sustainability of a currency board and thus enhance its credibility. Institutional arrangements, operational procedures, and monetary and prudential instruments can be designed to reduce risks of a systemic liquidity crisis while limiting discretionary interference from the monetary authorities. In addition, public debt policies can be reformed to limit the risk of a debt crisis. Nevertheless, some LOLR support may well be needed—preferably under central bank control—to contain financial sector problems at an early stage and avert contagion risks. This should be arranged in a manner that addresses systemic problems in the banking system, while seeking to avoid bailouts of insolvent banks. Indeed, the existence of such support facilities can enhance confidence in the domestic financial system, and hence lower intermediation spreads. To build up reserves to provide such support, CBAs may wish to set higher reserve requirements or to introduce liquidity requirements in foreign currency. CBAs can also assume traditional monetary functions, within clearly specified bounds, provided they have sufficient credibility and hold adequate excess reserves.

Scope for Day-to-Day Monetary Operations

Well-designed payments system and monetary arrangements can help deal with the limitations on the scope of monetary operations that a CBA imposes. In particular, allowing banks to hold their settlement balances with the monetary authority and ensuring their immediate convertibility at the official exchange rate can facilitate the adjustment of liquidity through capital inflows.

Automatic access to central bank liquidity can also be facilitated by using reserve requirements as introduced in a number of CBA countries.47 When required reserves are averaged over a sufficiently long holding period, they can be accessed by banks as an automatic liquidity buffer to help smooth out interest rate volatility in the money market and limit risks of settlement failures. Thus, the foreign reserves that are held inside the currency board to back required reserves can continue to form an active part of the financial system’s liquidity, and fluctuations in bank reserves can usefully complement capital flows, particularly over the shorter term.

Reserve requirements also act to sterilize capital inflows, limit their impact on domestic credit, and discourage their domestic intermediation.48 The portion of reserve requirements that is used for sterilization can be held in a fully backed separate sterilization fund. Thus, in the case of capital outflows, the foreign exchange can be made immediately available to banks.

To facilitate banks’ use of their foreign reserves for domestic liquidity, the central bank can also use foreign exchange swaps, as implemented, for example, in Argentina. Swaps facilitate short-term capital flows (thereby promoting interest rate arbitrage) and allow the central bank to provide fully backed liquidity without undermining its own foreign reserves base. However, as is the case in other fixed exchange rate arrangements, swaps can be dangerous if they are used to postpone needed policy actions, and costly if the currency peg needs to be changed.

In addition, a standing facility (such as a Lombard window) or conventional open market operations may help facilitate settlements, smooth out daily liquidity variations, and accelerate the adjustment of domestic interest rates to changes in foreign rates. In particular, interventions may be used to maintain the spread between the domestic and the reserve currency country interest rates within a narrow band, as in Hong Kong. In addition, open market operations can be used to facilitate the development of government securities markets and to promote financial deepening.49 In Estonia, for example, although the Bank of Estonia does not attempt to influence the interest rate directly, it has in the past issued certificates of deposit to facilitate the development of the interbank market and has stood ready to buy back its CDs (or to enter into repurchase agreements with banks) to ensure the liquidity of its bills.50 However, to avoid undermining the CBA, these operations should have a clearly defined scope and should maintain the foreign exchange cover of monetary liabilities foreseen in the CBA.

Prudential Issues and Lender of Last Resort

While the case against having a LOLR facility is often made by proponents of CBAs, its absence raises serious concerns. It can be argued that the absence of a LOLR should, in principle, enhance the soundness of the banking system by promoting market discipline, limiting moral hazard, and inducing banks to reduce their exposure. The restrictions a CBA imposes on the capacity of the monetary authority to assist banks in distress also have positive aspects. A CBA makes the costs and sources of any assistance from the public sector easier to identify. This makes it harder for the monetary authority to take on the quasi-fiscal costs of bank rescue operations, which not only risk loss of monetary control but could delay the resolution of crises.

Banks may fail, however, to take sufficient measures to avoid liquidity crises, for instance in the case of adverse external shocks. Moreover, banks continue to be exposed to some extent to moral hazard, as a systemic crisis may be expected to induce the authorities to come to their rescue in order to limit the damage to the payments system and to prevent a collapse of the CBA.51 Argentina’s recent experience, in which extensive official support was eventually provided to banks through a variety of channels, lends support to this view.52

The need for LOLR support can be reduced by adopting proper prudential regulations and supervisory arrangements (Box 6). Thus, strong bank supervision, proper accounting standards, loan valuation rules, stringent disclosure requirements, and risk management arrangements in the payments system should all be viewed as essential features of CBAs. In particular, capital adequacy rules should be more stringent than the minimum called for under the Basle standard. While a high required capital adequacy ratio may be costly to banks, it may, nonetheless, be needed to strengthen the banking system.53

Capital-asset ratios need to be accompanied by additional prudential regulations to limit interest rate and liquidity risks, particularly when weak bank supervision allows bank owners to avoid acting as residual risk bearers.54 To limit interest rate risk and promote interest rate flexibility, prudential regulations can be introduced that limit mismatches in the maturity structure of banks’ assets and liabilities.55 To increase the liquidity of the financial system and reduce its vulnerability to runs on deposits, banks may be subject to reserve requirements in excess of amounts strictly needed by banks as settlement balances, as in Estonia and Lithuania and, until recently, Argentina. However, to meet the liquidity needs of banks that are experiencing sustained liquidity shortages, reserve requirement rates need to be adjusted on an ad hoc basis (as in Argentina in the wake of the Mexican crisis) or compliance (as in Lithuania).56 In addition to requiring the use of discretion, these ad hoc modifications conflict with the monetary function of the instruments that call for uniform rates across banks and strict compliance.

Prudential Arrangements

At present, last-resort support and banking supervision functions are handled by the same institution in all countries with a currency board arrangement, except for Brunei Darussalam and Djibouti.1 In CBA countries that have a central bank, the latter are responsible for establishing prudential arrangements and supervising the banking system. However, in Djibouti, the National Bank’s banking supervision capability is severely limited. It maintains the soundness of the banking system by allowing only reputable foreign banks to operate in the country, and, hence, by implicitly relying on the supervising authorities of these banks’ home countries.

In those countries without central banks, that is, Brunei Darussalam and Hong Kong, prudential and supervisory arrangements vary. In Brunei Darussalam, the Financial Institutions Division of the Ministry of Finance has been in charge of banking supervision since 1993. In Hong Kong, the Hong Kong Monetary Authority (HKMA) was granted prudential and supervisory authority in 1993 with a view to strengthening the regulatory framework in response to recurrent instability in the financial sector during the early 1980s. Previously, these functions had been handled by the Exchange Fund and the Banking Commissioner’s Office.2

Many CBA countries have adopted internationally accepted banking supervision standards including, among others, a risk-based capital adequacy ratio and a liquidity ratio. Estonia followed the Basle Committee’s Accord by imposing a risk-based capital adequacy ratio of 8 percent. In view of the limited resources available for last-resort support, Argentina, Hong Kong, and Lithuania adopted more stringent standards.3 In Argentina, the ratio has been increased gradually from 3 percent in mid-1991 to 11.5 percent in January 1995. In Hong Kong, although the standard ratio is 8 percent, the HKMA has the right to increase the requirement up to 12 percent for any general licensed bank and up to 16 percent for any restricted licensed bank and deposit-taking companies. In Lithuania, because existing bank accounting practices are not up to international standards, the ratio was initially set higher than that of the Basle Committee’s Accord at 13 percent but was lowered to 10 percent on January 1, 1997.

Liquidity ratios have also been introduced in Argentina, Hong Kong, Estonia, and Lithuania. The ratios have been set at 18 percent and 25 percent in Argentina and Hong Kong, respectively, and 30 percent in Estonia and Lithuania. In Argentina, the liquidity requirement is being raised gradually to reach 20 percent by February 1998.

In addition, international standards on banks’ foreign exchange exposure limits were introduced in Hong Kong, Estonia, and Lithuania. In Estonia and Lithuania, the foreign exchange exposure limits exclude the deutsche mark and the U.S. dollar, respectively, from the computation as the reserve currency and the domestic currency share a similar risk in a CBA. In Djibouti, the National Bank has the authority to impose foreign exchange exposure limits, but has not exercised such power.

1 See Appendix IV, Table 2.2 Previously, the Exchange Fund managed resources for last-resort support while the Banking Commissioner’s Office had greater authority in bank supervision.3 By contrast, Djibouti imposes a lower risk-based capital adequacy standard of 5 percent. However, as already noted, all banks operating in Djibouti are foreign.

Moreover, reserve requirements can be lowered to inject liquidity, thereby increasing the scope for discretionary (and possibly unsound) monetary policy. In addition, high reserve requirements, unless remunerated at market interest rates, may harm bank profitability and promote disintermediation from the domestic banking system.

Liquidity requirements are better suited to prudential objectives, particularly to deal with systemic liquidity crises.57 The structure of liquidity requirements can be designed to induce banks to adjust the profile of their liabilities in a way that helps internalize some of the externalities associated with liquidity risk.58 In countries where bank supervision is strong and the banking system is sound, controls or restrictions over banks’ use of liquid assets do not need to be intrusive. Moreover, liquidity requirements can be fulfilled by allowing banks to directly deposit their reserves abroad. In the case of reserve requirements, such a provision would be more difficult to implement, since reserves are likely to be used also in daily interbank settlement. Thus, by endowing banks with broad responsibility for the use and management of their reserves, liquidity requirements can limit the need for discretionary central bank intervention while containing moral hazard.

While adequate prudential regulations and supervisory practices can reduce the need for a LOLR, they do not eliminate it. In the absence of timely liquidity support from the central bank, isolated banking system difficulties can spread as a result of contagion and spillover effects, particularly under conditions of uncertainty. The recent Argentine experience illustrates well such risks in the context of a large external shock.59 Because the proportion of banks’ liabilities that can be set aside in the form of liquid reserves is limited in a fractional reserve banking system, liquidity requirements reduce but do not eliminate such risks.

As long as fractional reserve banking is in place and domestic banks account for a substantial share of the banking system, CBAs are likely to require at least some resources for LOLR support.60 CBAs can provide LOLR support provided that they have sufficient excess foreign reserves. The foreign exchange backing for such support can originate from a common pool of bank resources or from the central bank if it has sufficient excess foreign reserves, as in Estonia. The central bank may obtain automatic support from other central banks, as in Hong Kong, where a protocol of this kind was established with other Asian central banks in the wake of the Mexican crisis, or may guarantee, on behalf of local commercial banks, lines of credit with foreign banks, as recently implemented by Argentina.61

To limit moral hazard, LOLR support should be collateralized with safe assets such as government securities. In cases where banks are encouraged to hold a fraction of liquidity requirements in the form of government securities, the provision of LOLR support becomes closely related to the support of the interbank money market and government securities market. Thus, to ensure proper coordination between monetary and LOLR operations, it is preferable that LOLR resources be deposited at (and administered by) the monetary authorities.62

To enhance systemic stability and encourage banks to restrain their risk-prone peers, an autonomous deposit insurance fund with limited coverage and funded by the banks themselves can also be introduced. Moral hazard can be limited by setting insurance premiums based on the riskiness of each bank’s portfolio. Although such a risk-based system is not easy to administer, it has been implemented, with apparent success, in Argentina.63

Implications for Public Debt Management

To limit stress on public finances and the risk of a debt crisis, public debt management should be adjusted to suit a CBA environment, especially when the public debt is large and the CBA has limited credibility. In particular, to avoid the risk of a bunching of maturing bills, it is helpful to have a balanced maturity structure of government securities. Nevertheless, open market operations may still be required to support the government securities markets and to prevent a severe liquidity squeeze in the event of a systemic crisis—particularly if government securities are an important component of banks’ liquidity. Sufficient foreign reserves backing is needed for such operations. In some cases, the government may be able to obtain the initial reserves by running a fiscal surplus or through a long-term external loan. Subsequently, a fraction of the proceeds from additional bill issues can be systematically sterilized and deposited at the central bank.64 At the same time, however, to avoid damaging the CBA’s credibility, interest rate increases should contribute early on to attaining market equilibrium.

Duration of a Currency Board Arrangement

Currency board arrangements can clearly be perceived as permanent arrangements in countries that derive obvious trade and other benefits from belonging to a common currency area. Particularly in countries that are exposed to speculative attacks or that may undergo a phase of strong real appreciation, the authorities may wish to impress upon the public the perception that CBAs are long-term arrangements. In some cases, however, CBAs may be viewed as transitional arrangements designed to support a currency until credibility and institutions strengthen or a large exogenous change in the economic environment makes it advantageous to switch to a different currency and exchange rate arrangement. While an early exit from a CBA could limit risks of overvaluation, exiting a CBA by depreciating is likely to inflict a severe blow to the policymakers’ credibility, particularly if the abandonment of the arrangement is not associated with an exogenous shock that clearly justifies it. Malaysia’s and Singapore’s experience shows that exiting a CBA from a position of strength—namely, by allowing the currency to appreciate—does not carry a similar penalty. It also shows that a law can be changed without serious adverse effect, provided policymakers respect its intent—that is, to maintain the value of the currency. Nevertheless, legal restrictions can play an important role in preventing surprise devaluations, thereby enhancing the CBA’s credibility.

Should Currency Board Arrangements Be Viewed as Transitory or Permanent?

The credibility enhancing effect of a CBA is likely to prove most beneficial at the beginning of a regime change. At the same time, credibility is easier to maintain when the public clearly understands the rationale for a CBA and is aware that it would be irrational for the government to abandon the new institution at an early stage. Over time, however, the weaknesses derived from a CBA’s inflexibility may become more relevant and apparent, and the arrangement’s usefulness may become less important as confidence in the overall stance of government policy has grown. Thus, while rigid rules may be desirable during a transition phase, these rules may, over time, become unduly constraining. Similarly, as the monetary authorities build up their central banking expertise and financial markets develop, potential impediments to increasing the scope for policy discretion are reduced. The gradual relaxation of the CBA’s rules, and its eventual abandonment in some cases, may therefore be viewed as the natural conclusion of a transitional process during which credibility is restored, institutions are built up, and financial markets develop. This paradigm would suit, in particular, countries where monetary institutions lack initial credibility or expertise but where full monetary and exchange rate flexibility is seen as an important long-term goal.65

A change in the external environment may be the catalyst that induces the abandonment of the CBA, as in Malaysia and Singapore. In both, the CBAs were abandoned from a position of strength and as a result of conscious policy choices, in the wake of the breakup of the Bretton Woods system.

However, the need to exit a CBA may also arise under stress, due to large external shocks or a buildup of internal pressures, in particular those resulting from increasing real exchange rate misalignments. In Argentina, the CBA was suspended in both 1914 and 1929 as a result of large capital outflows linked with the advent of World War I, in the first case, and the worldwide recession and sustained drop of commodity prices, in the second. Pressures from the agricultural sector to devalue were a key factor underlying the suspension (which became permanent) of the second CBA.

The more recent experiences of Hong Kong, Argentina, and Lithuania underline the fact that CBAs on occasion continue to be exposed to attacks. As long as it is possible to alter the exchange rate, whether by decision of the executive branch or by law, expectations of changes in the parity may persist. For example, high deposit rates continued to prevail in Lithuania for months following false rumors of devaluation. In Estonia and Argentina, markets still consider the currency of denomination as a relevant element in pricing financial assets, as reflected by the still substantial interest rate spreads between deposits in domestic and foreign currencies.

When a country decides to make a CBA a permanent or long-term policy feature, it may need to adopt measures that minimize the vulnerability of the arrangement to attacks. Allowing dollarization can lessen pressures on the CBA by providing some scope for hedging devaluation risks internally and limiting the benefits of a surprise devaluation.66 Institutional and structural reforms, particularly in the fiscal and labor market areas, can be used to deepen the authorities’ commitment to the CBA and reduce the costs of operating within this arrangement, thereby cementing the fixed exchange rate rule. Such reforms are currently being implemented in Argentina.67

Legal Issues in Exiting a Currency Board Arrangement

Although CBAs are subject to legal constraints on exchange rate policy, they differ in the nature of the rules and how they are expressed. Most currency boards establish an exchange rate by legislation. For example, in Argentina, the Convertibility Law currently establishes the exchange rate to which the central bank commits itself to sell foreign exchange at parity against the U.S. dollar and allows no provision for changing it. By contrast, the earlier Argentine CBAs included a clause allowing the government to rescind the arrangement in emergencies. At the same time, however, Argentina’s Convertibility Law does not require that the central bank purchase foreign exchange at parity against the U.S. dollar. Thus, as noted earlier, the exchange rate could be allowed to appreciate. Similarly, in Estonia, the law declares an initial exchange rate and merely states that the authorities will not allow a depreciation of the national currency. Consequently, the possibility of an appreciation of the rate is not legally prohibited. In Djibouti, notwithstanding that the law establishes the exchange rate, when the franc was revalued twice (against the U.S. dollar) during the breakup of the Bretton Woods system, the authorities were faced with either keeping to the letter of the law and accepting the devaluation of the U.S. dollar as cause for a concomitant devaluation of the Djibouti franc or revaluing the Djibouti franc and keeping to the spirit of domestic price stability. The latter course was chosen and the currency board arrangement persisted. Malaysia and Singapore also allowed their currency to appreciate after the breakdown of the Bretton Woods arrangement.

These examples suggest that a CBA is more than a set of legal rules. In fact, credibility cannot reside solely in the legal exchange rate commitment. As Fischer (1993) and Sjaastad (1993) have argued, governments that feel compelled to break rules will find a means to do so. Indeed, the public is well aware that laws can be changed. Hence, legal restrictions can form only a part of the fabric of a credible CBA. Moreover, the experiences of Malaysia and Singapore indicate that in some instances commitment and underlying economic strength are viewed as more important for macro-economic stability than the maintenance of a specific exchange arrangement.

Exit Strategies

As argued in the first section of this paper, legal restrictions to changing the exchange rate are nevertheless an important determinant of the CBA’s credibility. When a particular exchange rate is enshrined in the law, it may be quite difficult to adjust without the proposed change being known for some time before becoming effective. Somewhat different issues arise, depending on the nature of the exchange rate adjustment.

Appreciation

If it becomes known to market participants that an appreciation of the currency is likely, a capital inflow will be attracted. The subsequent dynamics of the money market are difficult to predict, but there is a clear possibility that market reactions would undermine the appreciation strategy. In the face of large capital inflows, the CBA may no longer be able to back the expanded monetary base at the contemplated new exchange rate. The CBA could also sustain large losses, as the appreciation would increase the value of the CBA’s liabilities relative to that of its assets.68

Exit Experiences

A key concern in exiting from a currency board arrangement is whether the exit would drastically reduce credibility. In this regard, reviewing the experience of past CBAs can provide some insights. Despite the fact that Argentina in 1914 and 1927 and Malaysia and Singapore in 1973 suddenly exited from their CBAs, the authorities did not suffer a loss of credibility or unstable economic conditions, as the decisions were made in response to exceptional external shocks that were clearly evident to the public. Ireland avoided disruptions to economic activity by relaxing the backing rule and the power to change the fixed exchange rate gradually overtime.

Argentina

Argentina had two experiences with gold-backed CBAs earlier this century, in 1902–14 and 1927–29.1

The abandonment of the CBA in 1914 followed a series of domestic and, more important, external shocks. During 1913—14, Argentina experienced an economic recession caused by a crop failure and a severe monetary tightening. The latter was due to a fall in the Conversion Office’s gold holdings that followed a decline in exports and large repayments of foreign bank loans. With the outbreak of World War I, capital inflows from Europe declined sharply and the situation deteriorated further. News about the War created a financial panic in Argentina. In order to avoid bank runs and further gold flights, the authorities closed all financial institutions, including the Conversion Office, for eight days. To avoid losing more gold, the authorities prohibited gold exports in August 1914. The limit on the backing rule was reduced to 40 percent and banks were allowed to rediscount commercial papers with the central bank in order to increase domestic liquidity.

After exiting from the CBA, the Argentine economy experienced further shocks that led to persistent devaluations of the peso. In 1924, Argentina began to have sizable export surpluses and attract capital inflows—mainly in the form of external borrowing from the New York money market—which led to an appreciation of the peso. With a view to protecting agricultural exports from further appreciation, the authorities reestablished the CBA by returning to the old gold parity and resuming convertibility. However, the new CBA was shortlived. In 1929, the world economy experienced a severe economic recession, a sharp and sustained decline in commodity prices, an emergence of protectionism, and a drastic reduction in foreign lending to developing countries. Under pressures from the agricultural sector to devalue the currency, and to avoid a severe monetary contraction and further gold losses, which could undermine the government’s ability to service its foreign debts, the President exercised his legal power to close the Conversion Office.2 Subsequently, the peso depreciated sharply.

Malaysia and Singapore

After the Malayan Currency Board was abandoned in June 1967, following the breakup of Singapore and Malaysia, Singapore established the Board of Commissioners of Currency of Singapore (BCCS) to issue notes and coins that were fully backed by foreign assets and convertible at a fixed exchange rate with the pound sterling. In Malaysia, Bank Negara Malaysia (BNM), established in 1958, also assumed the issuing of notes within a CBA framework. The Malaysian ringgit was fixed at parity with gold, which effectively resulted in fixing the parity between the ringgit and the pound sterling, as the latter also kept a fixed parity with gold. During that period, the currencies of Malaysia, Brunei, and Singapore were interchangeable and accepted at par in the three countries.

Following the floating of the pound sterling in June 1972, BNM and the Monetary Authority of Singapore (MAS) pegged their currencies to the U.S. dollar, within a band of 4.43 percent.3 This measure was adopted to maintain the parity of the currency with gold, and to prevent it from depreciating along with the pound sterling. When the U.S. dollar devalued against gold in February 1973, the Malaysian and Singaporean authorities opted to maintain the parity with gold, thereby revaluing the exchange rate with respect to the U.S. dollar (see figure at right). However, as the U.S. dollar continued to weaken, the ringgit and the Singapore dollar reached the bottom of the exchange rate band and depreciated against the currencies of their trading partners, which resulted in an increase in imported inflation. At the same time, expectations of an appreciation led to capital inflows and excess liquidity.

To enhance monetary control, the Malaysian and Singaporean authorities in June 1973 terminated the interchangeability of their currencies and adopted floating exchange rate regimes, resulting in an initial appreciation of their currencies. Despite maintaining a backing requirement for notes and coins, the decision to adopt a managed float was essentially an exit from the CBA. These exits were not disruptive, as they were effected from a position of strength and amid revaluation expectations.

Ireland

After becoming independent in 1927, Ireland established a currency board and tied the Irish pound to the pound sterling at parity.4 Unlike other exit experiences discussed above, Ireland exited its CBA gradually, thereby allowing the central bank to establish a credible track record that facilitated a smooth exit.

Malaysia, Singapore, and United Kingdom: Exchange Rates

(National currency per U.S. dollar; end of period)

Source: IMF, International Financial Statistics.

Although a central bank was created in 1943, its operations continued to be limited by the backing rule. The banking system resorted to banks in London for liquidity support, and the central bank lent neither to banks nor the government.5 The backing rule was relaxed by expanding the set of foreign assets eligible for backing and by lowering, in 1961, the backing coverage to around 75 percent. In 1965, central bank lending to banks and the government began on a modest scale. After 1971, exchange rate adjustments no longer required legislative change, but could be effected by the Minister of Finance in consultation with the central bank. Eventually, the fixed exchange rate with the pound sterling was abandoned after Ireland joined the newly formed European Monetary System (EMS) in 1979.

1 For more information on Argentina’s CBA and economic conditions during the period, see Salera (1941), p. 18–51.2Jimenez (1976), p. 71–72.3 Under the Bretton Woods agreement, Malaysia and Singa-pore received IMF approval to change their intervention currency and to widen the intervention band.4Honohan (1994, p. 19) points out that the Irish CBA coped well with shocks because the banking system had large foreign exchange reserves.5Honohan (1994, p. 9).

Depreciation

If a depreciation is anticipated, this will be reflected in capital flight, as holders of assets denominated in domestic currency attempt to convert them into the reserve currency.69 While there is no technical limit to the increase in domestic interest rates that can equilibrate the money market, there is a limit to how long a banking system could weather a large interest rate shock. Thus, there is also a strong potential for bank runs.

Administrative solutions can be imagined to alleviate the pressure on the banks caused by deposit withdrawals. For example, existing contracts denominated in domestic currency could be forcibly converted into the reserve currency equivalent prior to the devaluation, as proposed by Auernheimer (1993). Or, the convertibility of bank deposits could be suspended temporarily, as on several occasions during the gold standard. All such measures, however, would severely damage the policymaker’s credibility.

As in the case of an appreciation, a preannounced move to a downward crawling peg could be considered, as a way to minimize the credibility cost of breaking the exchange rate rule. However, unlike in the case of an appreciation, a downward crawl raises the risk of losing control of inflation. It may thus be difficult to correct for a strongly overvalued exchange rate.

Switch to a Float

A move to a float can be an appropriate exit strategy, particularly if a CBA currency is under pressure to appreciate, as illustrated by the examples of Malaysia and Singapore in 1973. Provided the exchange rate misalignment is not too large, for countries not wishing to move to a free float immediately, the currency could be allowed to float within a band that could be widened gradually or made into a crawling band. The risk, inherent in moving to a float, of losing the nominal anchor would clearly have to be weighed. Management of an exit strategy with narrow bands is likely to be easier in the case of an incipient appreciation than a depreciation.

Switch in the Peg

A further option would be to change the reserve currency, as was done earlier in Singapore and in Djibouti. The objective would be to attain a real effective appreciation (depreciation) through a gradual nominal appreciation (depreciation) of the new reserve currency against the basket of trading partners’ currencies. Presuming that the switch would occur at the relevant market cross exchange rates on the day of its implementation, this should not lead to destabilizing capital flows, although the resultant changes in the structure of domestic interest rates might well have some impact. However, the usefulness of such a switch would be limited because of the difficulties of predicting exchange rate movements, and therefore the impact on the real exchange rate of the CBA currency.70

Built-in Escape Clauses

To prevent policy surprises, and hence avoid the perception of a breach of policy commitment, CBAs could, in principle, incorporate an explicit exchange rate escape clause. Although the theoretical literature on this subject is not decisive, any such rules would most likely undermine the credibility of the CBA.71

In particular, as a trigger point for exiting the CBA is approached, the dynamics of capital flows are likely to force the authorities’ hand more quickly than would otherwise be the case, especially when the exit involves a jump adjustment of the exchange rate. For this reason, well-known escape clauses could induce one-sided speculation and lead to CBA failure, in cases where without such a clause the arrangement might have survived.

There may well be some asymmetry in the possibility of designing an exit clause depending upon whether an appreciation or a depreciation is envisaged. Thus, Argentina and Estonia have given their central banks discretion to appreciate the rate without specifying under what conditions this would be attempted.72 Cases where a devaluation would be contemplated would be more difficult to manage. For example, the law could allow the government to suspend the CBA under a national emergency. The advantage of this type of escape clause is that it can be triggered rapidly and would make speculation more risky. The disadvantage is that it makes discretion possible under conditions that may not be well defined, which may seriously affect the CBA’s credibility.

Exit Conditions

The timing for the exit will depend on the motivations that a country had for introducing the CBA. If it was introduced as a transitory arrangement until the authorities could develop the full range of functions typical of a central bank, then the degree of development of such functions would provide a way to gauge the appropriate exit point. In this case, exiting from a currency board should be seen as a success rather than a failure. Moreover, increasing monetization of an economy may also pose the question of whether it is optimal to stay with a CBA regime, given that balance of payments surpluses need to be generated to provide the required currency backing. Thus, in such cases, switching from a CBA to a conventional central banking arrangement may be viewed as part of a normal evolutionary pattern. This may have been the case for Singapore, for instance. The graduation of Ireland in the 1970s may also be seen as an example of this phenomenon (Box 7).

A country’s authorities may also be willing to go beyond the constraints of abiding by their own rules to those of abiding by externally generated rules—that is, those of a currency union. For instance, Estonia has aspirations of joining the EMU and its CBA could be viewed as a first stage toward adhering to the EMU. The Lithuanian authorities have the same objective, but present their future exit from a CBA as a step in that direction.

Exiting CBAs in countries that have introduced them to gain credibility is somewhat more problematic. The exit would have to wait at least until strong policies have been in place for a sufficiently long time to ensure that credibility will be maintained after the demise of the CBA. On occasions, this may imply withstanding substantial real exchange rate misalignments.

As noted earlier, whether a currency is under pressure to appreciate or depreciate can facilitate or complicate the exit from a CBA. In any case, strong macroeconomic policies, particularly with regard to the fiscal sector, will be required to minimize the disruption that exiting a CBA is likely to entail. Such policies will need to be stronger, the larger the loss in credibility caused by the exit.

Issues and Experiences
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    Malaysia, Singapore, and United Kingdom: Exchange Rates

    (National currency per U.S. dollar; end of period)

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