Abstract

Currency board arrangements (CBAs) have undergone a revival.1 Four countries have undertaken IMF-supported adjustment programs with a CBA, Argentina, Djibouti, Estonia, and Lithuania. Bosnia and Herzegovina and Bulgaria are each about to establish one. El Salvador expressed interest in establishing one as a way to enhance credibility and policy transparency. For the same reasons, proponents of CBAs have made the case for establishing them in other countries, such as Mexico following the 1995 crisis, Peru, Brazil, and Russia.

Currency board arrangements (CBAs) have undergone a revival.1 Four countries have undertaken IMF-supported adjustment programs with a CBA, Argentina, Djibouti, Estonia, and Lithuania. Bosnia and Herzegovina and Bulgaria are each about to establish one. El Salvador expressed interest in establishing one as a way to enhance credibility and policy transparency. For the same reasons, proponents of CBAs have made the case for establishing them in other countries, such as Mexico following the 1995 crisis, Peru, Brazil, and Russia.

The interest in CBAs has overlapped with that of exchange-rate-based nominal anchors. Although CBAs have distinctive characteristics, they have much in common with conventional fixed peg arrangements. Hence, much of the extensive analysis made of the latter also applies to the former. In particular, the ample debate on the relative merits of fixed versus flexible exchange rates is directly relevant to countries contemplating a CBA. In this context, what is of particular interest in CBAs is the decision to legislatively restrict the use of some policy tools—restrictions that are rarely explicitly present in conventional fixed peg regimes.

This paper focuses on two sets of key issues deemed particularly relevant for IMF surveillance and conditionality. First, based on the performance of past and existing CBAs, it reviews the costs and benefits of such arrangements and discusses the main conditions for entry. Second, it discusses the trade-off between flexibility and credibility in CBAs and whether they should best be viewed as transitional arrangements. In that context, it reviews alternative exit strategies.

The CBAs covered (and the year when they were established) include those of Argentina (1991), Brunei Darussalam (1967), Djibouti (1949). the Eastern Caribbean Central Bank (ECCB) (1965), Estonia (1992), Hong Kong (1983), and Lithuania (1994).2 In addition, the paper reflects the earlier experiences of Argentina, as well as those of Ireland. Malaysia, and Singapore.

While many lessons can be drawn from the currency boards of the colonial period, the paper does not discuss them in detail as their contexts differed significantly from those of the existing CBAs.3 Among other factors, the degree of capital mobility during the colonial period was limited, and most colonial governments lacked fiscal independence. Moreover, the banking systems of these colonies consisted of foreign banks that relied on their headquarters for liquidity support and interbank settlements. After gaining their independence, most colonies replaced their currency board with a central bank to strengthen their national sovereignty and conduct an independent monetary policy.

What Is a Currency Board Arrangement?

A currency board arrangement may be seen as a special case of a rules-based monetary system. Analogous to other spheres of economic decision-making, it is a system based on rules rather than discretion that serves to establish credibility and avoids losses resulting from decisions that can sometimes be undertaken within a myopic timescale.4

In its simplest form, a CBA can be defined as a monetary regime based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority—the currency board—to ensure the fulfillment of its legal obligation.5 This structure implies that domestic currency be issued only against foreign exchange and that it remain fully backed by foreign assets. Thus it eliminates traditional central bank functions like monetary regulation and the lender of last resort (LOLR); such a CBA is defined in this paper as a “pure CBA.”

Backing Rules

Backing rules differ substantially. In Djibouti and Hong Kong they mandate at least 100 percent backing of currency in circulation with foreign assets and gold. In Argentina, Estonia, and Lithuania, the CBAs also back the deposits held by commercial banks at their central banks, as the latter continue to provide payments and settlement services. In Argentina, however, up to one-third of backing can be met with U.S. dollar-denominated Argentine government debt; thus, in effect the central bank needs to back at least 66 percent of base money with foreign assets.1 Similarly, the Eastern Caribbean Central Bank and the CBA of Brunei Darussalam are required to back only 60 percent and 70 percent of reserve money with foreign assets, respectively.2 The Bank of Lithuania backs 100 percent of currency in circulation and all other central bank liquid liabilities. Its liquid liabilities include reserves and other deposits of commercial banks, government deposits, litas-denominated correspondent balances of former Soviet Union banks, and litas-denominated securities and promissory notes issued by the bank. The Bank of Estonia is not required to back its certificates of deposits even though it de facto has had sufficient foreign reserves to do so.

In practice, the initial level of official holdings of international reserves has played a role in the degree of backing provided to the currency. As the Bank of Estonia held substantial quantities of gold that had been deposited in foreign central banks before World War II, it could meet its backing requirements with its own net international reserves. However, the central banks of Argentina and Lithuania were constrained to fulfill their backing requirement on a gross international reserves basis due to a shortage of net international reserves when their CBAs were established. Part of Lithuania’s foreign exchange reserves was obtained from the IMF under a five-year Systemic Transformation Facility (STF) arrangement. In Argentina, the central bank had substantially negative net international reserves, owing to large short-term and long-term external obligations to the IMF and other creditors; some of these liabilities were extinguished in June 1992, through a capital injection from the government.

1 However, the actual foreign asset backing of base money was around 95 percent by the end of 1996. The central bank’s Charter also limits the increase in the central bank’s holding of Argentine government debt, regardless of currency denomination, to 10 percent a year.2 Following the introduction of a minimum cash balance requirement in December 1995, banks were required to maintain accounts at the Brunei Currency Board (BCB), which are backed in the same manner as notes and coins. The BCB must back at least 70 percent of its demand liabilities with external assets, of which at least 30 percent must be liquid.

Viewed from the perspective of today’s almost universal use of fiat money, the restrictions on currency issuance and the reserve backing rule of pure CBAs appear quite stringent. Thus in practice, almost every country that has established a CBA has introduced modifications to reflect local factors (Box 1 and Appendix IV, Table 1). For instance, in Argentina, Brunei Darussalam, and the Eastern Caribbean Central Bank, the minimum foreign reserve coverage is less than 100 percent of the monetary base, thereby allowing the CBAs to extend a limited amount of credit against their monetary liabilities. Other CBAs, such as Hong Kong, maintain foreign reserves in excess of what is needed to back the monetary aggregate covered by the arrangement.6 Such foreign exchange reserves can be used to conduct monetary operations or to provide LOLR support.

Even though CBAs do not require a full-fledged central bank for their operation, the currency boards of Argentina, Estonia, and Lithuania were established in institutional frameworks encompassing an existing central bank, which retained some or all of its traditional functions. For example, the Bank of Estonia (BOE) regularly informs the public of its holdings of foreign exchange reserves to back up the currency. It holds the excess foreign reserves, undertakes monetary operations, and exercises bank supervision. Similarly, the Argentine and Lithuanian CBAs retain many traditional central bank functions, including settlement of payments system transactions. Argentina and Hong Kong conduct daily monetary operations; Argentina, Estonia, and Lithuania have provided, in times of stress, significant last-resort support to the banking system.

Exchange Rules

While in principle a country could peg the exchange rate to a basket of currencies, in practice all existing CBAs peg their exchange rates to a single reserve currency, probably to assure transparency and simplicity. While Brunei Darussalam ties its currency to the Singapore dollar and Estonia to the deutsche mark, other CBAs covered in this paper tie their currency to the U.S. dollar. Except for Djibouti, which has tied its currency to the U.S. dollar while trading mostly with France and other European countries, CBA countries have adopted as their reserve currency the currency of their main trading partner or the one they use most for international transactions.1 The Djibouti franc was revalued twice against the U.S. dollar to maintain its gold parity when the U.S. dollar depreciated against gold and other major currencies during 1971–73, following the breakdown of the Bretton Woods agreement. In other CBA countries, the official exchange rate and choice of reserve currency have remained unchanged since the CBAs were established.

Despite the fact that a CBA establishes an official exchange rate, that rate applies only to the monetary authority’s liabilities covered by the arrangement, typically base money, but in some countries only currency in circulation. In addition, access to the official exchange rate is often restricted. Hong Kong has a particularly restricted access, which is limited to the three note-issuing banks. The three note-issuing banks have the right to exchange certificates of indebtedness for foreign currency at the official exchange rate at the Exchange Fund, and vice versa. The Exchange Fund is an agent of the Hong Kong Monetary Authority (HKMA), which maintains reserves for backing and handles currency conversion, and the certificates are issued by the Exchange Fund to back banknotes in circulation.

Most CBA countries restrict direct access to banks and certain types of financial institutions. Access is limited to banks in Djibouti and Estonia, and to financial institutions and exchange houses in Argentina. Lithuania limits access to authorized foreign exchange dealing banks. Unlike in Estonia where conversion at no charge is guaranteed by law, the Bank of Lithuania is entitled to establish commissions and fees for currency conversion.

As compared with Argentina, the restrictions in Hong Kong lower arbitrage opportunities, resulting in larger deviations between the market and official exchange rates.2 Some countries, however, have eliminated or minimized the spread between the official and market exchange rates. In Argentina, the central bank formally eliminated its bid and offer spread, bringing the market exchange rate almost to parity with the official exchange rate as of the 1995 currency crisis. Similarly, the Bank of Estonia reduced the spread between its bid and offer rates before abolishing it in July 1996. Brunei Darussalam has equated the market and official exchange rates at all times by having a very liberal arrangement in which the authorities of Brunei Darussalam and Singapore have agreed to accept and allow banks to accept both Brunei and Singapore dollars in both countries at parity.

1 Argentina’s decision to tie the peso to the U.S. dollar was also influenced by the high degree of dollarization.2 See Bennett (1994, p. 19) for more information.

Institutional frameworks differ substantially across countries, to a large extent depending on the institutions prevailing when the CBAs were established. In Estonia and Lithuania, the original central banks’ balance sheets were modified to separate the currency board operations from the rest of the central bank. In Djibouti, the ECCB, and Hong Kong, existing CBAs were integrated into monetary authorities or central banks once the latter were established. The CBA accounts in Argentina, Djibouti, and Hong Kong are not formally separated from those of the monetary authorities.

What Distinguishes a Currency Board Arrangement from Other Pegged Exchange Rate Arrangements?

CBAs are a special form of pegged exchange rate arrangements. They differ from conventional pegs in the nature of the restrictions they set on changing the level of the exchange rate, and most importantly on the sources of reserve money creation (Box 2). The first essential characteristic of a CBA is the existence of a well-publicized legal barrier to changing the exchange rate, and attendant legal restrictions on the use of other policy tools. That the exchange rate can only be changed with great difficulty adds to the CBA’s credibility. In addition, the backing rule eliminates (or strictly limits, when less than 100 percent of the base is backed) the scope for issuing unbacked monetary liabilities, hence ensuring that the CBA does not run out of foreign reserves to maintain the parity. While the central bank may still give credit to banks (or governments), it can only do so if it holds foreign reserves in excess of what is needed to back the monetary base.

A CBA’s credibility depends on the legal framework underlying its exchange rate and backing rules. In Argentina and Brunei Darussalam, the official exchange rate can be changed only by an act of parliament. However, the law in the former allows for de facto revaluation as the central bank is not required to buy U.S. dollars at the fixed exchange rate.7 In Estonia the law provides room for the central bank to revalue the kroon. In Lithuania, when the CBA was introduced the government was entrusted with the power to change the exchange rate after consulting the central bank. However, in June 1994, the law was amended to grant the central bank power to change the exchange rate in consultation with the government, in accordance with the central bank’s constitutional right to control money emission. In part due to this weak institutional commitment to a fixed exchange rate, rumors of devaluations affected the CBA’s credibility during the winter of 1994/95 and prevented interest rates from converging to international levels.

To these well-specified and mutually reinforcing rules, it is necessary to add a third “unwritten” but equally important rule. While large excess foreign reserves can strengthen a CBA, they must be used in a way that clearly subordinates concerns over monetary and banking sector developments to the objective of preserving the parity.8 CBAs face trade-offs between rules and discretion that are not unlike those of a conventional central bank, and, hence, their credibility depends on attitudes as much as on rules and institutions.

CBAs are not, of course, the only arrangements that involve formal restrictions on discretionary monetary policy or a strong commitment to maintain an exchange rate parity. In particular, currency unions severely restrict monetary financing of fiscal deficits: this is the case not only for existing currency unions, such as the countries of the ECCB and the CFA franc zone, but also the prospective European Monetary Union (EMU). Also in the late 1970s, countries in the southern cone of Latin America adopted exchange rate regimes based on a prean-nounced devaluation schedule as part of a policy package that implied restrictions on monetary financing; adherence to those schedules also implied a strong commitment by the authorities.

How Do Currency Board Arrangements Function?

Under a CBA, reserve money issue follows similar rules to those of a gold standard. With only a limited margin for central bank policy discretion, changes in money demand are accommodated by endogenously determined changes in international reserves, rather than by changes in the central bank’s net domestic assets (NDA).9 Thus, reserve money varies in close relation to the level of official international reserves, and interest rates are determined—mostly or totally—by local market adjustments to monetary conditions prevailing in the reserve currency country. Even so, under a CBA there will always remain a possibility, no matter how small, that the arrangement could be changed or that commercial banks will be unable to ensure the convertibility of deposits, and this will build a risk premium into domestic interest rates. Also, there may be instances where the CBA comes under attack and interest rates will need to be raised sharply—as occurred in Argentina in early 1995.

Interest rates play a major role in facilitating adjustment. In economies with open capital accounts, capital flows tend to reduce monetary dise-quilibria and facilitate the approximation of local interest rates to those in the reserve currency country. While this mechanism applies to all fixed pegs, in CBAs it is stimulated by the containment of exchange rate risk, which facilitates arbitrage. In addition to improving the efficiency of a CBA’s monetary adjustment mechanism, free capital mobility enhances the potential for rapid trade and financial integration. By allowing banks to borrow abroad in case of need, it also reduces the need for a domestic lender of last resort. When capital controls or limited financial development restrict capital mobility, the adjustment takes place more gradually through changes in absorption and in the trade account.10

As is also the case in any fixed exchange rate regime, it has to be recognized that capital mobility can on occasion add to the problems of operating a CBA—for instance, the persistent capital inflows into Estonia after the initial stabilization, and capital outflows from Argentina in 1995. Some CBAs, including Estonia’s (until 1993) and the ECCB’s, have operated or continue to operate with capital controls.11 Conceivably, in some cases, existing capital controls could be useful in limiting capital flows during a transitional phase, as when financial liberalization is incomplete, or when CBAs are introduced in an economy with unsound banks (or weak bank supervision).

While CBAs incur the cost of printing and exchanging money, they earn seigniorage in the form of interest income on foreign asset holdings, albeit subject to fluctuations in the value of foreign assets and gold. In Hong Kong, the currency board is allowed to retain full seigniorage, which it uses to increase its foreign exchange reserves.12 In other CBAs, earnings generated from foreign exchange reserves are not separated from profits generated from other activities and, hence, are not subject to a separate profit transfer rule.13