1. Choice of exchange regime and currency convertibility

Decisions regarding the choice of exchange regime and degree of currency convertibility need to be made before issuing a new national currency. This choice has a major impact on the degree to which the country controls its monetary and exchange rate policies, and thus the acceptability of the new currency. It also helps to determine both which macroeconomic variables will bear the burden of long-term adjustment (international reserves or exchange rates, price levels, and interest rates) and the extent of the short-run impact of exchange system developments on the real sector, e.g., output and employment.

When a country introduces a new currency, normally only one institution--generally the central bank--is given authority to issue of the currency. This, in effect, gives the central bank the power to set either the quantity or the price of the currency. ^1/ Many consider the most important price to be that of domestic money in terms of foreign money: the exchange rate. ^2/ That is, the central bank can control either the exchange rate or the money supply. Many countries wish, nevertheless, to control both the monetary supply and the exchange rate, and their search for partial control over both sometimes leads them to rely on exchange controls. The policy tradeoff, however, cannot be avoided.

Several exchange regimes are analyzed below, including the tradeoff in the degree of control of the money supply and the exchange rate implied by each regime. The focus is on purer, more transparent regimes where the policy tradeoffs and the constraints on the authorities are clearer than with hybrid systems. Relatively pure systems were chosen by the countries that abandoned the ruble area and introduced new currencies. Estonia established a currency board in June 1992 with the kroon pegged to the Deutsche mark; Latvia let the Latvian ruble float freely against other currencies in July 1992. Similarly, Lithuania floated its talonas against other currencies in October 1992. Finally, Ukraine adapted free floating of its Karbovanets in November 1992. The three countries that floated have issued transitional currencies pending the “introduction” of their national “real” currencies (lat in Latvia, litas in Lithuania, and grivna in Ukraine). However, as is discussed below, there appears to be little real benefit to introducing such transitional currencies (see subsection 3).

2. New legislation and negotiations with the old currency area

Before the new currency can be introduced, certain key legislation will need to be enacted. A functioning central bank or currency board will also need to be in place. If the country had been part of a larger single currency area, it is also advisable for certain agreements with the other--former--members of that area to be concluded. Legislation is needed to:

(a) make the new currency legal tender;

(b) give the central bank the authority to issue the new currency;

(c) specify the conditions for putting the new currency into circulation in place of the old currency, including the conversion rate between them during the initial conversion period and how long the conversion period will be;

(d) govern foreign exchange transactions (conforming with the chosen exchange system) and empowering the central bank or some other governmental body to draft supporting regulations; and

(e) specify the treatment of different types of financial assets and liabilities and financial contracts during and after the introduction of the new currency.

A full-fledged central bank or currency board will need to be in place and functioning. ^1/ While either institution would need the legal authority to issue the currency, a central bank should also be capable of performing the whole range of functions including:

(a) the capacity to formulate and conduct monetary policy and to conduct--and in cases formulate--exchange rate policy (these roles require adequate information systems and the ability to use the usual array of policy instruments);

(b) the legal authority and ability to regulate, supervise, license, and provide lender of last resort support to financial institutions (to promote and safeguard a sound financial system);

(c) the legal authority and ability to act as banker and fiscal agent to the government (preferably subject to the overall credit limitations as laid out in the law on central banking);

(d) any commercial banking operations taking place at the central bank should be moved to a separately capitalized and managed commercial bank; and

(e) responsibility for the management of the country’s official foreign exchange reserves.

If a member of a single currency area, the country will need to negotiate with the member(s) of such area to settle the following issues that are likely to arise in the currency conversion process:

(a) whether nonresidents will be permitted to hold new currency deposits, including whether nonresidents may convert their existing deposits into the new currency;

(b) treatment of depositors, resident and nonresident, who wish to keep their deposits in the domestic banks but denominated in the old currency;

(c) treatment of depositors, resident and nonresident, who wish to convert their deposits into old currency bank notes;

(d) disposition of old currency notes taken out of circulation by issuing the new currency;

(e) payments, clearing, and settlement arrangements with the old currency zone; and

(f) disposition of the assets and liabilities of the central bank of the former currency area which inter alia include:

• (i) official foreign exchange reserves;

• (ii) bilateral clearing account balances; and

• (iii) foreign debts of the old currency area’s central bank that cannot be allocated to individual republics (these talks may spill over into discussions of the other external debts that cannot be attributed to individual republics).

3. The issuance of coupons

The issuance of coupons is not a necessary nor a desirable stage for the introduction of the new currency. Coupons are normally issued either as a statement of national sovereignty as an “intermediate” step ahead of issuing the new national currency or to alleviate a shortage of old currency bank notes. They are generally issued, initially, at par with the old currency and circulate at the same time with the old currency as legal tender. Subsequently, they may become the nation’s sole legal tender, ahead of the ultimate issuance of the new national currency. ^1/ As stated above, this was the case of Latvia, Lithuania, and Ukraine that floated their provisional currencies after declaring them the sole legal tender in their countries.

Any depreciation of the coupons would open up arbitrage possibilities between coupons and deposits, which are technically denominated in old currency. In this case, the country has, in effect, unilaterally withdrawn from the old currency zone. Banks in the old currency zone may then stop accepting bank transfers from the coupon-area since convertibility of deposits into old currency bank notes is no longer assured. (Of course it may not have been assured in the first place.) This in turn may cause problems in the payments system between the “coupon-area” and the old currency area.

The key question is whether a coupon issue is a good intermediate step. This does not seem to be the case. Since they are issued on a temporary basis, the coupon bank notes may be of relatively low quality and hence are easier and cheaper to produce but also to counterfeit.

If the country wishes to withdraw from the old currency area in an orderly manner, it might prefer to start by issuing its own currency. Issuing coupons at par with the old currency and then expanding the money supply in order to “dump” old currency-denominated deposits for goods produced elsewhere in the old currency area could result in retaliation. On the other hand, keeping the coupons at parity with the old currency gives the country no monetary freedom and it could result in large inflows of old currency if domestic monetary policy is tighter than elsewhere in the area. Issuing coupons may, nevertheless, be necessary if a shortage of bank notes develops before the country has time to plan its move to a new currency.

4. Currency reform versus introducing a new currency

A currency reform involves some kind of expropriation of money and financial instruments at the time a new currency is introduced. This is normally done by exchanging selected old currency-denominated bank notes, deposits or financial instruments at less favorable conversion rates, which effectively taxes selected individuals or holders of selected financial instruments. ^1/ While such measures are generally inadvisable, this discussion is included because the authorities in transitional economies are often encouraged to consider such strategies.

A currency reform is often seen as a way to absorb a buildup of excess liquidity--a “monetary overhang”--resulting from a rapid expansion of money and credit in the presence of price controls. However, even in this case, a more efficient way is to free prices and allow them to rise or to absorb excess liquidity with tight fiscal policy. ^2/

The main problem of the expropriation feature of currency reform is that it results in the destruction of savings. The problems with currency reforms are compounded because correct conversion rates are difficult--or impossible--to calculate and multiple rates are by their nature arbitrary and discriminatory. People will also seek ways to avoid using the less favorable rate. ^1/ Multiple rates can also encourage cross-border currency flows and the dumping of “excess” old currency holdings for goods. Bribery and fraud commonly occurs to evade this form of taxation. ^2/

1. Designing and printing the bank notes

A new currency cannot be introduced until an adequate supply of new currency bank notes has been produced. The first decision in this process is whether the country will produce its own bank notes or whether it will use a printer. The bank notes must then be designed, which requires choosing the initial value of currency and the denomination of the bank notes. The quantity of notes to produce must also be decided before the printing can begin.

Time permitting, governments would generally prefer to turn over the naming, designing and, possibly, denominating the new currency to a special committee, made up of dignitaries, bankers, government officials, artists, etc. The highlight of the committee’s work would be holding a competition to design the new bank notes and coins. By their nature, such commissions may take a long time to reach conclusions, causing long delays in the production process. These delays generally must be avoided when a new country is introducing a new national currency.

2. Deciding whether to choose a printer

A country planning to introduce its own currency may wish to produce the bank notes itself. However, using a bank note printing company for the initial production run may avoid delays. Under any circumstances, producing quality bank notes takes time. It normally takes a bank note company 18 months to three years to design, proof, print, and deliver a new bank note series, although it can be done in as little as 6 to 10 months. If one also has to set up a bank note printing operation and train its staff in all stages of producing the new currency, the delay could run into years.

Bank note printing companies also argue that a country needs a rather large population to produce bank notes economically, because setting up a modern bank note printing operation is expensive. ^1/ However, a number of smaller countries, e.g., Denmark, have expressed satisfaction with their own printing operations.

Bank note printing contracts tend to run three to five years and involve at least 50 million bank notes. Thus, starting with a printing contract can also give a country time to set up its own printing works, should it wish to do so. Should a country wish to take over the printing operation--or to change printers--after the contract has expired, it may be useful to arrange to take possession of the printing plates and to have access to the paper and dyes used in the printing operation. Companies often resist this proposal, but this, like everything else, is subject to negotiation and the bidding can be reopened if the favored bidder resists.

Printing quality bank notes is expensive. The main factors which influence the cost are the number of notes to be printed, the number and type of anti-forgery features, and the type of paper and inks. While costs are subject to negotiation--and are therefore a trade secret--they seem to vary between US$25 and US$60 per thousand bills, although producing superior quality notes can be considerably more expensive. Needless to say, bids should be requested from several companies. Some countries have also voiced satisfaction with using two or more companies to handle the printing.

3. Design and quality of bank notes

Bank notes should be designed both for ease of use and to minimize the risk--maximize the expense--of counterfeiting. Bank note users include the general public, cashiers, the central bank, and vending machines. ^2/ The public’s main interest is ease in checking the denomination of a bank note. This requires that its value be printed in large numerals on the front and back. Its value should also be spelled out on at least one side. Some countries also make each denomination to be a different length (for the visually impaired) and/or color (for rapid identification). The public also likes to be able to check for counterfeit bank notes. This is usually done by a combination of watermarks, see-through register marks, microlettering, intaglio relief print, variable color inks, and security threads (holograms are also likely to become popular). They also expect bills to have some identifying features such as a date, a serial number, selected signatures, and often some combination of portraits, pictures and images.

Cashiers and other individuals handling a large volume of currency may also want bank notes to have: conspicuously different designs on the front and back to speed the uniform sorting and stacking of notes, the main color running onto the edge of the bank note to determine denomination of a bundle from its side. They should also have extra security features such as: (i) quality rag paper, perhaps with florescent fibers in the paper; (ii) florescent inks; (iii) inks with special colors not generally available; (iv) extra-fine detail visible only with a magnifying glass; and (v) multi-step lithograph printing or partial engraving that is expensive and difficult to duplicate.

Initially, the central bank will be satisfied with the features listed above. Later on, however, sorting machines may be installed that allow testing for special security features. All notes will then need to be the same height to take advantage of the machines’ high-speed sorting features, although the length of notes can vary to help the visually impaired.

Bank notes wear out, but their useful life can be extended. ^1/ This can be done by using special, long-life papers and by treating the paper with special inks and lacquers. In general, the higher the underlying cost of printing a bank note, the greater the return from extending its life. This implies that special care should be taken with higher value bank notes, which are often more expensive to print because they need to be more secure from forgery. However, the poorer the country, the lower the denomination of bank note counterfeiters tend to be willing to forge. Thus, poorer countries may need to take more steps to protect their lower value notes from forgery than richer ones.

4. Initial value of the currency and the denomination of the bank notes

During the conversion period, the conversion rate(s) is the primary determinant of the initial value of units of the new currency for internal purposes. Whatever the planned relationship between the new and the old currency, the conversion process will be simpler if a simple conversion rate is used. The easiest solution is to have the new currency related to the old currency by a factor--preferably a power--of ten. It is also desirable for the new currency unit or its sub-unit (presumably one hundredth of the currency unit) to be roughly equal to the value of the smallest common purchase. ^1/ For example, a country leaving the ruble zone may wish to float its currency against the ruble, but the conversion rate(s) against the ruble still must be fixed during the initial conversion period. Since inflation effectively eliminated the use of the kopek and 1 ruble is the lowest normal purchase, the authorities may wish to have the initial conversion value of the smallest new currency sub-unit be equivalent to 1 ruble and the initial conversion value of the main new currency unit at 100 rubles.

Decisions can then be made on the denominations for the coins and bank notes. ^2/ One consideration is that cash boxes and sorting machines tend not to have more than seven slots. In addition, people tend not to use more than six or seven different units of coins or notes in circulation. If more are produced, certain of those units will normally become unpopular and fall out of general use. This can prove an expensive mistake.

The average day’s wage appears to be a good deflator to determine the appropriate denominations for domestic bank notes and coins. ^3/ While the choice of denominations is influenced by the level of financial development and access of alternative payments instruments, it appears that as a rule of thumb, the largest coin should be on the order of one fiftieth of a day’s wage and the smallest bank note should be on the order of one twentieth of a day’s wages.

One problem is that the public generally prefers bank notes to coins, so they will wish that the smallest note be of a relatively low value. However, lower value bank notes tend to wear out quickly, so the long-term cost of issuing them can be very expensive. ^4/ While coins are costlier to produce, their lifetime may exceed 20 years. Thus, once inflation is under control, savings can be achieved by minting coins in somewhat larger denominations than the public might prefer.

Coin and bank note issues generally follow one of two patterns:

• (i) 1, 2, 5, 10, 20, 50, 100, 200, 500; or

• (ii) 1, (2.5), 5, 10, 25, 50, 100, 250, 500.

However, sometimes coins follow one pattern of denomination and bank notes another. Furthermore, as noted, there should be no more than six or seven types of coins and six or seven types of notes. In less developed countries, the largest commonly circulated bank note tends to be in the range of 2-5 days’ pay. Larger notes tend not to circulate and may be primarily used in association with illegal activities.

5. Quantity of notes in circulation

Initially, sufficient new currency bank notes should be on hand to: (1) retire all of the bank notes outstanding in the country at the official conversion rate; plus (2) convert any likely illegal inflows of old currency notes less any old currency notes held by residents but not converted; (3) fulfill any rise in the demand for bank notes following the conversion; and (4) maintain sufficient inventories to handle the demand for new bank notes plus replacement notes pending the next printing of bank notes.

The amount of currency outstanding in the country can usually be estimated from the central bank’s records on currency transactions. If this is not possible, information on currency outstanding in the old currency area may be used to estimate the stock of old currency bank notes within the country. The increase in the demand for the new currency coming from illegal inflows, unexchanged notes, and the change in the demand for currency is difficult to estimate and the authorities should take account of these considerations by holding a large inventory in bank notes (even though this may be risky if inflation is rapid).

There are a number of inventory models for bank notes. They are often complex, but they are generally built up from models of the demand for currency, and the expected life of the currency and inflation. ^1/ The time until the next currency production run is also a key consideration. The central aspect of the model is the forecast of the demand for both the total quantity of bank notes and quantity of each denomination. Often the main variables in this part of the model are the average wage level ^2/ and the currency structure, i.e., the denomination of notes and coins in circulation. While these models are generally stable for a given country, the coefficients of the model vary from country-to-country.

1. Announcement and publicity

The public will need to know how to exchange old currency bank notes, deposits, and coupons for new currency bank notes and deposits during the conversion. The longer the period between the announcement and the introduction of the new currency, the easier it will be to explain the process to people and enterprises. As long as a single conversion rate is to be used and steps are taken to limit speculative inflows, there would not seem to be any particular risk in providing this information in advance, without specifying the date of the conversion. ^1/ The announcement of the exact date when conversion is to take place can be withheld until just before its start. The advance notification would include the amounts of old currency bank notes and coupons that will be changed into new currency bank notes and encourage the public to deposit any additional cash holdings in accounts with other banks. This would relieve pressure during the actual conversion.

The shorter the lead time, the fewer the means of publicizing how individuals and enterprises are to convert their old currency holdings. With a very short lead time, reliance will have to be placed on intensive reporting by radio, television, and newspapers. A slightly longer lead time would also permit the use of pamphlets, perhaps in the form of simple questions and answers, and posters. In any case, officials will have to be made available for interviews with the media. The optimal lead time will depend on the attractiveness of the new currency vis-à-vis the old and the country’s vulnerability to inflows from nonresidents.

The announcement of the currency conversion should explain:

(a) how residents and nonresidents are to convert old currency bank notes and coupons into new currency bank notes and how any bank note holdings in excess of the maximum to eligible for conversion into bank notes are to be treated;

(b) how residents’ and nonresidents’ old currency deposits and old currency obligations are to be converted;

(c) how residents’ and nonresidents’ nonbank financial assets/liabilities and other contracts denominated in the old currency are to be converted; and

(d) the regulations governing transactions in the old currency and other foreign currencies during and after the conversion period.

It would also be useful for the government to discuss its plans regarding the currency conversion with the other members of the old currency zone before making public announcements about the conversion. Hopefully, these discussions would minimize the risk of the conversion causing intergovernmental disputes, which could result in retaliation.

2. Institutions to undertake conversion

The conversion need not take place only at banks. Post offices and enterprises with a large number of workers may also be suitable conversion points. The use of additional sites may be especially useful if the number and the scale of operations of bank branch offices is limited. Employees would bring old currency notes and coupons to their place of employment for conversion to new currency notes (assuming that the enterprise has skills in currency handling as in the FSU). Pensioners would go to the post office or branch of the bank or savings bank where they receive their pension payments. Others would go to banks or savings banks.

The activity of nonbank conversion points should, however, be limited to the conversion of old currency notes and coupons into new currency notes. Cash balances in excess of this conversion limit should be deposited directly by the holder into a bank account, possibly in the days before the conversion. This would simplify the operation at work places, reduce security problems, and minimize administrative errors. Even so, significant security problems would remain as the new currency would have to be delivered to the work places before the operation with no possibility to require collateral. Thus, one possibility would be to limit the work places that would do conversions to state enterprises over a certain size.

3. Date to begin introducing the new currency

The main precondition for introducing the new currency is that it be distributed to the exchange sites. Once this is done, the choice of conversion date will depend on the completion of the prior preparations and on political factors. One practical consideration is that the new currency should not be introduced during a period of the year when an unusual number of transactions take place (e.g., when tax or other payments are made by enterprises to the government; during holidays (Christmas and New Year)).

4. Immediate period of preparation

The announcement of the conversion dates should be made several days before it begins in order to prepare the central bank, commercial banks, and other conversion points to do the conversion. Banks could stay open while making the preparations. The public might be advised to hold a minimum amount of old currency notes and coupons, since this would be the only way to acquire new currency notes in the first few days of the conversion period. At the same time, the public should also be encouraged to deposit with banks any old currency bank notes and coupons exceeding the amount that can be converted into new currency bank notes in order to relieve pressure on banks during the conversion period.

A short bank holiday might be declared, to allow preparations to be made by the central bank, other banks, and other exchange points. ^1/ A bank holiday will not be necessary, however, if banks can make the preparations and continue to do business.

5. The conversion period

During the conversion period old currency bank notes will be converted into new currency bank notes at the conversion ratio specified in the announcement. After the conversion period, this rate would no longer be assured. It should, however, be possible to apply for conversion for a limited time after the normal conversion period for persons who could document that they had been ill, absent, etc.

The length of the conversion period needs to be chosen so that banks and other conversion points will not be overwhelmed by requests for conversions. The length of this period would depend on the number of conversion points as well as the estimated number of persons who would be entitled to convert. If people were put on lists (such as those complied for elections) in order to acquire identification for the conversion, an accurate figure could be obtained for the number of persons who would be converting. The conversion period might be shorter at the nonbank conversion points. Of course, the longer the conversion period, the less pressure each day. However, a longer conversion period also poses some risk of speculative inflows, because the new currency/old currency conversion rate would remain fixed, offering the possibility for three-way arbitrage. It would seem that a conversion period of three to seven days would be adequate in most cases. During the conversion period, the central bank and perhaps commercial banks might need to be open for extended hours.

6. Legal tender during the conversion

The new currency should be legal tender from the first day of the conversion period, but it is less clear whether the old currency should also be legal tender during this period. Allowing the use of both the old and the new currency during the conversion would reduce pressure on residents to dispose of their old currency notes. It would also allow shops to help with the conversion process by having them exchange the old notes for new notes. On the other hand, allowing only the new currency to be legal tender would discourage nonresidents from entering the country with old currency notes to purchase goods during the conversion period. If there are two or more conversion rates, it would be necessary for the old currency to cease to be legal tender on the first day of the conversion.

If coupons have been issued, there is little reason not to allow them to remain legal tender during the conversion period. ^1/ In fact, allowing coupons to circulate would allow people to continue to make transactions without having to first obtain new currency bank notes. It would also relieve pressure for conversions on the first day, thus reducing waiting lines and the immediate burden on institutions doing the conversion, without the risk of an inflow of old currency notes. After the conversion period, coupons could be withdrawn from circulation as they are turned in at banks. However, the authorities may wish to put a deadline on the use of coupons not only because circulating the two types of currency together could be confusing--particularly if the conversion rate is not one-to-one--but more importantly, because coupons are likely to be easier to counterfeit than new currency bank notes.

7. Speculative inflows and limits on the conversion of bank notes

In some cases, the authorities may be concerned about the risk of speculative inflows of old currency bank notes from nonresidents during the conversion period. The likelihood of such inflows will depend on the attractiveness of the new currency relative to the old. After the conversion, the adoption of freely floating exchange rates will reduce the likelihood of such inflows.

To avoid converting large speculative inflows, the conversion of old currency notes may be limited to residents over a certain age. ^2/ In that case, nonresidents would not be permitted to acquire new currency notes for old currency bank notes and coupons, perhaps with the exception of tourists who might be allowed to change a limited amount upon presentation of identification papers which would then be marked.

To relieve the administrative burden on conversion points a limit could be set on the amount of old currency notes and coupons that each resident may convert into new currency notes. Amounts in excess of the limit would be deposited in existing bank accounts with withdrawal permitted shortly after the end of the conversion period. In two recent currency conversions (Estonia and Slovenia), citizens were initially allowed to convert the equivalent of two to three weeks of the average salary into new currency notes.

A system for identifying residents is required if (1) conversion is to be limited to residents; (2) limits are to be enforced on the conversion of old currency notes and coupons; or (3) each resident is to be permitted to convert old currency bank notes and coupons only once or at only one point. This may pose some problems since in many countries, notably the republics of the FSU, some people hold more than one passport or ID card. One possibility would be to enumerate people above a certain age, as for an election. Then, each person on these lists would be issued a card allowing him or her to convert old currency notes and coupons into new currency notes at the designated conversion rate, at a designated location.

8. Treatment of banks’ customers

All loans and deposits, etc., of customers in domestic banks (residents and nonresidents) denominated in the old currency should be converted into new currency on the first day of the conversion period to avoid forcing domestic banks to have open foreign currency positions on their balance sheets. ^1/ Depositors wishing to keep their deposits denominated in the old currency should, however, be given the opportunity to do so by asking within a very short specified period to be paid off in old currency bank notes at the official conversion rate. This currency could be made available by the central bank or the government from the old currency notes acquired during the conversion, but the banks may need additional (new currency-denominated) credit from the central bank to meet such withdrawals.

In the recent case of Estonia, nonresidents’ ruble accounts were not converted, but were repatriated with a corresponding reduction in Estonia’s claims on Russia. This is another way that an FSU republic could treat nonresidents’ deposits (without imposing a burden on its banks) if a similar agreement can be reached with Russia for reducing the republic’s claims on it. ^2/

Following the conversion, nonresidents should be permitted to maintain or open bank deposits in the new currency at will. At this time, the central bank may wish to extend the rules on foreign currency denominated deposits to cover newly opened old currency-denominated deposits.

9. Treatment of other old currency contracts

All financial contracts between residents that are expressed in the old currency should be converted to new currency. Contracts between nonbanks, resident and nonresident, would be governed by the laws of the republic in which they were drawn up. Contracts between a resident and a nonresident contracted in the country undergoing the conversion could remain denominated old currency unless both parties consented for them to be converted to new currency.

10. Disposal of old notes taken from circulation

First, old currency notes acquired by the central bank in the conversion process should be used to repay any debts that had originated as a result of putting old currency notes in circulation domestically.

Second, as mentioned in Section 8, old currency notes could be used to pay those depositors--resident and nonresident--that wish to retain old currency assets. This should be done within a very short period immediately after the conversion period to avoid the misunderstanding that the country was dumping old currency it had acquired during the conversion. ^1/

Any remaining old currency notes will be held by the authorities until the government has negotiated an agreement with the members of the old currency regime on how these bank notes are to be disposed of. ^2/ These talks might be part of broader negotiations over their claims on each other. However, assurances from the remaining members of the old currency zone that the real value of these balances would not be allowed to diminish pending the outcome of the negotiations would need to be secured.

It is inadvisable that the central bank holds the old currency notes pending the outcome of inter-governmental negotiations because it would not earn any income from them. ^3/ To avoid this problem the government could issue the central bank an interest-bearing security to acquire the bank notes from the central bank and ask the central bank to hold the bank notes in safekeeping for the government. Once negotiations with the old currency zone are concluded, depending on the outcome, the government might retire the security (for instance, by passing a claim on the central bank of the old currency area to the domestic central bank). Alternatively, the government can provide the central bank with an agreed income. Over the longer run, however, it would not be desirable for the central bank to rely on the government for its income, and particularly to cover its operating expenses.

1. The initial exchange rate and early movements in the rate

The choice of an initial exchange rate for a new national currency depends on the choice of intervention currency (normally, the main currency in which foreign currency balances are held or denominated), arithmetic convenience (e.g., keeping the zeroes to a minimum) and to some degree political considerations. More important than the initial exchange rate chosen are the subsequent movements in the exchange rate, but it is also more conducive to credibility in the new currency if policies are in place to allow those movements to remain relatively small. ^1/

Appropriate macroeconomic policies--especially monetary policy--are very important if the exchange rate is to be stable from the outset. In particular, interest rates need to reflect inflationary expectations. Such expectations will be heavily influenced by the introduction of the currency itself and the other macroeconomic policies in place at that time. The market-determined exchange rate for the new currency--or the level of foreign exchange reserves--is likely to move quickly to compensate for errors in the authorities’ judgment of inflationary expectations.

If at the outset there is evidence of considerable demonetization and dollarization in the economy, however, experience has shown that it may take some time--years rather than months--to reverse such developments. ^2/ Reversing these trends is likely to be difficult or impossible, unless the country maintains cautious monetary and fiscal policies. In the early period, as markets and prices adjust, a floating exchange rate would provide an important indicator (perhaps the only indicator) of the appropriateness of national policies.

If the new currency is introduced smoothly, in the sort of policy environment mentioned above, there could well be net demand for the new currency from the old currency area, causing the new currency to appreciate against the old currency. However, this should not present practical problems. In particular, it will not be possible to purchase domestic goods with “cheap” old currency, if the initial conversion into new currency is restricted to pre-existing balances. If this restriction is made effective (as discussed above), then subsequent nonresident demand for the new currency to purchase domestic goods will be reflected in the exchange rate by an appreciation of the new currency against the old. The goods in the country introducing the new currency would become increasingly more expensive to old currency area residents, choking off the demand. This occurred in the three Baltic countries during the period immediately after they withdrew from the ruble area.

2. Development of institutions

Under a new market-related exchange system, responsibility for foreign exchange allocation, and possibly exchange rate adjustment, would be transferred away from the government to the private sector. ^1/ However, while the central bank would no longer be involved in commercial transactions, it would still retain a number of important functions which may foster the stability and efficiency of the foreign exchange market. It will conduct official purchase and sales operations in foreign exchange--unless the exchange regime is a clean float--for which it will need to be linked into the interbank market on the same basis as commercial dealers. Under these circumstances, the market will need complete and current information regarding government needs, so that the exchange rate can reflect the true state of the economy. (Otherwise, sharp adjustments and uncertainty will result.)

Regulatory and prudential functions of the central bank would include monitoring for “fair trading” (spreads, rates for small transactions, etc.), anti-monopoly and anti-collusion, and capital adequacy and dealer licensing arrangements. However, official controls and margin requirements need not be imposed on the spot and forward positions of market participants (except perhaps for government and government enterprises), because they are difficult to apply in a binding manner, while permitting dealers to hold sufficient working balances to conduct their business efficiently. Instead, the central bank should monitor the exposure of dealers relative to their capital as part of its prudential supervisory functions; consulting with the affected dealers, and the association of dealers, when necessary. The central bank can also forestall any monopolistic or collusive tendencies by licensing additional dealers, including nonbank dealers.

A primary objective should be to foster competition in the foreign exchange market. This can be done by allowing freedom of entry into the market for creditworthy applicants. If the foreign exchange market is initially limited to few state banks and commercial banks, the market can be deepened by extending participation to other banks, with the proviso that they are not experiencing financial difficulties that would call into question their ability to honor exchange contracts. In addition, bureaux de change could also be licensed in order to improve retail service, to head off any collusion between the banks and to tap into the parallel market. These would operate mainly in currency and travellers checks.

Consideration could also be given to delegating responsibility for ensuring compliance of state enterprises with any transitional repatriation/surrender requirements to the fully licensed dealers. The central bank would supervise the dealer’s performance by spot checks, as well as by revising aggregative data.