APPENDIX Currency Handling and Management
Browne, F.X. (1981), “Forecasting the Demand for Currency and its Denominational Mix,” Technical Paper 5/RT/81, Central Bank of Ireland, Research Dept.
den Butter, F.A.G., and Coehen, R.L. (1982), “The Process of Soiling and the Life of Bank Notes in the Netherlands,” Applied Statistics, 31-226–237.
Garber, Peter M. and Michael G. Spencer, The Dissolution of the Austro-Hungarian Empire: Lessons for Currency Reform, WP/92/66, July 1992.
Gillieson, A. H. (1977), “Research Into the Extension of the Life of Bank Notes: Results of 1973, 1975 and 1976 Field Trials,” Technical Report No. 10, Bank of Canada.
Guitián, Manuel, “The Choice of Exchange Rate Regime”, prepared for a seminar on “Exchange Rate Policies in Developing and Transition Economies”, IMF Institute, December 3–11, 1992.
Hernández-Catá, Ernesto, “Introduction of a National Currency,” in Inter-State Economic Relations, in FSU CEPS Working Document No. 63, 16/18 January and 14/17 February 1992.
Laurent, Robert D. (1974), “Currency in Circulation and the Real Value of Notes,” Journal of Money, Credit and Banking, 6, 213–226.
Manski, Charles F., and Goldin, Ephraim (1982), “The Denomination-Specific Demand for Currency: The Israeli Experience,” international report, Bank of Israel, Currency Dept.
Osband, Kent and Delano Villanueva, “Independent Currency Authorities: An Analytic Primer”, IMF, Staff Papers, March 1993, pp. 202–216.
Quirk, Peter J., “Recent Experience with Floating Exchange Rates in Developing Countries”, prepared for a seminar on “Exchange Rate Policies in Developing and Transition Economies”, IMF Institute, December 3–11, 1992.
The authors are grateful for helpful comments to Hugh Bredenkamp, Adrienne Cheasty, Manuel Guitián, Carl-Johan Lindgren, Peter J. Quirk, Brock K. Short, and Peter Stella. Any remaining mistakes are, naturally, their own.
Monopolies are constrained by consumers’ demand. If they set the price, demand will determine the quantity. If they set the quantity, demand will establish the price.
Other relevant prices of money are in terms of goods (the reciprocal of the goods’ price level) or in the terms of financial assets (the reciprocal of the interest rate).
For a more complete treatment of the issues relevant to a choice of exchange regime, see Guitián (1992).
In some cases, like Argentina, the backing is 100 percent of new issues of reserve money (but not in the initial stock).
Except insofar as there are international reserves in excess of full coverage of the domestic currency. The Estonian central bank has recently used the margin provided by its excess reserves (above what is required to back the kroon) to finance some of the costs of commercial bank restructuring.
Intervention is the use of international reserves with the principal objective of changing or supporting the exchange rate.
Russia, Albania, Bulgaria, and Romania are the other countries in Central and Eastern Europe that are also independently floating, but have not introduced new currencies.
Quirk (1984), p. 12, documents the ineffectiveness of exchange controls in a number of Fund member countries. In the 1980s, many developing countries with extensive capital controls found that they did not prevent massive capital flight. More recently, virtually all industrial countries have abandoned their sophisticated exchange control systems because they were evaded to the point that they became inoperable.
The soft budget constraints on many state enterprises may allow them to hoard foreign exchange, while private enterprises would not.
A currency board system does not require the establishment of a central bank. Such is the case in Hong Kong.
There is, however, little if any difference between issuing a transitional currency and introducing a new currency. Once the domestic currency is no longer fully fixed against the old national currency, the country has effectively left the old currency zone and gained monetary independence--whether it wishes to or not. The only benefit to a transitional currency appears to be the hope, on the part of the authorities, that any mistakes or problems associated with the transitional currency will be forgotten when the “real” currency is introduced.
While a currency conversion converts all the financial assets and liabilities in the system at a single conversion--exchange--rate, a currency reform uses multiple conversion rates.
A currency reform can be a noninflationary way to absorb a monetary overhang, particularly if it is associated with a large-scale default on public sector debt, as in Western Germany after World War II. It works by cutting the value of financial assets, without a corresponding decline in the prices of goods and current expenditures. However, it does result in a redistribution of wealth from financial creditors to financial debtors, which can be massive. The undesired redistributional effects must then be offset by taxes or subsidies, making successful currency reforms quite complex. See Mayer and Thumann (1990).
Currency reforms may seem a conduit to help a disadvantaged group, such as pensioners, or to punish an unfavored group, such as criminals or profiteers. However, this is not the best way to address these problems. A subsidized conversion rate only gives the disadvantaged group a one-time transfer and does not confront their underlying problems, e.g., they cannot live on their income. On the other hand, an unfavorable rate is an inefficient way to seek out and punish criminals, which is better done on a case-by-case basis through the legal system. Rather, a temporary freeze of the accounts of those seeking to convert large amounts of funds with the police or the tax authorities examining the source of the funds can allow the prosecution of illegal activities to be handled through normal channels.
Several bank note printing companies estimated minimum efficient scale for producing bank notes ranged from a population of about 20 million to a demand for bank notes of 250 million annually, while the cost of setting up a bank note printing operation was estimated at US$35-45 million.
Although, in most countries issuing new currencies, vending machines probably would not warrant consideration on the short term.
Payne and Morgan (pp. 45 and 47) estimate the ideal value of the smallest currency unit is between one two thousandth and one five thousandth of the average day’s pay.
In some countries, the life of a low denomination note is as short as three to eight months, while in most cases it is under one year.
For studies on the demand for currency in a particular country see, Cramer (1983) for the Netherlands, Kimball (1981) for the United States, Manski and Goldin (1982) for Israel and Payne and Morgan (1981) for the United Kingdom. In addition, the impact of inflation is discussed in Chen, and Laurent (1974) and a planning model for central banks is presented in Fase, van der Hoeven and van Nieuwkerk.
Although some models estimate currency deflated by either nominal GDP or total deposits.
Although Agénor and Lennblad (1992), p. 18, do warn that--extended--periods of uncertainty about the conversion date may have adverse effects on prices and distort the portfolio decisions of private agents.
For example, the announcement of the conversion could be made at close of business on a Thursday. Friday could be a bank holiday and the conversion could begin on the following Monday. This would give banks three uninterrupted days to prepare. The disadvantage of declaring a Friday to be a bank holiday is that some people might be caught without sufficient currency for the long weekend. Thus, the announcement might be made on Friday, with Monday declared to be a bank holiday.
To minimize arbitrage possibilities, this would however require that the exchange value of the coupon would need to be restated in terms of the new currency from the start of the conversion period (presumably at the official conversion rate for old currency bank notes into new bank notes during the conversion period).
Some countries have attempted to reduce this risk by closing their borders during the conversion period. However, such extreme actions are expensive, difficult, and may not work.
Giving customers a choice of currency exposes the banks to foreign exchange risk. If the new currency were expected to appreciate against the old, banks’ borrowers would wish to keep their loans denominated in the old currency and to have their deposits expressed in the new. If expectations were fulfilled, the banks would suffer foreign exchange translation losses.
On the other hand, in the case of Ukraine, Russia agreed that all nonresident accounts would be converted into the new currency.
Accusations of dumping arise occur during most currency conversions. This could occur in the ruble zone of the FSU, as non-ruble zone FSU importers pay in cash rubles for ruble zone imports because of the breakdown of the inter-republic payments system.
It would be advisable that the disposition of the withdrawn currency be negotiated before the conversion.
It should also not bear the risk of inflation cutting the value of the old currency notes, since this could impair the capital of the central bank. However, if the interest rate on old currency deposits abroad was considered “reasonable” the bank notes could also be redeposited.
An initial exchange rate is not necessary with a free float; however, if any actions are taken to set a starting rate, even an indicative one that is not defended, large movements in the rate may be damaging to confidence.
Dollarization makes the implementation of monetary policy less predictable, and thus more difficult.
This could even be done before a country issues its own currency.
To do this, the Central Bank of Denmark has established 17 “depot banks” in the outlying areas. Each is operated by a commercial bank branch on behalf of the central bank to deliver currency to and receive it from commercial banks’ branches (including the branch operating the depot bank).