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The author is an economist in the Monetary and Financial Systems Department (MFD). Comments and suggestions made by Peter Nicholl, Kurt Schuler, MFD colleagues, and advisors to IMF Executive Directors are gratefully acknowledged.
The analysis does not attempt to analyze the link between the design of monetary institutions and actual macroeconomic performance. The appropriateness of the CBA for the six emerging markets under study and the alternative exchange rate regime that might be prescribed for ex-CBA countries such as Argentina are outside the scope of this study.
Argentina (from 1991 to 2001), Bosnia and Herzegovina, Bulgaria, Estonia, Hong Kong SAR, and Lithuania. The Hong Kong SAR CBA, in its twenty-first year of operation, is the longest-standing CBA of the emerging markets under study. It is followed by Estonia and Lithuania, in their twelfth and tenth years of operation, respectively, while the CBAs in Bulgaria and Bosnia and Herzegovina are in their seventh year of operation.
References may be made to Schwartz (1992), Liviatan (1992), Williamson (1995), Bennett (1994), Judy (1995), Enoch and Gulde (1997), and Ghosh, Gulde and Wolf (1998). Country studies are referred to in the appendix.
The discussion of Eichengreen and Masson (1998) on the adoption of greater exchange rate flexibility may be applied to the exit issues faced by currency boards.
In the Baltic countries, accession to the European Union (EU) provided the escape clause.
In the floating-versus-fixed debate, the choice is between adjusting now and adjusting later, since the adoption of an exchange rate peg may confer a temporary credibility boost on monetary institutions. Fundamental problems will need to be addressed sooner or later, however, as the fiscal vulnerabilities in the Argentine provinces attest.
Small open economies such as Brunei Darussalam (in 1967), Djibouti (in 1949), and the Eastern Caribbean Central Bank (in 1965) are examples. See Schwartz (1992) for the discussion of CBAs set up in Anglophone Africa during colonial times. The economic rationale for adopting a CBA is discussed in Santiprabhob (1997).
The theory of optimal currency areas (OCA) for common currencies may be extended to support the adoption of fixed exchange rates under CBAs. Frankel (1999) points out that OCA criteria were not met in Argentina, in spite of the fact that, in the early years, the CBA appeared to have worked rather well. He suggests the inclusion of six additional criteria highlighting the importance of fairly close correlation with the anchor currency in the case of an exogenous shock. These are as follows: (i) a strong need to impart monetary stability (owing to a history of hyperinflation, the absence of credible public institutions, and/or the exposure to nervous international investors); (ii) a desire for closer integration (enhancing the political credibility of the commitment); (iii) liability dollarization; (iv) access to an adequate level of foreign reserves; (v) enforcement of the rule of law; and (vi) high standards of financial sector prudential regulation and supervision.
The game theory dynamics underlying signaling, cheap talk, and reputational issues are developed in Gibbons (1992). Walsh (1999) applies a game-theoretic framework to monetary policy to illustrate how information on credibility is derived from policy targets and announcements. If CBA operations were to be formalized in a game-theoretic framework, signaling would need to be examined in a dynamic game between the government and economic agents. Information would be derived from given statutory provisions and any subsequent policy announcements, whether in conformity with or in contradiction of preannounced policy commitments. The literature on credibility refers to a Nash equilibrium outcome, where the policymaker takes the forward-looking private sector expectations as given, under incentive constraints on optimal and consistent policymaking.
Gulde, Kahkonen, and Keller (2000) review the performance of the Baltic states and Bulgaria. They state (on p. 2) that it is unclear whether higher output growth under a currency board is due to this bias or to a rebound effect, since the regime is established after a period of crisis. This implies that countries (e.g., Latvia) that are willing to adopt strict policies would do well, regardless of the exchange rate regime.
This refers to a question raised by Cottarelli and Giannini (1997), p. 64. A related question is whether price stability is pursued as an economic policy objective because it is economically meaningful, or whether it is justified by technical feasibility and political legitimacy. Cottarelli and Giannini (1997) argue that as a result of fostering consensus on the importance of price stability, monetary institutions seeking to obtain credibility through a rules-based approach generate institutional endogeneity.
This was recognized by the governor of the central bank of Estonia (Eesti Pank), as reflected in his public acknowledgment of the Estonian national support for the economic policies pursued by the currency board. (See Kraft 1997.)
Setting import tariffs and export subsidies may act as artificial relative price changes which create nominal price rigidity smoothening the business cycle. In the case of Argentina, such changes severely altered convertibility and led to an exchange rate spread of 8 percent. The subsequent downgrading by Standard and Poor’s suggests that the benefit was expected to be modest and offset by the cost of lost transparency in the so-called rules of the game.
In the first five years of CBA operations in Bosnia and Herzegovina, a substitution effect between domestic and anchor currency led to the expansion of foreign reserves, cash in circulation and bank credit in spite of a current account deficit
Instead, a study of Latin American economies (IMF, 1996, p. 62) confirms a significant relationship between changes in monetary aggregates and inflation.
Cottarelli and Giannini (1997) offer an economic history review of the notion of credibility and discuss the relative merits of exchange rate and monetary targets. They highlight the evolution of monetary frameworks in the post-Bretton Woods era and the switch toward greater discretion. As authorities invested in anti-inflationary reputations, they combined instrument flexibility and long-run goal credibility. This was supported by delegating monetary policy to an independent institution, backed by measures to guarantee transparency. It is suggested that the shift toward exchange rate targets was largely due to increased capital flows and the globalization of markets.
The higher the cost of reneging, the stronger the commitment and the greater its credibility. However, the greater the loss of flexibility (as devaluation is not permitted in adjustment to an external shock), the greater the cost of achieving disinflation.
They refer to the Bank of Finland’s practice of distributing monetary policy pamphlets to schools, as one way in which a central bank can instill an anti-inflationary culture.
Blinder (1999) affirms that “in the real world, [credibility] is not normally created by incentive-compatible compensation schemes nor by rigid pre-commitment. Rather it is painstakingly built up by a history of matching deeds to words. A central bank that consistently does what it says will acquire credibility almost regardless of the institutional structure.” (p. 64)
This is particularly well illustrated in the strict CBA framework adopted by Bosnia and Herzegovina.
The Hong Kong Monetary Authority regularly reaffirms its support for the dollar link— for instance, making statutory commitments less relevant in the enforcement of discipline. Hansson (1997) refers to the importance of policy announcements in the Baltic countries.
The statute and accompanying legal texts are the main sources of information. For exact legal and regulatory references see the box in the appendix.
The theoretical benchmark is described in further detail in the appendix.
The literature on speculative attack models suggests that if the perceived cost of adhering to a fixed exchange rate is prohibitive, expectations of a devaluation may become self-fulfilling, particularly in the absence of a sustainable fiscal policy and a sound banking system.
The downgrading of Argentine credit ratings subsequent to the shift to a dual peg is suggestive of a cost associated with adjusting the institutional framework in terms of lost simplicity and transparency.
Reference is made to the Krugman (1979) smooth pasting effect as the exchange rate approaches the boundaries, since economic agents know when the shift from one reserve currency to the other will take place.
Profits may also be computed as a product of the money base and the rate of inflation. Since the monetary aggregate depends on the required reserve deposit ratio, currency board profits may be increased by adjusting the ratio upwards.
The issues faced by the currency boards in the Baltic countries are discussed in Berengaut and others (1998).
The absence of indexation mechanisms, flexible labor markets and low labor costs were also determinant factors in this case.
Prolonged deflation is not without costs however, in view of its effects on the real value of debt, and the vulnerability of the banking system to corporate bankruptcies. Deflation under a currency peg may not be easier to achieve than a real exchange rate depreciation would be under floating.
The extent of inflation inertia may be illustrated by examining the time it takes inflationary expectations to converge to the credible fixed exchange rate equilibrium.
Superscript denotes ‘at’ and subscript denotes ‘of.’
As a result of financial innovation, a smaller proportion of money is held in cash.
Reference may be made to the events of 1998 in Hong Kong SAR when speculators affected stock prices by inducing money market rates to rise and the HKMA intervened in clear breach of its proclaimed laissez faire approach.
In its website and the information leaflets it provides on the CBA.