Back Matter

APPENDIX

Workings of a Currency Board: The Theoretical Benchmark

Definition

At the basis of a currency board arrangement is a legislative commitment to exchange domestic currency for a specified foreign asset (currency or commodity) at a predetermined fixed exchange rate, on demand.

Basic features

The choice of the reserve asset backing monetary liabilities is determined according to a number of country-specific factors. A currency board may opt for a peg to a single currency, preferably a strong or reserve currency, the currency most used for international transactions or that of its main trading partner. In determining the reserve asset at the basis of the arrangement, the authorities may select a commodity, such as gold, or a basket of currencies or commodities, instead of choosing to peg to a single foreign currency. Of course, the more complex the arrangement, the less transparent it will be. The choice will depend on the structure of the country’s economy, its patterns of trade, and its degree of openness. The currency to which the CBA is linked tends to be issued by a country with which there is substantial foreign trade, as emphasized by Schwartz (1992). The currency board also gains from being linked to a stable reserve currency. Had Estonia chosen to tie its kroon to the Swedish krona, as was initially suggested, it would probably have been to the detriment of economic stability, in view of the subsequent turmoil in the exchange rate mechanism (ERM). The deutsche mark turned out to be a much more stable option for the Estonian currency board at that time.

The dual currency board proposal

Pegs to a single currency may not be a viable solution for economies with a number of major trading partners. This is especially the case if the reserve currency tends to fluctuate in relation to that of the other trading partners of the CBA country. The issue of diversified external trade patterns is addressed in the dual currency board proposal of Oppers (2000). The use of a trade-weighted basket, however, apart from the implied loss of transparency, would render the management of convertibility more complex since it lacks a clear benchmark. A procedure would be required to review the weights of the basket over time, in line with the evolution of cross rates. In Oppers’s example, the dollar and the euro are combined as reserve currencies. When the former currency appreciates above a certain level, convertibility is based on the latter instead. This may circumvent a loss of competitiveness when the currency board currency is pegged to an appreciating reserve currency.27

Both appreciating and depreciating reserve currencies impose a cost on the CBA. The primary cost of an appreciating reserve currency is the overvaluation of the currency board real exchange rate. It may be noted however, that pegging to a depreciating reserve currency is not without its drawbacks. A lower real exchange rate is not necessarily less volatile, since this would depend on trade shares of various currencies and their covariances. Two additional drawbacks relate to interest rate and inflation dynamics associated with depreciating currencies. In a dual currency board, the convergence of interest rates would shift from one currency to the other, and display dynamics comparable to those of a target zone.28 Oppers claims that higher interest rates obtained from pegging to a more depreciated reserve currency would be offset by lower risk premia, compared to those associated with an overvalued real exchange rate.

The backing provided by reserve assets

The form and extent of asset backing required is a determinant factor in the effectiveness of a currency board. The monetary authority is bound to back any domestic currency issues with holdings of reserves or short-term interest-bearing assets, denominated in the currency to which the exchange rate is pegged. Although this represents a departure from the strict CBA model, where domestic issues are to be converted into foreign currency on demand, foreign currency-denominated bonds may be accepted and paid out instead of hard currency notes and coins. If the initial holding of foreign currency-denominated reserves so permits, and there is a perceived need to impart full credibility to the currency board arrangement, the degree of backing of domestic currency will be at least one hundred percent. It is to uphold the convertibility commitment that the degree of backing by reserves should cover a substantial value of the outstanding liabilities (notes and coins in circulation).

In order to guard against contingencies such as bank failures, holding surplus reserves is also beneficial. When the exchange rate is set above market-clearing levels (i.e., it is undervalued), the required foreign reserve backing is reduced. In addition, a margin for future real exchange rate appreciation is provided for, avoiding the need to resort to inflation as a mechanism for achieving the required real appreciation.

Monetary authorities wishing to set up a currency board must consider the possibility of startup problems and the constraints imposed on the financial system. This situation arises from gathering sufficiently hard currency to back the entire money supply. In spite of providing the assurance of convertibility at a fixed rate, a crisis might erupt in the financial system if reserves are insufficient to cover a broader monetary aggregate. Banks are then called upon to ensure the convertibility of their demand deposits. If credit lines prove inadequate, the fact that the currency board is unable to intervene may exacerbate the difficulties of the financial sector. The loss of the lender-of-last-resort function may thus be an acute drawback in the event of a liquidity crisis.

Currency board profit considerations

CBA profits are derived from the difference between the interest on the securities that it holds and any expenses incurred in the issue and management of domestic currency.29 These profits are usually transferred to government, in excess of the level required to build up foreign reserves to the required proportion of backing by the board. A margin of profits may also be maintained by the currency board in the form of an equity reserve to cover possible losses in the value of its reserve asset holdings. In principle, handling costs can be kept low if the board chooses to establish a minimum amount for transactions, thereby restricting dealings to large amounts of foreign exchange while allowing smaller amounts to be transacted through the banks. None of the currency boards surveyed, however, have established such arrangements. Estimates of the running costs of a CBA generally approximate 1 percent of CBA assets.30

Money dynamics under currency boards

Market forces essentially dictate the amount of notes and coins issued. The supply of reserves is determined either by the reserve country or by the producers of the commodity to which the exchange rate is pegged. The currency board acts only as a warehouse, and the only way of obtaining additional reserves is to run a trade surplus. The distribution and demand for reserves is determined by the nature of competition between banks within the currency board setup. Changes in money demand are accommodated by endogenous changes in international reserves instead of variations in net domestic assets, as would be the case in a central banking framework. Thus, domestic interest rates are determined by local market adjustments to monetary conditions prevailing in the reserve currency country. In cases where the credibility of the currency board arrangement is at stake, due to the danger of political interference, there is a distinct possibility of an in-built risk premium in local interest rates. Interest rates can also be subject to a differential as a result of bank inefficiency or credit risk.

Setting the exchange rate peg

The level at which the exchange rate is fixed has important implications for the operations of a CBA. This is particularly the case for an undervalued currency. It may have inflationary consequences that undermine any associated gains in export competitiveness. Operational difficulties may also arise if the CBA country is at a different business cycle stage relative to the reserve country, bringing timing issues to the forefront. If a currency board is introduced to limit exchange rate depreciation in a context of crisis, pressures induced by a speculative attack may have resolved any prior overvaluation. Nominal depreciation is not permissible within the parameters of the currency board, which results in slower convergence of domestic and international price levels. Overvaluation must therefore be addressed (correcting misalignment by devaluing at a rate consistent with market forces) prior to the establishment of the peg, especially under high inflation.

Various methods for identifying the equilibrium real exchange rate are advocated in the literature. One may consider the purchasing power parity approach, the estimated structural monetary and portfolio balance models, the underlying balance approach, or a “consensus” based on estimates derived from various models. In the absence of a devaluation, severe exchange rate misalignment may tend to be remedied by tight liquidity. A tight policy stance can exacerbate unemployment and undermine the very sustainability of the exchange rate regime. The appropriateness of the currency board arrangement will, therefore, also depend on measures such as the degree of wage and price flexibility, and the sustainability of government finances. For example, the choice of the exchange rate peg set in Estonia and Lithuania was determined by the pressing need to impart credibility to the currency board arrangement.31 An undervalued real exchange rate was likely to cause a disequilibrium in the goods market during the transition period preceding convergence to European levels of inflation. In the Baltic countries, however, overvaluation was limited due to high rates of productivity which maintained domestic competitiveness and facilitated relative price adjustment while foreign direct investment continued.32 The manner in which public perceptions of economic policies evolve, following the establishment of the peg, is critical for the duration of the transition period. Convergence may be slowed down if the government’s resolve to cut budgetary expenditure is perceived to weaken, leading to wage claims, premia on domestic prices and interest rates, as well as reduced demand for domestic currency.

The price-specie flow adjustment mechanism

The CBA provides for payments adjustment in the same manner as a gold standard price-specie-flow mechanism. In the event of a balance of payments deficit and a fixed exchange rate, money supply declines as the private sector converts its domestic currency holdings into foreign reserves so as to settle import transactions. The resulting rise in interest rates serves to attract capital inflows. The higher interest rates also exert deflationary pressures by reducing domestic absorption, which improves the current account. Another way to address the deficit and avoid a contractionary effect is to tap sources of foreign reserves such as FDI or portfolio investment, and thus rely on growth to equilibrate the balance of payments. In the original adjustment mechanism, however, if prices are downwards flexible in responding to reduced domestic demand, export competitiveness will also be improved. This allows output to reach a full employment level, resolving the balance of payments deficit through deflation33.

Such an adjustment hinges upon two additional features of currency board systems. The first is the automatic reduction in money supply when the balance of payments is in deficit. This does not hold true when monetary authorities attempt to sterilize the reserve outflow. The second is the underlying assumption of wage and price flexibility. If this is absent, the (nominally) fixed exchange rate will be overvalued in real terms. As a result of tighter money supply, interest rates rise, forcing a contraction in the economy. The larger the price fall to restore equilibrium, the smaller the fall in output. Labor market flexibility is also important in the event of an external shock such as, for instance, an increase in the price of a vital imported commodity. This is due to the absence of an exchange rate depreciation as a mechanism for adjusting relative prices. If the government’s commitment to the fixed exchange rate is fully credible, wage and price setters would eventually adjust their strategies to incorporate expectations of low inflation in order to remain competitive. Inflation persistence might still arise due to the prevalence of overlapping contracts or forms of indexation.34

Balance sheet issues

The CBA balance sheet is that of “an institution that issues base money solely in exchange for foreign assets, specifically the reserve currency.”35 The excess of highly liquid and interest bearing reserve holdings of the currency board over its issues of non-interest-bearing liabilities constitutes its net worth, as indicated in Figure 1 below. Base money consists of notes and coins (“cash”) and may also include part, or all of, the reserves held by commercial banks. In a ‘pure’ currency board, unlike a central banking system, commercial banks may be required to hold their reserves (other than vault cash) in foreign currency. When the banks face a shortage of vault cash, they would sell some of their foreign currency holdings to the currency board.

Central banks differ from the “pure” currency board in that part of their assets is domestic, including government debt. This implies that central banks tend to have higher ratios of broad money to foreign reserves because of this partly domestic backing of base money. In addition, central banks can discount commercial bank assets, and in so doing expand the monetary base, in the same manner as when reserves are purchased. Purchasing domestic assets in the course of a sterilization effort is intended to offset the decline in base money as a result of the sale of reserve assets in support of the exchange rate.

The monetary policy pursued by the currency board is automated. Base money increases when the commercial banks wish to convert their reserve holdings into cash, either as a result of changes in money demand or in a situation of a trade surplus. Conversely, the monetary base shrinks when banks exchange their cash for foreign reserves so that their clients may finance their imports in the event of a trade deficit. Money supply is therefore exogenous under a currency board as opposed to it being a policy instrument in the hands of the central bank.

Table A1.

Comparison of Currency Board and Central Bank Balance Sheets

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Convertibility is guaranteed since the CBA should always be in a position to meet foreign exchange requirements when the private sector wishes to convert its cash holdings. A central bank, on the other hand, may be unable to immediately convert its entire holdings of domestic assets, be they claims on commercial banks or government paper. In practice, coverage of base money alone is insufficient to stem a bank run. In the event of a loss of confidence, depositors will seek to convert their demand deposits into the reserve currency so as to guard against any financial loss. It follows that it is up to the commercial banks to ensure the convertibility of demand deposits, either by holding sufficient foreign reserves or by establishing credit lines with international banks. Since the reserve currency and the domestic currency are for all intents and purposes substitutes, the government could encourage banks from the reserve country to set up branches or affiliates in the domestic banking sector, provided that the regulatory framework is compatible. Prudential supervision and licensing requirements enforced in the home country would thus have to be brought in line with those of the reserve country. Under a “pure” CBA, banks would be required to draw on their deposits at the currency board. Otherwise, a financial crisis could escalate since the currency board is not in a position to bail the banks out in the manner of a lender of last resort.

Even in its pure variant, the currency board can still experience severe pressure in the event of a bank run. This is due to the fact that as banks run down their currency board deposits to meet their depositors’ requirements, they are constrained to replenish their reserves by liquidating assets and cashing in their outstanding loans. At higher levels of interest rates such actions carry the risk of a credit crunch. Since the currency board as such is unable to provide the required liquidity, it may limit the damage by temporarily relaxing commercial banks’ reserve requirements or turning to the international money markets in the event of financial market pressure. Convertibility may thus turn out to be quite costly for the currency board unless special arrangements are instituted. These include the holding of excess reserves earmarked for this purpose or the imposition of additional discipline on commercial banks. An independent monetary agency may also be set up to provide discount facilities for banks. Provided that the latter does not hold domestic assets the convertibility upheld by the currency board will not be undermined by the provision of emergency liquidity to the financial sector. This is illustrated below with reference to the balance sheets and money multipliers of a currency board with and without a monetary agency.

Money multipliers

Osband and Villanueva (1993) illustrate the workings of a currency board balance sheet. They assume that the introduction of a monetary agency is designed to respond to the market’s need for liquidity. Figure 2 below illustrates the balance sheet of the banking system both with and without the monetary agency.

Table A2.

Banking System Balance Sheet With and Without a Monetary Agency

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The creation of a monetary agency does not affect the ratio of broad money to the monetary base since the agency does not hold domestic debt and government paper. As in the case of a currency board, the money multiplier, as derived below, will be lower than that of a central bank. In order to define the money multiplier, base money is defined as:36

M0=CHnbp+RESbkscb(1)

That is the sum of currency holdings (CH)of the nonbank public (nbp) and reserves (RES) of the commercial banks (bks) held at the currency board (cb). The latter can be expressed in terms of deposits (DEP) with reference to a required reserve ratio denoted rr:

RES  bkscb=rr(DEP)(2)

Broad money is:

M1=CHnpb+DEP(3)

If M1 is expressed in terms of deposits, and a ratio c is set as the proportion of money held in cash, the following identity is obtained:

DEP=M1c(M1)(4)

In the definition of M0 currency holdings are re-expressed as the proportion of M1 money not held in deposits, and replaced in (2) to obtain:

M0=c(M1) + rr(DEP)(5)

The money multiplier is given by:

mm=M1/M0

Substituting from (5) yields:

mm=1/(c+rr(1c))(6)

The larger the nonbank private sector’s holdings of currency,37 or the higher the share of c in M1, the less reserves available to the banking system. The limited availability of reserves restricts banks’ advances to its client base. As a result, the money multiplier is smaller. Similarly, the higher the required reserve ratio, the tighter is liquidity and the smaller is the money multiplier. Deriving the balance sheet identities so as to re-express the money supply in terms of credit created and reserve backing highlights the potential for greater monetary expansion by central banks, as against strict CBA frameworks. This is due to the inclusion of net domestic assets (NDA), as illustrated in Figure 3.

Table A3.

Balance Sheet Identities 1/

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As above, superscript denotes ‘at’ and subscript denotes ‘of’. Abbreviations are as follows: FR is foreign reserves, NFA is net foreign assets, L&S is loans and savings, BOR is borrowing, cba is currency board arrangement, ma is monetary agency and p is public.

In a CBA framework with a monetary agency, money supply is M = CHnbp + DEP. If the balance sheet identities of Figure 3 (i) and (ii) are consolidated, the liabilities side expressed in terms of ratios to deposits (in lower case), while retaining the components of the money base, money supply under a currency board and a monetary agency can be re-expressed as follows:

[(chnbp+1)/(chnbp+chbks+resbor)]*(FR+NFAma)(7)

Monetary expansion is likely to be smaller under a currency board, contributing to its credibility and to the stabilization of inflation expectations. This is shown in the expressions for the money multiplier and the money supply and may be illustrated with reference to the CBA money supply expressed in (7). For a central bank, reserve backing increases with the addition of NDAma to the last term from the right. Hence a central bank would possess a greater capacity to expand the money supply on the basis of its net assets. Furthermore, the exclusion of domestic asset holdings from the balance sheet of a currency board imposes a tighter financing constraint on the government. Indeed, monetary liabilities can only be issued on the basis of increased foreign reserve holdings. Only foreign reserves are included in assessing the credibility of a currency board, since the liquidation of domestic assets may be problematic during a balance of payments crisis.

Including a monetary agency under a currency board does not alter its expansionary capacity. The extension of credit remains backed by foreign assets, while it may ease temporary liquidity constraints faced by the banking system. Otherwise, the principal monetary policy instrument at the hands of the currency board is the required reserve ratio. It would, therefore, also be relevant to examine domestic credit creation in assessing currency board credibility. Since base money growth is constrained by increases in reserves, bank credit would provide additional information on monetary dynamics under a currency board.

Liquidity management and the clearing system

In the day-to-day liquidity management by banks, automation in clearinghouse activity and the advent of RTGS (real-time gross settlement systems) reduces the importance of the market for settlement funds. Henckel, Ize, and Kovanen (1999) discuss the implications for the operations of currency boards, of the declining proportion of central bank settlement balances in total payment transactions. As currency and settlement balances shrink, their coverage by reserve currency holdings becomes largely irrelevant, and broader monetary aggregates must be considered. Economists have suggested that interest rate instability in the currency board systems which refrain from lending operations may increase as a result of clearinghouse participants borrowing intraday and leaving the market short. This is especially acute in the absence of foreign interest rate arbitrage acting smoothly enough to reverse such activities.38 The establishment of end-of-day liquidity support or the use of repurchase facilities for banks would, therefore, be recommended. This option is reflected in technical measures adopted by the Hong Kong Monetary Authority (HKMA). The issue is the correct setting of a repurchase rate in the interest of the international reserves position. In this case, the definition of the monetary base may be broadened to include fully backed commercial bank required reserves with the currency board, or bills issued by the board to provide additional settlement balances for banks.

The broader is the definition of monetary liabilities, the stronger the undertaking of convertibility. The HKMA39 recommends that the definition of money be comprehensive (so as to cover all forms of payment that can be used to settle transactions), that it be practical (so as to enable the authorities to exercise effective control over the quantity or price of money), and that it be featured on the balance sheet of the monetary authority. It also suggests a revision of the traditional currency boards’ focus on currency notes. This is due to the fact that large transactions are increasingly effected through electronic means, involving payments between banks on behalf of their customers and the clearing of checks. Yet, the backing of currency in circulation remains central to the maintenance of confidence for the general public. When the monetary base comprises balances held in the banks’ clearing accounts at the CBA, the latter would also be responsible for the interbank clearing system. The HKMA also recommends real-time settlement to minimize the need for end-of-day liquidity support from the currency board. It suggests that the board be responsible for clearing and that liquidity be provided only against collateral and at penalty rates; otherwise base money might be created without an increase in reserves.

If the financial system is efficient, the balances held at the currency board are likely to be small, and the resulting leverage may lead to unnecessarily sharp fluctuations in interest rates which would put undue pressure on banks. There are opportunities for arbitrage when market rates deviate from the parity through deposits and withdrawals of currency notes against credits and debits of the clearing accounts of banks, unless the convertibility undertaking extends also to currency notes. This is a particularity in the form and extent of convertibility upheld in Hong Kong SAR’s CBA. Indeed, the HKMA suggests that banks could also provide for the convertibility of their customers’ deposits since they have clearing accounts at the currency board which are fully backed by foreign reserves. The extent to which banks will allow their customers to withdraw large amounts of currency notes against their deposit balances is limited. This is particularly the case if the exchange rate is weaker than parity. In obtaining currency notes for their customers in exchange for foreign reserves the banks may consequently have to impose a fee reflecting this exchange rate differential.

Table A4.

Legislative and Regulatory References

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  • Zloch-Christy, I., 1999, “Point de vue sur l’instauration d’un conseil monétaire en Bulgarie,” Le Courier des Pays de l’Est, Vol. 437, pp. 2731.

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1

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.

2

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.

3

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.

4

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.

5

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.

6

In the Baltic countries, accession to the European Union (EU) provided the escape clause.

7

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.

8

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).

9

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.

10

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.

11

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.

12

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.

14

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.)

15

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.

16

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

17

Instead, a study of Latin American economies (IMF, 1996, p. 62) confirms a significant relationship between changes in monetary aggregates and inflation.

18

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.

19

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.

20

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.

21

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)

22

This is particularly well illustrated in the strict CBA framework adopted by Bosnia and Herzegovina.

23

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.

24

The statute and accompanying legal texts are the main sources of information. For exact legal and regulatory references see the box in the appendix.

25

The theoretical benchmark is described in further detail in the appendix.

26

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.

27

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.

28

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.

29

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.

30

Estimate drawn up by Hanke and Schuler (1991).

31

The issues faced by the currency boards in the Baltic countries are discussed in Berengaut and others (1998).

32

The absence of indexation mechanisms, flexible labor markets and low labor costs were also determinant factors in this case.

33

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.

34

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.

36

Superscript denotes ‘at’ and subscript denotes ‘of.’

37

As a result of financial innovation, a smaller proportion of money is held in cash.

38

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.

39

In its website and the information leaflets it provides on the CBA.

An Institutional Framework for Comparing Emerging Market Currency Boards
Author: Mrs. Marie T Dal Corso