Back Matter
Author: Patrick A. Imam

References

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APPENDIXES 1.

History of Cape Verdean Exchange Rate Arrangements20

Colonial Period

For four centuries after the uninhabited island of Cape Verde was colonized by Portugal in 1456, the main coins in circulation was the real, the currency circulating in Portugal at the time. During this period, Cape Verde became a trading center for African slaves and later a coaling and resupply stop for whaling and transatlantic shipping.

When Portugal set out in 1853 to establish a currency for its overseas colonies, in part to allow seignorage revenues to accrue to the colonies and to avoid the shipping of notes, it decreed in 1853 that coins in Cape Verde and its other colonies would have the same ratings as in Portugal. The local real was pegged one-to-one to the Portuguese real. The Banco Nacional Ultramarino, Portugal’s private monopoly note-issuer for its colonies, issued a separately marked note for Cape Verde when it opened its branch there in 1865. (Until 1930, the coins used in Cape Verde were Portuguese; its own first coins were issued in 1930).21

When the Portuguese monarchy was overthrown in 1910, the real (“royal”) was renamed the escudo (“shield”). Accounting in the new currency only began in Cape Verde and the other colonies in 1914. The escudo was, however, chronically weak until the currency reform of 1928, which explains why Portugal introduced exchange controls on September 24, 1914, and revoked them only in 1937. In 1948 the separate colonial foreign-currency funds were centralized in Lisbon. The currency reform of 1953 unified the Portuguese escudo and the currencies of its colonies, making them a true currency area similar to the sterling area or the French franc zone. Portugal established a Monetary Fund of the Escudo Zone in 1962. On February 21, 1963, Portugal issued a ministerial decree liberalizing capital movements in the escudo zone. On March 1, 1963, the fund took measures to organize a new payments system for the zone. However, Angola and Mozambique were persistently in deficit to the fund. The result was that high-priority payments were settled immediately at 1 overseas escudo = 1 Portuguese escudo, but low-priority payments experienced delays, which were a form of rationing, until funds were available to settle them at the official rate. Portugal imposed exchange controls on private transfers from overseas territories to Portugal on November 6, 1971.

Independence

In 1975 Cape Verde became independent after an evolution that took more than 20 years: In 1951 Cape Verde had become an overseas province of Portugal rather than a colony. In 1961 its citizens obtained full Portuguese citizenship. Even so, there was a strong independence movement, led by the African Party for the Independence of Guinea-Bissau and Cape Verde (Portuguese initials PAIGC). (Guinea-Bissau, on the African mainland, had also been granted provincial status.) Portuguese forces withdrew from Cape Verde and other colonies in 1975, following a coup of democratically minded leftist military against the Portuguese dictatorship in April 1974. Cape Verde became independent on July 5, 1975. In 1981, following a coup in Guinea-Bissau, Cape Verde abandoned hope of a union with it.

Until independence in 1975, the Cape Verde escudo had been equal to the Portuguese escudo. Cape Verde introduced the Cape Verde escudo (CVEsc) in 1977. The CVEsc was initially pegged to the Portuguese escudo and later repegged to a basket of currencies. In 1977–78 it depreciated by about 30 per cent and in 1982–84 by another 40 per cent. It has since been fairly stable against the Portuguese escudo. The central bank’s main monetary policy instrument was to maneuver the basket, consistently devaluing the CVEsc by 6–10 percent a year to maintain competitiveness. The BCV also rationed foreign currency when demand became excessive. As a result, foreign exchange queues were frequent. Due to shortages in their foreign currency holdings, commercial banks accumulated approved but unmet applications for foreign currencies from importers.

In 1998 a newly elected government announced a comprehensive economic reform program, including full convertibility of CVEsc. The peg system was initially changed to the Portuguese escudo, with a 6 percent devaluation, at the rate of 0.55 CVEsc/PSE, and then to the euro at the rate of 110.3 CVEsc. The IMF provided a precautionary Stand-by-Arrangement for 1998–2000 to underpin a donor-supported domestic debt operation. The government undertook serious reforms in order to support the change in the exchange system. One of the major supports for the reform effort was a credit line arrangement with Portugal agreed in July 1998, the Exchange Cooperation Accord. The accord provides a short-term precautionary credit line from the Portuguese government of up to US$50 million, to be repaid by the end of each year with annual interest of 0.5 percent. The accord also set up a committee of representatives of the ministries of foreign affairs and finance and the central bank of both countries to monitor economic conditions. The committee can recommend to the Portuguese government suspension of the credit line. A foreign exchange law was passed in June 1998 with the ultimate intent of removing all restrictions on current and capital account transactions. In 2004 the country accepted Article VIII of the IMF’s Articles of Agreement.

The economy grew rapidly once the euro-peg system was introduced, led by FDI in export-oriented manufacturing, construction of tourism facilities, and increasing remittances.

However, despite the strict internal and bilateral monitoring the fiscal situation worsened in 1999 and 2000 because of elections, a severe drought, and the mounting costs of cleaning up banking sector problem),. The government consequently breached its statutory limits on central bank financing, and the external balance rapidly deteriorated. By mid-1999 the central bank had depleted foreign reserves to defend the peg. The government responded to the crisis by temporarily reintroducing foreign exchange rationing, using some privatization receipts for current budgetary obligations, and, as a last resort to defend the peg system, drew on the Portuguese credit line. In 2000 the government again drew on the credit line but failed to meet the year-end repayment, triggering a temporary suspension of the facility. External assistance virtually dried up as fiscal performance deteriorated and arrears to foreign creditors accumulated. The government, with significant help from the Portuguese government, reinitiated its reform efforts and by late 2001 the situation was normalized.

After the crisis, the government’s comprehensive reform efforts significantly improved macroeconomic conditions. The fiscal deficit was reduced to about 5 percent of GDP and the current account deficit declined to less than 10 percent of GDP. Inflation fell to the low single digits. A dynamic private sector emerged and the export base became larger and more diversified, driven by FDI. Tourism income grew to more than 10 percent of GDP. Foreign reserves accumulated and the BCV developed a number of policy instruments to control inflation and currency pressures.

Table 1.

Exchange Rate Arrangements of Cape Verde

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Source: Kurt Schuler (2008) http://www.dollarization.org/
Table 2.

Cape Verde Monetary Authority

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Source: Kurt Schuler (2008) http://www.dollarization.org/
1

This paper was presented at the Conference Commemorating the 10th Anniversary of the Exchange Rate Cooperation Agreement between Portugal and Cape Verde, held in Praia on the 31stof October 2008. I would like to thank Philippe Callier, Eduardo Castro, Sandro de Brito, Roland Kpodar, Lamin Leigh, David Nellor, Rosa Pinheiro, Marcio Ronci, Daouda Sembene and George Tsibouris for their useful comments. The usual disclaimer applies.

2

See Appendix 1 for a history of Cape Verde’s exchange rate arrangements.

3

We will use dollarization and eurorization interchangeably, to mean the adoption of another country’s currency as the official legal tender.

4

While comparing the macroeconomic environment of dollarized economies before and after introduction of the dollar might appear informative, in practice this type of analysis would suffer from a selection bias: countries choosing to dollarize for economic reasons, especially recently, generally have done so precisely because of their poor initial economic conditions.

5

The Ecofin Council of November 7, 2000, in its conclusion on exchange rate strategies for accession countries, emphasized that “any unilateral adoption of the single currency by means of eurorization would run counter to the underlying economic reasoning of EMU [Economic and Monetary Union] in the Treaty, which foresees eventual adoption of the euro as the endpoint of a structured convergence process within a multilateral framework. Therefore, unilateral eurorization would not be a way to circumvent the stages foreseen by the Treaty for the adoption of the euro.” However, this applies only to EU accession countries. Non-accession countries can therefore eurorize unilaterally without the consent of the European Commission, but will not be able to influence monetary policy decisions, or ask for seignorage revenues.

6

Historically, bimonetary systems have also existed, though they are unusual. Before the euro was introduced, the Belgium-Luxembourg Monetary Union ensured that the Belgium franc was legal tender in Luxembourg, but Luxembourg also issued its own currency, which circulated at par. The National Bank of Belgium was responsible for monetary and exchange rate policy for the union and held foreign reserves. Seignorage revenue were shared pro rate between the two countries based on population (Organization for Economic Cooperation and Development, 1997). This peculiar structure, which requires the consent of both countries, means that today such an arrangement would only be possible with ECB consent, an unlikely scenario (see Stark, 2008).

7

Dollarization would not eliminate the risk of external crisis; investors may still leave the country if the fiscal position change or banking problems arise, as happened in Panama (see Moreno-Villalaz, 1999).

8

It is possible to make the case that the overseas development assistance that Cape Verde has obtained has acted as a de facto shock absorber (like a fiscal transfer) during shocks. Now that Cape Verde has graduated to lower-middle-income status, aid will gradually decline and cannot be relied upon as a shock-absorbing tool.

9

While the euro enjoys a solid reputation for monetary stability, which is enshrined in the status of the ECB, the situation is not guaranteed to hold forever. Most currencies at one time or another suffer from weaknesses. While the euro is likely to remain stable for the foreseeable future, the option to switch to a different currency would be lost. Since this is not likely to be a problem in the foreseeable future, though, this cost is likely to be minute.

10

Another question the government must consider before eurorizing is how the decision will be taken: Will there be a referendum on giving up the escudo for the euro, or a parliamentary vote?

11

Because monetization is higher in developed than in developing countries, for the latter the rate of growth of demand for money may be higher in the short run than in the steady state if levels eventually converge to those of more developed economies. This entails an additional seignorage cost in the form of higher flow costs in the transition period.

12

According to Article 33 of the ECB, which deals with the allocation of net profits and losses of the ECB: “The net profit of the ECB shall be transferred in the following order: (a) an amount to be determined by the Governing Council, which may not exceed 20% of the net profit, shall be transferred to the general reserve fund subject to a limit equal to 100% of the capital; (b) the remaining net profit shall be distributed to the shareholders of the ECB in proportion to their paid-up shares.”

13

The value of future increases in the demand for money represents the larger part of total seignorage costs. Thus, the final number depends heavily on the expected rates of growth and inflation and on the evolution of the currency-to-GDP ratio, which so far has been assumed for simplicity to be constant.

14

Note that if Cape Verde eurorizes, the existing central bank loses most of its functions, and will shrink, though it does keep some such as a financial supervisory agency. A smaller central bank would imply lower running costs, which would compensate in part for the loss of seignorage revenues.

15

Using the matching estimator technique on a data-set for 199 countries covering 1970-1998, Edwards and Magendzo (2001) find that dollarized countries have a lower growth rate than nondollarized countries, even though their inflation is much lower. This confirms that dollarization is no guarantee of improved growth.

16

According to the “Annual Report on Exchange Rate Arrangements and Exchange Restrictions,” the official classification by the IMF, exchange rate arrangements are divided into three broad categories: (i) pegged or fixed arrangements: currency unions, currency boards, dollarized countries, and fixed exchange rates. (ii) flexible arrangements: free floats, where monetary authorities do not intervene, allowing market forces to determine the exchange rate, and managed floats, where intervention is done to “lean against the wind”; (iii) and exchange rates with “limited flexibility,” an in-between category of arrangements that run the continuum from adjustable pegs, in which countries can periodically realign their pegs; to crawling pegs, in which the peg is frequently reset through a series of devaluations; to a basket peg, where the exchange rate is fixed in terms of a weighted basket of foreign currencies; to target zones (exchange rate regimes with bands), where the authorities intervene when the exchange rate hits pre-announced margins on either side of a central parity.

17

Since the capital account crisis of the 1990s, an argument that has gained in importance is that the balance sheet effects from currency movements (e.g., large external debt denominated in foreign currencies, or significant foreign-currency liabilities in the commercial banking system) may cause governments to favor exchange rate stability (Hausmann et al., 2001). This literature, however, is based on the credibility literature and simply reflects the resulting balance sheet problems as opposed to the purely flow problems.

18

The goodness of fit model estimates from a logistic regression are maximum likelihood estimates arrived at through an iterative process. They are not calculated to minimize variance, meaning that the Ordinary Least Square (OLS) approach to goodness-of-fit does not apply. Several pseudo R-squares have been developed to evaluate the goodness-of-fit of logistic models, with McFadden’s pseudo R-squared being probably the most popular. In this model, the log-likelihood of the intercept model (MIntercept) is treated as a total sum of squares, and the log likelihood of the full model (MFull) is treated as the sum of sequared errors. The ratio of the likelihoods R2=1lnL(M^Full)lnL^(MIntercept) suggests the level of improvement over the intercept model offered by the full model.

19

In a discrete dependent variables, such as a probit model, we assume that responses follow a binomial distribution. Let Y be a binary outcome variable, and let X be a vector of regressors. The probit assumes that Pr(Yi = 1|Xi = x) = 1 – φ (–xiβ) = φ(xiβ) = φ(xiβ), where φ is a cumulative distribution function of the standard normal distribution. The β parameters are estimated by using the method of maximum likelihood (see Greene, 2000, for an illustration).

20

This section draws mainly from http://www.dollarization.org and various Article IV reports on Cape Verde.

21

The Banco Nacional Ultramarino, was not required to keep its colonial currencies at par with the Portuguese escudo, though its revised charter of 31 November 1901 did require it to accept notes of one branch at any other branch at a discount of no more than 2% (except regarding Mozambique)

Introducing the Euro as Legal Tender—Benefits and Costs of Eurorization for Cape Verde
Author: Patrick A. Imam