Bennett, Adam G. G. (1993a), “The Operation of the Estonian Currency Board,” Staff Papers, International Monetary Fund, Vol. 40 (June 1993), pp. 451–470.
Bennett, Adam G. G. (1993b), “Discussion” in The Economics of New Currencies, ed. by Richard Portes (CEPR, October 1993), pp. 108–112.
Greenwood, John G. (1984a), “The Operation of the New Exchange Rate Mechanism,” Asian Monetary Monitor, Vol. 8, No. 1 (1984), pp. 2–12.
Greenwood, John G. (1984b), “Why the HK$/US$ Linked Rate System Should Note Be Changed,” Asian Monetary Monitor, Vol. 8, No. 6 (1984), pp. 12–17.
Hanke, Steven, and Kurt Schuler (1991b), “Keynes’ Russian Currency Board,” in Capital Markets and Development, ed. by Steven Hanke and Alan Walters (San Francisco: Institute for Contemporary Studies Press, 1991), pp. 43–63.
Hansson, Ardo, (1993), “The Estonian Kroon: Experiences of the First Year”, in The Economic of New Currencies, ed. by Richard Portes (CEPR, October 1993), pp. 85–107.
Osband, Kent and Delano Villanueva, “Independent Currency Authorities: An Analytic Primer,” Staff Papers, International Monetary Fund, Vol. 40 (March 1993), pp. 202–16.
This paper is a slightly shortened version of a paper presented at the Sixth Seminar on Central Banking in March 1994, organized by the Monetary and Exchange Affairs Department of the IMF and the IMF Institute, which features in the respective conference volume. The views expressed are the author’s and do not represent those of the IMF. The author is grateful to Klaus Gerhaeusser, Kenneth Miranda, Tapio Saavalainen and others who have provided helpful comments.
Impressed by the success of the Estonian scheme, the Lithuanian authorities asked the Fund in November 1993 to help set up a similar system. On April 1, 1994 Lithuania became the second state of the FSU to operate a currency board. The Lithuanian scheme was modelled on that of Estonia.
See Osband and Villaneuva (1993) and Williamson (1994) for an analytical discussion of currency boards. See also Bennett (1993a) and (1993b) and Hansson (1993) for a discussion of the Estonian case and Greenwood (1984a) and (1984b) for the Hong Kong system. Hanke and Schuler (1993) provide a useful list of currency boards in the last hundred years.
The two countries differ slightly, however, in their definition of legal tender. In Argentina, both the peso and the US dollar are legal tender, whereas in Estonia only the kroon is legal tender—transactions between residents cannot be settled within Estonia in any other currency.
An alternative arrangement, in the absence of any reserves, would be to operate with only 100 percent marginal backing for the note issue. Such an arrangement could only work if there were no outstanding stock to guarantee, since it, would not otherwise be proof against speculative attack. The accumulation of convertible notes would be a gradual process, and for a while there would have to be a dual system with both new and old notes.
The Exchange Fund is also custodian of the reserves of the government, which has traditionally run a surplus, but these are in principle not available for the purposes of ensuring convertibility.
The austral was subsequently replaced by the peso, at a conversion rate of one peso for 10,000 australs.
The eligibility of government bonds as backing is also limited in flow terms to a maximum of 10 percent, of the monetary base per annum. Bonds held as backing must be valued at secondary market prices.
Although broadly equivalent in absolute amount, the Larger size of the Lithuanian economy meant that relative to its proposed currency board liabilities, the Lithuanian gold, plus subsequent accretions of reserves, was sufficient backing only in gross terms. Net of foreign exchange liabilities, the Lithuanian currency board arrangement was significantly less than fully backed. In this sense, the Lithuanian scheme was closer to that of Argentina.
The vast majority of foreign exchange transactions and foreign currency deposits were US dollar denominated prior to the introduction of the currency board system. Accordingly the Lithuanians decided to peg to the US dollar.
The early precursor to the Baltic currency boards—the system proposed by Keynes for the North Russian government in 1918, also allowed up to a third of liabilities to be backed by claims on the government, see Spring Rice (1919) and Hanke and Schuler (1991).
Although the bands were rather narrow, the rate fluctuated within them and it was felt that the bands probably covered a range that was close to the market equilibrium for the austral at the time. The convenience of a rate of exchange of precisely 10,000 australs (now one peso) to the dollar may have influenced the final choice of exchange rate.
The exchange rate for the Litas in the months prior to the’ introduction of the currency board was stable at 3.90 to the US dollar. Immediately following the enactment of the Litas Stability Law the exchange rate began to weaken, reaching 4.07 as the market speculated about the rate. In the event, the Lithuanians chose 4.00—a round number which had the virtue of showing a commitment to a strong exchange rate, while not being so strong as to wipe out the surplus reserves of the Banking Department.
This follows the model of the Bank of England, likewise divided into Issue Department and Banking Department. Unlike the Bank of Estonia, however, the Issue Department of the Bank of England does not hold foreign exchange as backing for the note issue, but rather domestic securities. As with the Bank of Estonia, this division is purely an accounting device and does not reflect the organizational structure of the bank. The Bank of Lithuania now also prepares accounts in this way.
For further information regarding the evolution of the balance sheet of the Bank of Estonia see Bennett (1993a).
The central bank is nonetheless prohibited from extending any new credits to the public sector.
Other methods of influencing liquidity included short term borrowing in the interbank market and the shifting of treasury deposits from the banking system into sterilized Exchange Fund deposits. See Yam (1992) for a discussion of the implications of the recent reforms.
This is not to say that there is a free for all in the setting of interest rates. In Hong Kong the banks operate a cartel, setting interest rates on deposits following regular meetings between banks. Banks are also to expected to consult the Monetary Affairs Committee about their decision. An earlier legal maximum of 60 percent per annum was removed from the Money Lenders Ordinance in 1988 when it was realized that this could be an impediment to operation of market forces in defending the exchange rate. This complemented the move in 1987 to allow banks to impose negative interest rates on deposits, to deal with situations when the exchange rate was undue upward pressure. Ironically, these measures appear to have dampened the variance of interest rates since their introduction (Chart 2)
It might be felt that the lower variance of the exchange rate that results under, a monetary base, as opposed to currency, definition of the currency board would recommend the former versus the latter. With less variance available in the exchange rate, however, it is possible that more of the burden of adjustment to changes in money demand will fall on domestic interest rates. In consequence it may be that interest rates are more variable under a monetary base currency board than under a currency system.
That the rate has been consistently appreciated since 1991 suggests that the authorities, through open market operations, have been actively tightening monetary conditions. Left to itself, the market would draw in sufficient liquidity to remove the premium.
Since 1989 there has been a tendency for Hong Kong interest rates to be slightly above equivalent US rates, suggesting that the authorities may have been systematically tightening liquidity—as the behavior of the exchange rate would also indicate.
It is notable that the Convertibility Law in Argentina involved the prohibition of all indexation arrangements, including those for wages.