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For the latest thinking about the international financial system, monetary policy, economic development, poverty reduction, and other critical issues, subscribe to Finance & Development (F&D). This lively quarterly magazine brings you in-depth analyses of these and other subjects by the IMF’s own staff as well as by prominent international experts. Articles are written for lay readers who want to enrich their understanding of the workings of the global economy and the policies and activities of the IMF.

AS A NUMBER of countries in the former USSR and Eastern Europe have ventured out on their own, gaining or regaining political independence, many have been struggling to establish economic independence. Some have made moves to introduce their own currencies, but the process is difficult, demanding both sound economic policies and new institutional arrangements.

In recent years, Croatia, Estonia, the Kyrgyz Republic, Latvia, Lithuania, and Slovenia have chosen to introduce their own permanent currencies; others have introduced provisional currencies, and many more are likely to follow suit soon. Countries typically introduce a separate currency not only because it is a symbol of national independence but because it gives them the authority to determine national monetary and exchange rate policies.

Introducing a new currency is not easy. Monetary independence requires a degree of financial stability based on sound financial policies implemented at the time the new currency is introduced. Lack of adequate supporting policies may cost the new currency its credibility, which may be difficult and expensive to restore. What are the necessary steps prior to, during, and immediately after the introduction of a new currency?

First things first

The success of a new currency depends, to a large extent, on careful preparation. Certain key issues need to be addressed, including the choice of an exchange rate regime, the development of a central bank, financial market operations, supporting legislation, and the use of coupons as an intermediate step in the move toward a new currency.

The exchange regime makes a difference. When a country introduces a new currency, usually only the central bank is given the authority to issue it. The central bank thus acquires the power to set and control either the quantity of money and its exchange rate—the price of domestic money in terms of foreign money. Inevitably, the choice of an exchange rate regime involves a trade-off in terms of the degree of control the country will have over its monetary and exchange rate policies. Exchange controls are sometimes used to weaken this trade-off. In discussing this complex topic, we have focused on the more transparent regimes under which policy trade-offs and constraints are somewhat clearer than they are under hybrid systems.

In a pegged currency system, monetary policy is aimed at maintaining the exchange convertibility of the new currency at a fixed exchange rate. Under this system, a country pegs its currency to that of a larger or more developed country to maintain monetary stability. Conversely, Russia’s monetary instability was a major factor behind the choice made by many of the states of the former USSR to introduce new currencies that would insulate them from inflationary pressures.

At the other end of the spectrum, in a freely floating exchange rate regime, the exchange rate adjusts to variations in the supply and demand for the domestic currency. This regime allows the country to pursue an independent monetary policy. Other exchange rate regimes are variations of these two pure systems and allow for a limited degree of policy independence.

Relatively pure pegged or floating systems were chosen by the countries that abandoned the ruble area and introduced new currencies. Estonia established a currency board in June 1992, with the kroon pegged to the deutsche mark; Latvia let the Latvian ruble float freely against other currencies in October 1992 and, after stability was regained, introduced the lats in March 1993. Similarly, Lithuania floated the talonas against other currencies in October 1992 and introduced the litas in June 1993. The Kyrgyz Republic introduced the som as a freely floating currency in May 1993. Ukraine adopted free floating of its karbovanets in November 1992 and plans to introduce the grivna in the future. In part, many of these countries adopted a freely floating regime to protect their limited foreign exchange reserves.

How well do foreign exchange markets work? The credibility and strength of the new currency, as expressed by its exchange rate, is enhanced by the following:

• exchange rate unification, which increases confidence in the new currency and eliminates the distortions created by dual or multiple exchange rates.

• currency convertibility, which eliminates controls over international transactions, eases the country’s integration into the international economy, and minimizes governmental interference in the exchange regime. This is particularly important for economies in transition, where an increased role for private sector initiative, in a context of reduced government interference and widespread free markets, is a necessary part of structural reform.

• a competitive and efficient exchange market that directs foreign exchange to its most profitable uses. Such a market needs nonbank dealers licensed to trade in the new currency, in addition to a traditional and perhaps oligopolistic banking structure.

• a streamlined and organized central bank or currency board. As banker to the government, a central bank needs to undertake government foreign exchange transactions efficiently (initially this activity is often a significant part of the market). The bank will organize a foreign exchange department, establish the prudential monitoring and supervision of foreign exchange dealers at banks and elsewhere, and set out principles and procedures for intervening in the markets and managing international reserves.

New currencies emerge in the states of the former USSR

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Source: IMF Working Paper WP/93/49. “Introduction of a New National Currency; Policy, Institutional, and Technical Issues,” by Hernán Cortés-Douglas and Richard Abrams. June 1993.

Legislation supports the changes.

Legislation makes the new currency legal tender, gives the central bank the authority to issue the new money, governs foreign exchange transactions and empowers the central bank or another governmental body to draft supporting regulations, and specifies the treatment of different types of financial assets, liabilities, and contracts during and after the introduction of the new currency. All the countries introducing new currencies have adopted such legislation before or shortly after issuing their currencies.

In a single currency area, joint decisions must be reached on the disposition of currency notes taken out of circulation when new notes are introduced; on payments, clearing, and settlement arrangements; on the disposition of the assets and liabilities of the former central bank; and on the treatment of residents and nonresidents with respect to the rights of holding deposits in the new and old currencies.

Are coupons a possibility? Coupons are generally issued either to serve as an “intermediate” step, ahead of the new national currency, or to alleviate a shortage of old currency bank notes. Several countries have issued coupons as an intermediate step in the face of continuing macroeconomic instability and high inflation, postponing the introduction of the permanent currency until their economies improve. Initially, coupons are issued at par with the old currency and circulate as legal tender along with the familiar bank notes. Just prior to the issuance of the new national currency, coupons may become the nation’s sole legal tender. Latvia, Lithuania, and Ukraine floated their provisional currencies after declaring them the sole legal tender in their countries.

Making money

Once these decisions are made, practical considerations for the production of the new currency and preparations for the actual conversion need to be addressed. What value should be placed on the currency initially? How many notes should be produced? And how should the bank notes be denominated and designed?

Valuing the currency. The conversion process will be simpler if a simple conversion rate is used. The easiest solution is to have the new currency related to the old currency by a power of ten. It is also useful to have a new currency’s sub-unit (presumably one hundredth of the currency unit) roughly equal the value of the smallest common purchase. In Lithuania, for example, the talonas—a temporary coupon—was issued at par with the ruble in May 1992, and the litas—the permanent new currency—was issued at 1 litas per 100 talonas in October 1992, under a flexible exchange regime. On the other hand, Estonia fixed its new currency—the kroon—against the deutsche mark at an 8:1 ratio in June 1992 and used the deutsche mark/ruble exchange rate to determine the conversion rate against the ruble.

Deciding the quantity of notes. Initially, enough new currency notes must be printed to replace all the bank notes outstanding in the country at the official conversion rate and allow for conversion of any likely illegal inflows of old currency notes (less any unconverted old currency notes held by residents). Following conversion, more notes may be needed to meet any rise in demand and to maintain sufficient inventories (plus replacement notes pending the next printing of bank notes). Inventory models for bank notes are used for estimating the demand for bank notes and the quantity of each denomination.

Designing the bank notes. Bank notes are designed both to be easy to use and to make counterfeiting difficult and expensive. Bank note users include the general public, cashiers, the central bank, and even vending machines. The public’s main interest is ease in recognizing the denomination of a bank note; printing the value in large numerals on the front and back of the note and using different colors for the denominations make notes easier to tell apart. A date, a serial number, selected signatures, and some combination of portraits, pictures, and images are also helpful identifying features and can be aesthetically pleasing.

The conversion itself

After the new currency is produced, preparations for the actual conversion need to be addressed.

Making it public. The public needs to know how to exchange old currency bank notes, deposits, and coupons for new currency bank notes and deposits during the conversion. The announcement of the currency conversion usually explains how residents and nonresidents are to convert bank notes and coupons and how any bank note holdings in excess of the amount that may be converted are to be treated. In addition, the announcement describes how deposits and obligations in the old currency—as well as nonbank financial assets and liabilities and other contracts—are to be converted and lists the regulations governing transactions in the old currency and other foreign currencies during and after the conversion period.

The period between the announcement and the introduction of the new currency can be used to explain the conversion process to people and enterprises. During this period, the public may deposit any additional cash holdings in accounts with banks, relieving pressure on banks during the actual conversion.

The conversion period—the period of time during which actual conversion takes place—has been three to seven days for most countries. The Kyrgyz Republic, one of the last states of the former USSR to introduce a permanent currency (May 1993), used three conversion periods to exchange soms for rubles—the first two were of five days each (May 10–14, May 17–21) and the final one two days (June 3–4). The official conversion period was the first, with the second one open to individuals who justifiably were not able to participate in the first. In the third period, the som had already appreciated (260 rubles per som), compared to the previous periods (200 rubles per som). Unfortunately, the announcement of the conversion was made only three days before the actual conversion, accounting for much of the slow start of the changeover.

Spending during conversion. The new currency is made legal tender from the first day of the conversion period. Allowing the use of both the old and the new currency during the conversion reduces pressure on residents to dispose of their old currency notes. It also allows shops to help with the conversion process by exchanging old notes for new notes.

In Latvia, Lithuania, and Ukraine, coupons were issued and permitted to circulate, allowing people to continue to make transactions without first having to obtain new currency bank notes. The coupons also relieved pressure for conversions on the first day, reducing both waiting lines and the immediate burden on the institutions doing the converting. After the conversion period, the coupons were withdrawn from circulation and turned in at banks. Usually, there is a deadline on how long coupons may be used, not only to avoid confusion but also because coupons can be easy to counterfeit.

Limiting old currency inflows. Authorities may be concerned about the inflows of old currency bank notes from nonresidents purchasing goods during the conversion period. To avoid large inflows, governments usually allow only residents over a certain age to convert. Nonresidents are not permitted to acquire new currency notes, with the exception of tourists, who are usually allowed to change a limited amount. Estonian authorities declared the kroon the only legal tender during the conversion and used a short conversion period. Some countries—for example, Slovenia—have even closed their borders during the conversion period, but such extreme actions are expensive and generally difficult to enforce.

Bank loans and deposits. Domestic bank loans and deposits (of residents and nonresidents) denominated in the old currency are converted into new currency on the first day of the conversion period to avoid leaving domestic banks with open foreign currency positions on their balance sheets. Both residents and nonresidents are covered, and depositors wishing to keep their deposits denominated in the old currency are usually given the opportunity to do so by asking to be paid off in old currency bank notes within a short period at the official conversion rate. (The currency can be made available by the central bank or the government from the old currency notes acquired during the conversion.) In Estonia, nonresident ruble accounts were not converted; instead, they were repatriated, with a corresponding reduction in Estonia’s claims on Russia. In Ukraine, all nonresident accounts were converted into karbovanets, with Russia’s agreement.

Other old currency contracts. All financial contracts between residents that are expressed in the old currency need to be converted to new currency terms. Contracts between a resident and a nonresident in the country undergoing the conversion can remain denominated in old currency.

Disposing of old notes. Old currency notes that the central bank acquires during the conversion process may be used to repay any debts that originated and to pay those depositors—resident and nonresident—wishing to retain old currency assets. The latter needs to be done immediately after conversion to avoid giving the impression that old currency is being “dumped.” In general, people prefer the new currency, so this issue has not arisen. Remaining currency notes have usually been held by governments to be disposed of according to the agreement negotiated with the members of the former currency regime. Assurances from these countries that the real value of the currency will not be allowed to diminish pending the outcome of the negotiations can be sought, especially when inflation is very high.

What have we learned?

Prudent monetary and fiscal policies in Estonia and Latvia were the key elements of success in introducing new currencies and in bringing the average levels of inflation down to a monthly rate of one percent. Financial profligacy in Ukraine, on the other hand, resulted in raging inflation as the country’s provisional currency—the karbo- vanets—depreciated even more rapidly than the ruble. Thus, some of the states of the former USSR that introduced new currencies and adopted tight domestic financial policies escaped the monetary instability affecting some parts of the ruble area.

The recent demonetization implemented by Russia in July 1993 eliminated all pre-1993 notes of less than 10,000 rubles and separated the Russian currency from the other states of the ruble area. The move forced Azerbaijan, Georgia, and Moldova to declare their provisional currencies sole legal tender and sever their ties with the ruble area. Together with Turkmenistan, these three republics have announced that they will introduce new national currencies before the end of 1993.

The remaining countries in the ruble area signed an agreement in September 1993 to create a unified currency area. But months after the demonetization, these countries are still without access to the currency that was once their legal tender, restricting their economies to the uncertain supply of old rubles and subjecting them to the risk of increased inflation that could result from inflows of old notes from other republics. Unless an agreement is reached soon with Russia, these states may also find it expedient to issue provisional currencies to cope with these challenges.

Further information on technical aspects and a bibliography can be obtained from the authors’ IMF Working Paper WP/93/49, “Introduction of a New National Currency: Policy, Institutional, and Technical Issues,” June 1993.

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