Mr. Sigitas Siaudinis is Head of the Monetary Policy Division of the Bank of Lithuania, Ph.D. He has studied the operation of the world’s currency board arrangements and has defended a doctoral dissertation on this topic at Vilnius University. Ten years ago Mr. Siaudinis was among the many opponents of the currency board system but later changed his opinion.
[*] The author’s fields of activity: implementation of monetary policy and money market. The author’s views expressed in the article do not necessarily represent those of the Bank of Lithuania.
“Lithuania’s currency board is entering its tenth anniversary at a time when the country’s economy has shown a robust growth for several years now. The country also meets all of the Maastricht criteria applied to EU member-states that wish to join the euro area. Most Lithuanian and foreign experts as well as the society uphold Lithuania’s goal and possibilities to retain the present exchange rate of the litas and the currency board both when Lithuania joins the Exchange Rate Mechanism II (ERM II) (the interim phase required by the European Union to assess a country’s readiness for membership of the euro area) and participates in ERM II until membership of the European Monetary Union. However, currency boards in Lithuania and elsewhere have not always enjoyed such friendly attitudes. In fact, these attitudes have changed significantly over the past ten years.
Lithuania adopted a currency board in the last decade of the past century, during this model’s Renaissance. Three years earlier (in 1991) a currency board arrangement was installed in Argentina. In 1992 Estonia launched one, and in the third year of Lithuania’s currency board, this model was implemented in Bulgaria and Bosnia.
At that time the opinion among the academics and monetary policy executives prevailed that a currency board was a suitable mechanism for quickly stabilising the currency of a developing country and gaining confidence in it (the latter motive prevailed when a currency board was being implemented in Lithuania, where hyperinflation had been overcome before the currency board was introduced). Many thought that currency boards would not be stable regimes because the economy had a limited degree of flexibility, as the common view was, in reacting to stronger external shocks, the authorities lacked determination to enhance this flexibility by pursuing structural reforms and commitment to rigid fiscal policy and because there was a growing likelihood of a liquidity crisis in a naturally developing financial sector. Therefore, a currency board could be just a temporary “shield” in active preparations for a more flexible monetary policy or for joining a suitable monetary union (if such existed), while a sudden collapse would have been very painful (for more see R. Kopcke (1999)).
During the first years after the adoption of a currency board in Lithuania, the country’s membership of the European Union, not to mention the then springing European Monetary Union, looked distant and uncertain. For many, the revival of our economy seemed too slow, and the young financial system experienced quite a few bank failures and a systemic crisis at the end of 1995. In such circumstances the new ruling rightist majority (the autumn of 1996), supported by many prominent Lithuanian economists (including central bank economists), adopted a plan for a gradual exit from the currency board arrangement. This plan was spelled out in “Monetary Policy Programme of the Bank of Lithuania for 1997-1999.” As markets predicted depreciation of the litas, interest rates remained high until 2001 although the average annual inflation rate fell to a one-digit figure in 1997 and has stood below 2 percent since 1999.
Ironically, when the Russian crisis severely injured the Lithuanian economy in 1999, the plans to abandon the currency board, which until then had been considered an inflexible regime that impeded proper reaction to changing economic conditions, were postponed. At that time the official obligation to retain the currency board arrangement for some time and to tighten up fiscal policy, which the government of Lithuania assumed towards IMF while negotiating the renewal of the Stabilization Programme, made it possible to avoid insolvency with the help of foreign loans drawn in 1999. (The agreement with IMF was formally signed in March 2000, i.e. after the critical period for government finances had been overcome).
When the second-generation currency boards proved their vitality and collected longer time series of economic data, prominent experts announced research studies showing the effectiveness of currency boards as long-term strategies (A. Ghosh (1998); A. Gulde (2000); L. Batiz (2000)). Following international discussions in 1998 and 1999, EU institutions officially announced in 2000 that a country with a currency board arrangement would be able to join ERM II and prepare for membership of the euro area (the ECB president declared this position in April 2000; the European Council announced special statement in Nice, December 2000). At the same time EU authorities emphasized that a currency board would be a unilateral commitment on the part of its home country to comply with a stricter regime than required by ERM II. Country’s possibility to maintain a fixed exchange rate and a currency board was to be considered individually in accordance with general procedures of multilateral negotiations by evaluating this model’s stability and suitability for the country’s convergence with the economic nucleus of the euro area.
Three out of the four best known and currently functioning currency boards are in countries seeking membership of the European Union and the euro area. These are Bulgaria, Estonia and Lithuania. These countries are planning to preserve their currency board arrangements until they join the euro area.
Lithuania’s clear aspiration to join this monetary union, the expected not too distant accession into the union, a competitive economy, fiscal discipline, a fairly healthy and undeveloped banking system (the low risk of a liquidity crisis in the case of the contraction of money demand), an objectively small internal financial market (the little space for speculative attacks), obligations towards EU institutions to proceed with structural reforms in order to increase the economy’s flexibility – a combination of all these factors have markedly increased confidence in the country’s currency board system so that even conceptual critics of this exchange rate regime have recognized its success.
The level of real income (GDP in PPP per capita) and prices in Lithuania are slowly converging towards the richer EU countries but now it constitutes only 40 to 50 percent of the euro area average. Therefore, despite a long period of higher inflation, the real exchange rate of the litas remains considerably undervalued. In terms of the exchange rate, Lithuania has a long way to go to a long-term equilibrium towards which it is gradually converging. However, Lithuania does not stand out in the trajectory of the current and acceding EU member-states in terms of the real income and price level.
Under such circumstances it would be difficult to prove that a different exchange rate regime would be better and negative consequences of its replacement would be too obvious. The opponents of the currency board in Lithuania did not offer any convincing alternative exchange rate mechanism. They did not dispel the doubts regarding its transparency either.
Hong Kong’s currency board has faced much bigger challenges than the future EU member-states. In the light of accelerating integration with the Chinese economy, whose price level is several times lower than that in Hong Kong, Hong Kong’s economy has experienced a prolonged deflationary downturn. At the same time plans of a monetary union are not being contemplated due to the existing enormous economic differences and limited convertibility of the Chinese currency. Nevertheless, both Chinese and Hong Kong authorities as well as prominent economists are of the opinion that it would be most beneficial to maintain the present exchange rate regime and to achieve more flexibility of the real economy.
The differences between the instruments of day-by-day implementation of a currency boards and the Eurosystem’s monetary policy (i.e. differences in their operational frameworks) are obvious. They have been frequently emphasized by the opponents of the currency board. However, the trends of liquidity management of the banking system in the euro area show that this is not going to be a serious obstacle for countries with currency boards.
Since the monetary union came into being, large banks in the euro area have extended their liquidity management to the international euro market and have increasingly centralized management of their financial group’s treasury. Small and medium-sized banks, like those in Lithuania, have increasingly orientated their activities towards the domestic market and in most cases managed their liquidity through transactions with the aforesaid international banks. The number of credit institutions directly participating in the monetary policy operations of the euro system and competing on the international scale has decreased to 4 or 5 percent of potential participants (institutions which are subject to the minimum reserve requirements applied by the ECB). So the interbank euro market is becoming increasingly important in redistributing bank reserves in the euro area not only domestically but also on the international scale. A currency board mechanism provides natural incentives for domestic banks to actively operate in this market in managing their liquidity.
When modern-day currency boards were being implemented, they were compared with their successful predecessors, the first generation (orthodox) currency boards which functioned in more than 70 colonies from the middle of the 19th century until the first half of the 20th century. The advocates and opponents of the currency board use the differences between these generations to support their arguments. The advocates of the orthodox model reproachfully note that the institutions implementing modern-day currency boards (usually central banks) have maintained some additional monetary policy instruments and the functions of banking supervision and a lender of last resort, and that they can thus distort self-regulation of the money supply and injure the long-term macroeconomic stability. The opponents contrarily emphasize that currency boards functioning in the modern financial markets should be more flexible as they are not flexible enough. Most advocates and opponents agree that modern-day models are not pure currency boards but rather quasi-substitutes.
Publications analyzing the peculiarities of currency boards and justifying this arrangement appeared at the close of the last decade of twentieth century (C. Ho (2000). However, this topic was not yet profoundly analysed, most likely because the second-generation currency boards also ensure self-regulation of money supply. So the main question revolved around the choice between a currency board and more flexible exchange rate regimes.
It would be difficult to prove that the collapse of the currency board in Argentina (in 2001) was caused by its deviations from the orthodox standard rather than by fundamental factors, such as the appreciation of the anchor currency against the main trade partners, many years of wasteful fiscal policy, inflexible labour market, monopolized economy and inability to tighten up economic policies in the face of a crisis.
Still, a closer look at the circumstances under which modern-day currency boards are functioning and at their general features distinguishing them both from the orthodox model and other fixed exchange rate regimes of today makes it possible to avoid many disputes.
Orthodox currency boards were a handy mechanism for colonies in transforming the currency of the metropolis for local use. The central bank of the metropolis performed the functions of banking supervision and a lender of last resort to the banks whose branches composed the banking systems in the colonies.
The modern-day currency boards are in most cases chosen by independent states. These models are also based on self-regulation of money supply, but they bear more responsibility than their predecessors for preserving the stability of the banking system. They are also operating under conditions of much more sophisticated financial markets and more mobile capital movements. In addition to the features of the orthodox model (free capital movements, a fixed exchange rate established by law and automatic buying and selling of the anchor currency), they have the following peculiarities:
1. The legal requirements of backing the national currency with the anchor currency reserves are less strict: the requirement is to back only part of the central bank’s liabilities (the money base, as in Argentina), liabilities in national currency (Estonia and Lithuania) with general and not net international reserves. Such milder requirements were determined by the established backing of the central bank’s liabilities before the currency board was introduced and a wish to maintain the function of a lender of last resort in the case of systemic banking crises whose likelihood was particularly high at the beginning of financial stabilization. The qualitative change in adopting currency boards was not in complete backing but in a switch to automatic money supply tied to the dynamics of the balance of payments. It should be noted that reinvesting part of the profit earned with foreign assets allowed many of the long-standing currency boards (including those in Estonia, Hong Kong and Lithuania) to reach the orthodox standard – an excess of the central bank’s net foreign reserves over all of its domestic liabilities.
2. The operating of first-generation currency boards was usually limited to the exchange of notes and coins. Currency boards functioning in the modern financial markets implement a faster and cheaper way for self-regulation of money supply. Exchange in non-cash form prevails. The main counterparties of the central banks as well as in the cases of the other modern exchange rate regimes are local banks which effectively indicate the net money demand of the economy. Not accidentally central banks organize the systems of interbank settlements and integrate them closely with the mechanism of the money supply self-regulation. The central banks in Bulgaria and Lithuania also directly exchange currency for government institutions. This frequently causes additional liquidity fluctuations in the banking system and “switches on” the self-regulating mechanism –exchange transactions between banks and the central bank.
3. By using additional monetary policy instruments, central banks implementing modern-day currency boards aim to maintain a buffer of the banking system’s liquidity which banks are required to form without borrowing from the central bank and which makes the self-regulating mechanism more stable in periods of short-term fluctuations in money demand. The central banks in Bulgaria, Estonia and Lithuania apply minimum reserve requirements in this case, whereas the Hong Kong monetary authority forms an analogous buffer by issuing its debt securities among the banks. Previously the central banks in Estonia (from 1993 until 2000) and Lithuania (from 1997 until 2000) also conducted open-market operations to smooth liquidity fluctuations in the banking system. These disputable operations were forgone after banks had developed possibilities of liquidity management in domestic and international markets.
4. Comparison of modern-day currency boards with other fixed exchange rate regimes shows that actual backing is not a universal distinctive feature. In the last decade before membership of the euro area, the orthodox backing total domestic liabilities of the Austrian central bank was positive and bigger not only than that in Lithuania, but also than the Estonian backing in recent years. The analogous coverage in the Netherlands (prior to the monetary union) and in Latvia (at the present moment) is below 100 percent but exceeds the Bulgarian level. The most essential difference in these exchange rate regimes is reflected in the monetary policy instruments that the central banks regularly apply. Currency boards are traditionally based on self-regulation of money supply (on buying and selling of the anchor currency as initiated by commercial banks). Under other fixed exchange rate arrangements central banks seek equilibrium first of all with the help of open-market operations designed to maintain a level of interest rates on the money market corresponding to a fixed exchange rate. They carry out currency interventions in the second “defence echelon” of the exchange rate, but at the same time they tolerate bigger exchange rate fluctuations in the market around the official fixed exchange rate than currency boards do.
In generalising the peculiarities of the second-generation currency boards, we can say that these peculiarities stem from the aim to ensure the self-regulating mechanism of money supply in the environment of modern financial markets. For this reason the modern-day currency boards should not be labelled with a prefix “quasi.”
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