CURRENCY BOARDS AND “DOLLARIZATION” Developing countries with a long history of unstable exchange rates often

find it difficult to convince the public that government policy will maintain stable exchange rates in the future. This lack of credibility on the part of a government can be overcome if some sort of constraint is placed on the discretionary policy-making ability of the authorities with control over monetary and exchange rate policy. One such form of constraint is a currency board. This form became the prototype for successful exchange rate in the 1990s with the success of Argentina and Hong Kong in maintaining their currency value. However, the failure of the Argentinian currency board in 2001 led to a search for a new way to solve the credibility

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achieve a credible fixed exchange rate by holding a stock of the foreign currency equal to 100 percent of the outstanding currency supply of the nation. As a result of such foreign currency holdings, people believe that the board will always have an adequate supply of foreign currency to exchange for domestic currency at the fixed rate of exchange. Critics of currency boards point to such reserve holdings as a cost of operating a currency board. However, since the board holds largely short-term, interest-bearing securities denominated in the foreign currency rather than actual non-interest-bearing currency to back its own currency, these interest earnings tend to make currency boards profitable.

During the Asian financial crisis in 1997 to 1998, the debate over currency boards was heightened by a proposed currency board for Indonesia. The Indonesian government wanted to introduce a currency board to buy credibility for the rupiah and halt a rapid rupiah depreciation. Critics emphasized several potential problems with a currency board that eventually led to the abandonment of the Indonesian plan. Critics emphasized that a currency board can only succeed if a sustainable fixed rate of exchange between the domestic currency and the U.S. dollar is chosen. An obvious problem is what exchange rate is correct? If the exchange rate overvalues the domestic currency, then the currency board would be “attacked” by speculators exchanging domestic currency for dollars, bet- ting on a devaluation of the domestic currency. Because the currency board has a finite supply of dollars, an exchange rate fixed at unsustainable levels would eventually lead to a large loss of dollar reserves so that the currency board collapses and the exchange rate is eventually devalued. Another problem related to a currency board is that the requirement to maintain foreign currency backing for the domestic currency would con- strain the central bank from responding to a domestic financial crisis where the central bank might act as a “lender of last resort” to financial institutions. Because the central bank cannot create domestic currency to lend to domestic institutions facing a “credit crunch,” the financial crisis could potentially erupt into a national economic crisis with a serious recession.

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supervision of the domestic banking system and act as lenders of last resort to troubled banks. However, such central banks have no discretionary authority to influence the exchange rate; if they did, the public would likely doubt the government’s commitment to maintaining the fixed exchange rate.

Appendix 2A shows that there are a dozen countries with currency boards. The ECCU member countries, Djibouti and Hong Kong, use the U.S. dollar as the pegged currency for their currency boards. Three countries, Bosnia-Herzegovina, Bulgaria and Lithuania, have chosen to peg the euro using a currency board, and Brunei-Darussalam has chosen to have a currency board pegging the Singapore dollar. The choice of fixed versus floating exchange rates is often a difficult one for govern- ments. In the case of developing countries that have made a choice for fixed rates, but face a skeptical public due to past policy mistakes, a currency board may be a reasonable way to establish a credible exchange rate system. Hong Kong has had a long successful currency board that even survived the Asian financial crisis. However, the recent experience of Argentina shows that a currency board is no guarantee of success.

For a decade, Argentina maintained a currency board arrangement that supported an exchange rate of 1 peso per U.S. dollar. However, large fiscal deficits resulted in the essential insolvency of the government. At the same time that the government amassed large debts denominated in U.S. dollars, economic fundamentals were consistent with peso devaluation. The fixed exchange rate of the currency board was no longer consistent with the economic realities created by the expansionary fiscal policy, and an economic crisis erupted in late 2001 and early 2002 that resulted in a run on dollars as people tried to exchange pesos for dollars at the obviously over-valued exchange rate of 1 peso per dollar. The crisis in Argentina saw rioting in the streets, the resignations of two presidents in quick succession, a freeze on bank deposit withdrawals, and a break with the fixed exchange rate. Once the currency board arrangement was ended, the peso quickly fell in value from one-to-one parity with the U.S. dollar to a level of 3 pesos per dollar. The Argentine case serves as a

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One major advantage of a “dollarized” economy is that there is no possi- bility of speculative attacks. In addition, the inflation rate comes from the adopted currency, generally leading to lower inflation rates for the “dollarized” economy. Finally, trade between the “dollarized” economy and other countries using the target currency becomes transparent, without any need to convert currencies or prices.

However, there are some drawbacks also with “dollarization.” The central bank of a “dollarized” economy does not perform in the usual way. They do not engage in the monetary policy actions typical of central banks. The central bank of Ecuador, for example, does not have any influence over the money supply in Ecuador. This means that the central bank loses its ability to serve as a lender of last resort to troubled banks. In addition, it loses all seigniorage benefits. As the bank no longer issues currency, it cannot collect any seigniorage revenue. Even in the currency board case some seigniorage revenue exists, although it is tied to the foreign currency returns rather than domestic currency. However, in a “dollarized” economy the seigniorage return goes to the issuer of the currency rather than the “dollarized” country.

Most “dollarized” countries are small in geographic size. For example, the Republic of San Marino is a small country, with about 30,000 inhabi- tants, situated within Italy. Because of its small size and geographic posi- tion, it is not surprising that the Republic of San Marino has chosen the euro as its currency. Note that even though the Republic of San Marino uses the euro, it is not part of the European Monetary Union and cannot vote in the European Central Bank. It has adopted the euro on its own, rather than apply for admission to the euro system. Because many of the traditional “dollarized” countries are small, the success or failure of using “dollarization” as a solution for developing countries is still debated. However, recently countries such as Ecuador and El Salvador have “dollarized.” In time these countries will provide more information about the applicability of “dollarization” to major developing economies.

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have to follow the monetary policy of the key currency in order to experience the same inflation rate and keep the exchange rate fixed.

Flexible or floating exchange rates occur when the exchange rate is determined by the market forces of supply and demand. As the demand for a currency increases relative to supply, that currency will appreciate, whereas currencies in which the quantity supplied exceeds the quantity demanded will depreciate.

Economists do not all agree on the advantages and disadvantages of a floating as opposed to a pegged exchange rate system. For instance, some would argue that a major advantage of flexible rates is that each country can follow domestic macroeconomic policies independent of the policies of other countries. To maintain fixed exchange rates, countries have to share a common inflation experience, which was often a source of problems under the post World War II system of fixed exchange rates. If the dollar, which was the key currency for the system, was inflating at a rate faster than, say, Japan desired, then the lower inflation rate followed by the Japanese led to pressure for an appreciation of the yen relative to the dollar. Thus the existing pegged rate could not be maintained. Yet with flexible rates, each country can choose a desired rate of inflation and the exchange rate will adjust accordingly. Thus, if the United States chooses 8 percent inflation and Japan chooses 3 percent, there will be a steady depreciation of the dollar relative to the yen (absent any relative price movements). Given the different political environment and cultural heri- tage existing in each country, it is reasonable to expect different countries to follow different monetary policies. Floating exchange rates allow for an orderly adjustment to these differing inflation rates.

Still there are those economists who argue that the ability of each country to choose an inflation rate is an undesirable aspect of floating exchange rates. These proponents of fixed rates indicate that fixed rates are useful in providing an international discipline on the inflationary policies of countries. Fixed rates provide an anchor for countries with inflationary tendencies. By maintaining a fixed rate of exchange to the dollar (or some other currency), each country’s inflation rate is “anchored” to

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expect a currency to depreciate, they will take positions in the foreign exchange market that will cause the depreciation as a sort of self-fulfilling prophecy. But speculators should lose money when they guess wrong, so that only successful speculators will remain in the market, and the successful players serve a useful role by “evening out” swings in the exchange rate. For instance, if we expect a currency to depreciate or decrease in value next month, we could sell the currency now, which would result in

a current depreciation. This will lead to a smaller future depreciation than would occur otherwise. The speculator then spreads the exchange rate change more evenly through time and tends to even out big jumps in the exchange rate. If the speculator had bet on the future depreciation by sell- ing the currency now and the currency appreciates instead of depreciates, then the speculator loses and will eventually be eliminated from the market if such mistakes are repeated.

Research has shown that there are systematic differences between countries choosing to peg their exchange rates and those choosing floating rates. One very important characteristic is country size in terms of economic activity or GDP. Large countries tend to be more independent and less willing to subjugate domestic policies with a view toward maintaining a fixed rate of exchange with foreign currencies. Since foreign trade tends to constitute a smaller fraction of GDP the larger the country is, it is perhaps understandable that larger countries are less attuned to foreign exchange rate concerns than are smaller countries.

The openness of the economy is another important factor. By openness, we mean the degree to which the country depends on international trade. The greater the fraction of tradable (i.e., internationally tradable) goods in GDP, the more open the economy will be. A country with little or no international trade is referred to as a closed economy. As previously mentioned, openness is related to size. The more open the economy, the greater the weight of tradable goods prices in the overall national price level, and therefore the greater the impact of exchange rate changes on the national price level. To minimize such foreign-related shocks to the domestic price level, the more open economy tends to follow a pegged

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exchange rate is adjusted at short intervals to compensate for the inflation differentials.

Countries that trade largely with a single foreign country tend to peg their exchange rate to that country’s currency. For instance, since the United States accounts for the majority of Barbados trade, by pegging to the U.S. dollar, Barbados imparts to its exports and imports a degree of stability that would otherwise be missing. By maintaining a pegged rate between the Barbados dollar and the U.S. dollar, Barbados is not unlike another state of the United States as far as pricing goods and services in United States Barbados trade. Countries with diversified trading patterns will not find exchange rate pegging so desirable.

The evidence from previous studies indicates quite convincingly the systematic differences between peggers and floaters, which is summarized in Table 2.4 . But there are exceptions to these generalities because neither all peggers nor all floaters have the same characteristics. We can safely say that, in general, the larger the country is, the more likely it is to float its exchange rate; the more closed the economy is, the more likely the country will float; and so on. The point is that economic phenomena, and not just political maneuvering, ultimately influence foreign exchange rate practices.

There is also concern about how the choice of an exchange rate system affects the stability of the economy. If the domestic policy authorities seek to minimize unexpected fluctuations in the domestic price level, then they will choose an exchange rate system that best minimizes such fluctuations. For instance, the greater the foreign tradable goods price fluctuations are, the more likely there will be a float, since the floating exchange rate helps to insulate the domestic economy from foreign price disturbances. The greater the domestic money supply fluctuations are, the more likely there will be a peg, since international money flows serve as shock absorbers that reduce the domestic price impact of domestic money supply fluctuations. With a fixed exchange rate, an excess supply of domestic money will cause a capital outflow because some of this excess

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supply is eliminated via a balance of payments deficit. With floating rates, the excess supply of money is contained at home and reflected in a higher domestic price level and depreciating domestic currency. Once again, the empirical evidence supports the notion that real-world exchange rate practices are determined by such economic phenomena.

CURRENCY BOARDS AND “DOLLARIZATION” Developing countries with a long history of unstable exchange rates often