Some Other Considerations

The simple model discussed in the previous section identifies three fundamental arguments that should be taken into account when a country decides about its currency regime. There are of course additional considerations that need to be discussed. Indeed, apart from the credibility benefit and the cost of being vulnerable to foreign shocks, the literature identifies a number of other costs and benefits of a currency board in comparison to an independent central bank.9

4. Transaction costs An entirely fixed exchange rate will reduce the transaction costs of international trade and investments. Transaction costs are lower since international transactions face less exchange rate uncertainty. If exchange rate uncertainty has a negative impact on trade and international investment, a currency board with a fixed exchange rate regime will lead to a better international allocation of the means of production. However, most empirical studies find hardly any support for a negative relationship between exchange rate uncertainty on the one hand and trade and investment on the other.10 This transaction costs argument applies to fixed exchange rates in general. A currency board may provide an additional credibility effect as it is a stricter rule-based system which may lead to more capital inflows. The magnitude of the transaction costs depends, of course, on the size of (future) international transactions with the pegging country. Other relevant considerations for the choice of the currency to peg to are the denomination of the pegging country's exports and imports and the denomination of its international debt. The domestic acceptance of a foreign currency may also be taken into account (Enoch and Gulde,

5. Political support Currency boards do not require sophisticated money markets and monetary policy operations to be effective (Kopcke, 1999).11 Furthermore, to make an independent central bank work requires time. Credibility has to be earned and therefore a currency board may be preferred in a situation of a severe credibility problem and/or crisis. Indeed, currency boards have often been adopted at the end of a prolonged crisis. Still, a currency board is not an easy way out. At the outset, it may be difficult to gather sufficient currency reserves to back the monetary base (Pautola and Backe,

1998). Not least, it requires broad political support (Ghosh et al., 2000). A lack of popular support may result in a self-fulfilling speculative attack (see below). Finally, the introduction of a currency board also takes time as the fixed exchange rate is established in the law and the authorities may first have to clear up a legacy of monetary, fiscal and financial failures of the past (Enoch and Gulde, 1997).

6. Lender of last resort A currency board implies that the central bank cannot (fully) act as lender of last resort. As this safety net for the financial sector is missing, a prerequisite for a currency board is a reasonably healthy financial system. The authorities should ensure that financial institutions have adequate capital, proper reserves for losses, and that they provide full disclosure of their financial accounts and have access to credit markets abroad. This is all the more important as in the past decades, except for the Eastern Caribbean Central Bank, all existing currency boards have experienced at least one banking crisis (Santiprabhob, 1997). Roubini (1999) argues that a monetary tightening when a currency board is subject to a speculative attack can bankrupt the domestic financial system and the domestic banks as tight base money means that, given required reserve ratios, banks are forced to recall loans and firms may go bankrupt.

There is, of course, another side to this coin as a currency board can be seen as a precommitment for a no-bail-out of distressed banks. In other words, it reduces the moral hazard problem of banking supervision. Especially if banking crises result from poor management and supervision, a currency board may be beneficial.

7. Misalignments A currency board runs the risk of a real misalignment. If a country's inflation remains higher than that of the pegging country, the currency can become overvalued (Pautola and Backé, 1998). While fixing the exchange rate is a fast way to disinflate an economy starting with a higher inflation rate, pegging the exchange rate will not necessarily reduce the inflation rate instantaneously to that of the pegging country. There are several reasons why inflation will not fall right away (Roubini, 1999). First, purchasing power parity does not hold exactly in the short run since domestic and foreign goods are not perfectly substitutable and the mix of goods and services in the countries concerned may differ. Second, non-tradable goods prices do not feel the same competitive pressures as tradable goods prices, thus inflation in the non-traded sector may fall only slowly. Third, as there is significant inertia in nominal wage growth, wage inflation might not fall right away. Often wage contracts are backward looking and the adjustment of wages will occur slowly. Finally, differing productivity growth rates may be reflected in differences in price increases (Samuelson-Balassa effect). If domestic inflation does not converge to the level of the pegging country, a real appreciation will occur over time. As Roubini (1999) points out, such a real exchange rate appreciation may cause a loss of competitiveness and a structural worsening of the trade balance which makes the current account deficit less sustainable.

Indeed, Rivera Batiz and Sy (2000) report that currency boards experienced substantial real effective exchange rate variability. The currencies of the Latin American and Baltic countries that introduced a currency board showed substantial appreciations. Still, this appreciation could, apart from the reasons outlined above, also be caused by real undervaluation of the currencies concerned. For instance, Richards and Tersman (1996) attribute the real appreciation of the currencies of the Baltic countries to the initial undervaluation. Also, the appreciation of the currency board countries, Estonia and Lithuania, was at the time not greater than that of Latvia. More recently, the IMF (1999) also concluded that appreciation of the Estonian kroon, the Lithuania litas and the Latvian lat was inevitable as the currencies were undervalued when the peg regimes were established. In addition, appreciation is due to the large depreciation of the Russian rouble (see also Keller, 2000).

8. Financial crises Recent financial crises have led various observers to conclude that pegged exchange rate regimes are inherently crisis prone for emerging markets and that these countries should therefore be encouraged to adopt floating exchange rate regimes (Eichengreen et al., 1998). It is often argued that those countries that were most severely affected by the recent financial crises had de jure or de facto exchange rate pegs or had otherwise severely limited the movement of their exchange rate. In contrast, emerging market economies that maintained more flexible exchange rates generally fared much better. As Mussa et al. (2000, pp. 21-2) conclude:

There is an undeniable lesson here about the difficulties and dangers of running pegged or quasi-pegged exchange rate regimes for emerging market economies with substantial involvement in global capital markets, as evidenced by the fact that only the emerging markets with the hardest pegs were able to maintain their exchange rates. . . . The likelihood of prolonged speculative attack and, indeed, of a downturn in sentiment is reduced to the extent that the credibility of the peg is high; this is most obvious in the case of a currency board.

Although it is sometimes claimed that speculative attacks cannot occur under currency boards, recent experience shows otherwise (Roubini, 1999). Still, most of the countries that introduced a currency board recently were not forced to devalue or to exit the currency board (Rivera Batiz and Sy, 2000). It therefore seems that currency boards may be better able to deal with financial crises and speculative attacks than other pegged exchange rate regimes.

9. Seigniorage The seigniorage benefits of an independent central bank and a currency board differ. It is sometimes argued that a currency board will not bring any seigniorage. This is wrong, as a currency board generates profits from the difference between the interest earned on its reserve assets and the expense of maintaining its liabilities (notes and coins in circulation). Still, although not zero, under a currency board system the seigniorage that a country can collect is limited.12 As Kopcke (1999, p. 30) puts it: '[the] principal seigniorage offered by a currency board is the option it gives to its economy to create its own central bank'.

10. Fiscal policy As a currency board cannot provide credit to the government, this could encourage sound fiscal policy making. If the fiscal authorities know that a budget deficit will not be monetized, their incentives to have large deficits will be reduced. However, that disciplining effect should not be taken for granted, especially not if a country has lacked fiscal discipline in the past (Pautola and Backe, 1998). Indeed, Roubini (1999) argues that the choice of the exchange rate regime does not determine inflation or fiscal deficits. On the contrary, the choice of the exchange rate regime might be determined by the fiscal needs of the country. In other words, like a healthy financial system, sound public finances may be considered as a prerequisite for the successful operation of a currency board (Kopcke, 1999).

A similar case of possible reversed causality exists regarding central bank independence. On the one hand, it has been argued that CBI may enhance sound fiscal policies. On the other hand, causality may also run the other way, that is, a country will grant its central bank an independent status only if the fiscal need for seigniorage is low (Roubini, 1999). There is, however, only weak evidence suggesting that CBI and fiscal policy outcomes are correlated. Sikken and de Haan (1998), using data for 30 less-developed countries over the 1950-94 period, report for instance that some proxies for CBI are significantly related to central bank credit to government but that CBI is not related to budget deficits (see Eijffinger and de Haan, 1996 for a further discussion).

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