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ECONOMIC POLICY 48: Level pegging: Stabilizing value through currency boards The problem: how to hold firm Stable money is a pre-requisite for a thriving, free market economy, so how does a small developing country maintain the value of its currency? And how does a country whose economy was previously controlled by rigid soviet-style planning authorities establish a monetary system which commands the respect of foreign investors? The idea: find an anchor Currency boards can act as means of providing a stable monetary system, particularly for countries that have experienced bad inflation records. A currency board fixes the value of a nation's currency at a specific and fixed rate to that of another stronger currency (often its main trading partner, or the US dollar). Thus, in effect, when a country establishes a currency board it imports the (more stable) monetary policy of the other country. Autonomous monetary policy is abandoned, which may prove a blessing for citizens who have had to endure long years of inflationary mismanagement. Results: going by the board Currency boards were used by several countries prior to the Second World War. The definitive model was established in 1912 by the West African currency board, which pegged the currencies of Gambia, Nigeria, Sierra Leone and the Gold Coast (now Ghana) to the pound sterling. Currency boards are still being employed, typically by small countries such as Singapore, Hong Kong, Brunei, the Cayman Islands and Gibraltar. Over the years, some countries have switched from pegging the UK£ to the US$. For example, in Hong Kong, the currency board began pegging the US$ in 1983, although it had pegged to the UK£ until 1972. Some counties find that the economic stability created by a currency board is strong enough to allow them, eventually, to break free of this self-imposed restriction, and begin to manage their own monetary policy from a solid foundation. Thus since 1973, the Singapore dollar has floated against the US $ to which it was previously pegged at a fixed rate. In Argentina, President Menem established a one-to-one currency convertability with the US$ in April 1991. This currency peg prohibited the government form printing new pesos unless they were backed by US$ or gold reserves in the central bank. While it lasted, this policy was highly successful. Argentine inflation had reached the huge rate of 4,924 per cent in 1989 and 1,344 per cent in 1990. After pegging to the dollar, it crashed precipitously to 8 per cent in 1991, then down and down until it reached only 0.9 per cent in 1998. But then prices started to fall in real terms - deflation - and it became clear that the government's overspending and debt were still unsustainably high and Argentina entered an economic and political crisis. It was not just that pegging to the dollar was unsustainable for an economy in such rough shape as Argentina. Other troubled South American countries were devaluing to keep themselves competitive, making it harder for Argentine exporters to trade with them. For this reason, Domingo Cavallo, the former finance minister of Argentina, argued that each of the Latin American countries in Mercosur should be linked through a system of currency boards. Once those currency boards become credible, he proposed that Mercosur nations should adopt a common currency, which again would be linked to the US$ as an anchor currency via a currency board. Assessment: a counter-inflationary force Currency boards are one of three main options for countries seeking to underpin a free market economy - the other two being a freely floating exchange rate or pegged exchange rates with capital controls. Currency boards have provided a counter-inflationary anchor which enables governments of smaller countries, or of countries unable to establish autonomous domestic financial regulatory institutions, to establish a clear and overriding exchange-rate regime. In recent years a number of eminent economists, including Sir Alan Walters and Professor Steve Hanke of Johns Hopkins University, have advocated the merits of currency boards in various situations. Hanke urged the creation of one in Russia, where other options aimed at maintaining the value of the currency have floundered. He also recommended a currency board for the government of Indonesia, but attempts to establish one in Spring 1998 failed to gain IMF support. Shortly afterwards, the currency collapsed and the country fell into political and economic chaos. Sir Alan Walters observes that currency boards tend to depoliticize the monetary system, since they protect the public purse from plundering politicians who are often tempted to embark on large inflationary public expenditure programmes in response to pressing political and social problems. Yet even currency boards are no panacea: at times of crisis, as demonstrated by recent experience in Argentina and Hong Kong. Argentina demonstrates that pressure on a currency builds up whenever governments are determined to overspend and ignore the principles of sound economic management. Where rates are floating, there is no institutional barrier against such mismanagement, and the currency goes into a slow slide - which of course may bring its own problems. By contrast, a currency board forms a strong institutional a barrier against such mismanagement. To some extent the government's credibility rests on it being able to deliver on the exchange-rate promise, so there are good reasons not to risk it. But if economic mismanagement or incompetence still occurs, the same exchange-rate pressure can build up unseen until, eventually, the
fixed exchange rate can no longer be supported, and shears violently.. When competing neighbour countries deliberately devalue their currency in order to sell more goods abroad, a small economy employing a currency board can become uncompetitive, since its own experts look expensive - at least in the short term, for as long as the neighbours can sustain their devaluation. Unless productivity can be improved, a recession may result, with people having to accept falling nominal wages or lose their jobs. In such circumstances, currency boards may become politically unsustainable. And ultimately, the credibility of currency boards rests on how confident people are that the board will honour its exchange obligations at a specific and fixed parity, and how robust it can and will be at resisting the political pressures to do otherwise. For further information:
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