Hard Currency Pegs: Currency Boards and Dollarization

If a government or central bank wanted to fix its exchange rate with a foreign currency, it can do so by standing ready to exchange its domestic currency for foreign currency at the fixed rate. Usually, the exchange rate is allowed to vary within narrow limits, which is called a soft currency peg.

However, sometimes governments, especially a smaller countries ruled by leaders who do not have the economic knowledge to run a country, or who, more often than not, rule the country by force, often resort to printing money to solve fiscal problems. This always results in rampant inflation, causing the people to lose confidence in the domestic currency.

When politicians print money without regard to the needs of the economy, the money can no longer be a store of value, since its value will be inflated away. Neither can it provide a unit of account, or pricing information, since prices could change daily, or even hourly. Consequently, the local currency stops working as money — people stop using it for trade and seek other solutions. The solution to the credibility problem is to fix the exchange rate to some foreign currency that is trusted, which is referred to as the reserve currency. There are 2 general methods of fixing the exchange rate without the un-trusted central bank or government — currency boards and dollarization, where the people start using a foreign currency, which is often the United States dollar — hence, the name. Because the exchange rate is fixed and cannot be varied, using a currency board or dollarization is sometimes referred to as a hard currency peg.

While some governments desire to have a fixed exchange rate, the main purpose of currency boards and dollarization is either to restore confidence in the domestic currency or to adopt another currency that can't be manipulated by local politicians. The fact that the exchange rate is fixed is merely a consequence of how currency boards and dollarization work. If the only objective was to achieve a fixed exchange rate with a foreign currency, then the central bank can easily achieve this goal by acquiring the necessary reserves of the foreign currency and standing ready to exchange the foreign currency with the domestic currency in the desired ratio.

Whenever a country adopts fixed exchange rates, it gives up control of its own domestic monetary policy — a country cannot have an open market, and control both domestic interest rates and foreign exchange rates. A country can only control 2 of the 3; it cannot control all 3 factors simultaneously. Consequently, the macroeconomic cycles of the pegging country should follow those of the reserve country, since the central bank of the reserve country will adjust interest rates according to its own domestic monetary policy. Or the pegging country should select the currency of a major trading partner, since changes in the value of the respective currencies can have a big impact on the pegging country.

Hence, during the late 1990s, when several emerging markets in Asia pegged their currency to the United States dollar but traded mostly with Japan, their exports suffered when the dollar appreciated against the yen. Sometimes, a basket peg, which is a peg to several currencies, can better serve the needs of the country. For instance, because many of the emerging countries in Southeast Asia trade with the United States, Europe, and Japan, it makes more sense for them to have a peg to the dollar, euro, and yen, as demonstrated by the 1997 Asian crisis, where Singapore, which has a basket peg, fared better than Hong Kong, which has a dollar peg.

With either dollarization or currency boards, interest rates must be equal to the reserve currency country's prevailing rates. With dollarization, unequal interest rates would cause investments to flow into or out of the country as it seeks higher returns. With currency boards, the interest paid on currency board notes must be equal to what can be earned on the reserve currency; otherwise, arbitrage will equalize the Interest rates, as investors borrow the cheaper currency to earn the higher interest of the other currency.

Currency Board

Because an economy suffers greatly without a domestic currency, a profligate government is eventually forced to try to reestablish credibility in the domestic currency. However, promises by the government or the central bank are often not enough, because they are not trusted. A currency board helps to reestablish credibility by standing ready to exchange either the domestic currency or a newly issued currency-board note for a reserve currency in a specific ratio at any time. Furthermore, the exchange rate is enshrined in law. That the domestic currency can be converted to the foreign currency at any time prevents politicians from changing the value of the currency by printing more of it.

Generally, the reserve currency is widely available and trusted and can be acquired from the country's balance of payments. The currency board usually has to issue its own notes to distinguish it from the un-trusted domestic currency. Even with a currency board, the people often use the reserve currency, anyway, which helps to prevent a currency board from changing the exchange rate.

Without domestic assets, a currency board cannot buy government debt or lend money, including acting as a lender of last resort. Consequently, it cannot conduct monetary policy. With currency board notes, the currency board could invest its reserve currency to earn a return, since the amount of the reserve currency demanded by the public will only be a fraction of the currency board notes for the same reason that fractional reserve banking works. A surplus reserve is maintained to cover any losses from investments. Countries with currency boards will also set up lines of credit with banks in the reserve country, so that they can borrow the reserve currency when needed. Argentina, for instance, had letters of credit with U.S. banks so that dollars could be borrowed, if necessary.

The main advantage of currency boards over dollarization is that currency boards can earn interest earned on investments of the reserve currency.

Because a currency board cannot act as a lender of last resort, banks must maintain a higher reserve-to-deposit ratio so that customers can withdraw their money when they want. Consequently, the money supply contracts, which will initially cause unemployment. Eventually the economy will adjust to the lower money supply with the appropriate prices and wages, but the initial shock can cause a deflationary spiral, where people hold onto their money because it becomes more valuable in time, which causes prices to drop even further.

For a currency board to survive, it must be able to withstand a speculative attack on its currency, which it will probably be able to do if it follows the following principles:

Consequently, an orthodox currency board, which is one that follows the above principles, should not buy government debt, regulate commercial banks, or act as a lender of last resort, since such activities can endanger the peg. A currency board that maintains these key attributes will be able to withstand a speculative attack. The Argentinean currency board, which was maintained from April 1, 1991 through January 6, 2002, was not orthodox, since it violated each principal at one time or another, eventually causing a financial crisis that forced Argentina to adopt a floating exchange rate in 2002.

When a country sets up a currency board, there is a transition period between the domestic currency and the foreign currency or the currency-board notes. Prices, including wages, are changed from the domestic currency to the new currency according to the ratio established between the 2. Bank deposits are also adjusted. The central bank ceases to be an institution conducting monetary policy — its assets and liabilities are transferred either to the government or a commercial bank.

Dollarization

Dollarization generally occurs in stages. Unofficial dollarization is said to occur when the people recognize that their domestic currency is becoming worth less and less, and thus, they start using a foreign currency as a store of value, but they continue using the domestic currency to pay taxes and other bills. Semiofficial dollarization is the next stage, where both the domestic and the reserve currency are used extensively in the economy.

Official dollarization occurs when only the reserve currency is used and everything is repriced in terms of the reserve currency. The government officially recognizes the reserve currency as the official currency, eliminates the domestic currency, and, thus, eliminates the need for a central bank or other monetary authority. Consequently, like countries adopting a currency board, the officially dollarized country imports its monetary policy from the reserve currency country.

Another major drawback of dollarization is a lack of seigniorage, which is the profit that the government earns by creating money. Even currency boards can earn some profit by investing the reserve currency. Hence, the government's only revenue is from taxes.

Dollarized countries generally issue their own coins because much of the reserve currency is obtained from people receiving money from relatives in the reserve country, which is almost always in the form of paper currency, since coins have a much higher weight-to-value ratio. Indeed, statistics from the Federal Reserve show that there is more United States dollars outside of the United States than within. Hence, almost all dollarized countries issue their own coins.

Prices of most goods and services in the dollarized country will become equalized with those of the reserve country, since arbitrage will eliminate major price differences between the 2 countries. For instance, Panama has been dollarized since 1904. So if a brand of TV costs $300 in Panama but only $200 in California, then an exporter will ship TVs to Panama to earn the difference in price minus shipping costs, and will continue exporting TVs until the prices are equal. Hence, an officially dollarized country becomes part of the reserve currency zone, much as the European nations became part of the Euro zone when they adopted the euro. However, dollarization is not the same as a monetary union since the monetary needs of the dollarized country is not considered by the central bank of the reserve country nor can it use the services of the central bank, such as its discount window, where banks can borrow money as a last resort.

If the dollarized country allows full financial integration — where there are no limits on the transfer of the reserve currency, either into or out of the country, and no limitations on foreign businesses operating within the country, then dollarization helps to prevent the booms and busts of many small economies that have an independent monetary policy. Furthermore, local businesses must compete with foreign businesses, which require local businesses to be more competitive, which is better for the people, since they get better goods and services.

Even though an officially dollarized country has no central bank that can act as a lender of last resort, such services could be provided by arranging lines of credit from commercial banks of the reserve country.