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What Role for Currency Boards?

John Williamson. 1995. Washington, D.C.: Institute for International Economics, Policy Analysis in International Economics Series.

A currency board is an arrangement under which a country fixes its exchange rate and maintains 100 percent backing of its money supply with foreign exchange. They were common in British colonial territories in the 19th century, but fell into disuse when colonial regimes were dismantled. In 1983, however, Hong Kong, the largest of Britain's few remaining colonies introduced a currency board. In recent years fixed exchange regimes backed by currency board type of arrangements were adopted in Argentina (1991), Estonia (1992), and Lithuania in early 1994. Since then, interest has revived in currency boards as a means of stabilizing currencies and bringing order to economic conditions generally but not without a price. John Williamson argues in this excellent monograph that although most of the recent literature have urged their adoption in many countries - most notably Mexico, Russia and Ukraine - it would be a mistake for those countries to accept such advice.

This study starts by defining what a currency board is and explaining how it differs from a central bank. This is followed by a brief sketch of the historical record of currency boards in colonial situations to the most recent experiences of the Baltic Countries. The heart of the study, however, is the analysis of the advantages and disadvantages of currency boards. Williamson agrees that this type of arrangement have certain virtues. They assure convertibility, instill macroeconomic discipline that limits budget deficits and inflation, provide a mechanism that guarantees adjustment of balance of payments deficits, and thus create confidence in a country's monetary system. However, a currency board also carries a series of important disadvantages. For example, it may be difficult for a country to gather enough foreign reserves to back the monetary base 100 percent at the outset. Also, there is a danger of fixed exchange rate quickly becoming overvalued if a currency board is introduced in an attempt to stop high inflation. Moreover, a fixed exchange rate can make adjustments more costly and painful by preventing the use of the exchange rate to facilitate the process. A currency board precludes the active use of monetary policy to stabilize the domestic economy and is unable to act as a lender of last resort when domestic financial institutions face an illiquidity crisis. Furthermore, the ability of a currency board to discipline fiscal policy is critically dependent upon the political willingness of the government to be disciplined.

Since there are both important advantages and disadvantages in adopting a currency board in place of a central bank, it is to be expected that each arrangement will be preferable under some circumstances. Williamson identifies three situations where a currency board will be superior: a) where the collapse of the local monetary authority has been so complete that only renunciation of monetary sovereignty will serve to restore it; b) where the economy is small and very open to world trade and finance, as in most cases of currency boards, so that the cost of not being able to use the exchange rate as an instrument of adjustment is unimportant; and c) where a country is determined to use a fixed exchange rate as a nominal anchor in stabilizing inflation whatever the cost.

Applying the analysis to some of the countries that have recently been urged to adopt currency boards, Williamson argues that there is little ground for urging such a step on Mexico; it is not small, the monetary crisis was limited in the sense that the demand to hold pesos did not collapse, and it would be ill-advised to resort again to using the exchange rate as a nominal anchor. The case is slightly stronger in regard to Russia and Ukraine, where a currency bard might have the benefit of inducing a quicker substitution of domestic for foreign money, but even in these cases a decision t give up the foreign exchange rate instrument would be too much of a gamble in the long run when it seems that the worst of the money crisis is over. There is little doubt that currency board arrangements are making a comeback. However, governments that operate them must accept restrictions on the way to conduct fiscal, and specifically monetary policies. The constraints mean, as pointed out by Williamson, that currency boards are not always the answer for every developing country and/or transition economy.
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Author:Cabarrouy, Evaldo A.
Publication:Comparative Economic Studies
Article Type:Book Review
Date:Mar 22, 1997
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