Currency boards or central banks?
executive | March 3, 2021
With Lebanon going through hyperinflation, some economists have deemed the establishment of a currency board (CB) necessary to help curb inflation. To better assess the possible establishment of a CB, and its probable effect on the Lebanese monetary situation, Executive Magazine talked to Steve Hanke, professor of Applied Economics at Johns Hopkins University and one of the world’s leading experts on hyperinflation and exchange-rate systems, particularly CBs and dollarized systems. Professor Hanke is the architect of CB systems installed in Estonia, Lithuania, Bulgaria, and Bosnia and Herzegovina between 1992 and 1998; he currently sits on the Board of Directors of the United States National Board for Education Sciences.
1) Could you please start by explaining the mechanism of a CB, as opposed to the central banking mechanism?
A currency board issues, notes, and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. As reserves, it holds low-risk, interest-bearing bonds denominated in the anchor currency and typically some gold. The reserve levels are set by law and are equal to 100 percent, or slightly more, of its monetary liabilities (notes, coins, and, if permitted, deposits). A currency board generates profits (seigniorage) [Editor’s note: seigniorage is the profit a government makes by issuing currency, for example the difference between the face value of coins and their production costs] from the difference between the interest it earns on its reserve assets and the expense of maintaining its liabilities. By design, a currency board has no discretionary monetary powers and cannot engage in the fiduciary issue of money. It has an exchange-rate policy (the exchange rate is fixed) but no monetary policy. A currency board’s operations are passive and automatic: its sole function is to exchange the domestic currency it issues for an anchor currency at a fixed rate.
Consequently, the quantity of domestic currency in circulation is determined by market forces; namely, the demand for domestic currency. A currency board cannot issue credit. It cannot act as a lender of last resort or extend credit to the banking system. Nor can it make loans to the fiscal authorities and state-owned enterprises. Consequently, such a regime imposes discipline on the economy through a hard budget constraint.
In opposition to this, central banks can engage in active monetary policy. As a result, when compared to countries that employ central banking, currency-board countries have lower fiscal deficits, lower debt-to-GDP ratios, lower inflation rates, and more rapid growth.
2) In the case of Lebanon, inflation is “imported” due to a large trade deficit. Is this situation any different from that in Bulgaria in 1997 when you helped establish a currency board? All in all, how is a CB, in your opinion, effective in situations of hyperinflation in developing countries?
I do not agree with the premise of your question. As Milton Friedman correctly told us back in 1963, inflation is always and everywhere a monetary phenomenon created by monetary policy and an overly aggressive expansion of the money supply by the central bank. That is what has happened in Lebanon. Indeed, that’s why Lebanon entered the world’s 62nd episode of hyperinflation in history in July 2020. As for Bulgaria, it was engulfed in an episode of hyperinflation in 1997. Bulgaria’s hyperinflation was much more severe than Lebanon’s. The monthly inflation rate in February 1997 was a staggering 242 percent per month. Currency boards have been totally effective in smashing hyperinflations. There have been over 70 currency boards in history, and none have failed.
3) What would be the foreign currency monetization base for Lebanon?
The logical anchor for the Lebanese pound issued by a currency board would be the US dollar, particularly since Lebanon is already highly dollarized.
4) How would the mechanism be put in place on day one of the first meeting of a CB? How would the new rate of the Lebanese pound be established?
To set the currency board’s fixed exchange rate, I suggest following the procedure that was used in Bulgaria to establish its currency board in 1997. After the announcement of the installation of a currency board for Lebanon, the Lebanese Central Bank would refrain from issuing any monetary liabilities (the monetary base would be frozen). The Lebanese pound would then be allowed to float for 30 days. After that 30-day period, a careful examination of the results of the floating exchange rate, including benchmark calculations of “a fair value” determination, would be undertaken, and the fixed rate would then be set. That’s exactly what was done in Bulgaria.
5) Lebanon has been running high deficits due to a heavy debt burden and a growing public sector. What effect, in your opinion, would it have on the Lebanese Government budgets? Could it result in the Lebanese government having to lower its expenditures?
Fixed-exchange rate regimes, like a currency board, impose a hard budget constraint. This reins in fiscal authorities, even in countries with weak institutions. Bulgaria illustrates this point. All economic indicators improved rapidly and dramatically after the currency board’s hard budget constraint was imposed. And, stability has been maintained by various types of governments in Bulgaria for over 20 years. Indeed, if we focus only on the fiscal balance, we observe a great deal of fiscal discipline and relatively small deficits. As a result, Bulgaria has the second-lowest debt-to-GDP ratio in the European Union: 18.6 percent. Estonia is the only EU country with a lower debt-to-GDP ratio: 8.4 percent.
6) Are there any new statements or research on the consequences of CBs by the World Bank, International Monetary Fund, and others?
All international organizations that assess the performance of currency boards come to the same obvious conclusion: currency boards smash inflation, establish stability, and turn banking systems from being insolvent to solvent, among other things. Allow me to present a few assessments by the IMF and OECD that have followed the installation of currency boards in Estonia, Lithuania, Bulgaria, and Bosnia and Herzegovina.
Estonia (1992): An IMF press release of March 1st 2000, remarked, “The policy of strict adherence to the currency board arrangement has served Estonia well and the currency board arrangement remains the cornerstone of the authorities’ policy framework.”
Lithuania (1994): The IMF Executive Board assessment issued on May 4th 2006, shortly after Lithuania repaid its last outstanding obligation to the IMF, observed that “directors welcomed the continued rapid growth with low inflation, and observed that Lithuania’s performance over the past five years ranks among the best within the European Union (EU). Directors attributed this impressive outcome to strong macroeconomic policies, firmly supported by the currency board arrangement that has served the economy well, the implementation of wide-ranging structural reforms, and integration with the EU.”
Bulgaria (1997): In the final review of the last Standby Arrangement Bulgaria has had, in March 2007, the IMF’s First Deputy Managing Director said, “Bulgaria is reaping the benefits of sustained sound macroeconomic policies and structural reform efforts with solid real per capita income growth, falling unemployment, and broadly moderate inflation… The authorities have maintained a firm fiscal stance that remains the central policy pillar supporting the currency board arrangement. This is reflected in the record budget surplus in 2006, which resulted from strong spending restraint and dedicated revenue collection efforts.”
The 1999 Organization for Economic Cooperation and Development (OECD) Economic Survey of Bulgaria stated, “By mid-1996, the Bulgarian banking system was devastated, with highly negative net worth and extremely low liquidity, and the government no longer had any resources to keep it afloat.” The OECD also observed, “By the beginning of 1998, [six months after the installation of its currency board], the situation in the commercial banking sector had essentially stabilized, with operating banks, on aggregate, appearing solvent and well-capitalized.”
Bosnia and Herzegovina (1997): A 2020 IMF staff report on Bosnia and Herzegovina noted that, “the banking system appears well-capitalized and liquid on average,” and that the “currency board arrangement continues to serve the economy well.”
7) Is it an authority that would be within the central bank or completely different from it? Would it entail abolishing the current central bank system or just reform it?
A currency board could be contained within the central bank as long as its accounts and operations were totally ring fenced from the rest of the central bank’s activities. That is the case in Estonia, Lithuania, Bulgaria, and Bosnia and Herzegovina. Or, it could be a totally separate operation, such as the case in Hong Kong.
8) There is ongoing criticism of Lebanon with regards to the policy of pegging the pound to the US dollar. Could you expand on the difference between a “peg” and a fixed rate?
A strictly fixed rate is a regime in which the monetary authority is aiming at only one target at a time. Fixed rates operate without exchange controls and are free-market mechanisms for balance-of-payments adjustments. With a fixed rate, there are two possibilities: either a currency board sets the exchange rate but has no monetary policy—the money supply is on autopilot—or a country is dollarized and uses a foreign currency as its own. Consequently, under a fixed-rate regime, a country’s monetary base is determined by the balance of payments, moving in a one-to-one correspondence with changes in its foreign reserves. With this free-market exchange rate mechanism, there cannot be conflicts between monetary and exchange rate policies, and balance-of-payments crises cannot rear their ugly heads. Fixed-rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance-of-payments crises.
Although pegged and fixed exchange rates appear to be similar, they represent totally different types of exchange rate regimes. Pegged-rate systems are those in which a monetary authority is aiming at more than one target at a time. They often employ exchange controls and are not free-market mechanisms for international balance-of-payments adjustments. Pegged exchange rates are inherently disequilibrium systems, lacking an automatic mechanism to produce balance-of-payments adjustments. Pegged rates require a central bank to manage both the exchange rate and monetary policies. With a pegged rate, the monetary base contains both domestic and foreign components. It is important to note that pegged rates, in fact, include a wide variety of exchange-rate arrangements, including pegged but adjustable, crawling pegs, managed floating, etc.
Unlike fixed rates, pegged rates invariably result in conflicts between monetary and exchange rate policies. For example, when capital inflows become “excessive” under a pegged system, a central bank often attempts to sterilize the ensuing increase in the foreign component of the monetary base by selling bonds, reducing the domestic component of the base. And, when outflows become “excessive,” a central bank attempts to offset the decrease in the foreign component of the base by buying bonds, increasing the domestic component of the monetary base. Balance-of-payments crises erupt as a central bank begins to offset more and more of the reduction in the foreign component of the monetary base with domestically created base money. When this occurs, it is only a matter of time before currency speculators spot the contradictions between exchange rate and monetary policies and force a devaluation, the imposition of exchange controls, or both.
9) On a practical level, how do CBs hold reserves? Current reserves requirements at the Lebanese Central Bank are a certain percentage of deposits (for example 15 percent of commercial banks deposits in dollars), how would they be affected?
If the Lebanese pound was issued by a currency board at a fixed exchange rate with the US dollar, the only way one could obtain Lebanese pounds is by exchanging an equivalent amount of US dollars for Lebanese pounds. The asset side of the currency board’s balance sheet (read: US dollar reserves) would go up by an amount exactly equal to the value of the liabilities (read: Lebanese pounds) that have been issued.
The reserve requirements for commercial banks are completely separate from the currency board’s operations. Those requirements would be handled by the central bank. They have nothing to do with the currency board’s operations but are related to commercial bank regulations.
10) There is a lack of confidence in the economic governance of Lebanon. In light of this crisis of confidence, wouldn’t the mechanism result, in your opinion, in excessive pressure should the Lebanese economy be subject to outflows of foreign currencies?
The answer is absolutely “no.” The history of currency boards is uniform and clear: once established, a huge confidence shock ensues and foreign exchange pours into the currency board country. There are no exceptions. For example, in Bulgaria, just prior to the installation of the currency board, the foreign exchange level was USD 864 million. By the end of 1998, the year after the currency board was installed, Bulgaria’s foreign reserves surged to USD 3.1 billion.
11) How does the mechanism relate, in your opinion, to the Central Bank Digital Currency the Lebanese Central Bank is considering establishing with regards to US dollars held in Lebanon and subject to capital controls (“Lollars”)? Would this currency be viable if a CB were to be established?
The currency board system would transform the Lebanese pound into a clone of the U.S. dollar and establish stability. And while stability might not be everything, everything is nothing without stability. As a result, confidence would return, and the economy’s death spiral would come to an abrupt halt. This would improve the current tenuous state of the “Lollar.”
12) Lebanon is a highly dollarized economy, with most deposits being held in US dollars pre-crisis. Would the CB allow for them to be exchanged at the board?
Again, by attracting capital inflows and restarting the economy, a currency board would improve the state of the Lollar. That is, Lollars would become more valuable and liquid after the currency board was installed than they were prior to its installation.