FRBSF Economic Letter
1998-09 | March 20, 1998
Pacific Basin Notes. This series appears on an occasional basis. It is prepared under the auspices of the Center for Pacific Basin Monetary and Economic Studies within the FRBSF’s Economic Research Department.
In response to recent sharp devaluations in its currency, the Indonesian government recently raised the possibility of adopting a currency board. A standard currency board is a fixed exchange rate regime whose currency is fully backed by foreign reserves; that is, the government pledges to redeem its domestic currency for a foreign “hard currency” (in Indonesia’s case, United States dollars) at a fixed rate, and the full backing of outstanding currency implies that the government has the ability to fulfill this pledge.
In this Economic Letter, I examine the workings of a currency board and discuss its desirability for the Indonesian situation. While currency boards have succeeded for other nations, I argue that the characteristics of Indonesia — including its size, its trading pattern, and its history of fiscal responsibility — as well as the current problems faced by Indonesian financial markets and the nation’s reserve position, shed doubt on its potential for a successful dollar-backed currency board.
Because it is a pegged exchange rate regime, a currency board precludes a number of activities commonly associated with central banking. First, it precludes the pursuit of independent monetary policy. For example, consider the case of a nation under a currency board faced with a large capital outflow of dollars. This capital outflow may occur for completely external reasons, such as an increase in foreign interest rates. In the absence of any response by the central bank, the capital outflow would bid up the price of the domestic currency, resulting in an exchange rate depreciation. The maintenance of a fixed exchange rate requires the central bank to offset these capital outflows by selling its foreign reserves.
The standard way to accomplish this would be through a central bank open market operation. Effectively, the central bank would sell foreign reserves of equivalent amount to the capital outflow in exchange for outstanding currency. The capital outflow therefore would result in a reduction of the domestic money stock of the same magnitude and a correspondingly higher domestic interest rate. Maintenance of the exchange peg therefore precludes monetary policy independence.
Second, a currency board requires the central bank to maintain adequate foreign reserves to fulfill its obligation to redeem domestic currency. In cases in which confidence in the currency board may be in question, the backing tends to be close to or over 100 percent of anticipated central bank liabilities. For example, the Estonian currency board was launched with 90 percent backing of outstanding currency (Bennett 1993), and the Hong Kong currency board currently has reserves well in excess of the monetary base.
The extra reserve holdings can impose fiscal costs on nations maintaining a currency board. Domestic assets of developing nations typically yield higher real interest rates than do foreign reserves. The cost of maintaining a currency board would be roughly equal to the spread between interest rates on domestic and foreign assets times the face value of foreign reserves which must be held to support the currency board. These costs will result in reductions in the seigniorage revenue the central bank turns over to the treasury each year.
Finally, the maintenance of a currency board may preclude a central bank from performing as a “lender of last resort” during liquidity crises. It is commonly believed that when financial systems are illiquid (rather than actually insolvent), the central bank can forestall a crisis by moving in and providing temporary liquidity to banks by injecting funds into the system. But a central bank with a currency board may not have sufficient reserves to back both the currency and commercial bank liabilities, and thus it may not be able to perform as “lender of last resort.”
Given the costs of maintaining currency boards, one might wonder why they are relatively popular. The answer may be that they are an effective method of enhancing the credibility of a fixed exchange rate regime. For example, Connolly (1995) claims that the Argentine Convertibility Law “… clearly attempted to provide credibility by legally sanctioning a currency board system which, at least in principle, puts the central bank in a straitjacket with respect to deficit financing” (p. 641).
Central banks without currency boards often have abandoned pure fixed exchange rate regimes when faced with large capital inflows or outflows. Recall the example above concerning a central bank facing a capital outflow. To maintain its exchange rate peg, the central bank had to sell foreign assets and redeem domestic currency. The central bank could not maintain this policy indefinitely. Eventually it either would run out of reserves, or it would see its reserves fall below tolerable levels. If prices are sticky, this monetary contraction also could reduce domestic economic activity, which would enhance the desirability of abandoning an exchange rate peg. Moreover, knowing that there is some reserve level below which the exchange rate regime would be abandoned, rational investors would attack an unsustainable exchange rate peg, which would hasten its collapse.
With a fully backed currency board, however, investors would understand that the central bank would be able to redeem all outstanding currency demands without running out of foreign reserves. This is one sense in which a currency board provides a nation with an enhancement to the credibility of its exchange rate peg over a standard fixed exchange rate regime. Moreover, countries adopting currency boards typically impose legal restrictions that keep central banks from abandoning an exchange rate peg, particularly if the central bank’s purpose is to monetize a fiscal deficit.
Nevertheless, on occasion currency boards are also subject to speculative pressure, and this may have undesirable local effects, such as increases in domestic interest rates. For example, if a nation attempted to maintain an unsustainable overvalued exchange rate, it would face a complete redemption of its currency. Since the exchange rate is overvalued, these redemptions would take place at unfavorable terms to the central bank. While redemption into foreign reserves would be feasible, a country may choose instead to abandon the currency board. Investors, anticipating this potential outcome, may test the peg by attacking the currency. Alternatively, a central bank may abandon a currency board with a sustainable exchange rate peg to free reserves for other needs, for example, to back a shaky domestic financial system. Once reserves are allocated to such activities, the board is no longer fully backed and faces the same possibility of speculative attacks as standard pegged exchange rate regimes.
A fully backed currency board would be costly for Indonesia to maintain. Some have argued instead that the Indonesian currency board could be launched with less than full backing of old currency issues, as long as new issues are fully backed by foreign reserves. Advocates of an Indonesian board have stressed this possibility, pointing to the successful launching of a currency board by Argentina in 1902.
Nevertheless, if a board is launched with only partial backing, there will be little to distinguish it from a standard pegged exchange rate regime. While some legal restrictions on the behavior of the central bank may be introduced with the launching of the board, the board will not have the resources to fight off a speculative attack, and such an attack could bring the currency board down. Consequently, for a partially backed board to be successful, the rupiah must be pegged at a sustainable level.
One problem in creating such a currency board in Indonesia is the degree of uncertainty over the current “correct” value of the rupiah. Initial calls for a currency board have suggested that the exchange rate be pegged at 5,000 to the dollar, or about twice its current market value. The reasoning is that the current level of devaluation reflects the extreme set of domestic problems in Indonesia, and that an exchange rate of 5,000 to the dollar would be much closer to “purchasing power parity,” under which goods would cost the same in Indonesia as they do internationally.
If the exchange rate peg is set at a slightly undervalued level, there will be little incentive for speculators to attack the board, and in that case, partial backing may succeed. However, it is difficult to know what this level would be. If we suppose, for the sake of argument, that launching the board at 7,500 rupiah to the dollar would be a sustainable policy, then we would not expect a speculative attack at that level. However, this also would be true for a standard fixed exchange rate regime.
The additional cost of a currency board is real. Raising the additional foreign reserve holdings the Indonesian government would require to launch a currency board would place a fiscal burden on the nation. In addition, the large net foreign liabilities of the financial system are unlikely to be fully backed in any tractable Indonesian currency board. That implies that under a currency board, the central bank would not be able to act as lender of last resort in the event of a financial crisis in Indonesia; thus, the currency board restrictions on the central bank would further weaken an already fragile situation.
It has long been understood that the success of a pegged exchange rate regime requires a sustainable peg. This is also true in the case of a currency board. If the exchange rate is set at an unsustainable level, even a fully backed currency board is likely to be abandoned. The board itself, therefore, affords no immediate source of credibility. Historical experiences of other nations suggest that even currency boards with sustainable pegs suffer episodes of speculative pressure which lead to domestic interest rate fluctuations.
Currency boards have been most successful in cases such as Argentina, where the credibility of domestic fiscal policy was initially in question. The formal backing of a currency board combined with legal restrictions on the behavior of the Treasury served to assure investors that the central bank would not be able to monetize the debt. Alternatively, currency boards have worked in small emerging economies, such as Estonia and Bulgaria, where the creation of a credible fixed exchange rate regime was desirable.
Neither condition appears to apply in Indonesia. Indonesia has traditionally run relatively tight fiscal and monetary policy. The government credibility benefits that a currency board might bring therefore seem relatively unimportant. In contrast, the inability of monetary authorities to fulfill their lender of last resort duties to the troubled financial sector may imply that a currency board would raise investor concerns rather than lower them.
Moreover, as a large country with strong trade ties to other Asian nations, the wisdom of abandoning monetary policy independence and pegging to the dollar seems unclear. This is true because policy concerns arise with both pegging the exchange rate and choosing the dollar as the currency to which it pegs. However, a full discussion of these issues is distinct from the simpler issue of the desirability of a currency board as the means of maintaining a peg to the dollar.
Mark M. Spiegel
Bennett, Adam G.G. 1993. “The Operation of the Estonian Currency Board.” IMF Staff Papers 40, No. 2. (June) pp. 451-470.
Connolly, Michael B. 1995. “The Uses of a Currency Board: Argentina: April 1, 1991 to the Present.” Economic Notes 24, No. 3, pp. 639-656.
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