Currency boards

A  currency board is a monetary institution that only issues currency to the extent that it is fully
backed by foreign reserves. In other words, a currency board is an extreme form of the fixed
exchange rate regime under which local currency is fully backed by the US dollar or any other
chosen currency. Its major attributes include:
1 An exchange rate that is fixed not just by policy, but by law.
2A  reserve requirement to the extent that a country’s reserves are equal to 100 percent of its
notes and coins in circulation.
3A  self-correcting balance-of-payments mechanism, where a payments deficit automatically
contracts the money supply and thus the amount of spending as well.
4No central bank under a currency board system.

Thus, in addition to promoting price stability, a currency board also compels the government to
follow a responsible fiscal policy.
The first currency board was established in Mauritius, which was then a colony of Great
Britain, in 1849. The use of currency boards eventually spread to 70 British colonies. The intro-
duction of currency board like arrangements in Hong Kong (1983), Estonia (1990), Argentina
(1991), Lithuania (1994), Bulgaria (1997), and Bosnia (1998) constitutes a small resurgence in
their use worldwide.
Characteristics of countries that are candidates for currency boards include: a small, open
economy; a desire for further close integration with a particular neighbor or trading partner; a
strong need to import momentary stability; and a well-regulated financial system. During the
Asian financial crisis of 1997–8, advocates of currency boards had pushed for their wider use –
in particular, for Indonesia, Russia, and the Ukraine. A currency board, however, is unlikely to
be successful without the solid fundamentals of adequate reserves, fiscal discipline, and a well-
supervised financial system, in addition to the rule of law.
A recent episode with the Argentine peso shows that even a currency board arrangement
cannot be completely safe from a possible collapse. The currency board structure fixed the
peso–dollar exchange rate at parity through much of the 1990s by requiring that every peso in
circulation be backed by either gold or the US dollar. Argentina’s adoption of a currency board
system in 1991 curtailed its chronic inflation dramatically and attracted a substantial amount of
foreign investment for the first few years. However, a strong dollar eventually hurt exports from
Argentina and caused a protracted economic downturn. Argentina abandoned the peso–dollar
parity in January 2002 by first devaluing the peso to Ps1.40 per dollar and then floating it com-
pletely. As shown in figure 4.1, daily peso changes have become a way of life since then.
Perhaps the most prominent form of a rigidly fixed system is dollarization, the use of the US
dollar as the official currency of the country. Several countries have adopted the US dollar as
their official currency because they have suffered currency devaluation for many years. Panama
has used the dollar as its official currency since 1907. Ecuador adopted the dollar as its official

 currency in January 2000. In January 2001, El Salvador became the third country south of the
Rio Grande to abandon its domestic currency in favor of the dollar. A country that dollarizes
removes any currency volatility, thereby eliminating the possibility of future currency crises. One
major argument against dollarization has to do with the loss of sovereignty over monetary policy.

A Successful Foreign-Exchange System

A multinational company’s access to international capital markets and its freedom to move funds
across national boundaries are subject to a variety of national constraints. These constraints are
frequently imposed to meet international monetary agreements on determining exchange rates.
Constraints may also be imposed to correct the balance-of-payments deficit or to promote
national economic goals.
A successful exchange system is necessary to stabilize the international payment system. To be
successful, an exchange system should meet three conditions:
1Balance-of-payments deficits or surpluses by individual countries should not be too large or
prolonged.
2Such deficits or surpluses should be corrected in ways that do not cause unacceptable infla-
tion or physical restrictions on trade and payments for either individual countries or the
whole world.
3 The maximum sustainable expansion of trade and other international economic activities
should be facilitated.
Theoretically, continuous balance-of-payments deficits and surpluses cannot exist around the
world. Under a system of freely flexible exchange rates, a foreign-exchange market clears itself
in the same way a competitive market for goods does. Just like every commodity price, each
exchange rate moves to a level at which demand and supply are equal. Under a system of fixed
exchange rates, central banks or other designated agencies buy and sell on the open market to
absorb surpluses and to eliminate deficiencies of foreign currencies at the fixed exchange rates.
A  foreign-exchange rate is the price of one currency expressed in terms of another currency. A
fixed exchange rate is an exchange rate that does not fluctuate or that changes within a prede-
termined band. The rate at which the currency is fixed or pegged is called the “ par value .” A
floating orflexible exchange rate is an exchange rate that fluctuates according to market forces.
Although governments do not attempt to prevent fundamental changes in the exchange rate
between their own currency and other currency, they typically attempt to maintain orderly
trading conditions in the market. A flexible exchange system has a number of advantages:
1 Countries can maintain independent monetary and fiscal policies.
2Flexible exchange rates permit a smooth adjustment to external shocks.
3 Central banks do not need to maintain large international reserves to defend a fixed exchange
rate.
Howeve r,   a flexible exchange system has several disadvantages. First, exchange rates under a pure
version of this system are highly unstable, thereby discouraging the flow of world trade and invest-
ment. Second, flexible exchange rates are inherently inflationary, because they remove the exter-
nal discipline on government economic policy.
A system of fixed exchange rates provides the stability of exchange rates, but it has some
disadvantages:
1 The stability of exchange rates may be too rigid to take care of major upheavals such as wars,
re volutions, and widespread disasters.
2 Central banks need to maintain large international reserves to defend a fixed exchange rate.
3Fixed exchange rates may result in destabilizing speculation that causes the exchange rate
to “overshoot” its natural equilibrium level. Overshoot (beyond fair value) is natural after
devaluation. For example, all three developing-country financial crises since 1980 – the Latin
American crisis of the 1980s, the Mexican peso crisis of 1994, and the Asian crisis of 1997–8
– occurred under fixed exchange rate regimes.
Four concepts – appreciation, depreciation, revaluation (upvaluation), and devaluation – are all
related to changing the value of a currency. An appreciationis a rise in the value of a currency
against other currencies under a floating-rate system. A  depreciationis a decrease in the value
of a currency against other currencies under a floating-rate system. Under a system of floating
rates, a country’s exchange rate will appreciate if it raises interest rates to attract capital. Simi-
larly, its exchange rate will “depreciate” if it reduces interest rates.
A  re valuation is an official increase in the value of a currency by the government of that cur-
rency under a fixed-rate system. A devaluation is an official reduction in the par value of a cur-
rency by the government of that currency under a fixed-rate system. Under a system of fixed
rates, a country may “devalue” its exchange rate by setting a lower intervention price at which it
will intervene in the foreign-exchange market. It may “revalue” or “upvalue” its exchange rate by
setting a higher intervention price.

The International Monetary System

On January 1, 2002, the euro (€) officially became the national currency for 300
million people in 12 countries – Austria, Belgium, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, Portugal, Spain, and the Netherlands. This move consti-
tuted a major change in the region and has resulted in many fundamental changes.
In this case, the broad changes will be discussed, and then some of the specifics of
the process will be explored by focusing on Italy’s transition from the lira to the euro.
The euro was first used by monetary authorities and businesses on January 1, 1999.
On July 1, 2002, euro coins and notes officially replaced the national coins and notes
of the 12 Euroland countries. In recent years, the euro has been associated with deeper
capital markets and increasing demands by shareholders for better corporate gover-
nance. Steps have also been taken to pool economic data and to better coordinate
banking oversight across national boundaries. And the euro has helped drive long
overdue industry consolidations, from telecommunications to airlines. Overall, the
euro has become the world’s second-largest currency in terms of gross domestic
product and has assisted in the recent trend of slow but sure market-opening liberal-
ization in Europe.
The euro has also resulted in positive daily life benefits for European citizens. For
example, when these citizens travel to other euro countries, they can more easily
compare prices, and they will not have to stop at a foreign-exchange window and
hand over a foreign-exchange commission. Consumers are already gaining from their
new ability to compare prices in one currency. In 2001, the website of the French
national railway system started quoting a single, euro-denominated price, instead of
12 different prices; the result was consumer savings of as much as 20 percent. In short,
economic life in Europe has become simpler, and this is generally good for both con-
sumers and businesses.
To help further examine the impact of the currency change, the history of the euro
in one nation, Italy, will be discussed. Like most of its European Union (EU) partners,
Italy opted to phase in the euro gradually over 2 months. The lira, which traces its
origins back to  AD 794 and Charlemagne’s libra, ran alongside the new currency from
January 2002 until the end of February 2002, before it was officially decommissioned
on March 1, 2002 (although it is still possible to exchange lira for euros at the Bank
of Italy for another 10 years).
This transition period was not easy for Italy. According to the retailers’ association
Confcommercio, only 37 percent of Italians were aware that checks must be written
in euros as of January 1, 2002, while about 80 percent believed that the lira would
continue to circulate after February 28, 2002. Furthermore, a survey conducted in July
2001 by a public think tank showed that 30 percent of Italians were still not sure what
the euro was, about 43 percent were unaware of the timetable for the changeover,
and only 21 percent knew how much a euro would actually be worth (1,936.27 lira).
Beyond these public knowledge problems, the transition was not free. It is esti-
mated that the total changeover cost approximately 5 trillion lira ($2.3 billion). Much
of this expense fell on the business sector, which carried the overall costs of training
and upgrading equipment, estimated at $934 million. Confcommercio figured that big
retailers spent some 0.3 percent of yearly sales preparing for the euro, while small
shopkeepers ended up investing as much as 2 percent of their revenues.
To  combat these problems, the Italian government took some preventive steps.
First, shops and supermarkets were required to offer euro–lira calculators at check-
out points, and special toll-free numbers were created to help customers to report
irregularities. Second, little yellow and blue euro converters were sent to every Italian
home. In the end though, after the anxieties of the first few days of the changeover
had passed, Italians decided that the gadget really was not very useful and became
comfortable with the new currency.
There were also some practical changes that came with the new currency. The
single euro is a coin and the bills are larger than the lira bills. Therefore, the biggest
Christmas present in Italy in 2001 was a euro-sized wallet. Also, vending machines,
which are ubiquitous in Italy, had to be refitted for the euro. This often resulted in
pricing changes. In one humorous example, access to the only public toilet in Voghera,
a small town in northern Italy, now costs almost twice as much as it did before the
changeover. “It is all a question of coins,” the local administrators replied. “It is too
complicated to modify the token dispenser.”
This example also illustrates the single biggest problem Italy has had with the
transition – inflation. Before the euro was implemented, prices for goods could vary
by as much as 50 percent between nations. The transition therefore resulted in price
fluctuations to correct these differences; and it was southern countries such as Italy
in particular, which are poorer than their northern neighbors, that felt the impact of
these fluctuations. Additionally, there was suspicion in Italy, as in other countries, that
prices were raised due to opportunistic rounding during the changeover. With an
official exchange rate fixed at 1,936.27 lira per euro, opportunistic round-number
readjustments were inevitable.
Therefore, the changeover to the euro resulted in inflation, especially for the small
things that people buy every day – food, coffee, and haircuts. Higher-priced items,
such as cars and computers, have held steady or even in some cases declined in price
due to increased competition across the European Union. As the economist Katinka
Barish of the Centre for European Reform noted, “You might have competition on a
Euro-wide basis for cars, but you cannot do that on things like kebabs.” For example,
prices in cafés and restaurants rose 4.3 percent in 2002 – nearly double the general
inflation rate. Importantly, this is the inflation that people notice most, resulting in a
large difference between perceived inflation and actual inflation.
Italian consumers have been particularly indignant about price increases and some
groups have led strikes in which consumers vowed to stop buying things for a day.
One consumer, Jose Elorrieta, a Milan engineer and university professor with two
young daughters, says that the price of the high-end cured ham his family buys for
Christmas nearly doubled in 2002, to 60 euros a kilogram, or about $28 a pound,
compared with 36 euros a kilogram, or $16.80 a pound, at the end of 2001. “It is
the same story with clothes, with shoes – everything has gone up brutally, and it is
almost exclusively due to the introduction of the euro,” complains Mr Elorrieta, who
says he has cut back on holiday spending as a result.
The government has taken steps to combat inflation. The prime minister’s mother
complained that pasta prices had trebled since the euro’s launch and, in response, he
took action. To combat Italy’s fast-rising prices, he called for a 3-month freeze on
electric, gas, and postal prices. Even with these initial hiccups, however, the intro-
duction of the euro should be positive for both Italy and the continent. The move to
a standardized system, cooperation, and more accountability should result in economic
growth for the region. As the examination of Italy’s process shows, the change has
not been completely smooth, but overall it has been positive.