currency board

Greg Nowell GN842 at CNSVAX.Albany.Edu
Wed Sep 9 15:11:45 PDT 1998

Hummel: Can anyone describe the mechanics of how a country would create a currency board from scratch? I have two questions in particular: How would the currency board initially acquire the foreign reserves it needs to fully back its local currency issue? Since an orthodox currency board does not lend to the banks, how do those reserves relate to the reserves of the local banks?

Nowell: If you're desperate enough and people outside *want* you to do it, they'll lend you the money. At typical interest rates that would be 5-10% per annum of the foreign currency. Such a loan could be secured--in the case of a country like Indonesia--by revenue from oil exports. (Even when the price is low, it's still valuable).

The currency board has to back its obligations with its foreign reserves. It doesn't have unlimited monetization ability like a central bank. If our Fed decides to decrease liquidity, it buys money by selling bonds. The currency board would have to sell dollars to buy rupiah. Conversely the total number of rupiah which the board would dispose of to buy dollars (increasing liquidity) would be determined (have as a maximum amount) would be set by a ratio of rupiah to dollars fixed at the time of the original loan which sets up the board. Changing this ratio would constitute a devaluation or an upward revaluation, depending on which way.

Liquidity is increased by a trade surplus, if the board issues new rupiah to increase rupiah liabilities (note issue and bank deposits) as a fixed ratio of dollar holdings. Refusal to do so would be a de facto upward revaluation (rupiah:dollar ratio decreases).

Liquidity is decreased by a trade deficit. As the number of dollar assets declines the bank must decrease its liabilities in rupiah (according to the fixed ratio). Local banks turning to the board for loans to cover deposit liabilities face increasing interest rates. This in turn forces them to increase their rates to customers or otherwise ration credit, effectively deflating the economy (decreasing demand to the point that the deficit goes away through decreased demand--or so goes the hope).

Conceptually the system is like the gold standard, with one difference, that under the gold standard both banks and the central bank have gold reserves, though historically there always was a tendency for gold reserves to migrate to the CB. Under the post-WWI restoration of the "gold standard" many of the weaker economies in Central Europe used the convertible-pound as a stand-in for gold reserves. The pound was pegged to gold, they were pegged to the pound.

Under the gold standard you can increase liquidity either by finding gold (a matter of luck, or a good Boer war) or by decreasing the reserve requirement against lending (assuming that your interest rate and eligibility requirements are such that the system is "fully loaned out" to its maximum potential). Under a currency board you have to hit upon a way to increase holdings of the reserve currency, namely, something to export.

The brilliance of the Hong Kong currency board's intervention consists in the play against speculators. By buying stock people that had borrowed on margin to short the market were forced to buy HK currency to meet their margin calls. This would have led to an increase in dollar holdings by the currency board (or its client banks).

At the same time, it reversed the declining stock portfolios which were part of bank reserves against deposit liabilities. As these values had sank HK banks had been forced to decrease lending and because speculators were shorting the HK currency (converting it) in addition to HK stocks, the currency board was running out of dough to meet reserve obligations. By prohibiting shorting on the stock market they eliminated the following transaction sequence:

borrow a stock sell it take the HK currency and convert to dollars wait for HK currency to fall (caused in part by the act of conversion) wait for stock market to fall (helped along by shorting and fall of currency) buy currency back at much lower price buy stock back at much lower price and pay off "short position"

...which had the aforementioned effect of causing bank liquidity to dry up. Buying HK dollars in an effort to outgun the speculators would have been fruitless. By contrast, bidding stock values up against short positions was a major "burn" to speculators, forcing them to come back in (buying currency and stock) in order not to get caught having to pay back that borrowed stock at an appreciated price and quite possibly in an appreciated currency.

It appears to me to be a smart move by sophisticated players, contrary to the lambasting given it by Milton Friedman in the WSJ (in the back pages). It did however make the CB owner of about 8% or perhaps more of HK publicly traded businesses. "Financier socialism."

Note that the system hinges on quantity-money theory (fixed ratios or pegs) and that to the extent that investor desire to hold the rupiah changes for reasons not related to "quantity" then the currency board can face a problem anyhow. For example, Hong Kong's CB faced a run on its currency in spite of world-wide respect for its "sound management" with regard to accounting niceties. Just as an increase in investor preference to hold gold can force a liquidity crisis (forcing banks to contract note issue and deposits to match the desired ratio of gold) an increase in investor preference for US dollars could in theory have forced the Hong Kong currency board either to spend out all of its dollar reserves OR to announce that it would no longer maintain the established ratio (devaluation).

Fortunately the CB had the brains to see that there was a smarter way to beat the speculators. But that "trick" depended on the astute connection between stock market shorting and currency shorting. It is possible for speculators to bet against a currency without also shorting in the local stock market.

Incidentally, when currency boards "hoard" dollar reserves the effect on the potential for demanding US goods and services is the same as if we had under-the-mattress hoarding of the style evoked by the GT. In a sense it's "good" that our currency paper is so valuable we can export it in lieu of goods, getting real things for paper/electronic ones, but I would have to assume there's a downside. If people are willing to give you stuff "for free," it can only depreciate domestic investment and demand.

-- Gregory P. Nowell Associate Professor Department of Political Science, Milne 100 State University of New York 135 Western Ave. Albany, New York 12222

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