The Efficiency of the Currency board arrangement

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The Efciency o the Currency Board Arrangement 157

Nikola Fabris *

Gojko Rodi**

The Efciency o the CurrencyBoard Arrangement

Abstract: Te currency board arrangement has a relatively long his-tory and it originated in the British colonies. In the period aer theWorld War II, the interest in this arrangement died down, but it wasrevived with the initiation o the transition process in Eastern Eu-rope, when the number o countries in this arrangement increased.

Te currency board arrangement has an inuence on ast disina-tion, but there is a dilemma about its perormance in relatively sta-ble conditions. Te purpose o this paper is to make the comparisono selected perormance (ination and the current account decit)o countries under the currency board arrangement with countriesusing other exchange rate arrangements, relying on the example oEuropean economies in transition.

Tis paper conrms assumptions o the theory that countries un-der the oating exchange rate arrangement have the lowest cur-rent account decits (measured as a percentage o GDP), while thecountries under the currency board arrangement have signicantlyhigher decits. Contrary to expectations, it turned out that the rateo ination is lower in countries under the oating exchange ratearrangement when compared to other countries under the currencyboard arrangement, which indicates a lower efciency o this ar-rangement in a stable environment.

Key words: the currency board, ination, the current account decit.

Jel code: F31 and F32

* Te Chief Economist,Central Bank of

Montenegro andProfessor, Faculty of

Economics University of

Belgrade

Email:[email protected]

** Slobomir P University,Bijeljina.

Email:[email protected]

Journal of Central Banking Theory and Practice, 2013, 3, pp. 157-176

Received: 2 November 2012; accepted: 4 December 2012.

UDC: 336.748.12


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Journal o Central Banking Theory and Practice158

1. Introduction

Currency board is an institution which issues domestic currency with the ullcoverage o oreign currency (monetary gold and securities) based in xed ex-change rate (Dimtrijevi and Fabris, 2010). It is based on a practical metalismtheory and its goal is to increase the credibility o monetary reorm, especially inunderdeveloped monetary systems or aer hyperination.

Currency board is usually introduced in small, highly open countries1, whoseeconomies have aced macroeconomic instability in recent past. Te key qualityo currency board is that it guarantees the convertibility o local currency, price

and monetary stability, while promoting oreign trade with convertible oreignexchange areas. (Bogeti, 1997) In addition to that quality, the strengthening oscal discipline and the inability to monetize the budget decit is also attributedto the currency board. In act, strict prohibition o lending to government im-poses the policy o a balanced budget on the scal authorities.

Currency boards are, by denition, passive monetary institutions whose operat-ing is primarily based on automatism, unlike the standard central banks thathave a large dose o discretion. Tis nature o currency board gives rise to di-erent reactions o experts. While some authors consider this eature the mainadvantage o currency board (Hanke and Schuler, 1994, Bogetic 1997), other au-thors, however, consider the inability o conducting an active monetary policyas the main disadvantage o a currency board and the reason or its cancelling(Roubini, 1998). According to them, the passive role o currency board leaves theeconomy at the mercy o market whims. I there is a reduction in money supplycaused by, or example, a growing trade decit, the contraction o economic cy-cle and job losses appear. In this case, there is no way or a decline o reserves inthe banking system to be compensated by issuing o money by a central bank tobanks and the economy. able 1 shows the dierences between the basic charac-

teristics o an orthodox2 currency board system in relation to the central bank.

1 Te exception is Argentina which already had a currency board between 1991 and 2001.2 In orthodox currency board systems, there is no way to conduct an independent monetary

policy, i.e. institutions whose sole purpose is to change money on demand at a xed exchange

rate and to hold at least 100% o reserves o oreign assets relative to the money in circulation,are very rarely seen today. Most o nowadays currency boards have a greater or a lesser degreeo reedom in the use o certain monetary policy instruments (currency board alike).


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Table 1: A typical currency board versus a typical central bank

CURRENCY BOARD CENTRAL BANK

1. Usually supplies notes and coins only Supplies notes, coins, and deposits

2. Fixed exchange rate with reserve currency Pegged or oating exchange rate

3. Foreign reserves o 100 percent Variable oreign reserves

4. Full convertibility Limited convertibility

5. Rule-bound monetary policy Discretionary monetary policy

6. Not a lender o last resort Lender o last resort

7. Does not regulate commercial banks Oten regulates commercial banks

8. Transparent Opaque

9. Protected rom political pressure Politicized10. High credibility Low credibility

11. Earns seigniorage only rom interest Earns seigniorage rom interest and ination

12. Cannot create ination Can create ination

13.Cannot nance spending by domestic

governmentCan nance spending by domestic government

14.Requires no "preconditions" or monetary

reormRequires "preconditions" or monetary reorm

15. Rapid monetary reorm Slow monetary reorm

16. Small staf Large staf

Source: Hanke and Schuler (1994)

Aer detailed examination o able 1, it is evident that orthodox currency boardsystem is a theoretical concept rather than an active monetary institution. Nowa-days, we are more concerned with a partial currency board (currency board alike).Hanke and Schuler here imply a currency board that retains a greater or a lessernumber o monetary policy instruments.3

Te second part o the paper analyzes the history o currency board, with partic-ular emphasis on European economies in transition, and makes a comparison oactual perormance in the period beore the introduction o the currency boardand in a certain number o years aer the introduction o the currency board.Te third section analyzes the efciency o the currency board in relatively stableconditions, and compares the past ve-year movement o ination and currentaccount decit in countries that use the currency board arrangement with thatin other countries.

3

Tus, or example, Bosnia and Herzegovina has the ability to impose mandatory reserve tocommercial banks, while other currency boards in Europe have the unction o lender o lastresort, however, they are limited to the amount o surplus o the reserve currency.


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2. The Currency Board History

Te currency board is not a new concept. In international practice, it rst ap-peared in 1849 in the island o Mauritius. However, the theoretical basis or thecreation o currency board can be traced in the so-called Currency Schoolthatdominated in the UK in the rst hal o the nineteenth century. (Schuller, 1992)In act, we can say that currency boards draw their intellectual roots rom theconcept o the gold standard. British currency economists that were gatheredaround the Currency School advocated that excessive printing o money is themain cause o ination. Consequently, they believed that the issuer o moneyshould keep the equivalent amount o gold that should serve as the regulator o

the money supply in the market. As a result o impact o the currency school, in1844, the Bank o England gained a ormal monopoly on printing money and theobligation o holding gold reserves which correspond to the amount o money incirculation. Te golden base o a pound provided the stability basis or the nextninety years4 because the government aced an obstacle o printing additionalquantities o money that had no oundation in gold.

I we observe the history o the currency board, we can notice three character-istic periods. Te rst period lasted or a hundred years (mid-19th mid-20thcentury). During this period, currency board became an extremely popular wayo conducting monetary policy. During the previously mentioned period, somecountries - mostly British colonies - tied their currencies to the pound, ocusingon dierent goals.5 Te rst truly orthodox currency board was created in 1913 inWestern Arica as the West Arican Currency Board. Tere were two motives orits establishment; there was a desire or stability while simultaneously achievingcurrency seigniorage, which in the currency board represents the dierence be-tween the interest on the reserve currency and the costs o the release o domesticcurrency (Schuler, 1992). Aer that, many British territories decided to establishcurrency boards, such as the Eastern Arican currency board, the Central Ari-can currency board, the Middle East currency boards in Palestine, Jordan, Iraq,and so on. Currency boards were thriving during the period aer World War IIand remained popular until the 1950s.

4 Up to 1913 and the abandonment o the golden standard.5 Tus, or example, Mauritius introduced a currency board in 1849 as a response to the col-

lapse o banks, while in the ollowing year New Zealand, with the introduction o the currency

board, intended to use the so-called Currency School doctrine postulates, which advocated thegovernment monopoly on issuing money as opposed to the prevailing Free Banking doctrine atthe time.


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In the period rom 1950s to early 1990s, the interest in monetary arrangementsconsiderably diminished. Te reasons or the disappearance o currency boards6

were maniold, but they can be summarized as ollows (Schuler, 1992): Keynesian doctrine o the time emphasized the positive role o govern-

ment in creating economic trends during which the creation o a centralbank was set as the priority;

Given the act that currency boards were usually established on territoriesunder a direct or an indirect dominance o the United Kingdom, the desireor an independent central bank imposed as one o the key aspects o thenewly acquired independence and the separation rom the colonial past;

During the validity o the Bretton Woods xed exchange rate system, theBritish pound proved to be quite unstable7, and thus the currency boardsthat were tied to the pound8 lost their credibility and gave the reason orthe government to abandon them in avour o central bank.

Te third period or, as it is called, the renaissance o the CBA institution (Bo-getic, 1997) appeared in early 1990s. During this period, Argentina (1991-2001),Estonia (1992), Lithuania (1994), Bulgaria (1997) and Bosnia and Herzegovina(1997) adopted currency boards. Te next section will urther describe the crea-tion and operation o currency boards in Estonia, Lithuania, Bulgaria and Bosnia

and Herzegovina.

2.1. The history o currency boards in European economies in transition9

Tis section will show the emergence o currency boards in Estonia, Lithuania,Bulgaria and Bosnia and Herzegovina. It will explain the reasons or their in-troduction and show the achieved results in terms o GDP growth and inationcurbing in the period aer their introduction. As a source o data we used the

2007 World Economic Outlook Database.

Estonia was the rst country in the ormer Soviet Union to introduce its owncurrency and the rst European country which decided to introduce the cur-

6 During this period, currency boards were kept only in a small number o island countries likeSingapore, Hong Kong and the Falkland Islands.

7 In the period rom 1940 to1967, the British pound was devalued several times and, rom theinitial level o $4.03 it got to the level o $ 2.40 or a British pound.

8 A large percentage o currency boards used the pound as their reserve currency.9 In this chapter, the subject o observation is macroeconomic variables beore the introduction

o the currency board and a ew years aer their introduction.


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rency board in the second hal o the twentieth century.10 Te reasons or thiswere numerous: the elimination o inationary pressures that have emerged due

to the liberalization o prices aer the transition to a market economy, establish-ment o a macroeconomic supply and demand balance and, eventually, solvingthe problem o chronic shortages o cash. (Vensel, Sorg, 2002)

Aer gaining independence in 1991, Estonia was determined to carry out a rapidmonetary reorm. Tis decision was urther encouraged by a very bad situationthat was caused by the loss o the main part o the CIS export market.11 Despite

conicting opinions about the ways themonetary reorm is implemented12, thenewly elected Governor Kallas was ableto impose a currency board arrange-ment, with the help o representativeso the IMF, which would in the shortestpossible time provide a much-neededmonetary stability as a necessary re-quirement or uture reorms. (Knobl,Sutt, Zavoico, 2002)

How important it was to establish con-

trol over the rising ination caused byprice liberalization aer the establish-ment o independence, can best be seenat Figure 1 which shows a continuousdecline in ination aer the introduc-tion o the currency board.13

10 In Europe, currency boards have existed beore the Second World War. In 1918/19, , during the

struggle o the Bolsheviks and the imperial supporters, and according to the recommendationo John Maynard Keynes, the currency board was introduced in North Russia and providedstability o the currency at the time o the greatest turmoil and enormous ination o the Rou-ble in the rest o the Russia. Also, in 1923, a currency board was introduced in the ree city oDanzig, which maintained stability o the currency even though the highest hyperination inthe history raged in the neighbouring Germany. For more inormation, see (Schuler, 1992)

11 Over 90% o sales in 1991 were conducted with the Commonwealth o Independent States.12 One o the ideas which the Estonian government came up with immediately aer gaining in-

dependence was the introduction o vouchers, which would have equal value to the Rouble andincrease the amount o money in circulation, and also avoid - at least at that moment - the ques-tion o determining the exchange rate arrangement.

13 In truth, it should be recognized that the level o ination - annually - was in double digits until1998 (1994 - 47.6%, 1995 - 29%, 1996 - 23% 1997 - 11.1% 1998 - 8.2%). Source: CIA World Factbook

Figure 1: GDP and Ination in Estonia

(1994-2006)

Note: Infation right-hand scale; GDP let-

hand scale.

Source: Authors calculation based on the

World Economic Outlook data


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Disination was the cornerstone or the uture growth o the economy. De-spite the two crises in Estonia during the 1990s14, it can be noticed that Estonia

achieved high growth rates during the years beore the outbreak o the globalnancial crisis.15

However, it is important to note that the currency board arrangement - in and oitsel - cannot provide the basis or such growth i many other conditions havenot been met. As ar as Estonia is concerned, these conditions represent the max-imum commitment to maintaining a balanced budget, the closing o insolventbanks, and an ongoing commitment to maintaining the currency board regard-less o the crises that have occurred periodically.16

Te currency board in Lithuania was established on 1April 1994 as a result o acompromise between the government and the Central Bank o Lithuania (Alon-so-Gamma, et. al. 2002), which debated ercely over the best way o stoppinghyperination, as well as the stabilization o exchange rates. Tis debate resultedin a less rigid currency board system.17

Te results o the introduction o a currency board - as in the case o Estonia- gave visible results within the rst year o operation. Since the declared goalswere to reduce ination to an acceptable level and, consequently, the impact on

ination expectations, we can conclude that the CBA achieved excellent results.Ination has halved in the rst year, and subsequently took three more years toreach a single digit level.

Although the main objective - price stability was achieved relatively quickly, theunctioning o the CBA in Lithuania has not been ree o obstacles. Besides the al-ready mentioned unorthodox actors, the aggravating circumstance that was des-ecrating the spirit o the currency board was the permit to a commercial bank towithdraw the mandatory reserves in order to help the utilities sector nancially,

while the Lithuanian government was borrowing rom abroad on the collateralbasis in the orm o oreign exchange reserves (Antic, 2008). In addition, the s-

14 Te crisis o the banking sector at end-1992 and the 1999 crisis caused by the Russian crisis andthe devaluation o the Rouble

15 In the period rom 1994 to 2007, the Estonian real GDP rose to 144% (Source: the authors` cal-culations based on data rom CIA World Factbook, 2010)

16 Te Russian crisis which had led to a decline in GDP in 1999 o 5.1% and the global nancialcrisis that caused a decline in real GDP o 13.9% rom 2008 to 2009.

17

Te central bank was able to perorm the unction o the lender o last resort (limited to theamount exceeding 100% o oreign exchange reserves) and the unction o money market op-erations in order to control liquidity o the nancial system o the country.


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cal decit - in contrast to Estonia - was unacceptably high. Indeed, leaving thecurrency board appeared as an idea at one point, but in light o the Great Russian

crisis in 1998, which did not pass byLithuania, and the extreme instabilityin world markets, a decision was madeto remain committed to the pursuit othe existing monetary policy.18

However, stability reached with theintroduction o a currency board - de-spite all the problems named above -enabled a steady growth o the Lithu-anian economy in the coming years.19Tus, it was proven that tackling theroot o hyperination, which is usuallythe reason or the introduction o theCBA, contributes to the much-neededprice stability o the country which,consequently, represents the necessarycondition or the a smooth develop-ment o the economy in the uture.

Prior to the introduction o their currency board systems, Bulgaria was in verybad shape. Bulgaria had deaulted on its international debt, narrowly escaped arevolution in late 1996, and was battling hyperination that had virtually wipedout its banking system and sent the real economy into a ree all (Hanke, 2007).Te currency board was seen as a way to cope with constant nancial instabil-ity that ollowed it since the beginning o transition to market economy, whichescalated rom 1996 to 1997 with the emergence o hyperination20 and a drasticdeterioration in the balance sheets o commercial banks.21 Te causes o these

problems should be sought in the insufciently ast or rm reorms and the pater-nalistic attitude that the government had over the economy. Te reason or this

18 In 1997, the Central Bank o Lithuania planned to leave the CBA since the primary objective -price stability had already been achieved. However, the events in 1998 and a high exposure toshocks in the Lithuanian economy, convinced the ofcials that it is better to keep the CBA, atleast as a nominal anchor, and to look or the solution out o the crisis on the other side, throughscal adjustments.

19 Apart rom the all in1998 caused by the crisis in Russia;20 Te ination escalated rom 1,71% monthly in March 1996 to 242% monthly in February 1997.21 At the beginning o 1997, nine o ten Bulgarian banks with more than 80% share in total assets,

had a negative net worth. Even more than hal o private banks went bankrupt.

Figure 2: GDP and ination in Lithuania

(1994-2001)


hand scale.




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is that the substantive policy change did not happen until 1997 (Pavlov, 1999).In act, losses in the corporate sector caused by the collapse o the USSR22 were

mainly compensated by loans to the economy implemented by the state throughcommercial banks and the consequential deterioration o balance sheets o thebanking sector and the growth o ination. Te BNB tried to solve the problemo ination by increasing interest rates, but it achieved a negative eect as thecost o borrowing increased.23 On the contrary, also in 1996, the tax revenueshave declined rom 40% o GDP to only 14%, while real GDP ell by more than10% and urther aggravated the already alarming situation. As a result o all theseproblems, people lost condence in the national currency Lev, which was sig-nicantly depreciated during Q1 1997, rom 487 Lev to 1,588 Lev or 1 US dollar

(Gulde, 1999).All these issues simply imposed the awareness that a new solution must be soughtwithin a stable, transparent and - i possible - the rule-based system such as acurrency board, which will as soon as possible make the shi rom the recentpast and introduce nancial disciplineand stability to the country. Maybe thehyperination itsel contributed to theparliamentary consensus on the intro-duction o the CBA in Bulgaria as one

o the basic requirements or the intro-duction o the monetary arrangement.An additional actor that led to the cur-rency board choice was the ailure oprevious stabilization programs thathad not given any results.

Bulgaria - as well as Estonia and Lithu-ania was not without a result. I we

observe the rate o ination beore andaer the introduction o a currencyboard (Figure 3), we can see immediateresults which brought back ination tosingle-digit values aer just two years.

22 Over 80% o Bulgarian exports went to the USSR.23 As an i llustration o the growing costs o government borrowing is the act that Bulgaria in 1996

paid 10.1% o the GDP or the cost o servicing interest on the government debt.

Figure 3: GDP growth and Ination in

Bulgaria (1990-2006)


hand scale




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Besides curbing ination and the growth rate o real GDP, there was a sharp dropin interest rates on government bonds, which brought a huge relie to govern-

ment spending and a better reallocation o state resources.24

Te essence o a successul disination in Bulgaria is the act that the two mainhyperinationary channels were intercepted the BNB loans to the governmentand commercial banks. Tus, the state was prevented rom wasteul behaviourand the BNB imposed a strict discipline to banks that must result in the curtail-ment o hyperination.

Te ination rate - it is interesting to mention - declined substantially in April1997, i.e. two months beore the ofcial introduction o the CBA.25 Te reason or

this may be the double impact that the currency board has in reducing hyperin-ation using the eect o discipline, which is reected in limiting the growth omoney supply, and the eect o trust, which inuences inationary expectationsthat are built in the expected rate o return aer the announced establishment othe CBA (Beck et. Al, 2003).

Bosnia and Herzegovina in addition to other challenges that Estonia, Lithu-ania and Bulgaria were acing Bosnia and Herzegovina (BH) had the additionalproblem o a war devastated economy and complicated political-economic sys-

tem with two entities and de acto our currencies in circulation.26 As such, it wasacing the next challenges (Kovacevic, 2003):

Te transition rom a war to a peacetime economy, Te transition rom planned to market economy and Te transition rom the status o the ormer Yugoslav republic to an inde-

pendent state.

Establishing a currency board was built into the Dayton Peace Agreement rom

1995. Operationalization itsel lasted longer than in other states due to the spe-cic political situation in BH, causing the currency board to start on 11 August1997. I one bears in mind the political scene o the country at the end o the war,a great division o the society and the existence o actual states in the country, the

24 In March 1997, the interest rate on treasury bonds reached the level o 600% per annum, andaer a parliamentary consensus on the introduction o CBA, it ell to 100%, and only ew weeksaer the ofcial start o operation o the CBA, it ell to 6% per annum. (For more, see Bogetic,1997)

25 Te currency board was ofcially introduced on 1 July 1997.26 Yugoslav Dinar, Croatian Kuna, Bosnian Dinar and German Mark.


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existence o our currencies in circulation, it can be easily concluded that alterna-tives to the currency board, in act, never existed.

It is important to note that the currency board in Bosnia and Herzegovina is theclosest to its orthodox concept. Te only dierence lies in the act that the CBA inBH can aect the rate o mandatory reserves. Probable reason or this additionalconservatism in relation to the above mentioned examples is the specic politicalsituation in the time when the CBA was being created in Bosnia and Herzegovina.

Calculating the precise macroeconomic results or the immediate post-war pe-riod or the entire territory o BH is problematic because the available data orthe period rom 1995 to 1997 reer only to the Federation o BH.27 For this reason,

the data or this period are unreliable and we use data rom the time a currencyboard was introduced, i.e. rom 1997. Tey can be shown in the ollowing gure.Te currency board, as shown in previous examples, demonstrated eectivenessin curbing ination since the introduction o the CBA, ination ranged up to 6%,and usually below 3% per annum.28

Looking at these examples o countriesthat introduced a currency board in theearly 1990s we can note signicant an-

ti-ination eects, without any excep-tion: hyperination disappears in therst years aer the establishment o acurrency board and is retained at lowlevels thereaer. Obviously, the rea-son or the strong decline o inationmay be primarily due to the credibilitythat the currency board established.In terms o gross domestic product,

we can see a general trend o growth,which varies rom country to country,depending on the political stability andthe commitment to economic reormsand a healthy macroeconomic environ-

27 From 1995 to 1997, the National Bank o Bosnia and Herzegovina (it reers only to the BHFederation) operated on a system called the pseudo currency board, where one DM could beexchanged or 100 BH dinars.

28 It is important to mention that a part o BH, the Republic o Srpska, suered a hyperination inthe period rom 1992 to 1994 because it was using the Yugoslavian dinar.

Figure 4. GDP and Ination in Bosnia

and Herzegovina (1998-2006)


hand scale




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ment. Or to quote Karl Schiller29, Stability is not everything, but without stabil-ity, everything is nothing.

3. Empirical Study o the Impact o the Exchange Rate Arrangement

on Ination and the Current Account Defcit

In this section, the research topic is the comparison o the current account decit(expressed as % o GDP) and ination in countries under the currency board ar-rangement with the countries under other exchange rate arrangements. Te au-thors observed the movement o an isolated current account decit and ination

in relation to the exchange rate arrangement. Tis is a simplication, but it is notuncommon in literature.30 Given a relatively long time period during which thisarrangement is being applied to European economies in transition, this part othe paper gives the answer to the question about the eectiveness o this arrange-ment in relatively stable conditions.31

European economies in transition are subject to observation, and the classica-tion o exchange rate arrangements, which is taken rom the International Mon-etary Fund, is shown in the table 2.

29 West German Minister o Economy (1966-1972).30 For more details see: Kuttner, Kenneth and Adam Posen (2001) "Beyond Bipolar: A Tree-Di-

mensional Assessment o Monetary Frameworks," Working Papers 52, Oesterreichische Natio-nalbank.

31

Beyond the act that this region aced the eects o the global nancial crisis, the authors useassumption that it was a stable period due to the act that observed variables ination and cur-rent account decit had a declining trend.


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Table 2: Classifcation o countries by exchange rate arrangement

Country Exchange rate arrangement

Bosnia and Herzegovina Currency board

Bulgaria Currency board

Estonia Currency board

Lithuania Currency board

Croatia Fixed exchange rate

Latvia Fixed exchange rate

Macedonia Fixed exchange rate

Ukraine Managed oat

Georgia Managed oatMoldova Managed oat

Romania Managed oat

Serbia Managed oat

Albania Free oating

Czech Republic Free oating

Hungary Free oating

Poland Free oating

Source o data: IMF (2010), Annual Report on Exchange Arrangements and Exchange Restrictions,Washington.

3.1. The impact o the currency board arrangement on the current account

defcit

Classical economic theory assumes that the advantage o the ree oating ex-change rate arrangement is the act that it provides a balanced balance o pay-ments. Namely, i there is a current account decit, it will impact the growth odemand or oreign currency, which will lead to the weakening o the nationalcurrency, which will urther lead to the price increase o imported goods de-nominated in local currency. Expensive imports lead to the reduction o imports,leading to a gradual current account balance. At the same time, domestic prod-ucts denominated in oreign currencies become cheaper, which stimulates thegrowth o exports.

Fixed exchange rate arrangements (currency board being the most rigid orm)lead to overestimation o national currencies over time, which could stimulate

imports and discourage exports. Tereore, based on theoretical assumptions,it will be reasonable to expect that countries in the currency board arrangement


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will have a higher external current account decit (expressed as % o GDP) com-pared to countries with the ree oating exchange rate arrangement in place. 32

Namely, in the CBA, the exchange rate is a not variable that the state can use inorder to depreciate undesirable developments in the balance o payments, there-ore, the appearance o the current account decit is imminent in this monetaryarrangement (Galic, 2008). On the basis o empirical observations o the coun-tries under the currency board arrangement, Schuller (1992) came to the conclu-sion that many currency board systems have experienced simultaneous decitsin the current account and growth in the supply o money and that there has beenno obvious link between the two. Te ECB (2006), analyzing the external currentaccount decit on the example o the economies in transition, came to the con-

clusion that the largest current account decits were in countries under the cur-rency board arrangement. Mehl and Winkler (2003) came to the same conclusionwhen European economies in transition are concerned, stating that the currentaccount in the our countries is characterized by relatively high decits, mainlyreecting sizeable capital inows and, in the case o Bosnia and Herzegovina,oreign aid ows.

In order to conrm or challenge thishypothesis, we are looking at the av-erage amount o the current account

decit in the past ve years in select-ed economies in transition relative totheir exchange rate arrangement. As asource o data we used the 2011 WorldEconomic Outlook Database.33 Te re-sults are shown in the gure 5.

Empirical data have conrmed thendings o the theory, and it turned

out that countries in the uctuatingexchange rate arrangement have thelowest current account decits (as % oGDP). Countries under the currency

32 Unortunately, the studies o the links between the external current account decit and a cur-rency board are le out in literature so the resources that can be cited are very scarce.

33 Te authors are aware that this type o analysis is rather simplied because it shows only the

impact o the exchange rate arrangement on the external current account decit and the otheractors that may aect the balance o payment trends are ignored. However, we believe that inthe case o a large number o countries, the impact o these actors is diminished.

Figure 5: Current account defcit in % o

GDP (2006 2010, average)

Source: Authors` calculation


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board arrangement have the decits twice as big; a somewhat unexpected re-sult is that countries under the xed exchange rate arrangement have slightly

worse current account decits when compared to countries under the ree oatarrangement. Te worst result was achieved in the group o countries under themanaged oat arrangement.

3.2. The impact o the currency board on ination

I we start rom the postulates o economic theory, we can expect the countriesunder the currency board arrangement and with the xed exchange rate willhave a lower ination rate. Specically, that is when an exchange rate plays the

role o a nominal anchor, which, when controlled and xed, provides high cred-ibility o economic policy and low ination (Dimitrijevic and Fabris, 2007). Teargument is that there can be an inationary bias when monetary policy is setwith ull discretion. A central bank that wants to ght ination can commit morecredibly by xing the exchange rate. When workers and corporate managers havelow expectations o ination, they set their wages and prices accordingly. Teresult is that the country is able to attain a lower level o ination or any givenlevel o output.

Bearing in mind that the currency board is the most credible orm o the ex-change rate, in accordance with the postulates o economic theory, it should beexpected that countries under this arrangement have the lowest rate o ination.Such a conclusion was made by Ghosh, Gulde and Wol (1998) who showed thatcountries in the currency board arrangement had 4 percentage points lower in-ation than countries under other pegged exchange rate arrangements in theperiod rom 1970 to 1996.

Te theory results have also been conrmed by a number o other empirical stud-

ies. Observing the example o European economies in transition, Mehl and Win-kler (2003) concluded that the currency boards in Bulgaria, Estonia, Lithuaniaand BH brought price stability. ui and Kwan (2010), observing the example oHong Kong, ound that this arrangement reduced price volatility. Schuller (1992)concluded that ination has generally been lower and GDP growth per capitahigher under currency boards than under central banks. Ghosh et. al (2000) con-cluded that the currency board arrangements have been successul in providingcredibility aer a period o high ination and quite successul in this respect.Possen and Kuttner (2001), aer observing the exchange rate as the key variable

in an isolated environment, came to the conclusion that countries which adopted


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the currency board arrangement were more eective in lowering ination thancountries which adopted the uctuating exchange rate arrangement.

However, the results are the opposite owhat economic theory suggests (Figure6). Namely, the lowest average ina-tion rates were registered in a group ocountries under the oating exchangerate arrangement, while the worst re-sults (as well as the movement o thecurrent account decit) were registeredin a group o countries under the man-aged oating arrangement. Explana-tion o this result can be ound in theact that the exchange rate, as a nomi-nal anchor, is very efcient in terms ohyperination or high ination, whileits efciency is lower at lower rates oination. However, we should bear inmind other structural characteristics ocountries that are in this arrangement.

4. Summary and Conclusion

Te currency board arrangement is usually introduced when the current mon-etary arrangement does not give satisactory results, especially in the orm olow credibility and high ination. Tis arrangement, which has a long history,is applied now to our European economies in transition. Tis arrangement hasproved very efcient when it comes to lowering high ination. Tereore we canconclude that in the period o its introduction, this arrangement achieved goodresults in all our observed European transition economies.

Given the act that the European economies in transition continued to apply thisarrangement or many years aer the lowering o ination, there is a question owhether it is efcient in a relatively stable environment, that is, whether an exitoption should be pursued.

Te authors concluded that the application o this arrangement in the long run

leads to overvaluation o national currencies and thus the current account decitis almost twice as big as that o countries with the uctuating exchange rate.

Figure 6: Annual rate o ination

(2006 2010, average)

Source: Authors` calculation


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As or the ination rate, it turned out that countries in this arrangement have al-most 1.5 percentage point higher rate o ination than countries under the oat-

ing exchange rate arrangement. One can thereore conclude that the currencyboard arrangement is less efcient in stable conditions.

Te paper showed that countries under the managed oat exchange rate arrange-ment had the worst perormance compared to those who are not under the samearrangement.


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Reerences

1. Alonso-Gamo, P., Fabrizio, S., Kramarenko, V., Wang, Q. Lithuania His-tory and Future o the Currency Board Arrangment, IMF Working PaperWP/02/127

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3. Beck, S., Miller, J.B., Saad, M., (2003) Ination and the Bulgarian CurrencyBoard, Bulgarian National Bank Discussion Paper, DP/31/2003

4. Bogeti, . (1997), Valutni odbori u teoriji i meunarodnoj praksi, Montene-gropublic, Radio Antena M, Mermont, Podgorica

5. Dimitrijevi, B. i Fabris, N (2011), Makroekonomija, Edukons University,Sremska Kamenica6. Dimitrijevi, B. i Fabris, N. (2007), Makroekonomija, Edukons University,

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grad.9. Ghosh A.R., Gulde A. M. and Wol H. (1998), Currency Boards: Te Ultimate

FixIMF Working paper, 98/810. Ghosh A.R., Gulde A. M. and Wol H. (2000), Currency boards: More than aquick x, Economic Policy, Volume 15, Number 31, October.

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14. IMF (2011), World Economic Outlook, April.15. International Monetary Fund (2010), Annual Report on Exchange Arrange-ments and Exchange Restrictions, Washington.

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Annex

Table 3: Current account defcit, % o GDP (2006 2010)

Country 2006 2007 2008 2009 2010

Bosnia and Herzegovina -7.966 -10.716 -14.47 -6.865 -6.037

Bulgaria -17.53 -30.245 -23.262 -9.97 -0.786

Estonia 15.332 -17.191 -9.734 4.529 3.565

Lithuania -10.699 -14.56 -13.442 4.464 1.846

Croatia -6.972 -7.555 -9.157 -5.548 -1.925

Latvia 22.49 -22.329 -13.068 8.626 3.579

Macedonia 0.816 -6.538 -13.86 -6.42 -2.783

Ukraine -1.501 -3.694 -7.086 -1.475 -1.875

Georgia -15.13 -19.66 -22.629 -11.238 -9.813

Moldavia -11.379 -15.315 -16.303 -8.544 -10.867

Romania -10.389 -13.426 -11.635 -4.189 -4.233

Serbia 10.181 -15.96 -21.096 -6.892 -7.111

Albania 5.644 -10.371 -15.206 -14.03 -10.11

Czech -2.945 -3.299 -0.581 -1.128 -2.442

Hungary 7.605 -6.923 -7.299 -0.462 1.569

Poland -2.479 -4.762 -4.827 -2.229 -3.287

Table 4: Annual ination (2006 2010, end-year)

Country 2006 2007 2008 2009 2010

Bosnia and Herzegovina 4.548 4.944 3.809 -0.03 3.076

Bulgaria 6.081 11.58 7.188 1.638 4.446

Estonia 5.14 9.567 6.978 -1.71 5.416

Lithuania 4.495 8.15 8.469 1.271 3.629

Croatia 2.067 5.786 2.826 1.862 1.915

Latvia 6.757 14.03 10.4 -1.37 2.398

Macedonia 3.078 6.667 4.101 -1.64 2.956

Ukraine 11.65 16.55 22.34 12.33 9.096

Georgia 8.778 10.98 5.548 2.983 11.24

Moldavia 14.08 13.11 7.339 0.441 8.1

Romania 4.961 6.602 6.323 4.764 8

Serbia 6.606 11.02 8.603 6.578 10.29

Albania 2.513 3.057 2.162 3.7 3.4

Czech 1.69 5.474 3.614 0.984 2.303

Hungary 6.5 7.398 3.502 5.6 4.2

Poland 1.4 4 3.3 3.5 3.1

Documents

The Efficiency of the Currency board arrangement