Issue of Credibility: Making Currency Boards Operational Requires Wide Array of Technical Preparations

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There has recently been a revival of interest in adopting currency board arrangements as a means of stabilizing exchange rates and establishing economic order when more conventional systems might be ineffective. A currency board is required to maintain the foreign exchange cover of designated domestic liabilities-that is, the authorities commit to issue domestic currency solely in exchange for a specified foreign currency at a fixed rate, limiting their discretion to create money by extending credits to the government or the banking system. In Making a Currency Board Operational, Charles Enoch and Anne-Marie Gulde of the IMF's Monetary and Exchange Affairs Department argue that a successful currency board arrangement requires, in addition to adopting appropriate macroeconomic policies, an early preparation of the legal and institutional aspects of the transition. The range of necessary preparations varies, but generally involves changing the central bank law, reorganizing the central bank, devising appropriate guidelines for reserve management, and adapting the government's cash and debt management activities.

Doubt about the soundness of the banking sector is among the greatest threats to the credibility of a currency board arrangement. Countries experiencing banking sector problems require additional measures before initiating a currency board, including broad-based restructuring or closure of banks that do not comply with established prudential standards. Unless these preparations are made in time and a coherent system is in place, the credibility of the currency board arrangement itself- and with it the entire range of economic benefits desired from the adoption of the arrangement-will be at stake.

Currency and Level of Peg

In establishing a currency board, the authorities must choose a foreign currency against which to peg the domestic currency. In their selection process, they must consider several variables, including the direction of trade flows, the denomination of imports and exports, and the denomination of international debt. The currency of the predominant trading partner is often an advisable peg, as it reduces exposure to swings in the import value of reserves. In this regard, the authorities should analyze prospective trade patterns rather than assume that historical patterns will characterize the future. The domestic acceptance of a currency may also need consideration. Widespread dollarization-replacing the domestic currency with the U.S. dollar-could, for example, be an argument in favor of the U.S. dollar, even in a country...