Currency Boards when Interest Rates are Zero

• Author: James Yetman,David Cook
• Date: 01 February 2014
• Published date: 01 February 2014
• DOI: http://doi.org/10.1111/1468-0106.12055

CURRENCY BOARDS WHEN INTEREST RATES

ARE ZERO

DAVID COOK*Hong Kong University of Science and Technology

JAMES YETMAN Bank for International Settlements

Abstract. In a f‌ixed exchange rate system, any expectation that the peg may be abandoned will

normally be ref‌lected in an interest rate differential between instruments denominated in domestic

and anchor currencies: the possibility of a revaluation will drive domestic interest rates below those

in the anchor currency, for example. However, when interest rates are close to the zero lower bound,

there is limited scope for exchange rate expectations to be ref‌lected in interest rate differentials. Here

we introduce a new mechanism, based on the central bank balance sheet, which works to bring about

equilibrium in currency markets even when interest rates are zero. An expectation of exchange rate

appreciation will cause foreign exchange reserves to swell, increasing the cost to policy-makers of

allowing an appreciation and, therefore, lowering the likelihood of the f‌ixed exchange rate being

abandoned. Under normal circumstances, this channel reinforces the equilibrating effect of interest

rate differentials. When interest rates cannot adjust only this channel operates, implying that much

larger changes in reserves are required to equilibrate currency markets. We develop a simple model

to illustrate these arguments and f‌ind support for the predictions of the model using data for Hong

Kong, the world’s largest economy with a currency board.

1. INTRODUCTION

A currency board is a highly, but imperfectly, credible monetary policy frame-

work. One def‌ining characteristic is that domestic currency is backed by liquid,

risk-free assets denominated in an anchor currency.1If foreign exchange reserves

completely cover the total stock of domestic currency reserve assets, all domestic

currency could, in principle, be converted to the anchor currency at the pegged

exchange rate, making it a highly credible f‌ixed exchange rate regime.

Under conditions of perfect credibility, a currency board may be thought of as

operating on ‘automatic pilot’.2If interest rates in an economy with a currency

*Address for Correspondence: Hong Kong University of Science and Technology, Department of

Economics Lee Shau Kee Building, Clearwater Bay, Kowloon, Hong Kong. E-mail: davcook@

ust.hk. The views expressed here are the authors and do not necessarily ref‌lect those of the BIS. For

comments we thank Hans Genberg, Frank Packer and seminar participants from the Bank for

International Settlements and the Hong Kong Monetary Authority, as well as the Hong Kong

Economic Association Workshop on the Linked Exchange Rate and two anonymous referees. Lillie

Lam and Jimmy Shek provided excellent research assistance. Any remaining errors are ours alone.

1In practice, the term ‘currency board’ is often applied to economies whose domestic currency is

substantially, but not completely, backed by anchor-currency-denominated instruments. For

example, Ghosh et al., 273 (2000) def‌ine a currency board as ‘an exchange rate regime in which the

parity is f‌ixed, there is a f‌irm link between domestic money creation and foreign reserves, and a

substantial (at least 50%) coverage ratio’, implying foreign exchange reserves equal to at least 50%

of domestic reserve money. Hanke (2002) argues for a much more restrictive def‌inition, including the

absence of active monetary policy, which would preclude many examples of what are commonly

referred to as currency boards.

2See the discussion in Yam (1998) for the case of Hong Kong.

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Pacif‌ic Economic Review, 19: 1 (2014) pp. 135–151

doi: 10.1111/1468-0106.12055

© 2014 Wiley Publishing Asia Pty Ltd

board are higher (lower) than those in the anchor economy, investors will buy

(sell) domestic currency in exchange for the anchor currency. This international

capital f‌low will increase (decrease) liquidity in the domestic currency money

market, bringing interest rates down (up). This process will continue until

interest rates in domestic and anchor currencies are equalized.

However, the credibility of a currency board may not always be perfect.

Policy-makers have the option of abandoning a currency board in favour of an

alterative monetary policy framework if the f‌ixed exchange rate causes economic

fundamentals to deteriorate, in favour of a f‌loating exchange rate or a currency

board pegged to a different anchor currency. Such an exit may not even be very

disruptive to the domestic economy. Ghosh et al. (2000) argues that past exits

from currency boards were usually uneventful and were motivated largely by

political, rather than economic, considerations.

Imperfect credibility does not prevent the automatic pilot from operating

under normal economic conditions. If market participants expect that a cur-

rency board may be abandoned with some probability, domestic currency bonds

will tend to trade at a premium or discount relative to those in the anchor

currency, ref‌lecting both the probability that the currency board will be aban-

doned and the expected resulting appreciation or depreciation. For example, if

market participants expect an appreciation, and interest rates are equal in both

domestic and anchor currencies, then investing in the domestic currency assets

offers an excess return over assets denominated in the anchor currency. This will

attract capital f‌lows, increasing domestic liquidity, depressing domestic interest

rates and reducing the excess return. In equilibrium, this process will continue

until the excess return on domestic currency bonds has been largely eliminated.

However, this mechanism cannot work if the interest rate in the anchor

currency is zero, as when the anchor currency is stuck in a liquidity trap, for

example.3Suppose the interest rate is constrained by the zero lower bound, yet

market participants assess that there is a positive probability that the currency

board will be abandoned and the domestic currency allowed to appreciate.

Capital f‌lows will be attracted to the domestic currency but can no longer have

a depressing effect on domestic interest rates. Instead, the inf‌lows to domestic

currency will cause foreign exchange reserves to continue to swell, potentially

inf‌initely, as long as the positive probability of appreciation creates excess

returns.

In this paper, we introduce another mechanism that brings about equilibrium

in the foreign exchange market even in the event that interest rates are stuck at

zero. We refer to this new mechanism as the central bank balance sheet channel.

The effective operation of a currency board requires that the central bank have

large holdings of foreign currency reserves that are offset on their balance sheet

by domestic currency liabilities. This exposes the central bank to a large cur-

rency mismatch which increases in the size of the foreign exchange reserves.

3See, for example, the discussion in Yates (2004). Since the work of Krugman (1998), expectations

of future policy are seen to be central when economies are in a liquidity trap (see Eggertsson and

Woodford, 2004; Auerbach and Obstfeld, 2005). This is equally true in an open economy (see

McCallum, 2014; Nakajima, 2008; Cook and Devereux, 2011, 2013).

D. COOK AND J. YETMAN

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