Hard Currency Pegs
Dollarization and currency boards are among the examples of hard pegs, which severely limit the possibility of an autonomous (independent) monetary policy in a country. Therefore, sometimes the exchange rate that stems from a hard peg is referred to as a fixed exchange rate, as in the case of a metallic standard.
In the case of dollarization, a country adopts a foreign currency to be circulated in its economy as the medium of exchange. A currency board backs the money supply or domestic currency liabilities with foreign currency or foreign currency–denominated assets to support the pegged rate.
Dollarization is a general term that describes a country’s act of giving up its domestic currency and adopting another country’s currency to be used in all transactions. Despite the name, the replacing foreign currency doesn’t have to be the dollar.
Consider some historical examples for dollarization. One of the smallest European countries, Monaco, adopted the French franc in the 19th century and currently uses the euro, after France adopted the euro in 1999. Also, the U.S. dollar is the legal tender in Panama since the early 20th century.
Clearly, eliminating a country’s own money and, therefore, monetary policy is a radical step. After the domestic currency in circulation is replaced by a foreign currency, the country cannot have an autonomous monetary and exchange rate policy. Suppose that a country adopts the dollar.
Because this country doesn’t have its own money and its own central bank, it has to accept the monetary policy of the U.S., conducted by the Federal Reserve Bank (the Fed). Clearly, the monetary policy–making division of the Fed, the Federal Open Market Committee (FOMC), conducts its monetary policy in consideration of the economic outcomes in the U.S.; the dollarized country’s economic situation doesn’t matter to the Fed.
Therefore, the dollarized country loses its ability to address its domestic economic problems. In all countries, central banks have similar responsibilities: issuing currency, protecting the purchasing power of the currency or promoting price stability, implementing monetary policy to address business cycles (contractions and expansions), and regulating financial markets.
The central bank of a dollarized country is able to regulate the country’s financial markets and promote price stability by adopting a lower-inflation country’s currency.
The dollarized country’s central bank loses something else as well. In addition to the aforementioned responsibilities, all central banks act as a lender of last resort. In times of crisis, especially financial crisis, central banks inject liquidity into financial markets.
In the most recent financial crisis, the Fed acted as a lender of last resort and provided liquidity to financial markets through loans and purchasing especially mortgage-backed securities from financial markets.
The European Central Bank (ECB) did the same in early 2010 by buying Greek government bonds. In these examples, both the Fed and the ECB transferred toxic assets from the balance sheets of banks and other financial firms to their own balance sheets and provided financial markets with additional liquidity.
Risk premium of these financial assets (mortgage-backed securities and Greek government bonds) increased so much that, if not for the Fed or the ECB, nobody would have bought them. This situation is how central banks fulfill their function as the lender of last resort. Dollarization, however, completely eliminates the possibility that the dollarized country’s central bank can act as the lender of last resort.
You may ask what would inspire a country to dollarize. Usually countries dollarize because domestic institutions fail to keep inflation low. Following a severe banking crisis in 1999, Ecuador gave up its domestic currency, sucres, and replaced it with U.S. dollars in 2000. Ecuador was one of those countries that made too much use of the central bank’s ability to derive revenues from printing its currency, which is seignorage.
Inevitably, the central bank’s ability and willingness to print money led to higher inflation rates. In the late 1990s, Ecuador’s annual inflation rate reached 96 percent. After dollarization, Ecuador’s inflation rate substantially decreased. The average inflation rate between 2003 and 2011 was about 4.4 percent.
With lower inflation rates, interest rates declined as well. Whereas the average deposit rate was about 29 percent during the predollarization period, it was about 4.5 percent between 2003 and 2011.
Equating dollarization to common currency is a mistake. When countries decide to have a common currency, they are essentially a part of a monetary union. In a monetary union, such as the Euro-zone, all participating countries are included in the decision making regarding the monetary policy of the monetary union. Dollarization, on the other hand, implies a unilateral decision by a country to replace its domestic currency with a foreign currency.
Currency board is another example of a hard peg. Unlike dollarization, a currency board doesn’t imply replacing the domestic currency with a foreign currency. Even though the country keeps its domestic currency in circulation, a currency board necessitates that the central bank conduct monetary policy with one objective in mind: to maintain the exchange rate with the foreign currency to which the domestic currency is pegged.
What would impose discipline on the currency board’s monetary policy decisions is the fact that foreign currency reserves back domestic currency.
As in the case of dollarization, a disadvantage of having a currency board is that the central bank cannot implement monetary policy to address the country’s current economic problems. Additionally, the central bank loses its ability to act as the lender of last resort and may be able to provide temporary liquidity to the financial system during a financial crisis.
Also similar to dollarization, the main advantage of a currency board is its ability to control the inflation rate and promote price stability. Trying to keep the exchange rate at a certain level leads to discipline in monetary policies and prevents the central bank from conducting discretionary policies. Of course, if the central bank of a country can increase its reserves of the benchmark currency, it can increase the country’s monetary base.
Hong Kong is one of the most successful examples of a currency board. The Hong Kong Monetary Authority (HKMA) has maintained a fixed exchange rate of HKD7.8 to one U.S. dollar.
A not-so-successful example of a currency board arose in Argentina. Argentina introduced a currency board and pegged the peso to the U.S. dollar. However, the Argentinean currency board collapsed in 2001. Following that currency crisis, the central bank let the peso float.
The appreciation in the U.S. dollar in the late 1990s was one reason for the collapse of the Argentine currency board. As the dollar appreciated, so did the peso. Considering the relevance of exports for the Argentine economy, the appreciation in the peso made the country’s exports more expensive, hurting its export performance. Still, the Argentine fiscal practices may have been more damaging to the currency board.
Not only the central government, but also state governments (which have considerable autonomy in their budgets) substantially increased their spending based on loans from large U.S. banks. The central bank couldn’t monetize the debt because of the currency board and both the central and state governments kept increasing their spending.
However, at one point, the lenders became wary about the size of government spending in Argentina and weren’t willing to extent more credit. The result was a severe financial and banking crisis in Argentina in 2001, which ended the currency board.