Eastern European Economics, vol. 40, no. 1, January–February 2002, pp. 6–35. © 2002 M.E. Sharpe, Inc. All rights reserved. ISSN 0012–8775/2002 $9.50 + 0.00.
NIKOLAY NENOVSKY, KALIN HRISTOV, AND MIHAIL MIHAYLOV
Comparing the Institutional and Organizational Design of Currency Boards in Transition Countries ABSTRACT: The article carries out a comparative and descriptive analysis of the currency boards that have been introduced in three East European countries: Bulgaria, Estonia, and Lithuania. The initial conditions and specific features of currency boards in these three countries are presented in detail. There is also a focus on the institutional, organizational, legal, and political characteristics of these currency boards. Special attention is given to deviations from the orthodox currency board framework. Currency boards in the countries under consideration limit the scope for monetary policy, due to the presence of atypical balance sheet
Nikolay Nenovsky is affiliated with the University of National and World Economy, Department of Finance and the Bulgarian National Bank, Research Department; e-mail:
[email protected] or
[email protected]. Kalin Hristov is affiliated with the University of National and World Economy, Department of Finance and the Bulgarian National Bank, Research Department; e-mail:
[email protected]). Mihail Mihaylov is affiliated with the Bulgarian National Bank, Research Department; e-mail: Mihaylov.
[email protected]). This study has been carried out within the framework of the Phare ACE P97-8154-R project, financed by the European Union. The authors thank Kalina Dimitrova of the Bulgarian National Bank for research assistance. The authors are grateful for helpful comments from J. Miller, U. Hege, and R. Pikkani. 6
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items and the employment of a number of monetary policy instruments. The comparison of currency board operation in the three countries reveals significant differences in the historical background of currency board adoption, institutional design, and overall macroeconomic framework. This observation does not fit completely with the generally accepted view that currency boards in the three transition economies function in a similar pattern and that the differences among them are insignificant. The article suggests some new directions for the analysis of currency boards in transition countries. The Role of Initial Conditions and Institutional Design The monetary regimes of the transition countries are very diverse. At one extreme is the currency board. Despite the vast literature on the subject, two issues have been neglected: first, the study of the initial conditions of currency board establishment, such as the state of the economy, the political structure, and so forth. These factors determine, to a great extent, the dynamics of currency board functioning. The experience of transition economies shows that several motives determine the establishment of a currency board: (1) it is a way to build up credibility for the newly created national currency, and it enhances monetary sovereignty after the country leaves the ruble zone (Estonia); (2) it is done to follow other countries with similar economic structures, where this monetary regime has been implemented and operates very successfully (Lithuania); and (3) it is done to replace a discretionary central bank in order to restore confidence in the national currency and to overcome deep financial crisis (Bulgaria). While Estonia initiated the introduction of a currency board itself, and, thus, in the beginning, it had a disagreement with the International Monetary Fund (IMF), Lithuania, and especially Bulgaria, on the other hand, took steps toward currency board establishment mainly under pressure from the IMF. Second, in institutional and organizational aspects, currency boards adopted nowadays differ significantly from orthodox cur-
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rency boards that were typical of the colonial age. New currency boards preserve some elements of central bank discretionary policy to various extents, and they allow for deviations from the orthodox framework. These deviations include the presence of atypical elements in the balance sheet and the use of monetary policy instruments. In all countries, the requirement that commercial banks keep obligatory minimum reserves exists in one form or another. In Lithuania and Bulgaria, deviations from the orthodox form of the currency board are significant: the governments of these countries hold their accounts at the central banks and thus influence the stock of reserve money, that is, they conduct a form of quasi-monetary policy that is unconscious in most cases. In Estonia and Lithuania, programs for gradual abandonment of the currency board were prepared to make way for the use of monetary policy instruments. In general this unorthodox feature reflects in part the fact that chronologically they come into existence after central banks, representing a kind of path dependence; on the other hand, they are “surrounded physically and intellectually” by numerous central banks employing monetary policy instruments. The initial conditions and the unorthodox institutional and organizational form of the new generation currency boards frame the debate over “rules versus discretion” in a new way. And this, by itself, impacts the functioning of the automatic mechanism of the currency board and sets a task for its predefinition, and, moreover, for justification of its existence. Despite the lack of a clear definition, we suggest that the existence of an automatic mechanism is most often considered as a direct positive relation between the dynamics of the balance of payments and the dynamics of the monetary base or money supply (Walters 1989). Furthermore, the hybrid nature of the new currency boards can be related to credibility; the latter is often pointed to as the currency boards’ advantage over the discretionary central bank (Ho 2001). And, of course, finally all this influences the overall results of the currency board’s operation. In other words it influences what we take as evidence of the success of one currency board or another. The problems we
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have pointed out concerning the new currency boards gain particular importance in transition countries, especially in the context of accession and choice of the most appropriate monetary regime. Although in their official statements the EU and the European Central Bank accept the currency board as a monetary regime compatible with ERMII (exchange rate mechanism II), decisions on compatibility and the exchange rate level will be taken on a case-by-case basis (European Commission 2001). Although in recent years the significance of institutions to the success of the reforms has been increasingly emphasized, analyses of the different types of monetary regimes as institutions are almost absent.1 For example, in two of the few empirical studies on the significance of institutions and institutional change in the transition economies (Havrylyshyn and Van Rooden 2000; Raiser, Di Tommaso, and Weeks 2000), there are no variables to reflect the type of monetary regime. In our opinion, the introduction of the currency board in Bulgaria, Estonia, and Lithuania can be regarded as one of the main systemic institutional changes.2 The currency board can be treated as a system of formal rules of money supply and monetary behavior that are imposed on all economic agents. The transition to the currency board is a change that has to be analyzed above all in the context of a conflict of interests of certain economic and political groups that determine the supply of and demand for institutional change. In order to examine this in the frameowrk of a political economy of institutional change, it is necessary first to gather empirical evidence and to describe the currency boards in the three countries under consideration. One of the accompanying tasks of this study may be defined as descriptive, that is, the article presents the historical context in which the currency boards were introduced in the three countries. Another task is to present as completely as possible the institutional characteristics of the three currency boards to reflect the need to focus on the elements of discretion in the operation of the currency boards. In the current article, we do not aim to evaluate the performance
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of the currency boards in transition economies. Such a comparison has already been made to one extent or another (Ghosh, Gulde, and Wolf 2000). Rather, our purpose is to summarize the process leading to the choice of the currency board as a monetary regime in Bulgaria, Estonia, and Lithuania, the initial conditions, policy discussions on the arrangement design, and issues that arose during the implementation of the arrangement. Bulgaria, Estonia, and Lithuania experienced almost a half-century period during which money had lost its major functions and the monetary behavior of the public had been forcibly simplified and constrained. Despite the similarities, however, each of the currency boards in these countries has its specific features with respect to both the initial conditions prior to its establishment and its institutional, legal, and political characteristics. The article is structured as follows. The second, third, and fourth sections present major characteristics of the currency boards in Estonia, Lithuania, and Bulgaria, respectively. To simplify comparison of the currency boards in these countries, the main characteristics of the arrangements are classified into four groups: (1) the political will to introduce a currency board arrangement and the political commitment to maintaining it; (2) legal characteristics and legal commitment; (3) the institutional aspects of a currency board and the scope for discretion; and (4) macroeconomic liberalization as a basis of currency board operation. The results of the crosscountry analysis are summarized in Table 1. In the final section, the main conclusions of the empirical analysis are summarized and the directions of theoretical studies of currency boards in transition countries are stated. Estonia: Political Resolve and Economic Liberalization Introducing the currency board on June 20, 1992, Estonia became the first country of the former socialist bloc to adopt this monetary regime. The launching of the Estonian currency board de facto
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coincided with the restoration of the national currency that had been phased out in 1939–40. The creation of the kroon was perceived as a symbol of national sovereignty and a breakaway from the political and economic dictate of Moscow.3 Various scenarios were suggested for the introduction of the national currency. The choice of a currency board as a monetary regime was driven by the desire to introduce a stable national currency.4 According to Lainela and Sutela (1994), the IMF was initially skeptical about the idea of introducing national currencies in the Baltic States and especially in Estonia. One of the reasons was the IMF’s intention to establish traditional central banks, which was contrary to the plans of the Estonian authorities to use a currency board. This fact supports the argument that, unlike in Lithuania and especially in Bulgaria, in Estonia, the decision to establish a currency board was definitely a national choice. The simultaneous introduction of the country’s own currency and the establishment of a currency board enabled Estonia to move directly from the zone of the Soviet ruble to an independent currency that was 100 percent backed by foreign exchange reserves. There was no transition period with a discretionary central bank, no active monetary policy, and no parallel and transition currencies as in the other Baltic countries.5 The conversion of rubles into new kroons at a rate of 1 kroon per 10 rubles, or 1 kroon per 50 rubles, ran parallel with the fixing of the kroon to the deutschemark at a rate of 1 DEM = 8 EEK.6 The kroon then experienced a short period of spontaneous dollarization, albeit facilitated by the Bank of Estonia. The political will to maintain the currency board was underpinned by the strict legal framework of currency board operation in Estonia. The legal basis for the reform of the Estonian monetary system is set up by the Currency Law of the Republic of Estonia, the Law on the Security of the Estonian Kroon, and the Foreign Currency Law. Almost a year later, Parliament adopted the Law on the Central Bank.7 Unlike the Law on the Bulgarian National Bank, which explicitly provides the currency board rules,
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Table 1 Cross-Country Description of the Main Characteristics of the Currency Boards in Bulgaria, Estonia, and Lithuania Bulgaria
Estonia
Lithuania
Established
July 1997
June 1992
April 1994
Previous exchange rate regime
Floating
Ruble standard
Ruble standard and interim coupon
Access to convertibility at the monetary authority
General public and banks
In principle, general public; in practice, only banks
Commercial banks
Coverage of backing
100 percent of monetary base and government fiscal reserves
100 percent of monetary base
100 percent of currency and BOL’s liquid liabilities
Power to change the exchange rate rule and backing rule
Devaluation needs to be done by an act of the parliament
The BOE has the right to revalue the exchange rate. Devaluation needs to be done by an act of the parliament
Since June 1994, exchange rate can be changed by the BOL in consultation with government
Lender of last resort facility
By the BNB; restricted to systemic and emergency situations; limited to the amount of foreign exchange in excess of backing requirement, that is, reserves of the Banking Department
By the BOE; restricted to systemic and emergency situations; limited to the amount of foreign exchange in excess of backing requirement, that is, reserves of the Banking Department
Limited to the amount of foreign exchange in excess of backing requirement
Reserve requirements
Yes
Yes
Yes
Liquidity requirements
No
Yes
No
Treasury bills
No
No
Yes, since July 1994; weekly auction
Central bank bills
No
Yes; BOE CDs were initially issued in May 1993 with a view to increasing collateral that banks can use in interbank market
No
Government deposits
At central bank
At commercial banks
At central bank
Credit to government by the monetary authorities
Prohibited
Prohibited
Prohibited
Political commitment (political aspects)
Moderate (political unanimity with desultory voices for currency board abandonment
Strong (Full political unanimity)
Weak
13
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the Law on the Central bank of Estonia does not contain them. The Law provides an extremely broad and traditional formulation of the monetary regime and monetary policy rules. Nevertheless, it comprises provisions that create the basis for the stability of the national currency. According to the Law, the central bank is independent from all government agencies and reports only to the parliament. The Bank of Estonia is prohibited from lending to the government in order to avoid political pressure. The currency board principle is established by a separate legal act—the Law on the Security of the Estonian Kroon. It states that the reserve money has to be fully backed by gold and foreign exchange reserves and that the Bank of Estonia has no right to devalue the kroon. The Central bank is not authorized to devalue the kroon exchange rate—revaluation is not rejected—and Parliament is the only authority entrusted to do so with a qualified majority.8 The currency board arrangement in Estonia is based on three main pillars: a fixed exchange rate of the kroon against the DEM at the parity 8 : 1, the 100 percent backing of foreign assets for the currency board’s liabilities, and free convertibility of domestic currency to reserve currency. The decision to peg the kroon to a single currency and not to a basket was aimed at achieving greater transparency. In turn, the DEM was chosen because of its high credibility and Estonia’s orientation toward the EU.9 Legal constraints for backing refer to the base money, which includes cash in circulation plus reserves of commercial banks with the central bank.10 Under the currency board arrangement, the standing facility provided by the central bank is a means of stabilizing the monetary environment. The BOE provides the commercial banks with the possibility of adjusting their kroon liquidity. For licensed credit institutions, the central bank is obligated to exchange without limit the U.S. dollar, the Japanese yen, the Swedish krona, the pound sterling GBP, as well as the euro for kroons and vice versa. The Bank of Estonia does not have a margin on buying and selling the euro to commercial banks.11 In order to provide transparency for the operation of the cur-
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rency board, the Bank of Estonia was divided into an Issue Department and a Banking Department, much like the Bank of England. The Issue Department concentrates all high-liquid assets and liabilities, that is, the de facto currency board, and the Banking Department incorporates both less-liquid assets and liabilities and the net worth of the currency board, that is, the excess of foreign exchange reserves over the cover for monetary liabilities.12 Despite “strict” political and legal commitment to the currency board, the institutional structure of the Central Bank of Estonia allows for certain deviations from the orthodox design of the currency board. One of the peculiarities of the Estonian currency board is that the function of lender of last resort is preserved, although only to a limited extent. In the event of liquidity deficiency in the banking sector, the Bank of Estonia can give assistance to weak banks, but only up to the amount of excess foreign reserves held by the Banking Department.13 Another feature of the Estonian currency board is the use of monetary policy instruments, which are limited to required reserves, standing deposit facility, and central bank certificates of deposit. The method of calculating reserve requirements has changed many times through the years, reflecting attempts to achieve greater flexibility. The base for calculating reserve requirements has been widened as financial markets have developed and foreign borrowing has become available to the banks. In July 1996, the reserve requirement base was supplemented with the securities issued by the banks, in July 1997, net liabilities to foreign credit institutions, and, in September 1998, financial guarantees to financial intermediaries and to nonresident credit institutions. The current level is 10 percent plus 3 percent additional liquidity requirement.14 As of 1996, the requirement has had to be fulfilled on a monthly average basis. To lower market distortions, since July 1999, reserve requirements have been remunerated at the deposit interest rate of the European Central Bank. The second monetary policy instrument is the deposit facility offered by the central bank to commercial banks. The deposit fa-
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cility was introduced in 1996 in order to increase banks’ incentives to maintain liquidity in national currency. Since July 1999, the central bank has paid the European Central Bank deposit rate regardless of the nature of deposits, that is, on required reserves or deposits in the form of excess reserves.15 Another feature of the Estonian currency board is the presence of certificates of deposit (CDs) issued by the central bank. The CDs, introduced in 1993, were intended to stimulate the development of the domestic interbank market, that is, potential collateral, and to provide an additional buffer for the settlement system. Because CDs are a divergence from orthodox currency boards, volumes were kept very small and their role diminished. With more efficient bank liquidity management and increasing money market volumes, CDs lost their initial importance and the auctions were terminated as of May 2000. It should be noted that, unlike in Bulgaria and Lithuania, the Estonian government does not hold its accounts with the currency board, which makes the relationship between foreign exchange reserves and reserve money more transparent. The deposit insurance fund was established as late as 1998. This means that during the period 1991–98, the problems of asymmetric information were resolved on a market basis. The efficient functioning of the currency board requires full liberalization of the economy. The Estonian case is closest to the first best solution. In August 1994, the capital account was liberalized. Major markets and basic prices in the Estonian economy were also rapidly liberalized (Bennett 1993; Saarniit, Tamla, and Randveer 2000). Prices of nontradable goods are determined on a market basis, the labor market is very flexible, and unemployment is relatively low: about 4–5 percent (Saarniit 2000). Transformation of ownership and economic restructuring were fast and radical—as of 1999, 75 percent of GDP was generated by the private sector16 and the service sector was producing about two-thirds of GDP. Finally, it should be noted that the automatic mechanism of the
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Estonian currency board was tested several times, the most serious test being the Asian and Russian crises of 1997–98. The fast response of Estonian interest rates is indirect proof of the smooth functioning of the automatic mechanism. In view of pending EU membership within the next few years, and in order to enhance its negotiating stance, at the end of 2000, the Central Bank of Estonia adopted a plan for the reform of monetary strategy (BOE 2000). The currency board will be preserved during the transition to the euro zone. It should be noted that although reforms in Estonia progressed more rapidly than they did in other Central and East European countries, the country was one of the staunchest advocates of currency board preservation and its compatibility with ERMII, while the European Central Bank and the EC had doubts about the advantages of the currency board as a transitory monetary regime. The plan for reforming the monetary strategy involves two stages: up to mid-2001 and after 2001. The basic element of change is associated with the system of reserve requirements: a step-by-step attainment of the 2 percent EU level, focusing on liquidity requirements, like those in Argentina. A possibility for intraday credit to serve the needs of the payment system is envisaged. Open market operations (OMO) are planned for the period after EMU integration when domestic assets will appear on the Central Bank balance sheet. Lithuania: Ongoing Uncertainty About the Future of the Currency Board The introduction and functioning of the currency board in Lithuania differ significantly from the Estonian arrangement despite the similarity and common history of the two states. Different political choices regarding the monetary regime at the outset of transition predetermined to a great extent subsequent developments in these countries.17 In brief, the Lithuanian approach to the currency board can be defined as political “hesitation and uncertainty” throughout the
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period of currency board introduction and operation. While in Estonia the currency board was used as a means of building confidence in the newly established currency, in Lithuania the decision to introduce the currency board was influenced by Estonia’s successful monetary reform, as well as by concern that the absence of a monetary policy rule might lead the central bank to finance budget deficits. In contrast to Estonia, Lithuania sought support from the currency board after a discretionary central bank period, the use of a temporary currency, and a period of a floating exchange rate regime for the new currency. Although the Lithuanian parliament passed the law on the national currency as early as December 1991, political debates had the effect of delaying exit from the ruble zone.18 In May 1992, the Lithuanian authorities introduced a temporary currency (talonas), whose value was at par with the Russian ruble (1 : 1). Until October 1992, the new currency was in parallel circulation with the ruble; thereafter, the ruble stopped being legal tender.19 On June 25, 1993, the authorities announced the introduction of the new national currency, the litas, and talonas stopped being legal tender after July 1993. The use of foreign currency for transaction purposes was forbidden. At the initial stage of reforms, Lithuania experienced problems, as did Estonia, consistent with economic restructuring, liberalization of administratively set prices, shocks in international trade, and hyperinflationary processes in the ruble zone. Lack of tight fiscal and monetary polices added further uncertainty. As a result, the temporary national currency, talonas, devalued by more than 50 percent between October 1992 and April 1993 and the bulk of transactions, about 80–90 percent, was effected in foreign currency (Vetlov 2001). The introduction of the litas and the tightening of monetary policy in April 1993 led to a dramatic appreciation of the national currency and a rapid decline in inflation. In mid-August 1993, the Lithuanian currency regained more than half of its value against the U.S. dollar. Since then the exchange rate has been relatively stable and dollarization has held at about 50 percent.20
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Chronologically, the currency board was introduced after the litas was put into circulation, following a period of discretionary monetary policy and a floating exchange rate.21 The intention to introduce a currency board was announced by the Prime Minister at a press conference in October 1993 and became a point of lively and continuous debates22 as well as a clash of diverse economic, political, and ideological interests (Camard 1996). In contrast to Estonia, in Lithuania there was no consensus on the currency board. The idea of the currency board found support in the government and the IMF,23 but was opposed by the central bank—by both previous and new management (Aima 1998)—by commercial banks, and by many industrialists. The central bank spoke out against the introduction of the currency board with the argument that its monetary policy had been successful at curbing inflation and stabilizing the exchange rate. The Federation of Industrialists insisted on pegging the exchange rate at a lower level to preserve the competitiveness of Lithuanian exports. The Association of Commercial Banks, whose members had been earning large profits by trading in foreign currency, opposed the proposal completely. “Political uncertainty” about the currency board arrangement continued throughout its existence and made it a hostage of low confidence and credibility—and this, given the fact that the latter characteristics are the major advantage of the currency board and a guarantor of its stability. The weak political commitment to the currency board arrangement was reflected in its legal framework. The currency board was established by the Litas Stability Law of March 17, 1994, effective as of April 1. The law specifies neither the level of the exchange rate peg nor the reserve currency. The law mandated powers to change the exchange rate to the government. As late as July 20, 1994, the law was amended to assign certain powers regarding the exchange rate to the Central Bank of Lithuania. The level of the exchange rate and the reserve currency were determined only in the Memorandum of 1994 signed by Lithuania and the IMF. The U.S. dollar was chosen as the reserve currency
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and the exchange rate was fixed at a rate of USD 1 = LTL 4. In contrast to Estonian and Bulgarian currency boards, the institutional and organizational structure of the Bank of Lithuania remained unchanged. The Bank’s balance sheet was not separated, which made the currency board rule less transparent.24 According to law, the Bank is obliged, upon demand, to provide U.S. dollars both for bank notes issued by it and for all the other liquid liabilities of the Bank, including reserves and deposits of commercial banks, government deposits, and correspondent balances of other central banks.25 As in Estonia, at the outset the monetary base (high-powered money) was not fully backed by net international reserves. The Bank of Lithuania was the institution that started reforms with the least foreign exchange reserves relative to the size of the country among Baltic monetary authorities.26 The country was able to replenish its reserves by signing an agreement with the IMF. The liabilities to the Fund have maturities of up to ten years. Due to the long-term nature of borrowed funds, they are considered a reliable cover for the monetary base (highpowered money). In several months, as a result of capital inflows, the monetary base was fully covered by net foreign reserves and a surplus was generated. Although lending to the government was ruled out under the currency board arrangement, this did not represent a change in practice because the government had no outstanding credit from the central bank. On the other hand, the fiscal reserve of the government27 was included in the liabilities of the central bank and its volatility affects money supply (as in the Bulgarian case). The government can intervene in various ways in currency board operation. For example, in December 1994, the government pledged the assets of the currency board as collateral to obtain a loan from a private German bank (Camard 1996). Parliamentarians also contributed to this by issuing statements and open letters in support of currency board removal, and rumors of devaluation were continuously spread. The institutional design of the currency board in Lithuania pro-
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vides scope for the pursuit of discretionary monetary policy and for exercising the lender of last resort function. Kustaa Aima denies emphatically the existence of the currency board in Lithuania: In essence the Lithuanian system is a normal system of fixed exchange rate with certain limitations on money supply. Otherwise, the Lithuanian system meets the normal criteria of a currency board and Lithuania is generally said to have a currency board while in fact this is not the case. (Aima 1998: 23)
There are two monetary policy instruments: reserve requirements, which are often revised by law,28 and short-term financing of commercial banks. In December 1994, some banks experienced liquidity difficulties and the central bank took action in violation of established principles. In exchange for a loan to the national energy system, the largest bank in Lithuania was given an exemption from reserve requirements. In late December, banks were permitted to count treasury bills placed with them toward reserve requirements. Another feature allowing for the pursuit of monetary policy is the use of the excess of foreign reserves over the monetary base for lender of last resort operations. Thus, the central bank is able to expand short-term loans to commercial banks or buy government securities from them when liquidity deficiencies in the banking sector threaten the financial stability of the system. The Lithuanian currency board functions under conditions of delayed reforms in comparison with the other Baltic states: volatile price liberalization, late escape from the ruble zone, low central bank independence (Aima 1998), political scandals and disputes, weaker “identification” with northern neighbors (Lainela and Sutela 1994). Despite the success of the currency board success in Lithuania, at the end of 1996, political forces launched the idea of gradually abandoning the currency board while preserving the fixed exchange rate regime (Niaura 1998). The authorities justified their proposals for a change with the need to regulate and offset money market volatility and extend the use of the lender of last resort function,
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as well as the need to gain experience in the pursuit of monetary policy before joining the EMU. The idea of gradually abandoning the currency board found formal expression in January 1997, when the Bank of Lithuania announced its 1997–99 Monetary Policy Program. This document envisages the process of exiting from the currency board as passing through three stages (Dagilis 1998). The first stage involves the introduction and application of several monetary policy instruments. This is intended to reduce interest rate volatility, improve the secondary market for government securities, and ensure more efficient regulation of banking system liquidity. The range of instruments includes repo operations, auctions for time deposits, overnight deposits and short-term Lombard loans.29 It is noteworthy that the requirement for full monetary base cover with net foreign exchange assets will be preserved at this stage. The second stage of the program envisages amendments to the Litas Credibility Law. In practice, this is tantamount to exiting from the currency board.30 The idea is for the monetary base cover to be extended to include domestic assets such as treasury bills, credit to commercial banks, and other assets denominated in national currency.31 At the same time, the fixed exchange rate and convertibility of the national currency against the U.S. dollar will be preserved.32 The third stage of the program provides for the litas to be fixed first to a currency basket comprising the U.S. dollar and the euro, and later, if necessary, for the introduction of elements of flexibility.33 Uncertainty continued, however. Because there were “some unclear issues regarding monetary policy conduct,” in July 1999, the Management Board of the Bank of Lithuania adopted guidelines on the application of monetary policy instruments, defining the purposes, conditions, and limits for the use of such instruments. The Central Bank explicitly declared its intention to apply these instruments based on two limitations: first, preservation of the fixed exchange rate and unrestricted convertibility between the national and reserve currencies, and second, full cover for the national cur-
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rency-denominated liabilities of the Bank of Lithuania with foreign exchange reserves. Arguments supporting the intention to apply monetary policy instruments are the need to achieve and maintain equilibrium in financial markets based on fundamentals as well as the need to neutralize the impact of transitory disturbing factors such as changes in government deposits with the central bank, large financial transactions, the receipt and repayment of large external loans. Other central bank arguments in favor of using monetary instruments were the need to promote development of the Lithuanian financial market and to prepare for joining the EMU. In October 1999, the central bank passed a new resolution: to postpone reorientation to the euro as planned for 2000, and, in the second half of 2001, to fix the litas directly to the euro without passing through pegging to a currency basket comprising the euro and the U.S. dollar. Although the central bank’s position on the litas peg to the euro has not been changed, the time frame of this resolution was abandoned. At the end of June 2001, the Bank of Lithuania announced that the euro would be adopted as an anchor currency as of February 2, 2002. The official exchange rate of the litas against the euro will thus be established on the basis of the exchange rate of the dollar and the euro in the currency market on February 1, 2002. Bulgaria—the External Imposition of a Currency Board Following a Financial Crisis The causes and manner of introduction of the currency board in Bulgaria differ from those in Estonia and Lithuania. This is a classic example of the external imposition of institutional change in the monetary regime by Bulgaria’s foreign creditors and the IMF. At the same time, the Bulgarian currency board shares common features with the Estonian currency board, such as separation of the balance sheet, and the Lithuanian currency board, such as a start-up loan from the IMF as part of its foreign currency reserves.
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Bulgaria’s slow and faltering transition to a market economy since 1991 had logically resulted in the introduction of the currency board in mid-1997.34 The idea of currency board adoption was launched as early as the beginning of transition, in 1990–91 (Hanke and Schuler 1991), but at that time found no support among Bulgarian authorities and the IMF. If the currency board had been established at that time, as it was in Estonia, undoubtedly Bulgaria’s path over the past ten years would have been quite different. Failure to address the need for radical and consistent structural reform led to the accumulation of micro- and macroeconomic disequilibria, which, in turn, affected the financial sector. Many state-owned enterprises continued to incur heavy losses that were transferred to the banking sector or assumed directly by the budget. Monetization of huge budget deficits and quasi-deficits combined with frequent attempts to bail out problem commercial banks created inflationary pressure, forex market turmoil, and, ultimately, lev devaluation. The Bulgarian National Bank lost control over reserve money sources and the money supply as a whole (Nenovsky 1998). Flight from the lev was uncontrollable. The culminating point was the financial crisis of late 1996 and early 1997. The Bulgarian economy experienced a period of hyperinflation as prices rose by 43 percent in January and soared to 240 percent in February; a depletion of foreign exchange reserves to USD 440 million without monetary gold; the closure of fourteen banks whose balance sheets comprised about 25 percent of the consolidated balance sheet of the banking system; and flight from the national currency (OECD 1999). Real output, which had grown in 1994 and 1995 for the first time since the start of reforms, contracted by more than 10 percent, and foreign currency reserves declined to less than two months of imports (Gulde 1999). There was a growing awareness of the need for a new institutional framework for the monetary regime and a drastic change in monetary policy in order to end the continuous monetizing of losses in the economy. The currency board seemed to be the most suitable and politically acceptable solution. However, introduction of
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the currency board in Bulgaria should be viewed less as a result of political resolve for radical change and more as an unavoidable measure imposed at the insistence of the IMF and foreign creditors, who saw in the commitment a guarantee for the success of the stabilization program, the only possible way to ensure financial discipline and external debt service.35 The road leading to the choice of the currency board as a stabilization instrument was full of political uncertainties and discussions.36 The proposal for fixing the exchange rate and establishing full cover for reserve money was not made until November 1996,37 when the IMF mission initiated discussion with the Bulgarian authorities and major interest groups—including political parties, trade unions, foreign creditors, journalists, and academics (Gulde 1999). Proponents of the stabilization plan proposed by the IMF perceived the currency board as the only solution to the problem of establishing financial discipline and stability. There were many critics of the idea of introducing a currency board: arguments varied from utter rejection and treatment of the currency board as “external interference” in Bulgaria’s sovereignty to the argument that the present state of the Bulgarian economy did not allow for the introduction of such a rigorous regime. The idea of a currency board and of radical steps to stabilize the financial system gradually gained broad public and political support, politically justified in the declaration accepted by the major political parties on February 4, 1997. This allowed for the introduction of currency board rules in most government institutions prior to legislative regulation of the currency board principles.38 Early discussions about the need to introduce a currency board in Bulgaria were followed by discussions about the choice of reserve currency and the level at which the exchange rate should be fixed. Suggestions ranged from the U.S. dollar to the deutschemark, and to a basket of the two currencies in a set ratio. Although at that time the choice of the U.S. dollar seemed economically more consistent given its dominant role in transactions and central bank foreign currency reserves, the lev was fixed to the deutsche-
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mark for political considerations in view of Bulgaria’s long-term goal of EU membership.39 The Law on the Bulgarian National Bank, which was passed on June 5, 1997, established the legal framework for the functioning of the Bulgarian currency board. The manner of drafting the legal basis for the new monetary regime in Bulgaria reflects a strong political commitment. The reserve currency, the level of the fixed exchange rate, and the currency board principles are legally based on the Law on the BNB. Bulgaria has chosen the deutschemark as its reserve currency and fixed the exchange rate at BGL 1,000 per DEM 1, and, after lev redenomination and introduction of the euro, at EUR 1= BGN 1.95583.40 In addition to the requirement for maintaining the fixed exchange rate, the law sets forth the remaining core principles of currency board operation: full cover for the central bank’s liabilities with foreign currency reserves, the guarantee that the central bank will convert national and reserve currencies on demand and without limit, and the cutoff of lending to the government. With the Law on the Central Bank of June 1997, the institutional design of the central bank was modified. This allowed for greater transparency regarding currency board operation, namely, the establishment of a Banking Department and an Issue Department with separate balance sheets.41 As in the case of Estonia, the balance sheet of the Issue Department reflects currency board activity and comprises the most liquid assets and liabilities. The deposit of the Banking Department in the Issue Department, the “net worth” of the currency board,42 provides the link between the two departments. The specific design of the Bulgarian currency board reflects the sought-after tradeoff between the rule of financial discipline and flexibility. The elements of flexibility representing departures from the orthodox form of currency board are minimum reserve requirements, preserved lender of last resort function, albeit limited, and the presence of government deposits in the liabilities of the Issue Department. At the inception of the new monetary regime, the level of
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minimum reserve requirements was set at 11 percent of the deposit base of commercial banks and remained unchanged until June 2000.43 In July 2000, the BNB reduced minimum reserve requirements from 11 percent to 8 percent. The Central Bank’s decision was not an attempt to influence the money supply but rather reflected the policy of a step-by-step reduction of minimum required reserves to the level established in the euro zone. The preservation of a limited lender of last resort function also represents a departure from the orthodox form of currency board. In the event of a liquidity risk threatening the banking system’s stability, it is possible for the Bulgarian National Bank to extend, through the Banking Department, lev-denominated credits only to solvent banks with acute liquidity needs, provided that no other sources exist.44 Such credits may be extended if they are fully secured with adequate liquid assets, and the repayment term is no longer than three months. Despite initial concern over banking system turmoil, there has been no cause for the Bulgarian National Bank to perform the lender of last resort function from the currency board’s inception to the present time. Another feature of the Bulgarian currency board is the presence of fiscal reserves on the liability side of the balance. In this respect, the Bulgarian case is similar to the Lithuanian one. As in Lithuania, IMF tranches received by Bulgaria also appear on the currency board asset side as foreign currency reserves, thus creating the “impression” of its own sizable foreign currency reserves, which are necessary for currency board credibility. The fiscal reserve in Bulgaria accounts for 30–40 percent of the currency board balance sheet. The fiscal reserves include government deposits as well as the resources of some other institutions. At the end of May 2001, the terms of the deposit contracts of the central bank with the Ministry of Finance and the National Health Insurance Fund (NHIF) were revised. According to the new terms, for their resources with the central bank, the government and the NHIF will get the whole return obtained from the investing of the funds. Changes in this deposit (fiscal reserves), consistent with the dy-
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namics of budget expenses and revenues, affect reserve money and money supply and destroy the automatic link between balance of payments dynamics and reserve money dynamics (Nenovsky and Hristov 2001).45 Conclusions and Directions for Further Theoretical Research The article presents a descriptive analysis of the initial conditions, institutional, organizational, political, and legal characteristics of the currency boards introduced in three East European countries: Bulgaria, Estonia, and Lithuania. The new generation of currency boards differs significantly from the first, orthodox generation: the latter is completely free from government presence and leaves no possibility for government intervention. The comparison of currency board design in Bulgaria, Estonia, and Lithuania reveals significant differences in the historical background of currency board adoption, institutional design, and overall macroeconomic framework. This observation does not fit completely with the generally accepted view that currency boards in the three transition economies function in a similar pattern and differences are insignificant. In general, our empirical observations show that the institutional, legal, and political commitments are strongest in Estonia, followed by Bulgaria, and are weakest in Lithuania. Within the second generation of currency boards, the scope for discretion stems from the presence of atypical items in the balance sheet and the employment of a number of central bank monetary policy instruments, active or not. The most serious deviations from the orthodox form of currency board occur in Lithuania and Bulgaria, where the governments hold their accounts with the central banks and can influence the stock of reserve money, that is, they conduct a certain form of monetary policy, in most cases unconsciously. Therefore, reserve money dynamics become “hostage” to the financial state of the budget. Furthermore, in Estonia
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and Lithuania, programs for the gradual abandonment of the currency board were prepared, and these included the introduction of monetary policy instruments. Overall, our assumption that modern currency boards reflect a mixture of rules and discretion is confirmed, and this suggests that it is difficult to find discretionary central banks and currency boards in pure form today. While describing historical and institutional features of the introduction and functioning of the three currency boards in the accession countries, we have found a number of new directions for theoretical analysis. We shall mention some of them. First, it is necessary to find a method for integration of the initial conditions, institutional, organizational, and political factors in the automatic mechanism model and currency board mechanics. In the view of the institutional analysis, particular importance has to be paid to the initial conditions, which, in certain frameworks, determine the development path of the monetary regime. Second, it is interesting to study the relation between the delineated factors and credibility of the currency board as its basic specific feature. Third, the functioning and especially the introduction of a currency board could be considered with the methodology of political economy. Currency board introduction itself is an extreme institutional change, which should be seen not only as certain relations between financial and macroeconomic variables. This change could be regarded as a struggle between different groups of economic agents striving to impose the institutional framework, which supplies them with the greater part of the wealth of the economy. The currency board provides a convenient “laboratory” opportunity for exploring the impulses for, and the dynamics of, the institutional change of monetary regimes. Fourth, a fundamental question of practical significance appears. How can monetary discretion under a central bank be differentiated from monetary discretion under a currency board? Is there room for a liquidity effect under the currency board? A specific direction of analysis would be to decompose discretion, also the
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liquidity effect, according to different variables impacting the financial state of the government, included in its fiscal reserves. All this could be instrumental in answering a major question: what ultimately distinguishes modern currency boards from traditional central banks? The suggested directions for theoretical and applied research should be considered in the context of specific features of the transition economies and in view of the choice of most appropriate monetary regime for integration with the euro zone. Notes 1. Concerning the significance of the institutions as a factor of economic success, as well as the different approaches toward the institutions, see the review articles of Nelson and Sampat (2001) and Rizopoulos and Kichou (2001). 2. Criteria classification for distinguishing systemic from nonsystemic change has been developed by J. Kornai (2000). 3. It should be noted that introduction of the currency board and the national currency de facto brought a new national source of income for the country: seignorage; later in the text we will see that adoption of the currency board in Bulgaria led to lower seignorage. 4. Even before gaining political independence in August 1991, political forces in Estonia moved to create their own stable national currency intended to separate the country from a dissolving Soviet Union and dramatic ruble devaluation. As early as the late 1980s, a working group of experts was established at Moscow University, which included students from the Baltic region, known as the Group of Medvedev-Nit, whose task was to study the possibilities of launching an independent currency in the Baltic region similar to the gold chervonets of the early 1920s under the New Economic Policy (see also Kukk 1997; Lainela and Sutela 1994). The resolve of the Estonian authorities to exit the ruble zone and introduce a new currency was underpinned by the fact that the Estonian government developed a plan for “official dollarization” as early as the beginning of 1991. Due to its utter incompatibility with effective Soviet currency legislation, this plan was not formalized (Kukk 1997). 5. Except for a short-lived period of a so-called local Soviet ruble, when the Bank of Estonia started to quote the Soviet ruble at the black market rate (Kukk 1997). According to Kalev Kukk, this is a kind of “local devaluation of the Soviet ruble,” tantamount to putting into circulation a 100 percent backed currency. For a very brief period, the CBE legalized two types of local money, that of the city of Tartu, which arose spontaneously and mainly as a result of cash deficiency, and that of the Estonian Savings Bank. 6. For more details on ruble conversion into kroons, see BOE (2001) or
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Kukk (1997). Monetary reform can be considered an alternative to shock price liberalization in addressing the problem of “monetary overhang.” 7. Amended and renamed as a Bank of Estonia Act on June 18, 1998). 8. It is interesting to note that until 1996 the Finance Minister participated in the decision making of the Central Bank Managing Board (Aima 1998). 9. The fact of a meeting between the chairman of the Central Bank of Estonia and the president of the Bundesbank on May 8, 1992, during which a political decision was made to fix the kroon to the deutschemark, is less known (BOE 2000). 10. Estonia swiftly recovered its assets “frozen” in World War II, a total of 11.3 tons of gold from England, the BIS, and Sweden, which enabled it to launch the currency board, that is, to cover currency in circulation, commercial bank accounts, and some of the savings deposits. In actual fact, the Estonian currency board did not start with 100 percent backing for the selected liabilities and the item “Capital” appeared in the balance sheet with a net, in this case, negative value of the currency board (Bennett 1993). The 100 percent backing was reached in September on receipt of the second tranche of gold from the BIS. Latvia received 7 tons of gold and Lithuania, 6 tons. 11. Initially, there was a small margin, but it was abolished in July 1996. 12. Some difficulties emerged with the initial separation of the Central Bank balance sheet. They reflected in part the forced inclusion of some items in the liabilities of the Issue Department. For example, savings deposits of individuals with the Estonian branches of the Soviet Sberkassa, backed by foreign exchange reserves, were reported as liabilities. Initially, other “unusual” items, mainly reflecting relationships between Estonia and Russia, appeared on the Banking Department balance sheet, for example, liabilities to the Russian army in Estonia, for which there was not sufficient foreign exchange to cover. Subsequently, they were transferred as cash liabilities to the Issue Department together with an equivalent stock of foreign exchange reserves (Bennett 1993). 13. The Central Bank of Estonia used that surplus at the outset of currency board functioning (1992/1993) to recapitalize several commercial banks (Bennett 1993; Abrams and Cortes-Douglas 1993). 14. The latter was added after a speculative attack against the Estonian kroon in October 1997. 15. In jurisdiction there is distinction between reserves’ interest rate and deposit interest rate. 16. See EBRD Transition Report, 2000. 17. See Haan, Berger, and Van Fraassen (2001). 18. It is of note that Lithuania declared its political independence as early as March 1990, that is, before Estonia. The Central Bank of Lithuania was established, that is, restored, in 1990. 19. The Central Bank of Lithuania started withdrawing rubles from circulation in September 1992. 20. Vetlov (2001). 21. For a detailed comparative analysis of the new currencies of the three Baltic States, see Kukk (1997). 22. Half a year (Niaura 1998).
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23. Here, the IMF’s stance differed from that on Estonia. Some influential NGOs also supported the currency board, such as the Lithuanian Free Market Institute, in expounding liberal ideas. Some economists at the Institute supported the idea of a purely orthodox currency board based abroad. They suggested that the currency board should function as an investment fund, which is an extremely liberal form of monetary organization expressed only hypothetically. The advocates of currency boards and free banking also promoted monetary reform in Lithuania (Schuler, Selgin, and Sinkey 1991). 24. The balance sheet is split into two parts for operational purposes, but these are not officially published. 25. Only licensed banks are permitted to exchange money directly with the Bank of Lithuania. 26. Lithuania received its frozen gold reserves from Banque de France and the Bank of England in 1992. 27. Pautola and Backe (1998). 28. When signs of a banking crisis emerged in 1995, the central bank lowered required reserves from 12 percent to 10 percent in April 1995, and to 5 percent in May 1996. In addition, in March 1996, sanctions on the failure to maintain sufficient required reserves were abolished. Required reserves regained their level of 10 percent in June 1996 once the banking crisis subsided. 29. Repo operations with treasury bills and auctions for time deposits were introduced in the summer of 1997. 30. Although the program provides for a significant modification of the Litas Credibility Law, it does not repeal it completely. 31. Although this stage involves transition to a softer regime, the program envisages preservation of the fixed exchange rate system. 32. At this stage, the program envisages the newly introduced monetary policy instruments to be used mainly to tighten restriction in order to avoid pressure on the fixed exchange rate. 33. According to the Bank of Lithuania, the preconditions for the implementation of this stage are internal macroeconomic and financial stability, continuous growth in deposits, and low inflation. 34. For an excellent survey of Bulgarian transition, see Dobrinsky (2000). For more details, see Mihov (2000) and Horvath and Szekely (2001). 35. Before the program of April 1997 underlying the currency board, Bulgaria had signed four standby agreements with the IMF—in 1991, 1992, 1994, and 1996—but only one was fully completed (Gulde 1999). 36. The socialist government was forced to accept the currency board as an unavoidable measure, while, initially, the opposition rejected the need for currency board adoption. Once it became clear that the IMF would not abandon its decision, the opposition, which was later to become the governing party, supported the idea, and, at present, claims that the decision on currency board adoption was theirs. 37. Although consultations had begun as early as in summer. 38. A new standby agreement signed with the IMF in April 1997 played the role of a financial anchor for the forthcoming launch of a currency board in Bul-
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garia. The BNB started preparing for the new monetary regime—it stopped making new loans to commercial banks and began collecting old ones. In mid-June, open market operations were discontinued. Meanwhile, the government refrained from drawing loans from the central bank. 39. See Yotzov and Nenovsky (1997) on the advantages and disadvantages of alternative versions and the fixing of the exchange rate. See also the empirical study on the credibility of the introduction of the Bulgarian currency board done by Carlson and Valev (2001). 40. The Law provided for pegging the lev to the euro after the introduction of the single European currency. 41. On June 30, 1997, the BNB prepared a closing balance on the basis of the former accounting framework, and the opening balance of the currency board, on July 1, 1997, reflected the new structure of accounts. 42. The net worth item is also present in classic currency boards but its role is only that of a buffer to provide a guarantee against fluctuations in asset prices; under nonorthodox currency boards, the net worth makes it possible to perform the lender of last resort function as well. 43. In April 1998, the method was modified to allow greater autonomy and flexibility in commercial bank liquidity management. 44. The definition for liquidity risk is provided pursuant to Bulgarian National Bank Regulation No. 6 of the BNB. 45. Miller (1999) has found significant deviations from the automatic mechanism of the currency board in Bulgaria. The design of the Bulgarian currency board enables the government to conduct “unconscious, spontaneous” monetary policy by changing its deposit at the central bank (Nenovsky and Hristov 1998).
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