_ WORLD BANK LAT91N AMMERICAN AND CARIBBEAN STUDIES Proceedings Work in progress for public discussiont o-n Currency Boards and External Shocks EDITED BY GUILLERMO E. PERRY GUILLERMO CALVO W MAX CORDEN STANLEY FISCHER SIR ALAN WALTERS JOHN WILLIAMSON  Currency Boards and External Shocks How Much Pain, How Much Gain? EDITED BY GUILLERMO E. PERRY GUILLERMO CALVO W MAX CORDEN STANLEY FISCHER SIRALAN WALTERS JOHN WILLIAMSON THE WORLD BANK WASH I NGTON, D.C. Copyright @ 1997 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing January 1997 The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. 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Library of Congress Cataloging-in-Publication Data Currency boards and external shocks: how much pain, how much gain? / edited by Guillermo E. Perry ; Guillermo Calvo ... [et al.l. p. cm. - (World Bank Latin American and Caribbean studies) "Proceedings." Includes index. ISBN 0-8213-3864-1 1. Currency boards-Congresses. I. Perry, Guillermo. II. Calvo, Guillermo. III. Series HG230.5.C87 1997 332.4'6-dc2l 96-51060 CIP CONTENTS oreword . ......... Introduction and Summary, by Guillermo E. Perry ..........................................1 I. The Dilemmas of Currency Boards, by W Max Corden ......................................3 II. Features and Implications of Currency Boards: ,ome Thoughts about the Argentine Situation, by John Williamson ...............................7 V The Experience of Hong Kong, by Sir Alan Walters ................ ......................11 Argentina's Experience after the Mexican Crisis, by Guillermo Calvo ..... ......................15 71. Closing Remarks: What Have We Learned? by Stanley Fischer ...............................19 :ontributors ......................................................................23 Qotes . ..........................................................................25 iii  FOREWORD T ~HESE PROCEEDINGS PROVIDE AN ACCOLUNT OF A ROL NDTABLE DISCUSSION ON THE SUBJECT OF "External Shocks and Currency Boards: How Much Pain? How Much Gain?" held at the World Bank on October 4, 1996. The event was sponsored by the Office of the Chief Economist of the Latin America and the Caribbean Region, and its audience of more than 100 people included representatives of various national governments and central banks, the private sector, and acade- tia, as well as staff members of the International Monetary Fund, the World Bank, and the Inter-American )evelopment Bank. Because the panelists, all distinguished experts in the field of international macroeconomics, had a very pecialized audience at the time, some of the discussion may be unclear for readers without background on the vorkings of currency boards. Currency boards are institutions that replace central banks and ensure that a ountry's currency can be purchased at a given price (or exchange rate) upon demand, thus imposing a fixed xchange rate on international transactions. A variety of countries have adopted such systems, including vrgentina since 1991, Hong Kong since the early 1980s, and several countries undergoing transitions from lanned to market-oriented economic systems. Ecuador is currently considering establishing such a system. The key advantage of such a system is that it prohibits the use of liberal monetary policies, which can lead to igh inflation. However, currency boards also limit the ability of an economy to react to changes in international conomic conditions if foreign currency reserves dry up. These threats to the stability of the financial sector may ome not from any domestic cause, but from economic events that originate outside the domain of national conomies - so-called "external shocks," such as the fallout from the December 1994 Mexico peso devaluation the "tequila effect"). It was the impact of external shocks that was the focus of the World Bank discussion. The panelists addressed the challenges countries face when operating under a currency-board system of urrency exchange, with an emphasis on discussing how certain costs can be minimized while maximizing the ;ains. We hope the publication of these proceedings will provide stimulus to ongoing discussions regarding the osts and benefits of such monetary arrangements, not only in Latin America and the Caribbean but through- )ut the world. I am grateful for the cooperation of the participants, the panelists, and the World Bank. I am particularly ;rateful to Daniel Lederman of the Office of the Chief Economist, who managed the event from beginning to nd and edited the original transcripts. Mario del Carril made this timely publication possible. Finally, my staff, ncluding Patricia Mendez, Elizabeth Mirnosa, Jorge Forgues and Nelinda Andres, did a wonderful job organiz- ng the event. -Gitillermo E. Perry Deccmber 1996  I N 11 0 1P ,1t ( N 4A n ) [ 1M A RT 1. INTRODUCTION AND SUMMARY BY GUILLERMO E. PERRY HERE IS LITTLE DOUBT THAT A CURRENCY-BOARD REGIME CAN HELP ACHIEVE DRAMAT- ireductions in inflation rates. The transparency of the fixed exchange rate as a nom- inal anchor and the loss of monetary policy flexibility enhance the anti-inflation credibility of policy-makers. Currency boards also impose fiscal discipline because expenditures cannot be financed by printing money However, it is also clear that in ie event of negative external shocks, the loss in flexibility that a currency-board regime entails iay pose threats to the stability of the financial sector and can be very costly in terms of for- Dne output and employment. We did not intend the roundtable to concentrate exclusively on the issue of why or when Duntries may or may not benefit from establishing a currency board, because these had been ie topics of a previous conference at the World Bank.' So, issues related to the installation of ich a system (e.g., the initial level of reserves, the proper parity) or transitional issues (e.g., the )eed of inflation convergence) were not the focus of the discussion. Instead, the discussion cov- red issues related to the impact of external shocks on economies already operating under this ind of regime. In particular, we were interested in understanding how to mitigate the poten- ally dire consequences of external shocks. As is well known, external shocks may negatively affect the needed to maintain an equilibrium real exchange rate when cap- iancial stability of an economy, because, as discussed by John ital flows out or the terms of trade deteriorate. Under these con- illiamson, pure currency-board regimes do not offer a lender ditions the burden of adjustment consequently falls on the level last resort, which is a traditional role of central banks. On the of output and employment. The issue then is what we can do to al side of the economy, the "stickiness" of wages and prices mitigate these effects. eclude downward nominal adjustments. which would be Reducing the probability of being hit by severe external shocks may be a long-term endeavor The vulnerability to trade cannot eliminate systemic risks, and ultimately if the sw shocks in the long run can be reduced through trade and pro- arrangements and international piivate credit lines are r ductive diversification. With respect to shocks affecting the cap- enough, either the Argentine Central Bank or the fiscal autho ital account, as long as capital flows respond to endogenous fac- ties will need to provide funds to prevent potential collapses tors, a disciplined and credible macroeconomic stance seems to the payments system. In fact, the experience of Estonia I be crucial - although as Stan Fischer recalled in his comments, taught us that even while some hanks are closed in the idst the experience of the European countries in 1992 shows that the a systemic crisis, government lending can minimize the lossn degree of macroeconomic discipline required to maintain fixed Generally there seems to he a trade-off betxeen the use parities is. in fact, very demanding. Moreover, even with a strong reservcs to support convertihility or to support the hanking s, macro stance, consolidating credibility may take time, especially ter. In practice there may he a need for public institutions when weak credibility was the reason to institute a currency play some limited role of lender of last resort in order to mai board in the first place. Unfortunately, as Max Corden reminded tam the conxertihilitx of the currency as long as deposits us. capital flows also respond to exogenous factors, which are allowed to he withdrawn in cash Gtillermo Calvo argued th not related to domestic economic or pouLIcal events. So, what in faci, in the Argentine case, where a large share of deposits else can be done besides maintaining fiscal discipline? in dollars, a devaluation could have made the financial cri Let us look first at the issue of the vulnerability of the even xorse,4 financial sector and potential alternatives to a domestic lender of It may he true, hoxever, that in the long run banks w last resort. The historical experience with currency-board type no access to a lender of last resort may become very conser' regimes - such as that of Hong Kong prior to 1972 and more tive, because the moral hazard is eliminated. As Stan Fiscf recently since 1983, which has been successful, according to Sir pointed out in his presentaton, the existence of a curren Alan Walters, and that of the U.S states before the Federal hoard may produce healthy pressures. As international expe Reserve - have shown that modifications in the regulatory ences haxe demonstrated, in the short run it may he xise structure can reduce the need for a lender of last resort. Hong acctmulate excess internationa reserves, strengthen super Kong, for example, has a highly concentrated banking system sion, establish high reserve or liquidity requirements - as with a highly diversified international portfolio, which has per- Argentines haxe done and to haxe either the gox'rnment mitted the Exchange Fund to make limited use of reserves to an independent specialized agencx to act as a limited lender support very small banks during times of distress. Several U S. last resort states during the era of free banking permitted banks to branch Regarding the impact of external shocks on employmn out within states, which reduced the number of small banks and and economic activity hesides their impact on the financial s, also encouraged diversification. In general, regulations that per- tem, Max Corden emphasized that eforming the labor marl mit greater concentration of the banking sector and portfolio should he the first item on the agenda The remainin u diversification tend to reduce (but not eliminate) the need for a is hox much and hox last it will contrihute to achieving doxx public lender of last resort.- xard nominal wage and nontradahle price flexibility Sir Al Turning to the case of Argentina, we see that permitting Walters emphasized that Hong Kong has a xery flexible lal the internationalization of the financial sector can help both to market. (it would he interesting to knox hox much the currc reduce the vulnerabilitv of banks to negative external shocks and cV-board ri has contributed to this development.) Cord to smooth out capital flows, because foreign-owned subsidiaries also reminded us that to the eXtent that employment can can draw from credit lines to their parent banks when confront- affected By counter-cyclical fiscal policies, a country that F ed with negative external shocks. Although for good reasons, gained credibility and a high lexel of reserves could'eventua such as better client knowledge, countries like Argentina are attempt to Use fiscal policies to counter negatixe shocks. likely to maintain a sizable domestic banking system, they also These xere some of the issues coxered durtng the roun may obtain such "cushion effect" from swap arrangements, such table discussion. Professor Max Corden led the xay, folloxed as the one that the Argentine Central Bank signed recently with Dr. John \illiamson, Sir Alan Walteis, and Professor Guillerr some foreign banks. CaIxo. Dr. Stanley Fischer pioxided the final remarks, It is also exident, hoxdver, that tegulatory arrangements 2 II. THE DILEMMAS OF CURRENCY BOARDS BY W. MAX CORDEN LACTUALLY CAME PREPARED TO CAVE YOU MY VIEWS ABOUT WHETHER IT IS A GOOD IDEA TO have currency boards, and I can't stop myself from saying something on the subject. But the main task here is to consider a country that has decided to establish some system of that kind - whether it is Argentina, Hong Kong, or Estonia. What should it do to deal with the inevitable dilemmas? I will give you my views on that topic straight away with- ut filling in the details, so that there will be something for the other panelists to say Then I 'ould like to say a few words about the broader issue: What are the criteria for deciding whether country should have a currency board or not? So, assume that the decision has been made, there is a pretty firm political commitment, and ie country is stuck with all these problems, like those confronting Argentina today I will just iake three simple points: First, labor market flexibility is crucial. This is easier said tions to that little problem. an done. That is the big problem, and I am sure that it is a Second, if one could avoid shocks, it would be great, alor problem for Argentina, as for any substantial economy I because then there would be no problem Shocks that cannot be ive no elementary propositions to make about how to bring avoided are those that originate from, say, variations in U.S 'out labor market flexibility; that is the art of politics. And how monetary policies or from changes in the terms of trade. But a ies one persuade politicians and, above all, trade unionists, country can avoid capital inflow-outflow shocks, to some extent, at it is necessary, that n the long run workers are going to be by making the currency-board system credible. So if there is st as well off - or better off - with nominal wage flexibility going to be a currency board, it is necessary to convince the mar- iwnward than by hanging on to nominal wage levels while ket that the government really means it, that it is going to stick >minal demand declines when there is, for example, a capital with it and with the associated necessary policies - above all, itflow? That is the central issue. I have no simple answers, but tight fiscal policy. If it will run a big budget deficit and borrow im sure that other members of the panel will have simple solu- abroad, it will end tip with a debt crisis, in spite of the fixed .3 II [I~ 'A "I II , ' N It '1I 1 exchange rate. By the way, we have had such cases. I am think- Hong Kong has gone through penods of fairly high inflation ai ing particularly of Cote d'Ivoire, which had a fixed exchange rate has osed the inflation tax for financing govement. regime for a long time, as part of the African franc zone, very My first criteiion is. Dont bother introducing a system ti similar to a currency board, but nevertheless had fiscal and for- this unless the county has had some inflation prohlem. If the eign-debt problems If credibihty can be achieved, there will he is a country where a currency-hoard system appears to he so fewer shocks that come from sudden capital outflows. That is able hut wherc there has never really been a major inflatit easier said than done, but crecibility is the second reluirement, problem, 1 woufd say Let sleeping dogs lie.' There are oth and I think that Argentina is trying on that front. Hong Kong ways of keeping inflation down in the future. So, we arc n maybe has achieved a high degree of credibility, but the thing has rowing the problem down to those countries that have expe to be rcallv credible enced a significant inflation problen. Third, some fiscal flexibility can be helpful In the situa- The second ant most important consideration - coon tion where there is, say, an adverse-terms-of-trade shock or a from the theory of optimum currency areas is that there ii capital outflow problem, it helps to be able to engage in some scrious case for small and very open economies to have a cL temporary fiscal expansion, which could involve foreign rd system of some kind. The degree of openness - debt. This would offset, at least to sonme extent, the domestic ratio of tradabies to nontradables - is crucial. The argument deflationary effects resulting otherwise from the currency-board faxor of adopting a currency board is xeaker - and possil' system Of course, this means that big fiscal surpluses must be there fs no case for large economies (vith a fox ratio of tra run durtng the previous boom. In other words, one cannot tust ables This raises the practical question (which I dont haxe say that the obvious solution is to run a big budget deficit to time to get into) of xhere to drax the line. It seis to me oh' reduce the pain - what Cote d"Ivoire did when its terms of ou> that some small economies, let's say in the West Indies, pc trade deteriorated in the mid-1970s. If the government had sibly in Central America. and certain countries in Africa, are achieved big surpluses earlier and had run up high foreign initely candidaies for that sort of systen, unless they haxe ma reserves or investments abroad, then it can afford to use aged to avoid inflation in any case with xhate'er system th Keynesian fiscal stabilization, given that monetary policies are have now On the other hand, it >eems to me that countries su ruled out. So if one believes in the possibility of stabilization as Mexico or Russia are not candidates for an optimum curre through fiscal policy, and monetary stabilization is ruled out cy Of course, that can be disputed. Again, the interesting iss because of the currency-board system, one may want to leave is, xhere doe> one draw the line? some room for fiscal stabilization. (Incidentally, this is an impor- I xas inxot'cd in a NVorld Bank-sponsored study cornp- tant issue in Europe.) Of course, one may not believe in stabi- tg 1S developing countries' macroeconomic history, and ve 6 ization policies. That is another matter include a number of small economies.5 The small countries I To summarize, one has to look for answers to this almost come to mind are Goteclix ore. Cameroon, Kenya, and Gui insoluble problem under three headings: labor market flexibili- Rica Those are the countries that one would think of as go, ty, credibility of the system to avoid unnecessary capital inflow- candidates for currency boards. But one must ask xhether not outflow problems, and some degree of fiscal flexibility to bring nA exchange rate changs hase had real effects in those cou about some moderate degree of stabilization. tries or whether nominal devalcations xere rapidly xashec c Can I say a few words going beyond our limited task? by sage- ant price> rising. If nominal devaluations xere rapt What is my view of this whole currency-board idea? \N'ell, I IN, vashed ut, then there is no point to having a flexi would put it like this: The main argument for currency boards is exchange rate. 'hey might as xelf haxe Completely fix to avoid inflation; you tic your currency to a low-inflation cur- exchange rate regimes. And, if there is going to be an attempt rency, make a firm commitment, and you will keep inflation a fixed exchange rate, they arc much better offwith a curren down. Countries that have a great deal of other problems but board than vith a fixed but potentially adjustable exchange r have maintained a fixed parity, such as francophone African regine, because of the speculation problem. So I think there f: countries in the past, have achieved low inflation. So, it certam- lot to be said in faxor of a currency board relatixe to a fixed-hi ly works and there are other examples. If you really stick with adjustable exchange-rate regime. By "fixed-but-adjustable" it, you are going to get low inflation. But one Must remember ian a rate that is fairly firmly fixed, xith an attempt by that there can still be reasons for capital inflows. Hence. prices authoritie> to hang unto the fixed rate, but nexer eliminating will rise when the money supply rises as capital flows in, or possibility of exchange-rate realignment. when the terms of trade improve. For example, though Hong So, where does one drax the line? Looking at the expe Kong's currency board has prev'ented coriritious high inflation. Hngce of these countries, I era surprised to find that in Ca 4 1 [10 1 1 1 11 I I ica, for example, the nominal exchange rate change did have rit themselves to fixed exchange rates. To focus on the main ignificant real effects. So I am not sure where I would draw the point I have already mentioned that country experiences with ne, to be honest. Cameroon and Cote dIvoire had bad experi- nominal devaluations arc important: Do nominal devaluations nces even though they had fixed exchange rates. It was not bad hate real effects or not? If the effects quickly wash out, then such or their inflation, since they experienced much less inflation countries might as well have truly fixed nominal exchange rates, han those West African countries that were not in the franc and hence currency hoards or similar arrangements. one. But they did generate big budget deficits and ended up These arc the main issues. I hate ofready referred to vith crises. Out of the 18 countries included in the World Bank Wesi Africa (an important example>, and Hong Kong vill he dis- )roject, these two were the only ones with negative growth rates crs. Finally I tant to mention another coun- t the end of the period we studied (1965-1992). Of course. try among the 18 we studied for the World Bank. Indonesia has ioth had suffered severe adverse-ternms-of-trade shocks. So, had a more or less fixed-but-adjustable regime. What is notable vhere does one draw the line? What economy is small enough is that after its stabilization in the late 1 960s, it institutionalized o justify a currency board? Some line must be drawn, and most a Very efiective presidential decree that mandated that the gov- If us would think that, for example, the District of Columbia eminent cannot run hudget deficits. The deficit for this purpose hould not have its own exchange rate. Since the economy of is calculated in the following tay: Foreign loans and aid are ).C, and, even more so, of Maryland and Virginia. is larger than included as gotement revenue. That bois down essentially to hat of many small developing countries, clearly there must be saying that budget deficits cannot he money-financed. This case ome case for an automatic system of this kind. shows that it is possible to introduce some kind of rule or insti A third consideration is ones attitude toward risk and cri- ttion that pretents the monetization ot fiscal deficits tithout is. Any finance minister (I name no names) who commits him- going as far a> a currcncy-board system, and, indeed, tithout elf or herself to this kind of regime is running a risk. If it is suc- making a long-ierm fixed exchange rate commitment. I am not cssful, it is fantastic. If it is not successful, there is a disaster. saying that this type of arrangment carries the same credibility uppose someone says you should cross the Grand Canyon on a as a currency board, nor that it is ideal and till suIte every prob- ope, and if you get across, you will get a Nobel Prize and an 1cm. But then one has to ask box much credibility a currency- xtra million dollars, and you have a 50-50 chance of making it. board system carries, and here 1 think the experience of Hong s it a good decision in that case to cross the Grand Canyon? I Kong is relevant hink the same issue arises for finance ministers tehen they com- 5  FEVAN I k N\ [I M F I ,.\ C ,10 0F ( , FE[B 0 R tX'. I , tN F I- B~ 0 ,Ll I-H AkRi,EN T I \F I :AT'(N III. FEATURES AND IMPLICATIONS OF CURRENCY BOARDS: THOUGHTS ABOUT THE ARGENTINE SITUATION BY JOHN WILLIAMSON T SEEMS TO ME THAT CURRENCY BOARDS HAVE THREE FEATURES THAT CAN CONSTRAIN an economy's ability to react to external shocks. In the first place, a currency board implies a fixed exchange rate. That can be modified a little, as the IMF showed several years ago, but only to a predetermined crawl, which still does not give any major freedom to react to external shocks. The second feature is that it requires the monetary base to be contracted by 100 percent of a reserve outflow; there is no facility to sterilize the reserve outflow in order to preserve internal balance or the level of domestic economic activity The third feature is that it precludes any lender-of-last-resort facilities in the event of a bank run. The fixed exchange rate, of course, precludes the use of the exchange-rate instrument to help adjust the balance of payments when faced with some negative external shock that requires a payments improvement. The 100 percent marginal reserve requirement prevents any attempt to use sterilization to ameliorate the impact of a reserve loss. The lack of a lender-of-last-resort facility makes the banks more vulnerable to a confidence crisis. The consequence of the first two features is to ensure that a crisis impossible, one would need 100 percent backing of M2, any reserve loss is translated into a deflationary impact on the which is much stronger than a currency-board System. domestic economy One of the counter-advantages is that thatI think that the first two of those constraints are clearly reaction is guaranteed, which serves to mitigate the danger that less important in a small economy than in a large one. The tra- a loss of confidence will turn into a speculative run. So it is ditional optimal currency area analysis tells us that the exchange important to recognize that there is a significant offset there. But rate is a less effective instrument for facilitating balance of pay- it is also important to recognize that it is a misconception to ments adjustment in a small economy For this reason adjust- think that that danger is eliminated by a 100 percent reserve ments in a small economy have to come by deflation, and then requirement against MO, because M2 can be converted into MO you may as well have the 100 percent marginal reserve require- freely If it can't, then that constitutes a bank crisis. So, to make ment. Essentially you bae to take that medicine, and so there 7 CURRL\ ( B0ARID AND EXTERNA - IIHOC K HOHAN Mt C H PAIN, 110\\ 'IU G A IA \' is no great advantage in being able to avoid it in the short run, in Argentina By 1994, the current account deficit vas 3.5 per which is all that you get by sterilization. So I agree with what cent of CDP and increasing, and it did not look as though it wa Max Corden just said about currency boards' being rather good going to stop increasing as long as the boom persisted. The cor instruments in small economies but being more dubious with bination of a fixed exchange rate, a current account deficit, sub respect to large economies. stantial short-term international debt, and a weak banking sys As regards the third constraint imposed by a currency ter made Argentina the principal victim of the tequila effect. I board - the elimination of the lender of last resort - we also experienced capital flight; the banking system looked very vul used to think that that was another reason for thinking that cur- nerable: the government naturally dithered between tightenin rency boards were rather benign for small economies, because enough to restore confidence in the currency on the one hand small economies were likely to have a strong presence of foreign and trying to give some type of support to the banking systen banks, and the foreign banks would tend to put in money to by cutting reserve requirements and so on, on the other hand support the system in a crisis. But, of course, the foreign banks Argentina did avoid a complete collapse of confidence but, o suddenly stopped doing that in Argentina last year. So that does course, it ended up with a very sharp recession, and unemploy not look as convincing as it did. Perhaps other speakers will ment rose from the traditional lov levels to something like 11 address the question whether a change in policy could give percent. It seems to me that Argentina is unable to afford a brisl countries more protection against being cut off by the foreign recovery because it has to accept a period of the classical medi banks than Argentina found it had last year. cine of falling prices if it is to strengthen competitiveness ant For those reasons I concluded in a study I did last year0 overcome the problem of the currency overvaluation with a fixec that currency boards might make sense for small, highly open exchange rate. Of course, Max is right in saying that, to thE economies, but that they were a doubtful proposition for rela- extent that the current effort to make labor markets more flexi tively large economies. I also noted that there might be excep- ble can indeed succeed and can permit faster disinflation, tha tional circumstances that could justify the adoption of a curren- will help. cy board in a relatively large economy Here I instanced Sebastian Edwards has talked about this as being the "exi Argentina: The total loss of credibility it was suffering in 1991 problem."7 Having used a fixed exchange rate to good effect as seemed to me to provide a justification for what it did at that nominal anchor in bringing inflation down, how does a countn time. On the other hand, Argentina (by my book, at least) is a get out of the commitment to the fixed exchange rate in order t relatively large economy I wondered whether the traditional restore its competitiveness and make good use of its newly fount textbook concept of a small, open economy had not somewhat stahility? Personally I am not sure this is a very general problem misled us here. We tend to think of a small economy as one but it certainly seems to be present in Argentina, where (I gues! whose actions have no impact on the world economy, and by this is still true) the whole stabilization could be unhinged if th that token Argentina is a small economy But I think that really country took any action that was construed as abandoning thi is not the right concept here. The right concept is how much commitments made in the Convertibility Plan. Certainly an) scope an economy has for autonomy and how much scope there sudden devaluation, even if you could engineer it by having th could be once confidence was re-established. Maybe the Congress approve the necessary legislation with a super-major exchange rate was useless in Argentina in the circumstances of ty over the weekend while the markets were closed, would rsl the early 1990s, but maybe once confidence has been fully re- reawakening all the latent distrust of government that had mad established, there will be much more potential benefit there. In Argentina almost ungovernable. And so I do not see a good alter any event, the Convertibility Law adopted by Argentina in 1991, native to soldiering on. which included a currency board, was a spectacular success. It If and when this patience is rewarded by a return of con completely eliminated inflation. Argentina had four years of fidence, it is at that point that one wants to try to make the sys rapid growth, which accumulated to a 35 percent recovery of tem more flexible. The first step should be to follow the exam GDP That was impressive, and I doubt that it could have been ple of first Singapore and more recently Hong Kong in not mon achieved by simply fixing the fiscal situation, without those etizing 100 percent of the reserve inflow, which means movinf other measures of which the currency board was a major part. away from the strict concept of a currency board and beginnin1 Nevertheless, we have to face the fact that Argentina's cur- to build up foreign exchange reserves over and above those con rent situation is problematic - and for exactly the reason that it stitutionally needed, so that one will then have some scope foi suffered an acute external shock last year. It is normal for an acting as a lender of last resort in any future crisis. That also ha5 exchange-rate based stabilization to eliminate inflation only after the effect of enhancing the market's perception of the country" the currency has become overvalued; and I think that happened strength, so that it may subsequently become possible to modi gogt tpmrain sln stebompritd h o FFA LUK S AND IMPlI (ATIO \. )1 ,I F t C AR I 1 10 (,H1 T,I .\11oL I FIl1 \RCLN IlNF I ITUIAT[ON exchange-rate policy to move to a more flexible policy (my me that a measure of recession is a price that has to be paid to eference would be a crawling band, such as Colombia had exorcise the ghost of Argentina's past mismanagement. The hen Guillermo Perry was finance minister, and still has). But I important thing is to try to make sure that this price is paid only ink one would only want to move to that type of system when once. arket perceptions were that the currency was more likely to I am sure that there will be some people vho \ill tell me rengthen than to weaken, One would do it after a long con- this is too pessimistic, because Argentina is already coming out essional debate and avoid any impression of perpetrating some of recession. I think the point is that if it is not going to find itself ,w trick on the public, because it is that sort of perception that vulnerable to another crisis in two or three years' time, whenev- is been so fatal to the credibility of the Argentine government er the next foreign or domestic problem arises, it needs to have the past, and not the idea per se that one could have a more that extra element of flexibility built in, and it needs to get rid of ,xible policy regime. that overvaluation that vas there tvo years ago. If one allovs any Such a reform would seem to me to place Argentina in a recovery that begins to develop to mn at full throttle, one vill ,tter position to confront future shocks efficiently, and that is not have enough flexibility to face the next shock. My advice is hat I would like to see the authorities thinking about, rather to use any incipient recovery to build up the strength in order to an some sudden exit from the current dilemma, which would be able to have a more flexible system with vhich to confront ik throwing away everything achieved since 1991. It seems to Future shocks. 9  111 F FRIIN (F I I H0 \G K 0 N IV THE EXPERIENCE OF HONG KONG BY ALAN WALTERS Flexibility in the public sector begets rigidity in the private sector; just as rigidity in the public sector promotes flexibility in the private sector" - Baroness Thatcher THE "LINK" IN HONG KONG FONG KONG OPERATES A CURRENCY-BOARD ARRANGEMENT WHERE THREE commercial note-issuing banks issue Hong Kong dollar banknotes against hold- ings of certificates of indebtedness (CIs) issued by the Exchange Fund. The cur- rency-board system, introduced in October 1983, has redeemed and issued at a Uw. par value of HK$7.8 to the greenback. The note-issuing banks are required by law .o hold Cls as cover for the banknotes they issue.8 Money market operations are automatically directed toward the maintenance of the $7.80 :arity If, due to some shock or other, the market exchange rate appreciates to, say, 7.7, then nterest rates in Hong Kong dollars would be reduced, and net inflows into the Hong Kong dol- ar would recede. A fall in the demand for Hong Kong dollars would lead to a depreciation, but noney-market operations will arouse Hong Kong interest rates and restore the value of the cur- -ency to its par value of 7.8. Although accounts of most currency-board regimes repre- on the contrary it sits on a pile of cash - the HKMA has issued ent them as purely passive - exchanging currency notes on hills so that it can influence rates through open market opera- lemand - the actual operation of the boards are much more tions. To complete its instruments, the HKMA introduced a dis- ositive. The Hong Kong Monetary Authority (HKMA) can assist count window in June 1992, called a Liquidity Adjustment he overriding need to maintain the external value of the cur- Facility This gives the Authority more control over short-term ency through the so-called "accounting arrangements" These inter ermit the Exchange Fund to bring pressure to bear on inter- nature of the paper offered. Finally the HKMA has been given iank liquidity And although Hong Kong has no indehtedness - power to levy deposit charges. I I c(, RF \(Y BE0'\[1 \\ l L\IL R\A I 110 k 1,0\ \1L I l P\I IN , EH\ ML t\I \ It seems that the HKMA has most of the instruments of a THE WORKING OF central bank. It encourages sound credit policies in the banks - THE CURRENCYIBOARD LINK for example, keeping loan growth in line with GNP and limiting The fix resulted in the supply of money being largely determine( real estate exposure to 40 percent of the portfolio. The Authority by tbe demand. interest rates were very closely related to thos has as one of its objectives the "safety and stability of the bank- in the United States. The HKMA allowed the three issuing hank ing system through the regulation of banking business ... and the to supply vhatever notes were demanded. supervision of authorized institutions." But unlike central banks A common misperception IS that with a fixed exchang it has no discretion in its objectives. Its single objective is to rate the rate of inflation in Hong Kong should be very near ti maintain the parity that of the United States. Clearly this has not occurred in th 1983-1995 period - more than 12 years. The fixed exchang, HISTORY rate gives approximately the same rate of inflation only in trad Since its earliest days as a colony with the exception of the peri- ale goods, which provides the price anchor. The overall m0a od of Japanese occupation, Hong Kong has maintained a cur- tion rate is an average of tradables and nontradables. With th, rency-board arrangement. Up to 1973 the Hong Kong dollar was rate of infation of tradables fixed, the inflation rate of nontrad fixed to sterling, so virtually all reserves were in sterling. From ables will be determined by the relative productivity growth o 1949 to 1967 sterling was fixed to the U.S. dollar through the nontradable goods and services vis-A-vis tradables. Bretton Woods agreements - although there was little free con- One may readily conclude that the productivity growth ii vertibility of sterling into dollars until 1958, due to the infamous tradables has been high relative to that in nontradable sectoi "sterling balances" overhang. In 1967 Hong Kong adjusted with Nanufacturing and more recently financial and other service the sterling depreciation and incurred a substantial capital loss have made great strides in improving productivity whereas maim on its reserves. The Basel agreement of 1968 gave various service, haircuts and housing have not found many avenues o exchange-rate guarantees to holders of sterling, and Hong Kong productivity growth. Thus, while tradables have increased it participated. In 1971, however, the dollar went off gold, and all price only by 1-3 percent per annum, the general consume the major exchange rates were soon floating. price index has been near 8 percent. Hong Kong also floated. The (then) two note-issuing This high rate of domestic inflation could be brough banks continued to provide Hong Kong dollars in exchange for down to 3 percent, in line with inflation of tradables, with a cur foreign currency, but at varying parities. Hong Kong participat- rency-board type of arrangement if the parity were increase( ed fully in the great inflation of the 1970s. (I must confess that I every day by (1/365)x5 percent (on the assumption that the rel do not understand why inflation did not increase far more than ative productivity growth continues as in the past 12 years). It it did: in that sense the floating period remains something of a a crawling link, no less, but one can well see objections to sucl mystery that would repay further research.) a suggestion. Nor would a fix to a basket of currencies be mud The floating period was a misery of high inflation and low better than the fix to the dollar, since the vast majority of Hon! growth but even more important were the enormous swings in Kongs trade is with the wider dollar area of the Pacific. both prices and production. High volatility was the hallmark of the floating period 1974-1983. For example, the Hang Seng SHOCKS index fell 60.5 percent in 1974 and rose 105 percent in the fol- One of the main arguments against the currency-board system lowing year. GDP growth swung from the trough of 2.7 percent that it does not allow the use of the interest rate weapon to com in 1975 to more than 16 percent in 1976. Inflation varied from bat shocks. Indeed, measured in terms of domestic prices, rea 2.7 percent in 1975 to 15.5 percent in 1980. And the Hong interest rates became substantially negative in the 1991-199' Kong dollar duly depreciated against the U.S. dollar from period. The HKM.A could not control nominal interest rates HK$5.1 in 1981 to HK$9.60 in 1983. through arbitrage they had to be approximately the same as ii Under the fixed regime, from 1984 to 1994 the United States. Hong Kong suffered a boom in asset price * average real GDP growth was 6.4 percent, and Hong and particularly in house prices. It is not difficult to conclud Kong overtook the UK in per capita income; that, had the HKMA been able to raise nominal interest rate * the trade surplus was 7.7 percent of GDP; above those dictated by the link, the asset price inflation coul * the budget surplus averaged 2.1 percent of GDP; have been largely avoided. * inflation was 7.7 percent between 1982 and 1994, Perhaps so. But the evidence is not convincing. Counter compared with 12.6 percent between 1979 and 1983. examples abound. The most striking is Japan. Certainly the yen dollar exchange rate was not fixed, yet of all OECx countrie 12 IHL FXPRI N I OF H IN, KONG )an suffered perhaps the most paralyzing asset inflation from Hong Kong. It appears that the flexible exchange rate did not 87 to 1989, followed by deflation. The United Kingdom, contribute noticeably toward stabilizing the economy istralia, and the Scandinavian countries, together with even As liberalization of the PRC has proceeded, Hong Kong ible Switzerland, have all endured considerable, even traumat- has made tremendous structural adjustments as it has developed asset price inflation. All of these currencies were floating - closer finks \ith South China. The low wage costs of the PRC, me more dirty than others but nevertheless not constrained by combined with the know-how that has come from Hong Kong, y institutional fix. Certainly it is difficult to attribute the by no has seen manufacturing largely disappear from Hong Kong and rans unusual asset inflation of Hong Kong to the currency- migrate to the PRC. More than 70 percent of Hong Kong's GDP 'ard link. It is true that Singapore, with its appreciation against now derives from services. Truly it has become the service cen- z dollar, did have a somewhat smoother ride than Hong Kong, ter of South China and even for the vhole PRC. Most of this .t this would be a weak reed to lean upon. adjustment has occurred in a stable environment under the aegis In the case of Hong Kong one would clearly claim that the of the currency board during the last 13 years. ast disruptive shocks have been (and perhaps will be) politi- One might he forgiven for claiming that the currency 1. For example, there were the September 1983 threats of the board turned out vell because China reformed and provided the oples Republic of China (PRC) to invade and "restore order" impetus to growth that smoothed out the adjustments. Other response to the panics and run that precipitated the outflow countries that do not have a reforming China with its enormous capital in mid-1983. The political crisis fed on and magnified growth on their doorstep would suffer much more. z economic collapse. But all this occurred before the introduc- Again, hovever, one cannot draw such a simple conclu- n of the currency board. The collapse of the Hong Kong dol- sion. It is noteworthy that up to 1974, with a currency fixed to was the occasion for insisting that confidence could not be sterling, Hong Kong developed dramatically particularly in ;tored until the currency was once again fixed! Certainly the manufacturing and various services. Maoist China, however, nouncement, preceded by informal rumor, that the Hong went through the paroxysms, absurdities, and cruelties of the ng dollar was to be fixed stemmed the flight of capital. We Cultural Revolution and the Great Leap Forvard, Famine was w then a great reflux of capital back into Hong Kong. Goods common, and income per capita fell precipitously Such negative )oded back into the stores as panic-buying ceased. The recov- shocks would he expected to have large effects on confidence y seemed miraculous - and it was dubbed by the Econoniist and economic conditions in Hong Kong. Yet in spite of periodi- a unalloyed success." cally closed borders and the influx of droves of penniless, is- A number of shocks that would be expected to have a seri- ease-ridden, starving refugees, Hong Kong, with its currency .s effect on Hong Kong's finances - such as the BCCI failure allied to the dubious sterling, continued as one of the highest d fraud, the stock market crash of 1987, Tiananmen Square in growth countries in the world. Of course, it might have done ne 1989, the Gulf War of 1990, and the collapse of the better without a currency-board system - but that was tried tropean exchange-rate mechanism in 1992 and 1993 - from 1975-83 and found wanting. 2med to be dealt with relatively painlessly Perhaps the biggest ock was the "tequila crisis" in 1994. But the effect on Hong SPECIAL REASONS ng was very short-lived. The effect on the exchange rate was FOR HONG KONG'S SUCCESS iall and limited to the first few days of 1995. True, there was a Hong Kong, as everyone says, is different. With its free trade and )wdown in activity levels and some increase in unemploy- liberal regime, it is perhaps the most flexible economy in the nt, but this had little to do with the Mexican crisis. The cause world rivaled only by Singapore and perhaps New Zealand. is almost entirely due to the monetary squeeze being imposed It has enormous reserves (around $57 billion at the end of 1995) the PRC. about five times the note issue and near 40 percent of Hong Kong's M3 (a broad measure of the size of the financial system). HE PRC EFFECT Comparable levels are 6 percent in Germany and 2 percent in ie susceptibility of Hong Kong to gyrations in the PRC is obvi- the United States and Japan. .s. One might think that the switches in policy in the PRC One might argue that the solidity of the Hong Kong dollar uld be the main cause of instabibty in Hong Kong. Yet the evi- is underpinned by reserves that are far beyond the means of any nce does not support such a view. In fact, exactly the opposite normal" country such as Argentina or Colombia. And much of ay be true. The great liberalization of the PRC, ordained in the reserves is a consequence of persistent budgetary surpluses 78, began in 1979 and continued apace to 1983. This period (with notably low public spending) of around 2 percent of GDP incided with the greatest volatility in virtually all indices in during the period 1987-1994. The non-politicization of eco- 1:3 (URRFN CY BOA D; ANLD LXIE1RNAL FIK k HOW \liMUjH PAIN f1OW 0 Nl C H uAI\ nomic policy, which enabled these results to be achieved, is not maintain the status quo. possible with non-colonial governmental systems where the cen- Four years ago, on a visit to China, I argued to the Peopl tral bank is controlled by politicians anxious to pay for the vote. Bank (the PROs central hank) that, politics aside, the best mo Are the reserves overdone? In my view they are, and this etary policy for China would be to fix the renminbi to the U was a serious matter when the reserves were held in sterling bal- dollar. But, of course, politics is never merely an aside in ances in London or in T-bills in New York. The returns were very PRC. Nevertheless, the remarkable stability of the Chinese cL low and it was a waste of capital. Recently Hong Kong has been rency in terms of U.S. dollars over the last two or three years placing the funds under professional management, so the oppor- combined with the accumulation of very large reserves su tunity costs of holding such reserves will be considerably gests that there is a similar belief among China's policy-maker reduced. The transfer of power in 1997 could give a politica acceptable excuse for "unifying" the renminbi and the Ho: THE FUTURE Kong dollar. The renminbi has been trading at around 8.2 to S The PRC takes control of Hong Kong in 1997, but it has agreed to the U.S. dollar, and many forecasters believe that it will appi that for the next 50 years Hong Kong should have its own mon- ciate in the years ahead. There seems to be an opening for etary (and legal) system. This seems to mean that the currency PRC to unify the monetary systems. Instead of one nation, tx link will continue after the PRC gains sovereignty. In the absence systems - at least for monetary matters - there would be o of any serious outbreak of hostilities, I suspect this agreement system for all of China. will be honored by the PRC; it is greatly in their interests to 14 A R EN N I F I AN RISIS V. ARGENTINAS EXPERIENCE AFTER THE MEXICAN CRISIS BY GUILLERMO CALVO Y NOW WE HAVE COVERED ALL OF THE MAIN ISSUES INVOLVED IN THIS DISCUSSION. What I think would be useful is to discuss in greater detail the experiences of IArgentina and Mexico. First, I want to point out that it is not obvious that Argentina, because of having a currency board, suffered more from the shocks emanating from the so-called tequila effect than it would have with a flexible exchange rate. However, ie case of Argentina cannot be fully explained by a purely Keynesian-type shock, so to help Kplain it I will introduce elements related to the financial sector. Second, I will go over some of ie issues that have already been raised, but perhaps with a different twist and with a greater mphasis on Argentina. I am coming to this question, not from a theoretical point of view, or from the theory of opti- ium currency areas. I just want to understand what would have been the advantages for .rgentina of not having had a currency board. The first thing I will do is to take Argentina and Mexico he translated into a fall in the amount of tradables consumed. d compare them using a very simple Keynesian model. If we For example, suppose that the supply of tradables is exogenous, Dk at the numbers, you can see that after the December 1994 then you have to contract the demand for tradables. If in the valuation of the Mexican peso, Mexico's current account short run tradable and nontradable goods are complementary ficit shrank by about 8 percent of GDP and output fell by and are consumed in fixed proportions (just for the sake of argu- ore than 7 percent. Argentina's current account deficit shrank ment), then the demand for both types of goods Must fall by the 'about 2.5 percent and output fell by 4.4 percent. Those num- same proportion. If we assume that the sale of nontradables is 50 rs are in the same ballpark. Can we rationalize them? Well, a percent of output to begin with, then you can very easily con- ynesian attempt at rationalization would be that here you dude (i is just a simple calculation) that if the output of non- ive a shock affecting the capital account. The capital account tradables is demand-determined, the supply of nontradables will is to fall by this much; it was an exogenous shock that had to fall by the same proportion as the fall in the current account 15 L1, RRI NCY ARR \.) % D EX\ T E kNA I IH0CK H 1o 11 CH A \ 10V Mlb( l GA \? deficit. If this theorem were fully validated in practice, I should sequence of a surge in hankruptcies, perhaps related to find that the shrinkage in the current account is equal to the fall financial consequences discussed above, and for other reasoi in output. Of course, I don't expect to get the same numbers, but However, the basic thing you can say about devaluation is thai it seems that the numbers are large declines for Mexico, and they may speed up real exchange-rate realignment. That is somethi are relatively small declines for Argentina. that a country subject to a currency board, as Argentina is nc The bottom line is that in a first approximation the shock does not have. It is not obvious to me that a devaluation fo that these countries suffered after the tequila effect was to a large country like that will be expansionary On the contrary becat extent independent of the exchange rate - it would have been of this it could be a financial disaster. But one has to admit t difficult to avoid it. The way to avoid it would have been for the if you think that there is a misalignment of the real exchan structure of demand to change very sharply in the short run, and rate, devaluation appears to be simpler than letting the pri you have to be prepared to make that assumption. I believe that level go down, there are such instances (for example, when the current account What are the policies or issues that have come up regai deficit is financed by foreign direct investment) when there is lit- ing real exchange rate misalignment? As Alan and Max ha tIe relation between domestic consumption and the service reminded us, wage flexibility becomes central all of a sudd (nontradable) sector. In these situations you can cut domestic You need vage flexibility and as Max admitted, very few of consumption without affecting the demand for nontradables. knox how to make it effective and to make it function quiet But for countries like Argentina and Mexico, where the current enough to be a substitute for devaluation. I suppose that we ha account deficit was associated with consumption booms, then a lot to learn from this. As a mental note, Marty Weitzman f the reduction in aggregate demand had to have a negative effect an interesting book The Shar Economy that deals with on both, since I would expect that tradables and nontradables issue of flexibility Flexibility is unlikely to be sufficient; I thi tend to be more complementary on the consumption side. This you need flexibility and coordination. And that is the issue it reasoning indicates that you cannot rule out the hypothesis that Marty deals xith in The Share Econmy00 Argentina would have suffered a substantial fall in output even if In the case of Argentina. where the tax on labor is abc it had devalued or had a different exchange rate system. 50 percent of the xage paid by the firm, one possible way What can you buy from devaluation? This is an aspect we coordinating, if you believe that you have a misalignment, is have discussed with respect to Mexico, but there are financial lower the tax on labor, xhich must he offset by a higher incor aspects that one tends to forget when we focus exclusively on the tax. in general, this restructuring of the composition of tax rc effect on the real exchange rate. Let me mention some straight- enues does not make a difference in principle. But if wages ha forward points. If there is no explicit or implicit currency to fall, what you are doing is coordinating the fall in xages denomination mismatch, then the devaluation improves banks' cutting the age paid by the firm and financing that by chargi balance sheets. That is an advantage of devaluation. It can the cost of this to the xorker. So the xorker ends up receivi improve balance sheets if you have an external shock and a cer- less, and the firm ends up paying less. That is exactly vha y tain loss becomes non-performing, so devaluation can (in a way) would get in relative terms after a devaluation. The politi liquidate the debt. It also helps to stimulate the demand for problem, of course, is that it is a non-starter because it is deposits, and it prevents a run on banks. You saw it very clearly transparent. There is some discussion in Argentina about th in the case of Mexico, where the nominal level of deposits did and ve are going to see vhether that is possible or not. not fall. In contrast, in Argentina, where a devaluation did not Given the few options available, there is another approa occur, deposits fell by about 18 percent. So, there is a very dif- that has been mentioned (and I am responsible for bringing iti ferent expenence between the two countries in this regard. frequently in discussions and it is not something I like): If However, if bank liabilities are dollarized, as they were in other alternatives fail, then you can alays resort to a tempor, Argentina, then a devaluation that affects the real exchange rate real devaluation through a uniform tariff on imports that goes may have a negative effect on the health of the financial system. finance a uniform subsidy on exports. That will give you When the liabilities are in dollars. even if assets are in dollars, at same advantages of a nominal devaluation. Of course, admin the moment of truth the assets are loans to the domestic econo- tratively it is very complicated. Nevertheless, there are seve my and are affected by the real exchange rate. So, if you were to advantages: devalue, the value of those assets would be likely to deteriorate. First, it has a limit. You cannot raise tariffs in real terms Devaluations affect the real economy as well. Output may more than 30 percent, because beyond that nobody pays a fall, which has been the experience in Latin America as docu- there is tax exasion. So, there is some discipline to it; it is r mented by Sebastian Edxards and others.d It may fall as the con- like a nominal devaluation, xvhere you devalue 30 percent a 16 ; R .I N I l 1 \ ' \ 1 1 1 11 N C E A l l I C I ll 1t MI Xl I( A N I l\I ou can devalue by another 30 percent later. Here you cannot do the Keynesian argument with this financial argument, you could iat: higher trade taxes become ineffective. possibly explain a great deal of the falling out. Second -and I do not think this advantage has been suf- I will end with a discussion of how to avoid the credit ciently emphasized - you do not touch the financial system. squeeze. The first policy alternative is the one implemented by you are concerned about the effect that a devaluation can have Argentina, which is a tricky one - lowering the banks' reserve n a country like Argentina by affecttng the viability of bank requirements during the run. if depositors believe you and stop )ans, this approach does not touch the system at all. So, in prn- running, then you are fine, because you are able to keep the level iple, loans are more likely to continue to be paid. of loans relatively constant. The disadvantage of this temporary devaluation is very My conclusion from the previous analysis is that that vas imihar: You put this in place, but nobody believes it, and for it not enough because there was a composition effect. That is ) be effective the adjustment has to be credibly temporary More where the current account deficit must be taken into account, ian likely, it is not going to be credible, and if it is not credible, even when dealing with what is the ideal optimal level for bank ien there is not going to be adjustment. Therefore, at the end reserve ratios. In any case, for Argentina the reserve ratio prior f the road, you may find yourself with the same problems still to the crisis vas 20 percent, which vas not enough. In this type iere in spite of the imposition of trade taxes and subsidies. But of situation, you may want to have enough reserves not only to ou do have some breathing space. I mention this as the last stimulate but also to expand the level of loans, assuming that big ssort, not the first - as something you could do if the only firms are going to come in and crowd out small and medium Iternative were a nominal devaluation. firms. Finally let me say something about the credit squeeze in Another point concerns the linkages between domestic .rgentina. You hear a lot about that, partly as a result of the fall and international banks - the idea that it vould provide auto- i the demand for deposits, which dropped by about 18 percent matc ltquidity in this case it did not work properly Connected i the first half of 1995. Argentina cushioned that by lowering with this fact is that large state-owned banks may make the pres- ie banks' reserve requirements. So when you look at loans to ence of tnternational banks problematic. Argentina. I under- ie private sector, they hardly budged - maybe a 3 percent fall. stand, has free entry for banks; anyone who has a reputation as lowever, everybody talks about the credit effect. I propose the a banker can have a subsidiar in Argentina. However, we have Allowing explanation for why you could have gotten a big cred- not seen a wave of banks coming into that market, even though effect from the current account shrinkage. The cut in the cur- Argentina reputedly has one of the most inefficient banking sys- :nt account deficit could have had strong effects on the domes- tems in Latin America, and so in theory there must be a lot of c credit market if local borrowers do not have access to inter- room for making profit. A possible interpretation is that when ational capital markets and depend very heavily on domestic you have very large public banks, as is the case there, and those anks. For the sake of argument, let's assume that the current banks are always gotng to be protected by the fiscal authority, ccount deficit was going to finance new loans to prime bor- directly or through international official loans, banks may find Dwers. The deficit was cut by 2.5 percent of GDP Suppose those that competition is too difficult and makes entry into the market rime borrowers turn around and find funding for this 2.5 per- too risky ent. Loans to the private sector in Argentina correspond to To summanze, I think that there are likely to be shocks out bout 10 percent of GDP, and the 2.5 percent cut in internation- there that have similar effects on both flexible and fixed I credit implies that demand for domestically financed loans exchange rate systems. If the economy is dollarized, devaluation Dse by 25 percent of the total supply of domestic credit. That is is especially risky A currency hoard will alvays face the problem large amount. So even though the total is fixed (this is only an of realigning the real exchange rate. The solutions available have xample; unfortunately we do not have the numbers, which sup- not been sufficiently tried or they are not very transparent, like )osedly are now being collected), there could have been a very the real devaluation via trade interventions that I mentioned. But arge change in composition in favor of prime borrowers and I believe that in some countries, and Argentina is an example, gainst small- and medium-sized firms - those not having the existence of'a straitjacket like this is focusing the politicians ccess to international markets. attention on perfecting the labor market as they never have That is the bad news. The good news is that a small recov- before. There is so much room to conquer there - and there is ry in the current account deficit can turn things around very so much room for improvement - that in the end the process uickly You don't need a large current account deficit to have a may be painful, but it may help push basic and fundamental ig effect on the domestic credit market. So my bottom line in structural adjustment his respect for the case of Argentina is that if you put together 17  I F 1 k 1 , I I I 1 N L 1 VI. CLOSING REMARKS: WHAT HAVE WE LEARNED? BY STANLEY FISCHER IWILL TALK ABOUT GENERAL CONSIDERATIONS, MOST OF WHICH HAVE COME UP IN THE four preceding presentations, and then I will ask a question: If the World Bank had had a conference four years ago on currency substitution and currency boards, and we had start- ed from what we knew four years ago, what have we learned in the last four years? What events have intervened, and what conclusions could one draw from them? There is an xcellent publication that you all should look at on precisely this topic; it narrates the discus- ions of a conference held in January 1992, sponsored by the Latin American Region of the Vorld Bank, which featured, among others, Guillermo Calvo and Alan Walters.' Let me begin with the general considerations. There is no exchange-rate system that works est in all circumstances. Whatever exchange-rate system you have, you will at some point wish ou had a different system. That is to say that whatever we are talking about, we are not going D design a system that operates best in the face of all different shocks. The currency board is a commitment to a fixed exchange Incidentally, it is an interesting fact that the small-large te, and we have a standard analysis of when it is optimal to fix country consideration cannot be right; we very rarely recom- Te exchange rate in a very simple generalization of the Poole mend multiple currencies for a single country If the size of the rialysis: Fixing the exchange rate works best in response to economy is one of the key issues, we would be a lot more inter- ioney-demand shocks. But that analysis assumes away capital ested in recommending multiple exchange rates within coun- -count shocks. Looking a little further, we have the optimal tries. Why don't we? Probably because of the labor market flex- urrency area analysis of when it is optimal to fix the exchange ibility that is assumed, because of capital market flexibility that ite, and it says that when there is factor mobility - that means is assumed, and perhaps because of the assumption of fiscal pol- oth labor and capital, and includes the assumption of goods- icy flexibility Underlying all of these analyses, by the way, is iarket flexibility - it is probably optimal to have a fixed some sort of wage and price inflexibility That is the basic start- Kchange rate. ing point. If you were to conclude, based on your assessments 19 CURRENCY BOARDI AND EXIFRN AL oH0C K HOkW MUlC, H FA[N I110 MLJH GAIN regarding factor market flexibility, that at the best of times you macroeconomic shocks. do not want a fixed exchange rate for your country, you would There is anotber strand tbat I have not quite integrate not go into a currency board except to put constraints on the into my thinking but that I would like to put on the tabl central bank. Domingo Cavallo has spoken about the benefits of a curren A currency board is far more than a fixed exchange rate. It board. He says there is one tbing that a currency board mak also constrains the central bank in two ways - two features that clear: It makes clear the fiscal consequences of monetary polic were emphasized by John Williamson. The first is that it con- When you do not have the right to create liquidity you real strains monetary policies to operate according to gold principle understand what the central bank is doing when it engages standards, which says that in response to a deficit in the balance those activities. We somehow think that the central bank is cr of payments, you should contract the money supply, and a ating money that has no consequences - at least that is my na deficit could arise from either the current account or the capital ural mode of thinking. Actually there is a transfer involved froi account. So it says that in response to all such shocks (and somebody to somebody Domingo' argument, which I think in maybe they are the shocks that you should respond to), let the considerahle validity is that a currency board makes you unde money supply adjust. The second constraint is that a currency stand what the transfer is. So when you ask what the costs are board also precludes the operation of the central bank as a loosing the lender of last resort, you may want to ask how ofte lender of last resort, at least in the pure form of the currency are there shifts in the demand for the monetary base that yc board. should stop for example, those resulting from bank runs an Now, these are a lot of constraints to impose on monetary ing out of a clear blue sky rather than induced by inappropria policy I do not think that if you had a central bank you knew bank behavior. Those of us brought up on the stories of t would act optimally in all circumstances, you would go for a Great Depression think that that is what happens most often.IP currency board, but it is precisely because you know that that we look at banking problems in a lot of countries during the pa does not always happen, that you impose those constraints. That few years, we may not agree with what the central banks shou] is why we have had the emphasis from John and Max that you be doing most of the time. It may well be that you want to lc typically do it after a period of very high inflation, when the at what is being done and think about the transfers of resourc credibility of monetary policy has been destroyed, and you need that are being made. to put very tight constraints on what is going to be done. I still have not integrated my thinking fully on this issu Those constraints on monetary policy may be very expen- and I am still conscious of the fact that the Internation sive, and I am going to come to the Argentine case in a while, Monetary Funds Exchange Affairs Department requires the! but first I want to mention a very interesting question about the subsidies to be registered in the fiscal accounts. When yc lender-of-last-resort function. Until a week ago I was pretty sure recapitalize the banks via the central bank, the Fund says: Pi that imposing constraints on that role was quite ambiguous, but that into the budget, and preferably keep the central bank who then I listened to the governor of the Estonian Central Bank, and in its balance sheet, and recognize that there is a fiscal resour he said something we need to reflect on. He said that having a involved. I think that this practice is probably right, but I thin currency board was very useful in dealing with banking prob- once you start thinking that way you wonder whether th lems. Why did he say that? Because he could not bail out banks lender-of-last-resort function is worthwhile. Yet in our traditiot that should not be bailed out. The conclusion I draw in the al way of thinking about it, the role of lender of last resort com shocks analysis is that not having the lender-of-last-resort func- very naturally when thinking about bank runs; it is actual tion is a real loss if you are dealing with macroeconomic shocks straightforward and something that ought to be part Of the ro that come from outside the system. But if you are dealing with a of the central bank. shock that comes from inside the banking system as a result of Now, the question is: Can you have it both ways? Can yc poor bank management and supervision, it is probably a gain have the currency board with its credible commitment to a fixe not to have a lender of last resort. We will have to think a little exchange rate and have the flexibility that you want on bankir more once we are in the world of the second best, where a cen- policy and on monetary policy? The answer is yes; by buildir tral bank does not always do what it should be doing according up excess reserves or by getting access to credit, you can have to an unconstrained optimum. The question of whether losing both ways. if the central bank has the ability to increase the lender-of-last-resort function is unambiguously a bad thing reserves through loans, or if the central bank has built up a poe has to be reconsidered in a second-best world where a central of excess reserves, then it can do all these things as well. So yc bank faces pressures to bail out banks inappropriately and are not totally lost in the things we now call currency boards vhere the banks' troubles in the first place were not the result of you ant to preserve some flexibility but then you better recol 20 CLOIN, REMARKS WHAT HAkE WE LEARNED? .e that you are not operating under the theory of the gold stan- mission of financial crises is much greater than it was four years -d or under the theory of the pure currency board, but you ago. I do not doubt that in the Mexican situation the authorities *,e designed yourself an intermediate system that is halfway were able to keep the banking system afloat - via a range of ween discretionary monetary policy and the automatic poli- measures that we hold our noses at hut secretly admire - and s that we conventionally analyze when we are looking at the did not have masses of banks close down, xhich was actually an eration of currency boards. important element contributing to the fact that an 8 percent Let me make my last general remark about the question of adjustment in the external sector was accompanied by less than ce flexibility and labor market flexibility before I go to a num- an 8 percent decline in GDP Of course, a large part of that came - of specific cases. A lot of what concerns us and a lot of where from the switching that resulted from the change in the real leverage of monetary policy comes from is from wage and exchange rate, but I think some of it also came out of the free- ce inflexibility The question is: Just how ingrained is that? Is dom that Mexico had for safeguarding the banking system. omething that might change over time? How important is the Second, we have also had more currency-board experi- lity to adjust the money supply or the exchange rate? I fear ences since 1992 - namely Estonia and Lithuania. Both have t you have all heard me quote one of Bob Mundell's best lines, withstood very large banking crises, and the exchange rate has Ach is that everybody thinks that what Adam and Eve discov- held. And as I mentioned earlier, at least the Estonians believe d in the Garden of Eden was the secret of sex, but he says that the constraint helped in that case, although it does not help in [t is not what they really discovered. They discovered the the case where the shock is external. So that is an interesting new :ret of central banking - mainly, that by writing down a few experience. We have an enormous concern about the lender-of- mbers on a piece of paper, you could move the entire real last-resort function, and I want to come back to the question of momy It is quite likely that if we were to loose that knowl- how you build up some flexibility If you now assume that you we would move toward a system in which wages and have a reasonably well behaved central bank, as the central bank ces became more flexible. Now, it will take a long time for this of Argentina has now become, can you give it more flexibility? happen, but it's something that could eventually develop. Well, you have the Hong Kong solution: If you acquire sufficient Let me now turn from those general considerations to reserves to the point of being five times the money base, then ;wer the question I posed at the beginning: What have we you are basically free to conduct monetary policy as you please, rned in the last four years? and the constraint is not binding while the exchange rate con- I think that the first important lesson is that banking sys- straint is totally credible. That would be very nice if you could as and financial systems are extremely important, which was do it. It is not going to help Argentina right now because it is not dent in Guillermo Calvo's statement. We now understand bet- going to be able to generate that sort of current account sur- that where the currency-board constraint really bites is in the pluses in the short run. ,ssure it puts on the banks. I must say that I thought Third, we have the emerging Argentine experience with illermo's claim regarding the proportional equivalence pre-established lines of credit. Doing that with the private sector ween the extent of external and internal adjustment in is very interesting; we will have to see how strong those lines are xico and Argentina was a little much. I did the numbers for in the face of a serious international crisis. But given that the Mexican and Argentine crises; the response in Argentina, rel- amounts are not massive, they probably are very strong. So you cely to the domestic contraction given the external adjustment can get access to foreign lines of credit as a way of giving your- Mexico, was twice the size of the one experienced by Mexico. self a lender of last resort. There is another possibility that we in at is pretty large even within the rounding area for econo- the Fund have been asked about very often: Can we create a sts. So I think that the emphasis on the pressure exerted on lender-of-last-resort function for countries in trouble? Well, I say : banking system in a circumstance like that is indeed impor- that is just what we are. When you get into trouble, as you did Lt. It leads you in the direction of thinking about how we get in 1995, we lend to you, and you can use resources for the bank- )re international banks into the domestic market. Can we ing system or whatever. They say that they needed assistance prove the quality of our banking systems? Can we make them earlier, that in the future they will need lines of credit that are s vulnerable to shocks of that sort? Well, to be invulnerable to unconditional. Well, I don't think that the Fund would be in that jcks of the magnitude of the tequila effect on Argentina via the position, but there is in the international system some ability for iking system, you have to build a lot of excess capacity into banks that get into severe trouble when private credit dries up to it system and almost certainly impair its efficiency as a finan- at least offset some of it. I intermediary So the emphasis on banking systems and the The fourth new experience that we have had since early )rld Banks understanding of the role they play in the trans- 1992 is the debate over European Monetary Union (EMit, 21 CLRRINtY ['OARD) AND[) E\TERN.AL ,110C K I1G\\ VH UCII PAIN HOW MIINLLII CAIN? which has sharpened our understanding of how to operate in a pressures that move, on the whole, in a healthy direction. presumably irreversible fixed exchange rate system. This is one So, those are a few considerations that perhaps tell important element of the currency board, and the analysis of something different now from what we would have said ft what it takes to operate in that environment has emphasized all years ago. Where do they move you? They move you to s the things that Max has been talking about - fiscal flexibility, Banking systems aside, I am more favorably inclined tow labor market flexibility, capital market flexibility I think there is fixed exchange rate systems than I used to be. There is a cost a heightened awareness in the profession, and certainly among giving up the flexibility of the exchange rate. There is no qu policy-makers, of what it takes, and there is an emerging view tion about that, but it is so frequently misused that it is i that provided that you make progress in those areas, it may be entirely clear how large the cost is on average. But if you me quite helpful for large countries - not only for economic rea- that way, the emphasis should be on getting your banking s sons in the case of EMU - to operate with a single currency. tem in shape and doing all those things to make markets we Achieving progress in these areas requires a lot in the direction better, which you need to do in any case. For how many cot of legislation as well as labor market institutions like unions. But tries would you recommend currency boards as opposed t I don't think - and this is the part I find interesting - that any potentially fixed exchange rate with a domestic currency? In rigidities that are going to be removed in order to make the EMU end, I think that you would come back to the small counti look better are inflexibilities that we do not think should be but with a bit less certainty than four years ago. removed. The pressures that the EMU puts on the system are 22 I T ,'IF CONTRIBUTORS illermo Calvo is Distinguished University Professor and Guillermo E. Perry is the Chief Economist of the Latin ector of the Center for International Economics at the American and Caribbean Region of the Vorld Bank. He has iversity of Maryland, College Park, Maryland. He was a served as Minister of Finance and Public Credit and also as iior Adviser in the Research Department of the International Minister of Mining and Energy for his native Colombia. He was netary Fund. He has also taught economics at Columbia the Director of two leading Colombian think tanks on econom- iversity and the University of Pennsylvania. For a brief peri- ic issues, FEDESARROLLO and the Center for Economic during 1996 he was also an economic adviser to the gov- Development Studies (CEDE). .ment of Argentina. Sir Alan Walters is Vice Chairman and Director of the AIG Max Corden is Professor of International Economics at the Trading Group. He was Chief Economic Adviser to the govern- l H. Nitze School of Advanced International Studies of the ment of the United Kingdom between 1980 and 1989. He was .ns Hopkins University, Washington, D.C. He was Nuffield a professor of economics at the University of Birmingham, the ider in International Economics at Oxford University, a London School of Economics, and the Johns Hopkins ior Adviser in the Research Department of the International University inetary Fund, and has taught international economics at the stralian National University the University of Chicago, John Williamson is currently the Chief Economist for the rvard University and other prestigious academic institutions. South Asia Region of the World Bank. He is on leave from his post of Senior Fellow at the Institute for International inley Fischer is First Deputy Managing Director of the Economics, Washington, D.C. He has been professor of eco- ernational Monetary Fund. He was Vice President for nomics in universities worldwide, and was an adviser to the velopment Economics and Chief Economist of the World International Monetary Fund. ik. He was also the Killian Professor and head of the partment of Economics at the Massachusetts Institute of :hnology He has taught at the University of Chicago and nford University. 23  F, NOTES ;ee Nissan Liviatan, editor, Proceedings of a Conference on Currency 7 See Sebastian Edwards, "Comments." Brookngs Papers on Economic bstitution and Currency Boards. World Bank Discussion Papers No. Activity 2, 1995, p 282. 17, World Bank, Washington, DC, 1993. 8 Text is published here as prepared for presentation My debt to Serard Caprio, Michael Dooley, Danny Leipziger, and Carl Walsh, Andrew Sheng, Deputy Chief Executive of the Hong Kong Monetary he Lender of Last Resort Function Under a Currency Board: The Authority, is enormous. Much of this note is taken from his writings. ise of Argentina." Policy Research Working Paper No. 1648, ptember 1996, World Bank. pp. 7-9. 9 Sebastian Edwards, "Devaluations, Aggregate Output, and Income Distribution," Real Exchange Rates, Devaluation, and Adjustment. MIT bid., p. 12. Press, 1989. -tgh international reserves (as high as broad money) to guarantee 1o Martin L. Weitzman, The Share Economy: Conquering Stagflation. tancial stability (at the associated costs) seems to be a distinctive fea- Harvard University Press, 1984. re of fixed exchange rate regimes. 1 Nissan Liviatan, editor, Proceedings of a Conference on Currency an Little, et al., Boom, Crisis and Adjustment: The Macroeconomic Substitution and Currency Boards. World Bank Discussion Papers No. perience of Developing Countnes. New York: Oxford University Press, 207, World Bank, Washington, DC, 1993. r the World Bank, 1993 ohn Williamson, What Role for Currency Boards? Washington, DC: stitute for International Economics, September 1995. 25 WORLD BANK LATIN AMERICAN AND CARIBBEAN STUDIES VIEWPOINTS SERIES Latin America after Mexico: Quickening the Pace by Shahid Javed Burki and Sebastian Edwards Poverty Inequality, and Human Capital Development in Latin America, 1950-2025 by Juan Luis Londono Available in English and Spanish Dismantling the Populist State: the Unfinished Revolution in Latin America and the Caribbean by Shahid Javed Burki and Sebastian Edwards Decentralization in Latin America: Learning through Experience by George E. Peterson Urban Poverty and Violence in Jamaica by Caroline Moser and Jeremy Holland PROCEEDINGS SERIES Currency Boards and External Shocks: How Much Pain, How Much Gain? Edited by Guillermo E. Perry Annual World Bank Conference on Development in Latin America and the Caribbean: Rio dejaneiro, 1995 Edited by Shahid Javed Burki and Sri-Ram Aiyer  THE WORLD BANK A partner in strengthening economies and expanding markets to improve the quality of life for people everywhere, especially the poorest HEADQUARTERS 1818 H Street, N.W. Washington, D.C. 20433 USA Telephone: 202.477.1234 Facsimile: 202.477.6391 Telex: MCI 64145 WORLDBANK MCI 248423 WORLDBANK Cable Address: INTBAFRAD WASHINGTONDC World Wide Web: http:/vwv.worldbank.org/ E-mail: books@worldbank.org EUROPEAN OFFICE 66, avenue d'ina 75116 Paris, France Telephone: 1. 40.69.30.00 Facsimile: 1. 40.69.30.66 Telex: 640651 TOKYO OFFICE Fukoku Seimei Bidg., IOF 2-2-2, Uchisaiwai-cho Chiyoda-ku, Tokyo 100, Japan Telephone: 3. 3597.6650 Facsimile: 3. 3597.6695 Telex: 26838 13864 9 780821 338643 ISBN 0-8213-38