Argentina's Currency Board System

inSight

01 Jun 2000

Argentina's Currency Board System

Argentina's currency board system has arrangements that take it some way along the road towards dollarisation. While these arrangements may not be called for in Hong Kong, they throw useful light on the way in which currency board systems work.

Readers will have noticed from the published record of discussion of the meeting of the Sub-committee on Currency Board Operations of the Exchange Fund Advisory Committee held in May that the Sub-committee examined quite extensively the currency board arrangements in Argentina and their relevance for Hong Kong. I have found the discussion and the research work leading to it very interesting. It certainly helped us in the HKMA, who are supposed to be already quite familiar with the structure of different monetary systems, to clear our minds further over what dollarisation exactly means.

It has often been said that when a currency board system is under pressure, for whatever reasons, the natural alternative is dollarisation (or the replacement of a domestic currency by a foreign currency ? usually the US dollar). But it is not always clear what exactly is meant by dollarisation, or what exactly is involved in the process. The examination of the arrangements in Argentina by the Sub-committee threw useful light on this.

In any monetary system, there is usually a clearly defined pool of money in the domestic currency called the monetary base. The monetary base is on the liability side of the balance sheet of the monetary authority and is therefore subject to the control of the monetary authority. Such control can be exercised on a discretionary basis through the monetary authority determining either the price or the supply of some or all of the components of the monetary base. This is the case for many central banks, including the Federal Reserve Board and the European Central Bank, and they often exercise their management of the monetary base on a discretionary basis, but with a clear objective. The monetary policy objective is, generally, currency stability, but this is increasingly defined specifically either as a low inflation rate or as a fixed exchange rate. The control of the monetary base can also be exercised on the basis of a transparent rule, with little or no discretion on the part of the monetary authority. This is for the purpose of, and is clearly proven to be beneficial in, enhancing the credibility of the monetary policy objective, whatever it happens to be.

As we all know, in a currency board system, the monetary rule is for the monetary base, denominated of course in the domestic currency, to be changed only with a corresponding change in the foreign reserves fully backing the monetary base. This usually takes the form of an undertaking by the monetary authority to convert any amount of domestic currency forming part of the monetary base directly or indirectly into foreign currency (US dollars in the case of Hong Kong) at a fixed exchange rate. Thus there is a choice on the part of the holders of the monetary base whether or not to take advantage of the convertibility undertaking. For example, the licensed banks in Hong Kong holding Hong Kong dollars in their clearing accounts maintained with the HKMA have the choice of holding on to their Hong Kong dollars or converting them into US dollars at the exchange rate of the convertibility undertaking. The credibility of the fixed exchange rate under a currency board system therefore depends crucially upon the credibility of the convertibility undertaking.

But it is possible to go further by taking away that choice, and therefore eliminating any residual doubt concerning the credibility of the convertibility undertaking, by simply treating the monetary base, or part of it, as being denominated in the foreign currency instead of in the domestic currency. This was what Argentina did at the time of crisis in 1995 for the clearing balances held by commercial banks with the currency board. Thus, those clearing balances in the domestic currency are not just as good as the US dollar, given the comfort of the convertibility undertaking, they are in fact US dollars held with the monetary authority.

When the monetary base of a monetary system is denominated in US dollars instead of the domestic currency, this constitutes dollarisation. Let me hasten to add here that there is no need for the arrangements in Hong Kong to go that far. The Sub-Committee has in the past studied dollarisation, and has concluded that the disadvantages out-weighed the advantages but that it could be held in reserve as a possible contingency measure. This position has not changed.

 

Joseph Yam
1 June 2000

 

More information on the Currency Board System can be found here.

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