Another explicit objective of some central banks is to maintain a stable currency. Central banks have to decide between two distinct options, to allow the currency to float freely against other currencies or to attempt to manage the exchange rate. Most economists would agree that central banks can make a reasonable stab at maintaining a stable exchange rate or a stable inflationary environment but that it is not possible to achieve both at the same time.
Over the past 20 years central banks in most developed economies have chosen to target stable inflation and allow their currency to float freely. Floating systems may lead to more volatile exchange rates but those rates adjust gradually over time and reflect market perceptions of underlying economic fundamentals. Central banks in many developing countries have persisted with tr ying to achieve both objectives with a bias towards targeted stable exchange rates. There are a number of ways for a central bank to tr y to manage its country’s exchange rate. These include currency boards, fixed currency pegs, currency bands, managed devaluation and the use of trade-weighted baskets of currencies:
Currency boards. A currency board is a system where the local currency is based on that of another currency, usually the US dollar. It is for this reason that the adoption of managed currency systems is frequently referred to as “dollarization”. The system requires the central bank to maintain a reser ve of US$. A conversion rate between the US$ and the local currency is then fixed. The amount of local currency that the central bank can issue is then constrained by the amount of US$ reserves. In other words the local currency is fully backed by the foreign currency.
If those foreign reserves fall, by people or institutions selling the local currency and buying US$, the amount of local currency in circulation is automatically reduced by a corresponding amount. This has the effect of pushing up local interest rates. Currency boards can result in a stable exchange rate even at times of crisis but only at the cost of local pain. A potential currency crisis can usually be avoided through disciplined adherence to the currency board. This can only be achieved by imposing ver y high interest rates and at the expense of a recession. The Hong Kong dollar peg is one of the best-known currency boards.
Fixed currency pegs. Fixed currency pegs are another method of linking a local currency to the US$. The central bank attempts to fix the exchange rate at a particular level even though the local currency is not fully backed by US$ reserves. There are then two ways to try to maintain this level, open market operations by the central bank and capital controls. In open market operations the central bank intervenes directly in the foreign currency market. If holders of the local currency sell it and buy US$ the central bank steps in to supply the US$ at the specified rate. If on the other hand institutions sell US$ and buy the local currency the central bank issues the local currency. It then normally acts to sterilize these inflows by issuing bonds to mop up the additional local currency. The Thai baht and Argentine peso were both fixed currency peg systems maintained by open market operations, before their demise.
Currency bands. Some countries have operated using currency bands. Before the adoption of European Monetar y Union European currencies traded within specified bands against one another in a system called the European Rate Mechanism (ERM). When a currency came close to the top of its band European central banks would sell the currency and when it came close to the bottom they would buy it. The risks involved in such systems were highlighted when the British pound was forced out of the ERM by speculators who believed that sterling had entered the system at too high an exchange rate.
Managed devaluation. Some countries have tried to adopt a policy of a managed devaluation. Indonesia in the mid-1990s gives us an example of a currency where the central bank made it clear that it was aiming for a managed devaluation of approximately 10% per year. When the currency collapsed in 1997, however, it fell from 2500 to the US dollar to reach a low of 17 000.
Trade-weighted basket. This is a system that avoids some of the above problems. The objective is to manage the currency against a trade-weighted basket of currencies. No official target is given, which makes the currency less of a target. This system is intended to help maintain a country’s competitiveness with trading partners and shield the economy from imported price inflation.
The basic problems that most of these systems share are that the central bank risks pitting itself against the market and that in the event of a crisis there is no mechanism for a flexible adjustment. The result has often been a shar p correction resulting in a significant dislocation to both the financial system and the real economy. Argentina provided a good example in 2001 of the effects of the collapse of a managed currency system and its devastating impact on Argentineans’ life.
Capital controls are another way in which central banks may seek to manage their exchange rate and level of foreign reserves. These prevent a currency from being fully convertible. The degree of capital controls imposed may vary widely. The least onerous capital controls simply make foreign exchange more difficult by requiring central bank approval for all transactions above a specified level, with approval usually being granted after a certain period. Capital controls encourage companies to look for ways to circumvent such constraints and also usually result in some form of black market where rates offered differ significantly from official rates.
Organizations such as the IMF are usually opposed to the use of capital controls under any circumstances but, as we will argue in future posts “Banking crises”, the combination of open capital accounts and an overreliance on short-term foreign funding is an impor tant source of potential instability in developing countries.
MANAGED CURRENCY SYSTEMS
Typical DEFAULT clause
In case of default of any of the covenants herein, Nonresident may enforce the performance of this Agreement in any modes provided by law and the Resident hereby waives any statutory notice of such default. This Agreement may be forfeited at the Nonresident’s discretion if such default continues for a period of three days and thereupon this Agreement shall cease and come to an end as if they were the day originally fixed herein for the expiration of the term and Nonresident’s and/or its agents shall have the right, without further notice or demand, to reenter and remove all persons and occupants and property therefrom without being guilty in any manner of trespass, or without any prejudices to any remedies for arrears of rent or breach of covenants. Nonresident may resume possession of their premises and relet the same through the remainder of the term at the best rent Nonresident may obtain for account of the Resident who shall make good any deficiency, including the cost of reletting. In the event of cancellation or termination of this Agreement by Nonresident under the option provided for herein, Nonresident shall deduct from the Resident’s security deposit (if any) all unpaid rentals and damages and charges for which the Resident is liable hereunder any balances shall be returned to the Resident.
Examples of moral suasion
Examples of moral suasion by central banks and bank regulators include the following:
Bailouts. A healthy domestic bank may be asked to rescue a smaller failing bank. Privately owned banks are better able to resist this particular pressure than state-controlled banks but may be given little option. A foreign-owned bank is much better placed to resist such coercion.
Lending restraints. The central bank may ask banks to restrain their lending to a particular sector, usually the real estate market. This may be done informally or through the imposition of a limit on the proportion of total loans that a bank can lend to a particular sector.
In Hong Kong, for example, the Hong Kong Monetary Authority effectively imposed a 40% limit on the proportion of loans that a bank could extend to real estate developers and investors and for residential mortgages in the mid-1990s. Rapid asset inflation had pushed property prices to the point where they were among the highest in the world. The prudence of this policy was shown when property prices reversed in the late 1990s and approximately 40% of mortgagors found themselves with negative equity.
Directed lending. The central bank may set loan growth targets for individual banks at an overall level, by economic sector or by group of customers. These targets are intended to support government policy whether economic or social. The following are just a few such examples
In Taiwan the ruling government has at times instructed banks to give preferential treatment to people and companies adversely affected by earthquakes. This may be wor thy but could have been addressed in a more equitable way by the government making direct grants to the affected par ties so that they could meet their financial obligations.
In the US banks have to meet legislative requirements to lend to particular groups of people to support national housing policies and to prevent discrimination based on location. A high proportion of deposits gathered in a particular area, such as an inner city ghetto, must be lent out in that locale, for example.
In South Korea in the 1990s successive governments encouraged banks to lend to particular industrial groups and sectors. Banks were expected to support governments’ objectives to create and nurture national champions.
In some countries tax relief is given on part of the interest paid on home loans but is not given for rental expenses. This distorts the housing market by encouraging home ownership at the expense of those living in rented accommodation. In addition profits made from an individual selling their primary residence are exempt from capital gains taxation which is applied to profits made from trading other forms of assets.