Currency boards still left on the drawing board

Currency boards still left on the drawing board

By James T. Areddy

HONG KONG (Dow Jones): It's back to the ivory towers for
currency board proponents.

When exchange rate instability began rocking Asia two years
ago, the relatively obscure method of locking one currency
against another was touted by many as a safe harbor from the
turmoil.

But despite flirtation with the concept by Indonesia and
possibly other countries, the score for currency boards in Asia
remains exactly as it was before the crisis: Only Hong Kong has
one.

A workshop scheduled for next week in Hong Kong should show
how much the enthusiasm for currency boards has retired back into
the world of academia.

"This is not going to be an eye-catching sort of meeting. All
of this will be of relatively little popular interest," concedes
the event organizer, Hong Kong Baptist University Economics Prof.
Tsang Shu-ki.

The situation is a far cry from early 1998 when currency board
proponents found themselves center circle in the raging debate
about how to end Asia's financial crisis and drew followers with
promises of an easy route to stability.

Steve Hanke, a Johns Hopkins University professor most
identified with currency boards, was hired as a special adviser
to Indonesian President Soeharto at a time some of the
president's own cabinet ministers said they were having trouble
scheduling meetings with him.

When done by the book, a currency board should keep one
currency absolutely stable against an "anchor" currency, such as
the U.S. dollar. The foreign currency is held in reserve by the
monetary authority, backing the local currency 100 percent based
on the set exchange rate.

The currency board system is theoretically immune to breakage
because any weakening demand for the local currency triggers a
lift in interest rates, ultimately to a point that revives
confidence in the currency. The mechanism works the same in
reverse, letting interest rates -- rather than the currency
exchange rate -- reflect changing monetary conditions.

Malaysia took a slightly different route last year by
administratively locking its currency exchange rate and making it
illegal to conduct trade at any rate but the fixed one. With a
currency board system, the exchange rate is supposed to hold
automatically with virtually no administrative input.

Hong Kong's currency board has provided the city a lot of
stability since it was adopted in 1983 and that was an attraction
in early 1998 around Asia.

But the system has had only mixed success in the past few
years. And because of the way it managed its currency board, the
government was cornered into a costly -- and embarrassing --
fight with speculators in August, 1998.

After some changes, the Hong Kong system is technically more
orthodox and stronger today. But persisting high money market
interest rates suggest lingering concern about the Hong Kong
government's political commitment to it, analysts say.

Now, the recovery of Asian growth and currencies and the
reversal into deep recession for Hong Kong suggest that the
countries wouldn't have been better off with currency boards.
Some currency board supporters don't see much opportunity for
their use in this region.

Even Megawati Soekarnoputri, a leading candidate to be
Indonesia's next president, quietly dropped her backing for a
currency board immediately before Indonesia's June national
election.

Don Hanna, an economist at Goldman Sachs & Co., says currency
board proponents start with a "defeatist" view that policy makers
can't do a good job, since the currency board mechanism replaces
many of the central banking functions.

He says terrible mistakes were made by Asian policy makers in
recent years, but the recovery shows that decisions "by and large
have been very good."

Governments realize what they would have given up for that
stability, analysts say.

Unlike the situation with Malaysia's currency controls,
governments adopting currency boards would have lost control of
some of the policy tools that helped them revive, such as the
ability to lower interest rates to boost economic activity. A
currency board is completely undermined if interest rates are
adjusted.

Hanna says the loss of lender-of-last-resort functions with
the adoption of a currency board would have left countries
without a key policy lever, which would have been dangerous amid
a banking crisis.

"You need to have a very solid banking system to have a very
convincing currency board," he says.

Tsang says the Oct. 9 currency board workshop will lack the
"high-level ideological debate" of recent years.

"We are going to have a technical debate," he says, noting the
seven papers so far prepared focus on Hong Kong's system and
discuss issues such as lender-of-last-resort facilities and how
much of the money supply should be backed and guaranteed by U.S.
dollars.

Tsang says currency boards may have dropped from the popular
agenda, but remain interesting to monetary experts.

A paper published this month by the International Monetary
Fund says "the conventional wisdom" is that emerging-market
economies in Asia and elsewhere will increasingly migrate toward
pure floating exchange rates or fully locked currency-boards or
dollarization.

But the report adds, "These extremes have the attraction of
logical consistency, but suffer from a decided lack of political
realism."

Asia's financial crisis showed just how fraught with risk the
decision can be.

For example, when his currency slumped to more than Rp 15,000
against the U.S. dollar from a pre-crisis level of around Rp
2,000, Soeharto came so close to implementing a currency board in
Indonesia in the first quarter of 1998 that he ousted his
skeptical finance minister.

But the dollar now buys Rp 8,250, so it's doubtful policy
makers wish Soeharto had gone through with his plan.

"Commitment is a very delicate matter. Sometimes when you
start from scratch, it's better," says Tsang.

He explains that since there are such high stakes in making
the decision to adopt a currency board, mostly over which
exchange rate is best, few countries are likely to try it.

The exception would be new or war-torn states, he says,
pointing to Albania as a possible candidate for currency board.