Currency privatization as a substitute for currency boards and dollarization.

• Author: Selgin, George

A nation that seeks to fix the value of its currency relative to that of some other nation's currency can do so in at least three different ways: it can assign responsibility to the central bank for "pegging" the currency's exchange rate, without imposing any particular foreign-currency reserve requirement; it can establish a currency board that continues to issue a distinct local currency, but is required by law to exchange local currency for the foreign currency at a Fixed rate, and to hold 100 percent foreign currency reserves; or it can "dollarize," using the foreign currency itself as its circulating medium, while dispensing with its own former monetary unit.

Of these three alternatives, the first--a central-bank administered peg, backed by fractional and variable foreign currency reserves--is, as recent experience demonstrates, most vulnerable to speculative attacks that can cause its collapse. Dollarization, at the opposite extreme, rules out such attacks entirely. A currency board represents, in this particular regard, a middle ground, for although some currency boards may be capable of devaluating their currencies, and may for that reason still be objects of speculative attacks, a speculative attack can never force a currency board to devalue out of fear of running short of reserves. For this reason the fixed-rate commitments of currency boards tend to be more credible than the pegged-rate commitments of central banks, and currency boards are attacked less often.

Although a dollarized system is better able to maintain a fixed exchange rate than a currency board, it suffers from the disadvantage of exporting seigniorage instead of allowing it to be earned by a local authority. A currency board, on the other hand, earns seigniorage equal to the interest generated by its foreign currency assets. With regard to seigniorage, a currency board differs from a central bank principally in being unable to influence its seigniorage earnings by controlling the rate of growth of its assets and liabilities. Instead, that growth rate is dictated by its net dollar receipts.

After the collapse of the Soviet monetary system, followed by a series of speculative attacks on pegged exchange rate regimes, there has been much interest in the once relatively obscure currency board and dollarization alternatives. The aim of this article is to compare the currency board and dollarization approaches with a third, still obscure alternative--currency privatization. A privatized currency system resembles dollarization in employing a foreign currency (dollars, for the sake of concreteness) as the medium into which commercial bank IOUs are redeemed. It resembles a currency board, on the other hand, in relying upon domestically supplied currency that may be denominated in a distinct domestic unit of account. What distinguishes currency privatization from all commonly discussed alternatives, and what makes it more controversial than either, is that it assigns responsibility for issuing domestic currency, and for redeeming it in dollars, to commercial banks rather than to any public monetary authority.

I will argue that currency privatization is just as good as dollarization at preserving a fixed exchange rate, and better than a currency board at disposing of money-creation surpluses in a way that benefits the domestic economy. Currency privatization may therefore dominate these more familiar currency reform options. I will also argue that the usual reasons given for overlooking the currency privatization alternative are neither theoretically nor empirically well-founded.

Assumptions

In order to assess the relative strengths and weaknesses of currency boards, dollarization, and currency privatization as currency reform options, I will rely on some simplifying assumptions. I take for granted that we are dealing with a nation, call it Ruritania, having as its paramount goal the establishment of a credibly fixed exchange rate, meaning that such a rate takes precedence over other potential goals of Ruritanian monetary and banking reform. The assumption obviously is not valid for most countries, but it is valid for many countries that have suffered through the collapse of former pegged-or floating-rate central bank regimes. In other words, it is true for any country seriously contemplating the currency board and dollarization alternatives. I also assume that Ruritania initially has its own distinct monetary unit, which I will call the peso, and a monetary base consisting of a stock of IOUs issued by its central bank. I assume, furthermore, that the peso-dollar exchange rate has been devalued to the point where the Ruritanian central bank is holding 100-percent dollar reserves, although not legally obliged to do so. This assumption allows for the possibility of a costless and immediate transition to either a currency board or a dollarized system. I treat Ruritania's commercial banking regulations, and the overall soundness of its banking system, as given, and assume that private banks are initially prohibited from issuing their own paper notes. Finally, I will 'also assume that, if it establishes a currency board, Ruritania does not intend to let that board function as a lender of last resort (LOLR), for example, by starting out with greater than 100-percent dollar reserves. An orthodox currency board therefore offers no LOLR advantages over dollarization.

Central Banks, Currency Boards, and Dollarization

Suppose, then, that Ruritania chooses to convert its central bank into a currency board by prohibiting it from acquiring nondollar assets, by having it maintain...