The cedi depreciation fuels inflation, undermines business and economic activity and erodes the purchasing power of individuals and the nation as a whole.
The incessant cedi depreciation reflects the underlying weak structure of the economy, evidenced by a narrow industrial base and dependence on low-value export commodities. High levels of deficit financing have also added pressure on the cedi.
The ultimate solution to the cedi crisis lies in the transformation of the economy to increase the production of high value-added exports and import substitutes and in entrenchment of fiscal discipline.
Much lip service has been paid to these solutions, but no concrete actions have been taken to bring them to fruition. Meanwhile, the cedi crisis persists, even though it has witnessed some stability in recent times. In the search for answers to the cedi crisis, some analysts have mooted the idea of a “currency board,” although this has not received much attention.
We decided to revisit the issue and to rekindle debate on it. In this paper, we discuss the merits of a currency board for a stable currency. The paper draws on Hanke’s 1999 article that provides important reflections on currency boards. Hanke’s article contains an interesting and relevant statement, which we are pleased to quote up front:
“In the beginning, God created sterling and the franc. On the second day, He created the currency board and, lo, money was well managed. On the third day, God decided that man should have free will and so He created the budget deficit.
On the fourth day, however, God looked upon His work and was dissatisfied. It was not enough. So, on the fifth day, God created the central bank to validate the sins of man. On the sixth day, God completed His work by creating man and giving him dominion over all God’s creatures.
Then, while God rested on the seventh day, man created inflation and the balance-of-payments problem.”
The statement demonstrates the risks posed by a central bank in terms of its capacity to cause inflation and balance-of-payments problems and, consequently, currency crisis. The risks are inherent in the central bank’s mandate and operations. The key distinguishing features between currency boards and central banks relate to monetary policy, the exchange rate regime and issuance of credit.
Principally, a central bank issues domestic currency and exercises wide discretion over monetary policy. A central bank covers its currency by foreign and domestic assets. The latter is principally government securities and forms the “fiduciary issue.”
A central bank is usually limited by law in the amount of fiduciary money it can issue. However, in practice, many central banks succumb to political influence and exceed the legal limits by increasing their financing of the fiscal deficit. This amounts to “money printing,” which fuels inflation and currency depreciation.
By design, a currency board does not operate discretionary monetary policy, but rather rules-based policy. It holds reserves in foreign currency and gold set by law and equal to 100 per cent of the currency. A currency board cannot engage in “fiduciary issue.” Foreign reserves are the only asset on a currency board’s balance sheet. Because a currency board backs its currency fully by foreign assets, it can fully meet demand for foreign exchange. In that respect,the domestic currency cannot depreciate.
A second key feature that distinguishes a central bank from a currency board relates to the exchange rate regime. A central bank in developing countries usually simultaneously manages exchange rate policy and monetary policy. In so doing, a balance-of-payments crisis could arise as the central bank increasingly offsets reduction in the foreign component of the monetary base with domestically-created money.
When this occurs, it is only a matter of time before speculators spot the contradiction and try to take advantage of it. With currency board, the monetary authority sets the exchange rate—it is fixed—but it has no monetary policy. Consequently, there can be no conflicts between exchange rate policy and monetary policy and balance-of-payments problems cannot emerge.
A third distinguishing feature concerns the issuance of credit. A central bank can act as a lender of last resort (LOR) and extend credit to the banking system. It can also make loans to the fiscal authorities and state-owned enterprises.
Consequently, a central bank can go bankrupt. A currency board cannot extend credit to the fiscal authorities or state-owned enterprises. In addition, a currency board cannot engage in LOR activities. The fiscal regime, therefore, is subordinated to the monetary regime, and a “hard budget constraint” is imposed.
In the same way as the gold standard was adopted to control fiscal authorities, a currency board imposes a hard budget constraint. By putting the monetary authorities in “a straitjacket,” a currency board is viewed as a means to impose fiscal discipline.
Hanke cites many cases where currency boards adopted by countries at one time or another delivered overall superior economic performance than under central banks, including relating to real GDP growth, inflation and the fiscal deficit.
Sometimes arguments are made against currency boards, including the possibility of loss of competitiveness, loss of sovereignty, vulnerability to shocks and lack of lender of last resort status. Hanke cites concrete evidence to debunk each of these arguments. Further, on the argument that certain conditions are required for currency boards to be successful, including adequate reserves, fiscal discipline, strong and well-managed financial system, rule of law and optimum currency area, Hanke argues, based on concrete evidence, that they are not indispensable requirements.
Hanke re-emphasises the superiority of currency boards over central banks in developing countries and even goes to the extent of suggesting that there are more than many developing countries that should replace their central banks with currency boards.
A currency board may be the answer to Ghana’s incessant cedi crisis—at least in the interim. However, a currency board is not a panacea for the cedi or the economy’s long-term performance. The advantage the currency board brings is macroeconomic stability fostered through forced fiscal discipline. However, macroeconomic stability is necessary—but not sufficient—for sustained growth. While the currency board is in place, reforms will be needed to transform the economy from its “colonial structure” and to entrench fiscal discipline, which are the fundamental prerequisites for a strong currency and a robust economy.
— The writer is a Snr. Economist, IEA, [email protected]