Fixing the exchange rate through a currency board arrangement: Efficiency risk, systemic risk and exit cost

There are two major ways to fix an exchange rate: (1) exchange controls and government interventions in the foreign exchange market; and (2) arrangements that activate self-interested market forces, including the gold standard and the currency board system. While the gold standard is now history, currency boards have become fashionable lately. In essence, a currency board arrangement (CBA) issues narrow money, typically cash (notes and coins), with 100% foreign exchange reserves. It can theoretically fix the exchange rate of even the broad money through two automatic stabilizing mechanisms: specie-flow and cash arbitrage. Both appeal to the 'selfish' behaviour of market participants, without invoking the need for direct government interference. In a modern financial economy with large cross-border flow of funds and a diminishing cash base, both the presumed automatic stabilizers for the classical CBA are thrown into serious doubt. Hong Kong's linked exchange rate system (the link) is used as the key example to illustrate the 'efficiency risk' of a CBA failing to firmly anchor the spot exchange rate, in the light of the recent speculative currency attacks in East Asia. There are alternatives to strengthen a CBA by reducing its efficiency risk, e.g. the convertible reserves mechanism of Argentina, Estonia and Lithuania (the AEL model), which surpasses the arbitrage efficiency of the classical currency board and the old gold standard. Unfortunately, it has not been given the attention that it deserves in the literature. There are also proposals involving insurance options issued by the monetary authority that guarantee the fixed exchange rate. The latter actually also aim at eliminating the 'systemic risk' of the CBA by committing the monetary authority to an 'irrevocable' contract to defend the fixed exchange rate. These alternatives impose additional burdens on the CBA, as well as increasing the 'exit cost' from the CBA if it is deemed desirable to abandon the peg. This paper assesses the CBA as a genre in its historical context and the various alternatives to strengthen it. Hong Kong serves as the central illustration and is contrasted with the AEL model, while Indonesia is used as an example to illustrate some of the pre-conditions for a CBA to be an effective crisis solution. A key conclusion is that a balance has to be struck between the short-term security of a CBA on the one hand, and the long-term consideration of preserving flexibility for the choice of the optimal exchange rate regime in a possible scenario of external crisis, on the other.