MONETARY POLICY FOR CUBA IN TRANSITION. PART II
CUBAN CURRENCY BOARD

But one may ask, what is a Currency Board and where did it come from?

A Currency Board is a legal institution fully recognized by the government that issues notes and coins convertible into a foreign reserve currency at a fixed rate and on demand.

The fixed rate is permanent or at most altered only in emergencies. Market forces alone determine the money supply.

As reserves it holds high quality interest-yielding securities denominated in a reserve currency. The Board holds reserves equal to 100% or slightly more of its notes ( paper money) and coins in circulation plus its deposit liabilities( if any).

It generates profits known as seigniorage from the difference between the interest earned from the securities that it holds and the expense of maintaining in circulation its notes and coins.

The Currency Board has NO discretion in monetary policies. Market forces alone sets the money supply.

Under this system the national currency will be exchanged at fixed rates and the Currency Board usually holds reserves of 105 to 110% of liabilities to safeguard against possible loss in case the interest-earning securities that they hold would loose some value. Note that if notes and coins are destroyed the liability of the Board falls and its net worth increases. Therefore, under a Currency Board system the national currency is as sound as the foreign reserve currency.

A Currency Board has free convertibility of its currency: it exchanges its notes and coins at its fixed rate without limit. However, a Currency Board does not guarantee that deposits at commercial banks are exchanged into its notes and coins. Commercial banks are responsible to have enough reserves to respond for their contractual obligations.

As for foreign currency other than the reserve currency, the Currency Board has no direct role in determining exchange rates with them.

One of the most important characteristics or properties of a Currency Board is its lack of capacity to function as "lender of last resort" to commercial banks or other enterprises and does not regulate these banks - these regulations are usually enforced by the ministry of finance or some other branch of the government.

Since a Currency Board is a sort of warehouse to back its notes and coins in circulation his financial status is known at all times ie. it is transparent and as such it is protected from political pressure since it can not finance spending by the domestic government or state enterprises since it is not allowed to lend.

The increase of the nominal money supply not as a result of voluntary savings is inflation, and this the Currency Board can not generate unilaterally due to its basic function. Since the ultimate reserves of the Currency Board are in the currency of another country inflation in the anchor currency will eventually be rtansmitted to the currency board system.

A functioning Currency Board could be operational in a few weeks and usually performs its functions with a small staff who performs routine activities without the need of vast arrays of "official functionaries".

In a concise fashion these are the main functions and attributes in general of a Currency Board:

1. Supplies notes and coins only.

2. Fixed exchange rate with reserve currency.

3. Foreign reserves of 100 percent.

4. Full convertibility.

5. Rule-bound monetary policy.

6. NOT a lender of last resort.

7. Does NOT regulate commercial banks.

8. Transparent.

9. Protected from political pressure.

10. High credibility.

11. Earns seigniorage

12. Can NOT create inflation.

13. Can NOT finance spending by domestic government.

14. Small staff

( Ref:"Currency Boards for Developing Countries" by S.H. Hanke and K. Schuler. 1994 International Center for Economic Growth)

The idea of Currency Boards originated in Britain in the mid 1800's among a group of economists as a proposal for reforming the British monetary system. However,it was applied in British colonies, to provide them with the benefits of a stable currency, such as the pound sterling, without the cost for the colony of replacing its notes and coins that are destroyed or lost and the forgone interest that could gain as seignoirage.

Currency Boards have existed in about 80 countries - the first successful attempt to establish a Currency Board occurred in the Bitish Indian Ocean colony of Mauritius in 1849 - and later was implemented by several British Colonies in West Africa under the name of the West Africa Currency Board. By the 1930's several Currency Boards were in existence in Africa, Asia and other Pacific Islands - their greatest extent was in the late 1940's. In the 1950 and 1960's former colonies believed that Currency Bards were a vestige of colonialism that had to disappear and that part of the identity of a new country was to have its own Central Bank and destiny.

It was taken for granted then that the government could be relied on to act in the best interest of their citizens and that a Central Bank could pursue effectively a counter cyclical policy.

One of the most interesting Currency Boards was created by the British Treasury, at the inspiration of J. M. Keynes to provide for the monetary needs of an area of North Russia where noncommunist forces were operating during the civil war that the Russian Revolution of 1917. It should be noted that this was not a "full" Currency Board since 25% of its assets consisted of bonds issued by the North Russia government. When this government defaulted on its bonds the British Treasury made up the losses and the Currency Board was able to honor its obligations in the midst of war and a default by the government. Stop now and think how many Central Banks that operated under such strenuous conditions would have been a reliable debtor.

By 1970 Central Banks had replaced most Currency Boards but it survived in a few countries such as Bermuda, Gibraltar and the Cayman, Falkland and Faeroe Islands. Even H. Kong abandoned the Currency Board system until 1983 when, following a currency crisis, it decided to revive the Currency Board. Since then it has not suffered a monetary crisis and has weathered the 1977 Asian debacle.

In some countries the Central Banks have been converted to mimic certain characteristics of Currency Boards, such as in Estonia and Argentina which had already instituted a Currency Board from 1899 to 1902 and again from 1927 to 1929.

In this decade Argentina adopted a Convertibility Law ( 23.298) which involved tying the Central Bank so that it acts almost like a "Currency Board" - the Convertibility Law stipulates one-for-one parity between the Argentina Peso and the US dollar. Devaluations of the Peso would require a congressional enactment. The Central Bank is allowed to hold around 33% of its assets in the form of dollar denominated government bonds (BONEX) . Commercial banks maintain reserves at the Central Bank and the Central Bank can act as "lender of last resort".

In 1992 and again in 1994 following the Mexican currency devaluation the Argentinian peso came under pressure but the dollar-peso exchanged remained and the Currency Board-like arrangement was tested and toughened by the crisis.

Among the post Marxist countries of Europe, Bosnia, Lithuania and Estonia have adopted Cboards in 1992, 1994 and 1997 , respectively. Estonia replaced the Russian ruble by the kroon and used the Deutsche Mark as is anchored currency. Since then the kroon has become a hard currency and Estonia has enjoyed the best performance economically among the three Baltic States and former socialist countries in Central Europe.

Statistics of the performance of the Bosnian economy are difficult to pin down due to the damage caused by the civil war.

Very recently ( 1999) Montenegro has also announced is considering the formation of a Currency Board.

Whenever a Currency Board is suggested for any country there is always a miriad of objections usually not fired neither in number nor in intensity at Central Banks despite the immense economic and moral damage that they inflict upon the citizens of their respective countries -- not only they remain operational but have been bailed out by international financial organizations such as the International Monetary Fund which has become their "lender of last resort".

SOME CONCERNS WITH THE CURRENCY BOARDS

It is important that some of the popular objections be brought to the forefront and dealt with since the solutions and alternatives to some of them present challenging alternatives and proposals while others are definite a reassurance for its existence in an incipient economy.

Some authors object to the fact that there could be a cost in using a foreign currency rather than domestic assets to back the domestic money supply - since the Currency Board earns interest in foreign assets which could be below the one produced by those made at home. This is known as seignoirage.

In the case of any country during its transition period out of Marxism it is difficult to image that anyone could find a safer path than to use U.S. Treasury Bonds as securities. By allowing the Currency Board to have any type of investments in the national domestic market it would place potentially such belongings under the direct or indirect influence of political forces - even if there is a loss of certain mount of senoriagne it is well worthy it to gain free credibility.

Another concern with the Currency Board is referred as the transition problem - this is the danger that a fixed exchange rate that has traditionally provided the base for the Currency Bboard will quickly become overvalued if the Board is introduced in a high inflationary country. The question is perhaps more how long the period of over evaluation will last rather than if it will terminate.

Well founded economic theory and history leaves little room to doubt that a fixed exchange rate that is adhered long enough it will bring inflation under control and even lower the price level to a point where unemployment will improve.

What is in reality a great concern and would put in jeopardy the potential ability of the Board to curtail inflation could be the lack of commitment by the people and government to establish firmly support long enough for it to achieve this goal.

Let us face the reality that a Currency Board is not a universal cure improving all conditions vehicle and it can not perform in a vacuum. Faster and better results to maintain inflation under control would be greatly enhanced by fiscal responsibility by part of the government.

In some circles there has been objections to Currency Boards because they will not allow the government to run an active monetary policy. This objection is precisely one of its strongest virtues and any room left in some of the Currency Board-like arrangements for this to take place has resulted in levels of uncertainty and higher interest rates.

Another concern with these institutions, which definitely should be placed in the column of advantages, is the fact that they can not act as "a lender of last resort". Again it would violate its basic precept of issuing domestic currency only in exchange for foreign currency.

The "conventional wisdom" has led the people of many nations to believe firmly that there is a need for a lender of last resort to provide emergency lending resources to financial institution in difficulties. This belief could dangerously extended to many other areas of the market and quickly make the state conducive to own or finance a set of enterprises. But more important is what the historical record tells us - not having a lender of last resort policy has not resulted in any failure of any large bank and losses to depositors from the few small commercial banks that have failed have been tiny (the H. Kong arm of the Bank of Credit and Commerce International Bank in 1992 had $1B in deposits or approximately 0.6% of all deposits in the British Colony).

Alternatively there is also the possibility of developing interbank markets enabling banks to relieve their regular liquidity problems or borrow abroad. The existence of a Currency Board-like system which does not adjust to strict orthodox rules and allows any potential aperture for banks to have a Centyral Bank able and willing to rescue them raises the problem of moral hazard - temptation by banks to make riskier loans that they otherwise would not.

More important than all concerns mentioned so far are the political problems and the funding resources related to the initiation of the Currency Board.

In the political front there is no past record of any appropriation of the assets of the Board by the government that could not balance their budgets. However, there have been many Currency Boards replaced by Central Banks - most Currency Boards have operated under colonial systems in which there was a strong motivation and ability to maintain fiscal discipline.

Argentina and Estonia provide so far the most relevant cases for assessing whether a Currency Board can make a strong contribution to fiscal responsibility - and so far these cases suggest that indeed the Currency Board can make it happen. Governments have found that sound currencies enhance their stability and economic growth. The stability provided has enabled these new governments to implement reforms that otherwise would not have been possible.

By and large in Estonia, Lituania and Argentina Currency Boards have been sufficiently popular that the government succeeding those that originally recognized the system has left it in operation.

However, is it still possible for a country coming out of forge the political will to initiate and support a Currency Board and balance its budget?

Approaches and schemes that do not clearly eliminate Cuba's socialist monetary institutions will likely place the monetary system on an unsound basis for a long time into the future.

After all the former objections against the Currency Board have been reviewed we are left with the question of procuring the funding for it - supplying the hard currency reserves to back the entire monetary base. This was not an issue for colonial Currency Boards because the money was already circulating in the form of sterling.

What will be the reserves that the Communist Party will leave behind? As mentioned above, the Cuban Peso will need instant backing to become convertible. This quality requires resources that could come from the US government or international financial institutions but they will certainly add to the already overburden debt that the island has.

Having 100% reserves from the start is vital to ensuring the credibility of the Cboard as a politically independent body with again, no discretionary monetary policy.

One of the first national sources of foreign reserves could be the existing ones at the Cuban Central Bank. However there is no accurate account of such reserves and no much dependency should be placed on them.

Another internally initiated source of reserves could be obtained by selling state property in domestic currency and not reissuing it or by selling these assets for foreign currency.

These alternatives could take considerable time to produce the required reserves and their availability to the Currency Board would depend on the willingness of the national government to do so.

Therefore, it is clear that to obtain and facilitate reserves to the incipient Cuban Currency Board independently of international financial institutions and of the national government one must search for alternative sources.

Before we address the issue of sources one could ask what is the level of reserves required for Cuba at the beginning of the transition period.

Due to the uncertainty of the monetary statistics of Cuba today we could answer the question by resorting to a rule of thumb rather than follow an accurate calculation - for developing countries, the national currency per person could vary from 3 to 10% of the gross domestic product (GDP).

In the case of Cuba the GDP could be represented by the 11 million citizens of the island times approximately $500 per person - and therefore the total amount of foreign reserves necessary for the Cboard could be as high as $ 1B.

If we do not obtain these reserves as loans from international monetary lending institutions or from the US Government and do not desire to have any intervention from the national government and its politics - then where would they come from?

They could and should come from the Cuban people itself, mainly from the community outside Cuba. MODEL CUBAN CURRENCY BOARD CONSTITUTION

(This is presented here ONLY as a proposal and to illustrate the simplicity of the Currency Board Charter)

1. The Cuban Currency Board is hereby created. The Currency's Board purpose is to issue notes and coins, and to maintain them at a fixed exchange rate as specified in paragraph 6.

2. The Currency Board shall have its legal seat in Switzerland.

3. (a) The Currency Bboard shall be governed by a Board of five directors. Two directors, including the chairman, shall be persons chosen by the Government of Cuba. One director shall be a German national chosen by the Deutsche Bank, one director shall be a United States national chosen by the Morgan Guaranty Trust and one director shall a Japanese national chosen by Dai-Ichi Kangyo Bank.

(b) A quorum shall consist of four members of the Board of Directors including the two chosen by the Government of Cuba. The Board of Directors may meet at the Board's Legal seat and such other locations as it designates. Decisions shall be by majority vote except as specified in paragraph 15.

(c ) The first chairman and the first other member of the board of directors chosen by the Government of Cuba shall serve terms of five years and one year respectively. The first German national shall serve a term of two years . The first United States national shall serve a term of three years. The first Japanese national shall serve a term of four years. Later members of the Board of Director shall serve a term of 5 years. They may not be reelected. Should a director resign or die the appropriate organization as specified in paragraph 1(a) shall chose a successor to fill the remainder of the term.

4. The Board of Director shall have the power to hire and dismiss the Cboard staff and to fix salaries for itself and for the staff.

5. The Currency Board shall assume responsibility for the notes and coins formerly issued by the Banco Nacional de Cuba.

6. The currency with which the fixed exchange rate is maintained is hereafter called the reserve currency. Initially, the reserve currency shall be the US Dollar and the fixed exchange rate shall be the (1$ = 10 Pesos, for instance).

7. The Currency Board may set a minimum size for transactions, not to exceed 100,000 units of the reserve currency. It may adjust this size upwards in the same proportion as increases in the wholesale price index of the reserve-currency country. The Currency Board may not charge any commission for transactions of the minimum size or larger.

8. The Currency Board shall begin business with assets equal to at least 100 percent of its notes and coins in circulation. It shall hold these assets in investment-grade securities payable only in the reserve currency. The Currency Board shall not hold any securities issued by the national or local governments of Cuba, or in enterprises owned by those governments.

9. The Currency Board shall pay all net profits into a reserve fund until its unborrowed reserves equal I 10 percent of its notes and coins in circulation. It shall remit all net profits beyond those necessary to maintain I 10 percent reserves to the government of Cuba. The distribution of profits shall occur annually.

10. The Currency Board's head office shall be at Havana. The Currency Board may establish branches or appoint agents in such other cities as it sees fit.

11. The Currency Board shall publish a financial statement, attested by the directors, quarterly or more often. The statement shall appraise the Currency Board's securities holdings at their market value.

12. The Currency Board may issue notes and coins in such denominations as it sees fit.

13. Should the change in the wholesale price index in the reserve-currency country fall outside the range -5 percent to 25 percent for more than two years, or -10 percent to 50 percent for more than six months, within 60 days the Currency Board must either-

a. Devalue (if the index's change is negative) or revalue (if the index's change is positive) its currency in terms of the reserve currency by no mom than the amount of index's change over the period specified above, or

b. choose a new reserve currency and fix the exchange rate at the rate then prevailing between that currency and the original reserve currency.

14. If the Currency Board chooses to do 13(b), within one year it must convert all its reserve assets into securities payable in the new reserve currency.

15. The Currency Board may not be dissolved or its assets transferred to a successor organization except by unanimous vote of the board of directors.

FIN

(Reference: "Currency Reform For A Market Oriented Cuba" by S. Hanke and K. Schuler, The Blue Ribbon Commission On the Economic Reconstruction of Cuba, 1992)

BIBLIOGRAPHY

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