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.
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
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
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
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
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
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
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
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
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
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
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
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.
(Reference: "Currency Reform For A Market Oriented Cuba" by S. Hanke and K.
Schuler, The Blue Ribbon Commission On the Economic Reconstruction of Cuba,
"The Problem With Pegged Exchanges Rates" by K. Schuler, Kyklos, v.52, no
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