During the euro crisis, Denmark has attracted significant capital inflows as a relative safe haven. This has led to upwards pressure on the exchange rate. To counter the pressure, the DNB has set the main policy rate at an historic low of zero per cent. It has also set a negative deposit rate to further deter capital inflows. While negative interest rates are an extreme example, this highlights the unusual actions monetary policy may occasionally have to take in order to defend the fixed exchange rate.
Latvia has also been a member of ERM II since May 2005. It had previously targeted a SDR basket of currencies. The Latvian economy suffered a deep recession in 2008, with the Government requiring an IMF-EU programme between 2008 and 2011. To maintain the exchange rate peg during the period, the spread between the ECB and Latvian interest rate increased (although Latvian rates fell, they fell by less than the ECB rate), while economic conditions would have warranted looser monetary policy.
Spread 0 1 2 3 4 5 6 7 ECB Latvia Jan-11 Jan-08 Jan-05
Latvia Central Bank Interest Rate
Source: Eurostat
6.30 This suggests that the choice of the anchor currency would also have important implications for the suitability of the monetary policy for Scottish economic conditions. Evidence presented in Chapter 1 suggests that managing the exchange rate of the new Scottish currency against sterling would provide the most suitable framework, given the similarities and integration between the Scottish economy and the rest of the UK.
Currency board
6.31 Under common definitions of a currency board regime, foreign reserves must be retained to ensure full backing of notes and coins as well as banks’ creditors account with the currency board (monetary base). Convertibility between the domestic currency and the anchor currency is absolute and unlimited. Monetary policy is entirely committed to maintaining the parity and convertibility between the domestic and the anchor currency, although there is some scope for modern day currency boards to smooth balance of payment shocks through open market operations and the use of excess reserves (foreign exchange reserves accumulated beyond the backing requirement of the monetary base).9 6.32 Replacing the central bank by a currency board with legal responsibilities to ensure the
parity and convertibility of the currency strengthens the degree of commitment relative to more standard forms of peg described above. This is usually intended to emphasise the credibility of domestic monetary policy and reinforce confidence in the long-term convertibility into the anchor currency.
6.33 However, this would come at the cost of even more constraining monetary policy than observed with less extreme forms of managed exchange rate regimes. In particular, a currency board would make it particularly difficult for an independent Scottish state to rely on changes in the nominal exchange rate (devaluation or revaluation) to help adjust to large shocks, especially terms of trade shocks.
6.34 In cases of severe economic pressure, the currency board regime can be broken, letting the currency float to facilitate the required economic adjustment. This would limit the need for adjustment to take place internally, via changes in wages, employment and prices, but could create large exit costs for the economy. These exits costs are unavoidable, but intentional.
6.35 A large part of the benefits of a currency board derive from the strength of the economic and political commitment to maintaining the exchange rate parity. In particular, confidence in the long-term commitment to parity and convertibility creates an incentive for both the private and the public sectors to undertake long-term transactions (including taking on debt) in the anchor currency. Exiting the board and devaluating the currency, while helping to restore the competitiveness of the economy, could increase the cost of debt denominated in the anchor currency.
6.36 In responding to a large shock, policy makers would need to trade off the costs of maintaining the currency board and forcing the economy to undergo the necessary internal adjustments against the costs associated with exiting the currency board to facilitate the adjustment. Maintaining the board could require very strong policy discipline, as well as market confidence in the commitment to this discipline. As pressure from financial markets intensifies, there are cases where it may not be economically and politically feasible to maintain the required degree of discipline.10
9 J. Hawkins and P. Masson, “Economic aspects of regional currency areas and the use of foreign currencies”, in Regional currency areas and the use of foreign currencies, BIS Papers, May 2003
10 “Currency boards are at one end of the spectrum between monetary policy credibility and monetary policy flexibility. They maximize the commitment to stable policy at the expense of all ability to tailor monetary conditions to macroeconomic and financial circumstances (...) A currency board is appropriate only under the most exceptional economic and financial circumstances, but also only when there exists broad-based political support for moving to one extreme on the trade-off between policy credibility and policy flexibility.” (Eichengreen, (1997) “Comment on Yum K. Kwan and Francis T. Lui, Hong Kong’s Currency Board and Changing Monetary Regimes”)
6.37 Hong Kong has run a successful currency board since 1983. This has required the building up of very large excess foreign reserves in ”good times” to provide some self- insurance against shocks. Policy decisions to defend the board against speculative attacks have also been needed, despite incurring costs on the domestic economy. A number of countries that have adopted currency boards have failed to stay the course (most notably Argentina). Box 6C illustrates these experiences.