Achieving durable price and exchange rate stability: Is a currency board the answer?

Ghana has a long history of price and exchange rate instability. The underlying defective structure of the economy, in terms of the lack of diversification and over-reliance on imports, is a contributory factor.

However, many of Ghana’s peers in Africa and elsewhere, with similar economic structures, have been able to maintain lower rates of inflation and currency depreciation. This suggests that Ghana need not endure these conditions and should be able to manage its situation better.

A key feature of the successful peer economies has been their ability to maintain stricter monetary and fiscal management systems. On the contrary, Ghana has practiced more liberal fiscal and monetary policy regimes, with poorer outcomes. Addressing the underlying structural defects of the economy through transformation will certainly take time, given the wide gap between promises and concrete measures to that effect.

However, we do not have to wait for a complete transformation of the economy before we achieve an acceptable degree of price and exchange rate stability. Obviously, we cannot continue to operate the same lax fiscal and monetary policy systems and expect to have different outcomes. We need to think outside the box and seek alternative solutions.

A Currency Board is a stringent monetary and fiscal mechanism that delivers price and exchange rate stability in addition to preventing balance-of-points crises. It is for this reason that some experts have advocated for a Currency Board for Ghana as the solution to the country’s perennial price and exchange rate instability.

The question, however, is whether a Currency Board is the right model for Ghana. This paper examines the merits and merits of the Currency Board and its suitability for Ghana for addressing the country’s twin problems of price and exchange rate instability.

Principally, a central bank issues domestic currency and exercises wide discretion over the conduct of monetary policy. It can buy and sell domestic assets. On the other hand, by design, a currency board does not operate discretionary monetary policy, but rather rules-based policy.

An orthodox currency board issues note and coins convertible on demand into a foreign anchor currency at a fixed rate of exchange. It holds reserves in foreign currency and gold set by law and equal to 100 percent of the currency issue. A currency board cannot engage in the “fiduciary issue of money”, i.e. money not backed by foreign exchange.

Its operations are, therefore, “passive and automatic.” The sole function of a currency board is to exchange the domestic currency it issues for an anchor currency at a fixed rate. Foreign reserves are the only asset on a currency board’s balance sheet because it cannot buy and sell domestic assets.

Because the currency board backs its currency fully with foreign assets, it can fully meet the demand for foreign exchange in exchange for domestic currency. In that respect, in principle, there cannot be balance-of-payments crises and the domestic currency does not depreciate.

Currency boards are not without disadvantages, nevertheless, and one should not gloss over them. Key disadvantages of currency boards mentioned in the literature include

1. Loss of monetary independence or sovereignty: To the extent that it is not able to use monetary policy to influence macroeconomic conditions, especially growth, through changes in interest rates.

With a currency board, the national authorities cannot use financial policies, such as adjustments of domestic interest rates or exchange rates, to stimulate the economy. Under a currency board, economic adjustment can only take the form of wage and price adjustments, which can be both slower—and even more painful.

2. Possibility of loss of competitiveness: There is the possibility of the pegged currency becoming overvalued and, thereby, causing a loss of competitiveness. This may be countered by improving efficiency in other areas of the economy through appropriate reforms.

3. Vulnerability to shocks: Due to the loss of monetary independence and exchange rate flexibility, there is an equal loss of a chance for these instruments to contribute to the response to economic and financial shocks.

4. Lack of lender of last resort status. Notably, unlike a central bank, a currency board cannot be an unlimited lender of last resort to banks in financial trouble. However, an arrangement can be made for the currency board to provide loans from an emergency fund that is either set aside at the time the currency board is created or, over time, funded from central bank profits.

Further, key conditions are required for a currency board to be successful, which could be difficult to achieve and, therefore, limit its applicability. These include:

1. Adequate foreign exchange reserves This is needed to provide the required one-hundred percent backing for the domestic currency. A currency board can be credible only if it holds sufficient official foreign exchange reserves to cover its entire money supply, as appropriately defined.

In this way, financial markets and the public at large can be assured that every domestic currency bill is backed by an equivalent amount of foreign currency.

2. Fiscal discipline. This is necessary so as not to undermine the currency board system but also such that the budget can cope with the absence of possible financing that is available under a central bank system but absent from a currency board system.

3. Strong and well-managed financial system. This is required for the system to be able to stand on its own without the lender of last resort opportunity that is available under a central bank but absent under a currency board.

4. Strong legal system: This is required to support the currency board, particularly, regarding enforcement of the applicable rules. A sound legal basis is essential because a currency board arrangement derives much of its credibility from the changes required in the central bank law.

Ultimately, every country will have to take its own particular circumstances into consideration in deciding to adopt a currency board or not, weighing the merits against the demerits.

The fact that a currency board has worked or not worked for one country cannot be the basis for another country’s decision, although it can learn lessons from others’ experiences. Furthermore, as we saw above, a country may decide to adopt a currency board for a limited period only to deal with the prevailing economic or financial crisis and phase it out when the crisis has been resolved.

A currency board has obvious advantages in terms of its ability to minimize inflation, currency instability, and balance-of-payments crises. These are problems that have bedeviled Ghana for decades and for which no solution seems to be in sight.

For these reasons, it is not surprising that the call for Ghana to adopt a currency board has continued to gain momentum and currency. With policy discretion continuing to deliver poor outcomes, it is natural that there is a craving to impose rules to force the economic managers’ hands and ensure more positive outcomes.

However, we are also mindful of the several limitations of a currency board, as enumerated above, including especially, possible loss of monetary policy independence and flexibility to influence the economy, loss of exchange rate flexibility to respond to shocks, and as a competitiveness tool, lack of a lender of last resort function, which may be needed in financial crises situations, and lack of fiscal agency function as a backup for potential fiscal shocks.

For these reasons, we do not consider a full-blown currency board to be currently appropriate for Ghana. We would want to see rather a “currency board-lite” system for Ghana, essentially to mitigate some of the disadvantages of a full-blown currency board. What we envisage for Ghana is an alternative to a full-blown currency board that entails tightening monetary and fiscal rules as well as enforcement and oversight regimes.

On the monetary management side, we propose: a) Enforcement of the 5% ceiling on Bank of Ghana lending to the Government and the requirement that any such lending should be liquidated by the end of the fiscal year to which it applies without the possibility of securitizing it into a permanent debt; and b) Progressive increase of the minimum foreign exchange cover for the cedi issue from the current 40% to 70% during 2023-25.

On the fiscal management side, we propose: a) Scaling down the ceiling on the fiscal deficit from the current 5% to 3% in consonance with the ECOWAS and WAMZ convergence criteria and setting time limits and conditions for a return to the ceiling after agreed suspension in times of unanticipated economic shocks and crises; and b) Imposition of a ceiling of 60% of GDP on the public debt to be observed at any time.

The ceiling may be varied only with the approval of Parliament for reasons of unanticipated economic shocks and crises based on timelines and conditions for a return to the limit.

We also propose the strengthening of enforcement and oversight of the monetary and fiscal rules. The oversight regime should involve the setting up of a Parliamentary Budget Office manned by independent professionals appointed by the Public Services Commission.

The PBO will assist Parliament with independent budget analysis and forecasts and estimates of the costs of Government projects and programs, among other functions.

Entrenching these monetary and fiscal rules and backing them with strong enforcement and oversight regime, will ensure durable price and exchange stability in Ghana, while otherwise avoiding the pitfalls

associated with the rigid currency board alternative.

The support of Parliament and CSOs will be important for the adoption of the rules and in instituting the necessary enforcement and oversight regime.

For further information, kindly contact Dr.John Kwakye, Director of Research, IEA via email: j_kwakye@yahoo.com