7 Options for Alternative Exchange RateArrangements
- Christopher Browne
- Published Date:
- August 2006
Susan Creane, Jun Il Kim, and Laura Papi, with assistance from Agnes Isnawangsih1
The question of what exchange rate regime best fits an individual economy continues to be much discussed by policymakers and academics. For the Pacific island countries, the question has particular resonance given the small size and openness of their economies and their resultant vulnerability to external shocks. However, there is no unambiguous answer, because an exchange rate system should be determined according to each country’s macroeconomic and structural characteristics and economic, political, and institutional constraints. For that reason, the IMF supports the range of regimes chosen by individual countries in the region.
All the Pacific island countries have some form of pegged exchange rate regime, with the exception of Papua New Guinea, which has an independently floating exchange rate arrangement. According to the IMF official classification reported in the Annual Report on Exchange Arrangements and Exchange Restrictions, the currencies of Fiji, Samoa, and Vanuatu are pegged to a basket of currencies; the exchange rate regime of Solomon Islands is a crawling peg; and Tonga has a peg within horizontal bands. Other island countries are dollarized: Kiribati with the Australian dollar, and Marshall Islands, Micronesia, and Palau with the U.S. dollar. The analysis in this paper applies to the six countries that have their own currencies; it is assumed that those now dollarized will remain so.
This chapter discusses the pros and cons of a common currency union and the relative merits of a currency union that adopts the currency of another country (dollarization), most likely by using the Australian dollar. Then it outlines the theoretical criteria for establishment of a currency union and applies these criteria to the Pacific region using two different methods of empirical analysis. The chapter concludes with a discussion of some practical considerations related to forming a currency union in the Pacific island countries.
The Pros and Cons of a Currency Union
There are several potential advantages of a currency union over the maintenance by each country of an independent currency: lower inflation, to the extent that fiscal discipline is achieved; fiscal discipline, to the extent that the ability to finance budget deficits is limited or eliminated; and promotion of regional integration, to the extent that labor, capital, and goods are encouraged to move freely. These advantages, however, are realized only when supporting fiscal and structural policy actions are in place.
The main disadvantages for individual countries of a currency union are the loss of the exchange rate as a shock absorber, to the extent the fixed regime holds; the loss of independent monetary policy; the need for fiscal policy, prices, and wages to be sufficiently flexible; the loss of a lender-of-last-resort facility for individual countries; the loss of seigniorage, although some sharing arrangement can be devised within the union; and some loss of national sovereignty.
There are two possible types of currency unions: one that dollarizes or one with a common currency, either pegged to or floating against currencies outside the union. The potential advantages of dollarization or a common currency include more credibility, because the risk of devaluation is substantially reduced; less opportunity for inflationary financing, which can encourage investment; and closer integration with other countries that use the adopted currency, resulting in lower transaction costs and more stable prices. There are also some disadvantages to a common currency or dollarization, including that such an arrangement is much more difficult to reverse; large shocks, such as a sharp increase in world oil prices or a fall in the price of a key export, must be absorbed through nominal wages and domestic price adjustment; a much stronger and earlier level of political commitment is needed because most countries are reluctant to abandon their national currency; a loss of seigniorage, except in the unlikely case that the country whose currency is adopted agrees to share these revenues; and loss of the lender-of-last-resort role for individual central banks.
Do the Pacific Islands Meet the Criteria for an Effective Currency Union?
The benefits of adopting a currency union are greater when certain criteria are met. This section draws from the economic literature on optimum currency areas and fixed versus floating exchange rate regimes and applies the theoretical criteria for successful currency unions to the realities of the Pacific island region. Much of the analysis applies equally to currency unions with floating, pegged, or dollarized exchange rates and they are therefore differentiated only where relevant. In addition, some comparisons are made with the countries that comprise the ECCU, which are pegged to the U.S. dollar.
Trade openness, a measure of a country’s engagement in international trade, is calculated as the ratio of the sum of imports and exports to GDP. The importance of an economy’s openness in determining its suitability for a currency union is ambiguous. On the one hand, the more open the economy, the larger the impact of external shocks, and therefore the more useful the exchange rate as an adjustment tool. On the other hand, the more open the economy and the more the countries in question trade with each other, the greater the potential reduction in transaction costs from a currency union. The outcome will depend in part on the extent to which nominal exchange rate changes translate into real exchange rate changes. If prices and wages adjust quickly with the exchange rate, the exchange rate is not an effective adjustment tool and the latter effect (a reduction in transactions costs) might dominate.
Trade openness is generally high in the Pacific island region, but it varies across countries and is lower than in the ECCU. For trade in goods and services, it ranges between 77 percent in Tonga and 118 percent in Fiji (Table 7.1). Openness has been broadly stable over the past decade, with the exception of Solomon Islands, where openness declined sharply as a result of civil strife and the resulting decline in economic activity and has not yet fully recovered.
|Rest of the world||30.4||52.9||5.2||22.3||47.1||22.9||30.1|
|Rest of the world||10.2||10.3||15.2||10.6||11.5||25.3||13.9|
Direction of Trade
Regional trade is minimal—no more than 2 percent of total trade for any country in the region, although PICTA aims to address this.
Australia is a major trading partner for the Pacific island countries. All countries, with the exception of Samoa, import more from Australia than they export to Australia. Imports from the United States are lower than from Australia. Trade with New Zealand is generally less than with Australia, although Samoa and Tonga have strong trade links. On average, trade with developing Asia is significant, with a large variation across countries for exports. The Pacific island countries seem less integrated with their major trading partner, Australia, than the ECCU countries are with the United States.2
Overall, limited trade within the region suggests that a currency union with a freely floating exchange rate would bring limited benefits to the Pacific island countries in terms of reduced transaction costs. But small, open economies often can reduce transaction costs by adopting the currency of a large trading partner. If the region were to consider adoption of another currency or a peg to another currency, the Australian dollar appears more suitable than the New Zealand dollar or the U.S. dollar. The origin of aid flows, remittances, and tourism receipts generally supports this conclusion.
Business Cycle Synchronization
The greater the co-movements in business cycles among countries in a currency union, the lower the cost of foregoing exchange rate flexibility and the greater the benefits from the currency union. When co-movements in business cycles are high, the policies of the anchor country in the currency union should also be supportive of economic stabilization in the other countries.
The anchor country for Pacific island countries would be Australia, and together their economies represent 0.2 percent of Australia’s GDP. The United States is the anchor for the ECCU countries, which represent 0.008 percent of U.S. GDP. Among the Pacific island countries considered here, average economic growth correlations were a mere 7 percent in the past 10 years. Although average economic growth correlations with Australia have increased in the past decade, two countries had negative correlations with Australia. Even for the four countries with positive correlations, the degree of output correlations was on average only 18 percent, considerably less than the ECCU countries’ average of 41 percent within their currency union or 43 percent with the United States. An analysis of output co-movements confirms the above findings.
Overall, the evidence suggests that Pacific island countries do not appear well suited for a currency union with a freely floating exchange rate nor for one that is either pegged to or adopts the Australian dollar, partly because synchronization of business cycles is either limited or nonexistent both within the region and between the region and Australia.
Terms of Trade
The smaller the size of terms of trade shocks and the higher the co-movements in the terms of trade for a group of countries, the greater the benefits of a currency union. Although their size has declined in the last 10 years, terms of trade shocks are still sizable in the Pacific island region (Table 7.2), and they are larger than those in the ECCU, indicating that the costs of giving up their national currencies would be higher for the Pacific countries. The terms of trade shocks are also considerably larger than in Australia. The co-movements of these countries’ terms of trade with Australia vary widely, being negative for some and positive and large for others. Between pairs of different Pacific island countries, correlations also are highly variable, with some negative and others positive up to 60 percent.
|Papua New Guinea||6.35||8.72|
|Vanuatu||25 41||11 14|
For Tonga is 1987-94.
For Tonga is 1987-94.
Thus, the size and co-movements of the terms of trade indicate that, from this perspective, the region is not well suited for a common currency or for dollarization with the Australian dollar. Giving up the exchange rate as a tool for adjusting to terms of trade shocks would likely mean that adopting a currency union or dollarization would carry significant costs for these countries.
Natural disasters are another type of real shock that put a premium on maintaining the exchange rate as an adjustment tool. During the last five years most countries were subject to such shocks quite frequently, although the same disaster seldom affected more than one or two countries at the same time. This suggests that a common currency may not be desirable from this perspective.
The higher and more variable the inflation rate and the higher the co-movements in prices, the greater the potential benefits of a pegged currency or dollarization. Inflation rates across the Pacific region were modest in the last 10 years and their variability was limited. The relative price stability in the Pacific island region does not indicate a strong need for a currency union either with a pegged currency or with dollarization to foster monetary stability.
Greater factor mobility can allow needed adjustment in the absence of exchange rate flexibility. Although data for this type of analysis are lacking, anecdotal evidence indicates that labor mobility in the region is limited. While the citizens of some countries have migrated outside the region in large numbers, this is not possible for others. Domestic labor markets also appear to have limited flexibility, especially because of large public sectors.
The greater the fiscal flexibility, the lower the costs of ceding exchange rate flexibility. A very rough indicator of such flexibility is the debt-to- GDP ratio, because the higher the debt level, the less room there is for using fiscal policy countercyclically. Fiscal flexibility differs by country in the region but in most cases is limited, given that public debt ranges from about 40 percent of GDP for Vanuatu to about 90 percent of GDP for Solomon Islands.
The lower the seigniorage, the smaller the cost of giving up the national currency. Rough calculations indicate that seigniorage in the region has averaged about 1 percent of GDP in recent years. As a notional comparison, the average seigniorage in the ECCU was ½ percent of GDP in the decade preceding their currency union.
Assessing the Region’s Suitability for a Currency Union: An Index Approach
This section uses an index approach to analyze the region’s suitability for a currency union or dollarization. The index combines various criteria for a currency union to measure the expected variability in bilateral exchange rates. A low value of the index denotes a high suitability for dollarization.
There are two different specifications for the index: one using nominal exchange rate variability as the dependent variable, and the other using an exchange market pressure variable, which is defined as a weighted change in bilateral nominal exchange rate and official reserves.3 The latter may be more appropriate for countries using a fixed exchange rate regime. The regression analysis includes such explanatory variables as co-movements in output, prices, and the terms of trade, as well as trade openness and country size. Other variables that are discussed in the previous sections, such as indicators of labor market mobility and fiscal flexibility, either were not statistically significant or could not be included because of data constraints.
The findings are inconclusive about the region’s suitability for a currency union with a floating exchange rate. Neither do they point to a clear suitability for dollarization, although they do indicate that the Pacific island countries may have become relatively more suited for dollarization over the past two decades, as the variability in their growth rates has declined. However, there is no indication that this trend will continue over the long term. The results also suggest that should dollarization be undertaken, use of the Australian dollar would be more advisable than use of the U.S. dollar. Fiji, Samoa, Solomon Islands, and Tonga are the countries most suitable for dollarization with the Australian dollar.
Alternative Exchange Rate Arrangements: Transitional Issues
Forming a currency union or dollarizing entails a range of operational issues. This section examines the experience of existing currency unions with a number of these issues and compares this experience with the current situation in the Pacific island region and Australia.
All currency unions have adopted convergence criteria on key variables to promote stable macroeconomic policies and minimize the potential costs imposed on others by nonperformers. Some convergence criteria are used as preconditions for membership and some apply after a country joins the union, with varying degrees of enforcement. Criteria typically include numerical targets on variables such as government deficits and debt, inflation, reserves, interest rates, and exchange rates.
The need for fiscal policy maneuverability is critical for the success of a currency union given the absence of other macroeconomic policy options. For this reason, fiscal convergence criteria figure prominently in transition and eligibility criteria for countries joining currency unions. The Pacific island region has made some progress toward improved fiscal conditions in recent years and most could now meet a typical fiscal balance criterion (Table 7.3). However, only two countries converge with the fiscal performance of Australia, which has been running consistent surpluses in recent years.
|Fiscal Balance/GDP||Government Debt/GDP||CPI||Lending Rates|
|Papua New Guinea||-4||-6||-2||1||-1||62||73||70||57||51||9||12||15||2||2||16.2||13.9||13.4||13.3|
|Number of countries meeting criteria|
Public debt levels remain high in the Pacific island region, and there is uncertainty about the long-term sustainability of the consolidation to date. IMF work on debt sustainability analysis for “poor performers” sets thresholds in net present value terms of 30 percent of GDP.4 In the Pacific island region, all but Fiji and Samoa are classified as poor performers.
Additional fiscal convergence criteria used in other currency unions would be difficult for many countries in the region to meet. These include keeping the ratio of the wage bill to tax revenue below 35 percent and keeping financing of public investment from domestic revenue at above 20 percent of tax revenue.
Many currency unions include inflation and interest rate objectives. In the European Monetary Union (EMU), the inflation criterion is tied to the outcomes of the best-performing members, and in other currency unions the annual inflation target ranges from 3 to 10 percent. About half of the Pacific countries would meet the most stringent criteria and would also converge with Australia’s inflation rate. The EMU also sets convergence criteria on interest rates, whereby the average nominal annual interest rate on 10-year benchmark government bonds should be no more than 2 percentage points above the average of the three best-performing member states. Only about half of the Pacific island countries would meet this convergence criterion, with almost 9 percentage points difference in lending rates between the highest (Solomon Islands) and lowest (Fiji).
Convergence of financial sector structure and stability is another precondition for a successful currency union or dollarization. This is a means to allow policy decisions to be synchronized and to minimize potential losses imposed by countries with weaker financial systems. The Pacific region’s financial systems are relatively sound, in part because of the presence of foreign-owned banks. Financial supervision has been considerably strengthened in recent years, including through the efforts of the Association of Financial Supervisors of Pacific Countries and the Australian Prudential Regulatory Authority. At the same time, the level of financial development in the region is very low and formation of a currency union would promote the dismantling of barriers to intraregional capital flows and the establishment of regional capital markets.
At a more practical level, moving to a common currency or dollarization would require replacing all existing local currency liabilities of the central banks. This would entail having sufficient reserves or an agreed currency swap with the anchor country to buy the existing local currency. All cash in circulation and in vaults would need to be exchanged, as would local currency government and commercial bank deposits with the monetary authorities. Currently, all the regional authorities, with the exception of Tonga, have sufficient reserves to cover the outstanding local currency liabilities of the monetary authority.
This analysis suggests that the Pacific Island countries do not fully meet the criteria for a successful currency union or dollarization. Of particular concern are the costs that would be associated with the loss of the exchange rate as an instrument to adjust to terms of trade shocks and other external shocks, which are large in the region. At the same time, the potential benefits from improved credibility would be only modest. If the region were nonetheless to consider forming a currency union, it would make more sense to adopt the currency of an anchor country than to create a regional currency union with an independently floating currency, given the limited trade within the region. In this context, it would be more appropriate to adopt the Australian dollar than either the New Zealand or U.S. dollars.
If a decision is made to form a currency union, these countries will have to move a considerable distance to meet key convergence criteria. In particular, there are still large variances among them in public sector debt, interest rates, and exchange rates. Finally, creating a currency union or dollarizing would require in advance a strong political commitment to enhanced regional cooperation, and this will take time to achieve. Over the longer term, as trade in the region increases under PICTA, and as growth and inflation converge further, there may be growing benefit to the possibility of a currency union or dollarization.