Már Guðmundsson: Currency and exchange rate regime options
Introduction by Mr Már Guðmundsson, Governor of the Central Bank of Iceland, to a report
issued by the Central Bank of Iceland on Iceland's currency and exchange rate policy
options, Reykjavík, 7 September 2012.
* * *
1.1 Introduction
In the near future, Icelanders must make important decisions concerning the framework for
the currency and monetary policy, the structure of the financial system, and the degree of
integration with the world economy. These decisions must be taken in view of what can be
learnt from the financial crisis and from previous monetary policy implementation in Iceland.
Iceland has applied for membership of the European Union (EU) and, if membership
materialises, it will define a clear path for most of these issues. If Iceland does not join the
EU, the choices will be different. In both instances, Iceland must lift the capital controls that
are currently in place. According to EU rules, this must be accomplished before accession.
The experience of recent decades shows, however, that completely free movement of capital
comes with significant risk. To reduce that risk, it is necessary to develop a regulatory
framework that prepares the Icelandic financial system for the volatility that can accompany
free movement of capital. That regulatory framework may entail some restrictions on
Iceland's financial integration with other countries, particularly as regards domestic financial
institutions' freedom to conduct international business. The scope of such restrictions will
depend, however, on which currency option Iceland chooses.
This report was originally intended to explain in detail what EU membership and participation
in the Economic and Monetary Union (EMU) would entail as regards exchange rate and
monetary policy, and to analyse the pros and cons of Iceland's membership in the EMU. In
1997, the Central Bank of Iceland published a similar report, entitled The Economic and
Monetary Union of the European Union - EMU (available in Icelandic). Much has changed
since then. During the decade and a half of the EMU's existence, it experienced success for
much of the period, followed by the current severe crisis. Iceland faces a much more decisive
assessment of the pros and cons of EMU membership than it did in 1997. As a result, it is
timely to issue a new report on this topic. This publication is considerably broader in scope
than the earlier one, as it also contains an analysis of the advantages and disadvantages of
other options, including an exchange rate peg within a defined fluctuation band, a currency
board, or adoption of another currency. Some of these options have been the focus of recent
public discussion as alternatives to euro area membership through EU accession or the
current flexible exchange rate regime. Consequently, these options should be analysed just
as other possible solutions are. The possibility of retaining a flexible exchange rate regime
while making relevant changes to the economic policy and financial regulatory framework
based on recent experience was discussed in the Central Bank's 2010 report entitled
Monetary policy in Iceland after capital controls. The present report therefore does not
discuss those options in as much detail. In Chapter 3, however, is an in-depth discussion of
Icelanders' experience with independent monetary policy and a floating exchange rate. The
strategy formulated in coming months must take into account this material if all options are to
be considered. It is also necessary to examine which prudential rules would be applied in
order to reduce the risks related to domestic financial institutions' foreign assets and liabilities
and the risks related to unrestricted capital flows. These rules are discussed in a newly
published Central Bank report entitled Prudential rules following capital controls. That report
discusses the limitations on liquidity and foreign exchange risk and the restrictions on
domestic financial firms' international operations that must be in place if movement of capital
is unrestricted in other respects, particularly if Iceland retains its own currency. The
discussion below also takes account of these two publications.1
1.2 Iceland's experience with its own currency
Iceland has had its own currency since 1885, maintaining parity with the Danish krone until
June 1922, when it was devalued by 23%, followed by a temporary float (see Chapter 12). It
can be said that the króna came into existence as an independent currency at that time. The
experience with it has been mixed, and efforts to preserve the value of the currency have
been largely unsuccessful. The króna is now worth only 0.05% of its value prior to the 1922
devaluation; in other words, it has depreciated by 99.95%. In terms of consumer prices, the
króna has eroded in value even more, or about 99.99%. In other words, its purchasing power
in terms of goods and services is currently only 0.013% of what it was in June 1944, when
the Republic of Iceland was founded. Nevertheless, over this period, Iceland developed from
being one of the poorest countries in Europe to one of the richest in per capita terms, despite
the economic costs of persistent inflation. Currency depreciation and subsequent inflation
episodes have sometimes expedited the necessary adjustment following economic shocks,
however, thereby returning the economy more quickly to a path of economic growth.
Chapters 3 and 12 focus on certain aspects of Iceland's experience with an independent
currency. In Chapters 9 and 13, two key questions are asked. First, how effective is
monetary policy in achieving the goals with which it is tasked? Second, has the flexibility of
the exchange rate facilitated economic adjustment and stability, or has it instead been a
source of shocks? Summarising these findings reveals that Iceland's experience of
independent monetary policy and a flexible exchange rate has been poorer than that in many
other countries, in that monetary policy has not been successful in achieving its goals and
the flexible exchange rate has tended to be a source of shocks rather than a shock absorber.
It is likely, though, that the flexibility of the króna has facilitated adjustment to severe
downturns under certain circumstances, such as the collapse of the herring stocks in the late
1960s and the steep contraction following the 2008 financial crisis.
The possible reasons for this are explored in the above-mentioned chapters. It is too soon to
draw any final conclusions, however, and research beyond the scope of this report or
conventional economic analysis is needed in order to shed light on why the objectives of low
inflation and economic stability seem so elusive in Iceland, and why undisciplined
stabilisation policy and an environment of loose financial regulation and supervision was
allowed to flourish during the pre-crisis years. However, as is pointed out in the report, the
ineffectiveness of independent monetary policy and the possible procyclical influences of
floating currencies are not uniquely Icelandic phenomena, nor are they due solely to flawed
stabilisation policy. To some extent, they can also be attributed to exchange rate volatility
where, as with any other asset price, expectations and speculation play an important role. In
addition, there are indications that smaller countries have more difficulty than large ones in
pursuing independent monetary policy while they are becoming more integrated globally. In
this context, it is worth noting that, prior to the financial crisis, Iceland was by far the smallest
country in the world with a floating currency. Further discussion of the possible reasons for
small countries' vulnerability to such problems can be found in Chapters 9 and 13.
1.3 The euro project
At the core of this report is a discussion of the euro project. It examines what euro area
membership entails and what its strengths and weaknesses have proven to be so far.
Chapters 2 and 16 focus on economic developments in the euro area since its
establishment, with particular emphasis on the post-crisis period, and Chapter 17 compares
the effects of the financial crisis on countries inside and outside the eurozone, with emphasis
on a comparison of Iceland and Ireland. The objective is to inform the reader and report on
research findings, with the aim of promoting informed discussion and policy-making on this
major issue. Chapter 24 explores the changes that would be needed in Icelandic laws and
regulations with respect to the currency and the Central Bank should Iceland join the EU and
adopt the euro.
Chapters 21-25 describe the Eurosystem and the EMU accession process. According to
EU regulations, member countries are to adopt the euro once they have fulfilled the
Maastricht criteria for economic convergence. To fulfil the Maastricht criteria, the candidate
country's public sector debt and deficits must be within specified limits, its inflation and
longterm interest rates may not deviate beyond a certain limit from the levels in the three
EU countries with the lowest inflation, and it must participate in the European Exchange Rate
Mechanism, ERM-II, for at least two years. Denmark and the United Kingdom are the only
countries permanently exempted from euro area membership, and new EU member
countries are unlikely to receive such an exemption.
Chapter 23 discusses the Maastricht criteria, and Chapter 21 describes ERM-II and how new
member countries have fared under ERM-II. The conclusions of the analysis are far from
unambiguous. The convergence that took place during the run-up to the euro collaboration
proved risky for many countries, as capital inflows, declining interest rates, and increased
optimism contributed to steep rises in asset prices and real exchange rates. This resulted in
current account deficits and reduced competitiveness, which remained (and in some cases
intensified) long after entry into the euro area, as the conversion rate upon entry into the
currency area proved to be inconsistent with the underlying equilibrium exchange rate
because of the above-mentioned developments (see Chapter 22). Similar developments
could be seen before the financial crisis in countries participating in ERM-II, particularly the
Baltics. ERM-II countries have avoided a currency crisis, however.
Iceland can draw a number of lessons from this if it takes this path. ERM-II is a useful
prelude to full euro area membership and, other things being equal, will reduce exchange
rate volatility. But ERM-II membership is not a magic solution, and the accession process
can prove risky. As a result, it is important that economic policy and the regulatory framework
be designed to maintain economic stability and keep financial risk within acceptable limits.
Most of the changes that will improve economic policy under a flexible exchange rate will
also be helpful in the run-up to euro area membership. These changes are discussed in
greater detail later in this chapter.
Chapter 24 focuses on what euro area membership and full participation in European Central
Bank (ECB) operations entails. A number of amendments must be made to the Act on the
Central Bank of Iceland in order for the Bank to fulfil the requirements made of national
central banks in the euro area, as regards independence and the ability to carry out the tasks
entailed in euro area membership. In addition, increased requirements are made concerning
central banks' participation in the formulation and implementation of financial stability policy
(see Chapter 25).
Money serves as a medium of exchange, a unit of account, and a store of value. The better it
retains its value against goods and services and other currencies, the better a store of value
and the more reliable unit of account it is. The more it used in trade and the more generally it
is recognised in settlement, the better a medium of exchange it is. In this sense, the euro has
been successful, and the current crisis in the euro area has not yet changed this to any
marked degree. The euro is the world's second-largest international reserve currency, after
the US dollar, and is recognised in trade everywhere. Underlying it is one of the two largest
and most efficient financial markets in the world. As is discussed in Chapter 2, inflation has
been close to the 2% inflation goal for most of the euro's existence, averaging 2.1% from
early 1999 until mid-2012 and currently measuring just under 21⁄2%. On the whole, the euro
has retained its value against other currencies. At the end of August 2012, it was nearly 61⁄2%
stronger against the US dollar than at the beginning of 1999, and 4% above the average over
the intervening period. Euro area payment systems have proven effective, even in the
financial crisis. No controls have been imposed on movement of euro-denominated assets,
either within or outside the euro area. As a result, there is no currency crisis in the area, and
it is therefore misleading to speak of "the crisis of the euro" as such.
This does not change the fact that the euro area is currently faced with a complex web of
problems that, if worse comes to worst, could threaten its very existence if political support
for the currency union wanes. The eurozone's current economic and financial difficulties are
due in part to the fact that, together with the US, the UK, and Switzerland, the euro area was
one of the sources of the financial crisis that began in mid-2007 and peaked in autumn 2008.
In the beginning, the crisis had little to do with flaws in the design of the euro area. Ensuing
developments unveiled those flaws, however. When all is said and done, the flaws stem from
the fact that, even though the euro area is referred to as an economic and monetary union,
the economic and fiscal aspects were largely missing (see Chapter 15). Furthermore, the
EU regulatory framework for cross-border banking operations is severely flawed in that
EU-wide operational freedom was coupled with national supervision and deposit insurance -
and, in the case of non-euro countries in the EU, national liquidity facilities. This made it
much more difficult to address problems in the banking system at the peak of the financial
crisis. To some degree, this may explain why the European banking system was not
sufficiently restructured at that time and to a lesser extent than, for example, in the US. The
banking system was therefore more vulnerable when the sovereign debt crisis struck several
euro area countries as a result of prolonged lack of fiscal discipline (see Chapter 15),
economic policy, and the financial systems of the countries affected.
Therefore, the euro area is currently battling a fiscal crisis in some member countries, a
competitiveness and current account crisis in the region as a whole, a deep banking crisis in
some countries, and a fragile banking system in many others, which would be exacerbated if
the sovereign debt crisis should end in default by any of the countries concerned. A currency
crisis as such is not part of the problem, however, any more than it was in the US.
As is discussed further in Chapters 16 and 25, a number of reforms have already been
adopted in response to the shortcomings in the design of the euro area, but it is not certain
that they will suffice to preserve the currency union in its current form. Forecasting near-term
developments in the euro area crisis is beyond the scope of this report, however. The results
of the reforms made to date have not yet been fully tested. If they prove inadequate, the
crisis could be amplified and, in the worst-case scenario, could have severe repercussions
for the future of the euro area in its current form. If they are successful, the reforms could
strengthen the eurozone. The outcome has yet to be determined.
1.4 Euro area membership: pros and cons for Iceland
According to the conventional economic theory of optimal currency areas (OCA theory; see
Chapter 5), a given country is better suited for participation in a larger currency area the
more its shocks are symmetric with shocks to the other countries in the currency area, the
more open its economy is, the greater the share of trade is with the currency area, and the
more flexible its labour market is. These OCA criteria centre on the balance between the cost
of relinquishing monetary independence and the benefits of reduced transaction costs for
trade (see also Chapter 6). If economic shocks hitting the candidate country and the currency
area are symmetric, joint monetary policy will respond effectively to them, and a flexible
exchange rate will not be needed as a shock absorber. The greater the share of external
trade, the greater the benefits in lower transaction costs deriving from participation in a
monetary union. At the same time, the effects of nominal exchange rate movements on the
real economy will be less, particularly in small, open economies that price their exports in
foreign currency and face given import prices in foreign currency. In other words, changes in
the nominal exchange rate will have a smaller and more short-lived effect on the real
exchange rate. Finally, if economic shocks extend only to the home country and joint
monetary policy is insufficient to absorb the shock, labour market flexibility could take the
place of nominal exchange rate adjustment once the domestic currency has been
abandoned.
Consideration of these criteria based on historical data does not produce an unequivocal
answer about Iceland's suitability as a member of the eurozone. The Icelandic business
cycle has been rather weakly linked to that of the euro area - and actually, to most other
regions and countries as well (see Chapter 10). Iceland's export sector differs in structure
from that in most other industrialised countries (see Chapter 4). On the other hand, the
economy is quite open to trade and the euro area is by far Iceland's largest trading partner
(see Chapters 4, 8, and 20). In addition, the domestic labour market is quite flexible, although
downward flexibility of nominal wages has not been tested much and available data suggest
that it has been relatively limited to date (see Chapter 14).
The OCA theory has many shortcomings and does not take account of a number of potential
benefits of participation in a large currency area such as the eurozone. Historical experience
also suggests that currency unions can be successful even if the participating countries do
not fulfil the OCA criteria at the outset (see Chapter 5). In this context, the following points
are worth noting:
•
Research indicates that currency union membership will stimulate trade with the
currency union without reducing trade with other countries. In part, this is because
domestic firms will be enabled to participate more readily in external trade because
of the absence of exchange rate risk. According to an estimate of this trade boost
effect if Iceland were a member of the euro area (see Chapter 8), goods trade
relative to GDP could increase by 4-11 percentage points and, as a result, GDP per
capita could rise permanently by 11⁄2-11%.
•
Research shows as well that the increased trade between member countries with a
common currency could cause the business cycle in those countries to become
more symmetric over time, so that OCA criteria are met to a gradually increasing
degree.
•
The use of money is subject to considerable economics of scale; for instance, in
connection with currency issuance, the cost of providing monetary services (such as
monetary policy and payment intermediation), and cross-border foreign exchange
transactions. Other things being equal, participation in a larger currency area would
lead to a more efficient and less expensive monetary system.
•
In addition, small countries in a currency union can save foreign exchange reserves
to a greater degree than is possible with an independent currency.
•
The domestic foreign exchange market is small, undeveloped, and relatively
expensive to trade in (see Chapter 12). Euro area membership would provide
access to a large, deep financial market without exchange rate risk. This would
facilitate risk diversification domestically. In addition, the pool of financial products
would increase and competition in financial services would be enhanced, thereby
reducing the cost of capital. Simulations using the stylised dynamic stochastic
general equilibrium model in Chapter 7 indicate that domestic real interest rates
would decline, the domestic capital stock would grow, and GDP per capita would
rise permanently if a small country such as Iceland were to join a larger currency
area (see also Chapters 2 and 21 for a discussion of other countries' experience).
•
Upon joining the euro area, consumers would have access to a large market in
which they could use their home currency. This would facilitate price comparison
and boost competition. It would also be easier for domestic firms to gain a foothold
in larger markets and benefit more from economics of scale in their operations and
production.
•
With euro area membership, the risk associated with cross-border banking
operations would be reduced, as banking would take place in the home currency to
a larger degree and the ECB would be responsible for providing liquidity. As a result,
it would be possible to ease the restrictions on cross-border banking that would
otherwise be necessitated by foreign exchange risk and maturity mismatches in the
banks' foreign-denominated assets and liabilities.
•
EU and euro area member countries are subject to requirements concerning public
finances and other aspects of economic policy, which aim to improve policy
discipline. In addition, member countries participate in a variety of consultative fora
on economic policy and financial stability, which should also promote improved
policy in these areas. Another benefit of euro area membership is access to rescue
funds and a common safety net intended to address shocks in individual countries
and reduce contagion among them.
But euro area membership also entails risks for Iceland. It would no longer be possible to
apply independent monetary policy and a flexible exchange rate in response to shocks and
to expedite adjustments to changes in national income. Under certain circumstances, this
has been quite useful for the Icelandic economy. On the whole, however, domestic monetary
policy has not proven particularly effective in achieving set goals, and more often than not a
flexible exchange rate has proven a source of shocks rather than a shock absorber.
Consequently, relinquishing domestic monetary policy may not prove to be a great sacrifice
unless monetary policy can be improved and excess exchange rate volatility can be
mitigated. This possibility is explored later in this chapter.
Another risk is the crisis currently facing the euro area and the design failures that are a
partial cause of it. Because of this, it would be risky for Iceland to join the euro area before it
can be determined, based on further developments, whether the euro area would be a better
or worse choice in the long run.
1.5 Exchange rate targeting and adoption of another currency
In some respects, the structure of the Icelandic economy calls for a flexible exchange rate.
Offsetting this are excess exchange rate volatility and studies indicating that the Icelandic
króna has tended to be a source of shocks more than a shock absorber. Furthermore, there
are various benefits of euro area membership through EU accession, such as increased
international trade and access to a deeper financial market without exchange rate risk. But if
EU membership proves not to be an option - for instance, if an acceptable solution to the
euro area crisis cannot be found and/or if a majority of the electorate is opposed to it - and
Icelanders are either unable or unwilling to address the pre-crisis flaws in monetary and
economic policy without sacrificing exchange rate flexibility, other options should be
examined, such as some type of exchange rate targeting or unilateral or bilateral adoption of
another currency. These options are discussed in Chapters 18 and 19, while Chapter 20
focuses on the issues that must be considered in selecting a currency to adopt or use as an
anchor.
Exchange rate targeting entails defining limits on exchange rate movements and applying
monetary policy so as to keep the exchange rate within that band. Such bands can vary in
width, the commitment to the exchange rate target can vary in strength, and the commitment
can be backed by other declarations and policy actions that further support the target.
One form of exchange rate target familiar to Icelanders is a declared target of an exchange
rate index with a defined fluctuation band. Such an arrangement prevailed in Iceland before
the inflation target and floating exchange rate were adopted in March 2001 (see Chapter 12).
The original fluctuation band was rather narrow, at ±21⁄2%. It was then widened to ±6%, and
again to ±9%, after it proved more difficult, and in some ways riskier, to hold the exchange
rate within a narrow band once restrictions on capital movements were lifted. But it was also
growing imbalances in the domestic economy that contributed to the demise of the exchange
rate target. Those imbalances were due in part to excessively accommodative demand
management, which provided insufficient support for the exchange rate policy.
An exchange rate peg of this type has an advantage in that, in the long run, inflation will tend
to converge on inflation in the anchor currency area and exchange rate volatility will be
reduced. However, Iceland's experience in this area - and that of many other countries -
shows that it is difficult to maintain such a unilateral exchange rate peg when movement of
capital is unrestricted and the exchange rate policy receives inadequate support from fiscal
policy and other aspects of demand management (see Chapter 18). Thus it is not a given
that this would be a viable option for Icelanders, as such a policy might lack credibility
because of previous experience. Adopting an exchange rate peg and a deviation band in an
international collaboration with other countries could prove more propitious, however. Such a
policy would be more credible because it would be supported by the actions and credibility of
the other countries. The Bretton Woods exchange rate system, which was in place from the
end of World War II until 1973, is an example of this. The difference, however, was that most
participating countries also had capital controls. ERM-II, on the other hand, is an example of
an exchange rate targeting system based on international cooperation and unrestricted
movement of capital. It works because of the ECB's credibility and its obligation to intervene,
and because it is defined as a temporary arrangement with a clear exit path towards the euro
area. The markets are thus not tempted for an unlimited period by a commitment to a peg
that they can speculate against.
A currency board has the same advantages as a conventional exchange rate peg in that, in
the long run, average inflation should align with that in the anchor area (see Chapter 18).
Because a currency board is based on a pledge enshrined in law or even the country's
constitution - a pledge to convert the domestic currency to the anchor currency at a
predetermined exchange rate - volatility vis-à-vis the anchor currency disappears. Because
the pledge is more stringent than that implied by a conventional unilateral peg, it can also be
more credible. Furthermore, it is more difficult to force a change in the exchange rate peg
through speculative attack, but the repercussions of a successful attack could also be much
greater. As a result, it is extremely important that a currency board, like any other exchange
rate peg, be supported by fiscal and economic policy. If fiscal policy is not consistent with the
fixed exchange rate policy, the peg is likely to fail in the end, no matter how strong the formal
commitment to it is.
The main disadvantages of a currency board are that the central bank's possibility of
mitigating volatility in banking system liquidity is more limited, and the money supply
fluctuates with the foreign exchange reserves. This could put excessive pressure on the
domestic financial system and entails a risk to financial stability. The foreign exchange
reserves must also be much larger than under a floating exchange rate regime. Most of the
countries that have successfully used a currency board are small countries with close links to
the anchor area or those planning to adopt the euro.
There has been some discussion of the possibility of adopting another currency in Iceland
(see Chapter 19). When a country adopts another currency unilaterally, the foreign exchange
reserves are used to purchase banknotes and coin in the anchor currency, which is put into
circulation instead of the domestic currency. The central bank deposits held by the national
treasury and the domestic financial institutions are then converted to the anchor currency, as
are the financial institutions' domestic assets and liabilities. Technically, this can easily be
done, but what comes next?
Many of the pros and cons of unilaterally adopting another currency are the same as those
pertaining to the euro area: inflation is better anchored and exchange rate risk disappears in
trade within the currency area, although independent monetary policy and exchange rate
flexibility are relinquished as tools that can be applied in response to economic shocks. The
fact that no formal agreements are needed and the process can be concluded swiftly could
be viewed as an advantage over and above negotiated euro area membership. But the lack
of a contractual framework embodies many of the disadvantages of this option in comparison
with euro area membership or maintaining the domestic currency. The main problem is that
the supply of the new currency in the country will fluctuate with capital in- and outflows, while
counteractive measures are much more limited than with an independent currency or full
euro area membership. For instance, capital outflows could quickly develop into a liquidity
problem for the banking system and for treasury financing, which could ultimately lead to
default and a financial crisis that the domestic authorities would be unable to stop. The
likelihood of this could be reduced through preventive mitigating measures, such as running
the central government at a significant surplus and requiring that domestic banks either
maintain sizeable foreign exchange reserves of their own or have credit lines with foreign
banks. But all such measures come at a significant cost, the foreign exchange reserves are
always limited, and experience shows that credit lines with private banks are not secure,
particularly when they are most needed. Measures of this type can therefore never fully
replace the central bank's ability to provide liquidity support in its own currency, which is
virtually unlimited so long as the banks are solvent and can provide eligible collateral.
Unilateral adoption of another currency can therefore entail substantial risk to the stability of
the financial system. In this connection, some argue, however, that providing central bank
liquidity facilities to the banking system is harmful and that this is therefore not a
disadvantage. But the problem is that even though a banking system based on a maturity
transformation has contributed significantly to output growth and economic welfare, it is
extremely risky without the back-up of a central bank, as previous experience has shown.
The banking system could therefore fail "unnecessarily", at enormous cost in the form of
economic contraction and elevated unemployment.
In addition, there is the disadvantage of needing to spend the country's foreign exchange
reserves in order to acquire the anchor currency, whereas with negotiated adoption of the
euro via EU accession, the ECB would provide the Central Bank of Iceland with euros to
replace all outstanding domestic banknotes and coins. Seigniorage revenues would revert in
full to the foreign central bank, and when banknotes and coin are lost or destroyed, it would
be Iceland's loss and the anchor country's gain. With an independent currency or with
participation in the euro area, however, such a loss is incurred by the individual concerned
and not the economy.
As is discussed in Chapter 19, relatively few countries have unilaterally adopted another
currency, and most of those that have done so are small in size. Most are former colonies of
the anchor country or are Europea