An Assessment of the Sustainability and Desirability of a Currency Board Arrangement, with ...

587 Pages·2015·6.5 MB·English

STAFFORDSHIRE UNIVERSITY

Faculty of Business, Education and Law

Business School

Economics

An Assessment of the Sustainability and Desirability
of a Currency Board Arrangement, with Special
Reference to Bosnia and Herzegovina

Selena BEGOVIĆ

December 2014

A thesis submitted in partial fulfilment of the requirement of
Staffordshire University for the award of the degree Doctor of
Philosophy
Abstract

The purpose of this research is to investigate whether the currency board
arrangement (CBA) in Bosnia and Herzegovina (BH) is sustainable and desirable by
assessing its credibility and its effect on the economy. A CBA is a rigid monetary
regime under which a country fixes its exchange rate to some foreign currency and
maintains 100 percent backing of its monetary base with foreign exchange. In 1997,
BH adopted a CBA in its endeavour to achieve macroeconomic stabilisation in the
post-war period. As BH is now moving towards accession to the EU, an important
question concerns the desirability and sustainability of its CBA in the short to
medium term. Since there is no long data span for estimating the effects of the CBA
in Bosnia and Herzegovina in the empirical analyses other countries are also
investigated. Using a survey database for Central and South-Eastern European
countries the biprobit analysis finds that, other things being equal, a CBA is likely to
increase the credibility of the monetary authority, even in periods of crisis, since the
period for which credibility is investigated is the period of the global financial crisis
and the euro crisis (2009-2011). The results also suggest that CBAs are more likely
to increase the credibility of the monetary authority the lower the level of trust in
government and the worse the perceptions about the economic situation in a country.
In order to assess the desirability of a CBA its effect on macroeconomic performance
is investigated. The results of panel analyses of 25 transition countries with a range
of different monetary/exchange rate regimes, suggest that a CBA has a negative
effect on inflation, over and above that due to the fixed exchange rate and high
degree of central bank independence. The investigation of the effect of CBA on the
subjective evaluation of national economic performance suggests a negative effect of
CBA, presumably due to the strictness of the monetary authority under a CBA. The
important additional finding is that this negative effect becomes significantly smaller
the lower the trust in government. This again implies that a CBA is more effective in
a low trust environment, where it is more likely to be viewed as necessary for
stabilisation. Since the political situation in Bosnia and Herzegovina is still complex
and uncertain, the benefits of maintaining its CBA appear to be higher than the costs
and the regime is sustainable and desirable in the short to medium run.
Table of Content

Table of Appendices .................................................................................................. vi
List of Tables ........................................................................................................... viii
List of Figures ............................................................................................................ ix
List of Abbreviations ................................................................................................. x
Acknowledgements ................................................................................................... xii
Preface ....................................................................................................................... 13

CHAPTER 1: MACROECONOMIC TRENDS IN BOSNIA AND
HERZEGOVINA WITH A FOCUS ON MONETARY AND FINANCIAL
SECTORS ................................................................................................................. 19

1.1 Introduction .................................................................................................... 19
1.2 The macroeconomic situation in BH – historical facts and recent trends 21
1.2.1 The pre-war role of BH in ex-Yugoslavia, the impact of war and the
country’s post-war constitution .......................................................................... 21
1.2.2 The process of transition towards a market-oriented economy ................. 23
1.2.3 Assessing the progress of transition – quantitative and qualitative
approach .............................................................................................................. 27
1.2.4 Key economic indicators ........................................................................... 30
1.3 The monetary and financial sectors in BH ................................................... 37
1.3.1 Origins and the reasons for the introduction of the CBA in BH................ 37
1.3.2 Characteristics and the institutional framework of the CBA in BH .......... 38
1.3.3 Operation of the CBA in BH ..................................................................... 39
1.3.4 Commercial banks as the major “players” in BH’s financial sector.......... 50
1.4 Conclusion ....................................................................................................... 59

CHAPTER 2: THE CURRENCY BOARD ARRANGEMENT AS A
MONETARY FRAMEWORK: A LITERATURE REVIEW ............................. 61

2.1 Introduction .................................................................................................... 61
2.2 The main characteristics of a CBA and its evolution .................................. 62
2.2.1 The main characteristics of a CBA ............................................................ 62
2.2.2 Evolution of currency board arrangements ................................................ 64
2.2.3 Operation of CBAs .................................................................................... 66
2.2.4 The economics of monetary and exchange rate regimes: where does the
currency board fit in? .......................................................................................... 73
2.2.5 A CBA as a monetary framework.............................................................. 77
2.3 Strengths and weaknesses of a CBA ............................................................. 79
2.4 The CBA in the context of transition ............................................................ 90
2.5 Conclusion ....................................................................................................... 98
iii
CHAPTER 3: THE SUSTAINABILITY AND DESIRABILITY OF A
CURRENCY BOARD ARRANGEMNET WITH REFLECTIONS ON BOSNIA
AND HERZEGOVINA’S CURRENCY BOARD ................................................. 99

3.1 Introduction .................................................................................................... 99
3.2 The sustainability and desirability of a monetary regime/policy ............... 99
3.3 A critical assessment of studies investigating the sustainability of a CBA102
3.4 A short discussion of sustainability/desirability features of the CBA in BH111
3.5 The credibility of a CBA as a source of its stability and sustainability ... 113
3.6 Capturing the effects of a CBA ................................................................... 117
3.7 Conclusion ..................................................................................................... 119

CHAPTER 4: AN ASSESSMENT OF THE CREDIBILITY OF CURRENCY
BOARD ARRANGEMENTS IN BOSNIA AND HERZEGOVINA AND
BULGARIA ............................................................................................................ 120

4.1 Introduction .................................................................................................. 120
4.2 Indicators of confidence in and credibility of a CBA ................................ 121
4.3 Determinants of the confidence and credibility of a monetary
authority/regime ................................................................................................. 125
4.4 Descriptive analysis of the survey data ....................................................... 134
4.5 Econometric analysis .................................................................................... 142
4.5.1 The endogeneity issue .............................................................................. 143
4.5.2 Survey design characteristics ................................................................... 143
4.5.3 Marginal effects computed using the ‘margins’ command ..................... 145
4.5.4 Estimation of the ‘confidence’ and ‘credibility’ models as seemingly
unrelated regressions......................................................................................... 148
4.6 Conclusion ..................................................................................................... 164

CHAPTER 5: ESTIMATION OF THE EFFECT OF CURRENCY BOARD
ARRANGEMENTS ON INFLATION PERFORMANCE ................................ 167

5.1 Introduction .................................................................................................. 167
5.2 Theoretical rationale and critical analysis of the empirical evidence ...... 168
5.3 Characteristics of selected transition countries ......................................... 178
5.3.1 Choice of sample and sample specifics ................................................... 178
5.3.2 Major trends in selected transition countries ........................................... 180
5.4 Estimation of the effect of CBA on inflation .............................................. 185
5.4.1 Inflation determinants .............................................................................. 185
5.4.2 Descriptive statistics and model specification ......................................... 198
5.4.3 Static panel model estimations ................................................................ 199
5.4.4 Dynamic panel model estimations ........................................................... 208
5.4.5 Examining differences between CBAs .................................................... 214
5.4.6 Comparison between preferred static and preferred dynamic estimations216
5.5 Conclusion ..................................................................................................... 217
iv
CHAPTER 6: ESTIMATION OF THE EFFECTS OF CURRENCY BOARD
ARRANGEMENTS ON MACROECONOMIC PERFORMANCE ................ 220

6.1 Introduction .................................................................................................. 220
6.2 Estimation of the effect of CBA on growth ................................................ 221
6.2.1 Growth theories and the effect of monetary/ER regimes on growth ....... 221
6.2.2 Growth determinants in transition economies ......................................... 223
6.2.3 Descriptive statistics and model specification ......................................... 235
6.2.4 Methodology and results .......................................................................... 236
6.3 Estimation of the effect of CBA on growth volatility ................................ 239
6.3.1 Growth volatility as a proxy for macroeconomic performance in transition
countries ............................................................................................................ 239
6.3.2 Output and growth volatility measures and determinants ....................... 241
6.3.3 Model specification and descriptive statistics ......................................... 252
6.3.4 Estimation strategies and results .............................................................. 254
6.4 The effect of a CBA on the subjective assessment of a country’s economic
performance ........................................................................................................ 256
6.4.1 Theoretical background and model specifications ................................... 257
6.4.2 Estimation issues and results ................................................................... 262
6.5 Conclusion ..................................................................................................... 273

CHAPTER 7: CONCLUSIONS............................................................................ 275

7.1 Introduction .................................................................................................. 275
7.2 Main findings and contributions to knowledge ......................................... 276
7.3 Policy implications ........................................................................................ 282
7.4 Limitations and suggestions for further research ..................................... 288

REFERENCES ....................................................................................................... 292

v
Table of Appendices

Appendix 1.1: World Governance Indicators, 2011 ................................................ 325
Appendix 2.1: Trends in macroeconomic variables in European transition countries
(1998-2012) .............................................................................................................. 331
Appendix 3.1: Interest rates on short-term and long-term loans in BH, Croatia,
Estonia and Latvia and Macedonia .......................................................................... 341
Appendix 4.1: General description of the survey data (socio-demographic
characteristics).......................................................................................................... 342
Appendix 4.2: Responses to the questions about the local currency stability and the
stability of euro ........................................................................................................ 346
Appendix 4.3: Correlation matrix between the questions of interest ....................... 360
Appendix 4.4: Responses to the questions about the economic situation in a country
and trust in government ............................................................................................ 361
Appendix 4.5: SUR results of the 'credibility' model (country as cluster) ............... 368
Appendix 4.6: Testing for the joint significance of the variables used in the
'credibility' model ..................................................................................................... 381
Appendix 4.7: SUR results of the 'credibility' model (region as cluster) ................. 382
Appendix 4.8: Robustness check of the 'credibility' model - question about
perceptions of financial stability in a country included (SUR, cluster country,
weighted) .................................................................................................................. 391
Appendix 4.9: Robustness check of the 'credibility' model - questions about
perceptions of financial stability in a country and perceptions and expectations about
the financial situation of a household included (SUR, cluster country, weighted) .. 395
Appendix 4.10: Robustness check of the 'credibility' model - large database used,
'trust in government' variable excluded (SUR, cluster country, weighted) .............. 399
Appendix 4.11: Robustness check of the 'credibility' model - without interaction
terms (SUR, cluster country, weighted) ................................................................... 403
Appendix 4.12: Single equation (probit) – current local currency stability ............. 410
Appendix 4.13: Single equation (probit) - future local currency stability ............... 419
Appendix 4.14 Multinomial probit and probit without the interaction terms – ....... 429
Appendix 5.1: Correlation matrix between explanatory variables........................... 435
Appendix 5.2: Estimation of inflation regression by OLS ....................................... 435
Appendix 5.3: Estimation of inflation regression by FE and RE model + Hausman
test ............................................................................................................................ 436
Appendix 5.4: Inflation model - Between and within variance for all variables ..... 438
Appendix 5.5: Inflation model - FEVD (with 4 CBA countries) ............................. 439
Appendix 5.6: Inflation model - System GMM (4 CBA countries) MSG and CCBI
treated as endogenous .............................................................................................. 445
Appendix 5.7: Inflation model - Calculation of the long-run coefficient on CBA .. 456
Appendix 5.8: Inflation model - FEVD (strong and weak CBA) ............................ 456
Appendix 5.9. Inflation model - Strong and weak CBA - System GMM ................ 460
Appendix 5.10: Inflation model - Calculation of the long-run coefficients on
strongCBA and weakCBA ....................................................................................... 475
Appendix 5.11: Inflation model - Preferred dynamic model with ‘defactofix’ variable
treated as endogenous .............................................................................................. 476
Appendix 6.1: Growth model - Correlation matrix .................................................. 479
Appendix 6.2: Growth model – OLS estimation and diagnostic tests ..................... 479
Appendix 6.3: Growth model - OLS with country-time dummies for outliers –
estimation and diagnostic tests ................................................................................. 483
vi
Appendix 6.4: Growth model – Fixed and random effects estimations ................... 485
Appendix 6.5: Growth model - FEVD ..................................................................... 487
Appendix 6.6: Growth model – separating a CBA to strong and weak - FEVD ..... 494
Appendix 6.7: Dynamic estimation of growth model .............................................. 500
Appendix 6.8: Growth volatility model - Correlation matrix .................................. 509
Appendix 6.9: Growth volatility model - OLS and FE estimations and diagnostic
tests ........................................................................................................................... 509
Appendix 6.10: Growth volatility model - Between and within effects .................. 511
Appendix 6.11: Growth volatility model - FEVD ................................................... 512
Appendix 6.12: Growth volatility model - Dividing a CBA variable to strong and
weak ......................................................................................................................... 516
Appendix 6.13: Subjective assessments - Correlation matrix .................................. 520
Appendix 6.14: Subjective assessments of economic situation (SUR estimation
(country used as cluster)) ......................................................................................... 520
Appendix 6.15: Subjective assessments of the economic situation in a country(SUR
estimation (region used as cluster)).......................................................................... 543
Appendix 6.16: Subjective assessments – Robustness check (SUR estimation
(country used as cluster weighted)).......................................................................... 550
Appendix 6.17: Subjective assessments - Single equations - Perceptions about
economic situation in a country (country as a cluster) ............................................. 565
Appendix 6.18: Subjective assessments - Single equations - Expectations about
economic situation in a country (country as a cluster) ............................................. 573
Appendix 6.19: Multinomial probits (with ‘do not know’ category and without
interaction terms) and comparison with probits without the interaction terms ........ 581

vii
List of Tables

Table 1.1: EBRD transition indicators (1995-2013) .................................................. 28
Table 1.2: Selected economic indicators, Bosnia and Herzegovina (2000 – 2013) ... 33
Table 1.3: Monthly Balance Sheet (final) of the CBBH as of 31st December of each
year ............................................................................................................................. 41
Table 1.4: BH's balance of payments (2000-2013) .................................................... 45
Table 1.5: Average reserve requirements (2005-2013) .............................................. 50
Table 1.6: Consolidated balance of commercial banks in BH: Selected items .......... 52
Table 2.1: Differences in the role of a central bank in a CBA regime ....................... 63
Table 2.2: IMF’s Classification of exchange rate arrangements and compatible
monetary policy frameworks...................................................................................... 75
Table 2.3: The main deviations of modern CBAs from orthodox currency board rules
.................................................................................................................................... 92
Table 2.4: Fulfilment of Maastricht criteria in EU but not yet EMU countries ......... 97
Table 3.1: Summary of the studies investigating the CBA’s sustainability (in
chronological order) ................................................................................................. 104
Table 4.1: Percentage of ‘do not know’ answers and the level of education of those
respondents ............................................................................................................... 124
Table 4.2: Answers to the questions of interest in CBA and non-CBA countries (in
percentages of total respondents in particular group) (controlled for weights) ....... 136
Table 4.3: Perceptions and expectations about the stability of the local currency vs.
the stability of the euro (controlled for weights) ...................................................... 139
Table 4.4: SUR results - Estimation of the ‘credibility’ model (as specified in
Equation 4.1 ............................................................................................................. 154
Table 4.5: The effect of having a CBA compared to not having a CBA on
perceptions/expectations about the local currency stability at different levels of trust
in government, perceptions and expectations about the economic situation ........... 157
Table 4.6a: SUR results (the first part) - robustness checks for the ‘credibility’ model
(the results for the first two columns continue in Table 4.6b) ................................. 161
Table 4.6a: SUR results (the first part - continuing) - robustness checks for the
‘credibility’ model .................................................................................................... 162
Table 4.6b: SUR results (the second part) - robustness checks for the ‘credibility’
model (the results of the first two columns from Table 4.6a continuing) ................ 163
Table 5.1: Summary of the empirical research of the currency board effect on
inflation and growth ................................................................................................. 171
Table 5.2: Inflation regression variables – label, description, expected sign and data
source ....................................................................................................................... 196
Table 5.3: Comparison of average trends in inflation and inflation determinants
between countries with a CBA and countries with other regimes ........................... 198
Table 5.4: Results from the OLS and FEVD - Equations 5.1-5.4 ............................ 204
Table 5.5a: Results from the one-step ‘system’ GMM - Estimation of Equation 5.10
and 5.11 .................................................................................................................... 212
Table 5.5b: Diagnostic tests for the estimations with one step ‘system’ GMM ...... 212
Table 5.6a: Strong and weak CBA specifications estimated by FEVD and ‘system’
GMM ........................................................................................................................ 214
Table 5.6b: Diagnostic tests for the estimations with one step ‘system’ GMM ...... 215
Table 5.7: Comparison of the long run coefficients on CBA, strong CBA and weak
CBA from the preferred static and dynamic model ................................................. 217
viii
Table 6.1: Summary of the empirical research of the growth determinants in
transition countries ................................................................................................... 225
Table 6.2: Growth regression variables – label, description, expected sign and data
source ....................................................................................................................... 234
Table 6.3: Comparison of average trends in GDP growth and growth determinants
between countries with a CBA (four countries) and countries with other regimes
(twenty one countries) .............................................................................................. 235
Table 6.4: Summary of the empirical research on the effect of different ERRs on
output growth and volatility ..................................................................................... 247
Table 6.5: Growth volatility regression variables – label, description, expected sign
and data source ......................................................................................................... 251
Table 6.6: Comparison of average trends in GDP growth volatility and growth
volatility determinants between countries with a CBA and countries with other
regimes ..................................................................................................................... 253
Table 6.7: SUR results - Estimation of the perceptions/expectations about the
economic situation in a country (as specified in Equations 6.7, number of
observations: 40,832) ............................................................................................... 265
Table 6.8a: SUR results (the first part) - robustness checks ................................... 270
Table 6.8b: SUR results (the second part) - robustness checks (continuing results
from the first three columns from Table 6.8a) ......................................................... 271

List of Figures

Figure 1.1: Inflation rates in BH and the Eurozone ................................................... 34
Figure 1.2: Monetary aggregates in BH – schematic illustration............................... 43
Figure 1.3: Monetary aggregates in BH (2000-2013) ................................................ 44
Figure 1.4a: Monetary multipliers for BH (2000-2013) ............................................ 46
Figure 1.4b: Money multipliers (calculated as a ratio between the broad money and
the monetary base) for selected Central and South Eastern European countries ....... 46
Figure 1.5: Financial market development indicators (1-7 best) for the selected
countries ..................................................................................................................... 47
Figure 1.6: Changes in the reserve requirement rate and the total reserves held by
banks in CBBH .......................................................................................................... 49
Figure 1.7: Long-term interest rates in BH, Austria and Euribor 12-months ............ 56
Figure 1.8: The structure of commercial banks’ loans and deposits by currency ...... 57
Figure 2.1: CBA’s strengths/benefits and weaknesses/costs diagram ....................... 82
Figure 3.1 Sustainability and desirability of a CBA ................................................ 101
Figure 4.1: Determinants of the confidence and credibility in a monetary
authority/policy ........................................................................................................ 128
Figure 4.2a: Perceptions about the local currency’s stability in CBA and non-CBA
countries ................................................................................................................... 137
Figure 4.2b: Expectations about the local currency’s stability in CBA and non-CBA
countries ................................................................................................................... 137
Figure 4.2c: Expectations about the exchange rate between the euro and local
currency in CBA and non-CBA countries ............................................................... 138
Figure 4.3a: Perceptions about the economic situation in CBA and non-CBA
countries ................................................................................................................... 140
Figure 4.3b: Expectations about the economic situation in CBA and non-CBA
countries ................................................................................................................... 140
Figure 4.3c: Trust in government in CBA and non-CBA countries ........................ 141
ix
Figure 4.4a: The average marginal effect of CBA on the probability of high current
confidence and expectations about local currency stability conditional on the level of
trust in government .................................................................................................. 155
Figure 4.4b: The average marginal effect of CBA on the probability of high current
confidence and expectations about local currency stability conditional on perceptions
about current economic situation ............................................................................. 156
Figure 4.4c: The average marginal effect of CBA on the probability of high current
confidence and expectations about local currency stability conditional on
expectations about future economic improvement .................................................. 156
Figure 5.1: Regional patterns of progress in transition (according to the EBRD
aggregate index) for CEB, SEE and CIS countries .................................................. 181
Figure 5.2: Average Cukierman’s central bank independence index (updated) for
CEB, SEE and CIS countries ................................................................................... 182
Figure 5.3: Real GDP growth (in percentage changes) in CEB, SEE and CIS counties
.................................................................................................................................. 183
Figure 5.4: Real GDP per capita (in constant 2000 US$) in CEB, SEE and CIS
countries prior to the sample period (1990-1998) .................................................... 183
Figure 5.5: Inflation rates (measured as percentage changes in consumer price index)
in CEB, SEE and CIS countries ............................................................................... 184
Figure 5.6 The average marginal effect of CBA on inflation conditional on money
supply growth ........................................................................................................... 213
Figure 5.7 The average marginal effect of strong CBA on inflation conditional on
money supply growth ............................................................................................... 216
Figure 6.1: Volatility of real GDP growth in CEB, SEE and CIS counties ............. 240
Figure 6.2: Volatility of real GDP growth in countries with CBA and countries with
other regimes ............................................................................................................ 252
Figure 6.3: The average marginal effect of CBA on the probability of high current
confidence and expectations about the economic situation in a country conditional on
the level of trust in government ............................................................................... 268

List of Abbreviations

AME - Average marginal effect
BAM - The international code for Bosnia and Herzegovina’s currency
BH - Bosnia and Herzegovina
CA - Current account
CBA - Currency board arrangement
CBBH - Central Bank of Bosnia and Herzegovina
CBI - Central bank independence
CCBI – Cukierman’s Central bank independence index
CEB - Central Eastern Europe and Baltic
CEFTA - Central European Free Trade Agreement
CIS - Commonwealth of Independent States
CP - Consumer price
CPI - Consumer price index
EBRD - European Bank for Reconstruction and Development
ECB - European Central Bank
EMU - European Monetary Union
ER - Exchange rate
x